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**UNITEDSTATES**

**SECURITIESAND 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 June 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            .** |

 

**Commissionfile number 001-33782**

 

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**ARYxTHERAPEUTICS, INC.**

(Exact name ofregistrant as specified in its charter)

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

 

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

(Address ofPrincipal Executive Offices including zip code)

 

**(510)585-2200**

(Registrant’sTelephone Number, Including Area Code)

 

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Indicateby check mark whether the Registrant (1) has filed all reports required tobe filed by Section 13 or 15(d) of the Exchange Act during thepreceding 12 months (or for such shorter period that the registrant wasrequired to file such reports), and (2) has been subject to such filingrequirements for the past 90 days.    Yes  o    No  x

 

Indicateby check mark whether the registrant is a large accelerated filer, anaccelerated filer, a non-accelerated filer, or a smaller reporting company. Seethe definitions of “large accelerated filer,” “accelerated filer” and “smallerreporting company” in Rule 12b-2 of 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 |

 

Indicateby check mark whether the registrant is a shell company (as defined in Rule 12b-2of the Exchange Act).    Yes  o    No  x

 

Asof July 31, 2008, 17,683,145 shares of the registrant’s common stock,$0.001 par value, were outstanding.

 

 

 

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**ARYxTHERAPEUTICS, INC.**

 

**FORM 10-QFOR THE QUARTER ENDED JUNE 30, 2008**

 

**INDEX**

** **
| ** **                                    | **Page**                                                                                                         |
|-----------------------------------------------|------------------------------------------------------------------------------------------------------------------|
| **PART I  — FINANCIAL INFORMATION** | ** **                                                                                                       |
| ** **                                    | ** **                                                                                                       | ** ** |
| Item 1.                                       | Financial Statements                                                                                             |   |
|                                          | Condensed Consolidated  Balance Sheets as of June 30, 2008 and December 31, 2007                       | 2 |
|                                          | Condensed Consolidated  Statements of Operations for the three and six months ended June 30,  2008 and 2007 | 3 |
|                                          | Condensed Consolidated  Statements of Cash Flow for the six months ended June 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                      | 12 |
| Item 3.                                       | Quantitative  and Qualitative Disclosures About Market Risk                                                      | 20 |
| Item 4T.                                      | Controls and  Procedures                                                                                         | 20 |
|                                          |                                                                                                             |   |
| **PART II — OTHER  INFORMATION**    | ** **                                                                                                       |
| Item 1.                                       | Legal Proceedings                                                                                                | 21 |
| Item 1A.                                      | Risk Factors                                                                                                     | 21 |
| Item 2.                                       | Unregistered  Sales of Equity Securities and Use of Proceeds                                                     | 40 |
| Item 3.                                       | Defaults  Upon Senior Securities                                                                                 | 40 |
| Item 4.                                       | Submission  of Matters to a Vote of Security Holders                                                             | 40 |
| Item 5.                                       | Other Information                                                                                                | 40 |
| Item 6.                                       | Exhibits                                                                                                         | 41 |
|                                          |                                                                                                             |   |
| SIGNATURE                                     | 42                                                                                                               |
|                                               |                                                                                                                  |  |  |  |

 

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**PART I — FINANCIAL INFORMATION**

 

**ITEM 1.  FINANCIAL STATEMENTS**

 

**ARYxTHERAPEUTICS, INC.**

 

**CONDENSED CONSOLIDATED BALANCE SHEETS**

 

**(Inthousands)**

 
| ** **                                          | ** ** | **June 30,** | ** ** | **December 31,** | ** ** |
|-----------------------------------------------------|------------|-------------------|------------|-----------------------|------------|
| ** **                                          | ** ** | **2008**          | ** ** | **2007**              | ** ** |
| ** **                                          | ** ** | **(unaudited)**   | ** ** | **(Note 1)**     | ** ** |
| **ASSETS**                                          |       |              |       |                  |       |
| Current assets:                                     |       |              |       |                  |       |
| Cash and cash equivalents                           |       | $                 | 34,536     |                  | $          | 55,476 |   |
| Marketable securities                               |       | 12,877            |       | 7,640                 |       |
| Restricted cash - current                           |       | 150               |       | 150                   |       |
| Prepaid research and development expenses           |       | 1,321             |       | 582                   |       |
| Other prepaid, receivable, and current  assets      |       | 835               |       | 1,051                 |       |
| Total current assets                                |       | 49,719            |       | 64,899                |       |
| Restricted cash                                     |       | 1,203             |       | 903                   |       |
| Property and equipment, net                         |       | 3,687             |       | 3,655                 |       |
| Other assets                                        |       | 266               |       | 168                   |       |
| **Total assets**                                    |       | $                 | 54,875     |                  | $          | 69,625 |   |
|                                                |       |              |       |                  |       |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**       |       |              |       |                  |       |
| Current liabilities:                                |       |              |       |                  |       |
| Accounts payable                                    |       | $                 | 415        |                  | $          | 1,369 |   |
| Accrued compensation                                |       | 730               |       | 1,055                 |       |
| Accrued research and development expenses           |       | 3,933             |       | 2,510                 |       |
| Current portion of notes payable                    |       | 5,631             |       | 3,536                 |       |
| Current portion of deferred revenue                 |       | 17,544            |       | 3,913                 |       |
| Other accrued liabilities                           |       | 916               |       | 1,074                 |       |
| Total current liabilities                           |       | 29,169            |       | 13,457                |       |
| Deferred lease credit                               |       | 1,617             |       | 1,793                 |       |
| Notes payable                                       |       | 8,838             |       | 3,444                 |       |
| Deferred revenue                                    |       | —            |       | 15,584                |       |
| Commitments and contingencies                       |       |              |       |                  |       |
| Stockholders’ equity:                          |       |              |       |                  |       |
| Common stock                                        |       | 18                |       | 18                    |       |
| Additional paid-in capital                          |       | 159,466           |       | 158,053               |       |
| Accumulated other comprehensive loss                |       | (110              | )          | —                |       |
| Accumulated deficit                                 |       | (144,123          | )          | (122,724              | )          |
| Total stockholders’ equity                     |       | 15,251            |       | 35,347                |       |
| **Total liabilities and stockholders’ equity** |       | $                 | 54,875     |                  | $          | 69,625 |   |

 

The accompanying notes are an integral partof these financial statements.

 

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**ARYxTHERAPEUTICS, INC.**

**CONDENSEDCONSOLIDATED STATEMENTS OF OPERATIONS**

**(Inthousands, except per share amounts)**

**(Unaudited)**

 
| ** **                                                                    | ** ** | **Three Months Ended June 30,** | ** ** | **Six Months Ended June 30,** | ** ** |
|-------------------------------------------------------------------------------|------------|-----------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                                                    | ** ** | **2008**                                            | ** ** | **2007**                                          | ** ** | **2008** | ** ** | **2007** | ** ** |
| Revenue:                                                                      | ** ** | ** **                                          | ** ** | ** **                                        | ** ** | ** ** | ** ** | ** ** | ** ** |
| Collaboration services                                                        |       | $                                                   | 164        |                                              | $          | 22 |   | $ | 232 |   | $ | 186 |   |
| Technology license fees                                                       |       | 974                                                 |       | 974                                               |       | 1,948 |   | 1,948 |   |
| Total revenue                                                                 |       | 1,138                                               |       | 996                                               |       | 2,180 |   | 2,134 |   |
|                                                                          |       |                                                |       |                                              |       |   |   |   |   |
| Costs and expenses:                                                           |       |                                                |       |                                              |       |   |   |   |   |
| Cost of collaboration service revenue                                         |       | 164                                                 |       | 22                                                |       | 232 |   | 186 |   |
| Research and development                                                      |       | 10,045                                              |       | 6,499                                             |       | 17,645 |   | 11,016 |   |
| Selling, general and administrative                                           |       | 2,664                                               |       | 1,727                                             |       | 5,596 |   | 3,624 |   |
| Total costs and expenses                                                      |       | 12,873                                              |       | 8,248                                             |       | 23,473 |   | 14,826 |   |
| Loss from operations                                                          |       | (11,735                                             | )          | (7,252                                            | )          | (21,293 | ) | (12,692 | ) |
|                                                                          |       |                                                |       |                                              |       |   |   |   |   |
| Interest and other income, net                                                |       | 308                                                 |       | 543                                               |       | 857 |   | 1,179 |   |
| Interest expense                                                              |       | (469                                                | )          | (311                                              | )          | (963 | ) | (643 | ) |
| Net loss                                                                      |       | (11,896                                             | )          | (7,020                                            | )          | (21,399 | ) | (12,156 | ) |
|                                                                          |       |                                                |       |                                              |       |   |   |   |   |
| Basic and diluted net loss per share                                          |       | $                                                   | (0.67      | )                                                 | $          | (6.50 | ) | $ | (1.21 | ) | $ | (11.41 | ) |
| Weighted average shares used to compute  basic and diluted net loss per share |       | 17,641                                              |       | 1,080                                             |       | 17,636 |   | 1,065 |   |

 

The accompanying notes are an integral partof these financial statements.

 

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** **

**ARYxTHERAPEUTICS, INC.**

**CONDENSEDCONSOLIDATED STATEMENTS OF CASH FLOW**

**(Inthousands)**

**(Unaudited)**

 
| ** **                                                                                                                                                        | ** ** | **Six Months Ended June 30,** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                                                                                                                                        | ** ** | **2008**                                          | ** ** | **2007** | ** ** |
| **Cash flows from operating activities:**                                                                                                                         | ** ** | ** **                                        | ** ** | ** ** | ** ** |
| Net loss                                                                                                                                                          |       | $                                                 | (21,399    | ) | $ | (12,156 | ) |
| Adjustments to reconcile net loss to net  cash used in operating activities:                                                                                      |       |                                              |       |   |   |
| Depreciation and amortization                                                                                                                                     |       | 565                                               |       | 512 |   |
| Amortization of warrants and revaluation to  fair value                                                                                                           |       | 214                                               |       | 7 |   |
| Stock-based compensation                                                                                                                                          |       | 1,137                                             |       | 479 |   |
| Change in assets and liabilities:                                                                                                                                 |       |                                              |       |   |   |
| Prepaid research and development expenses                                                                                                                         |       | (739                                              | )          | (550 | ) |
| Other prepaid, receivable, and assets                                                                                                                             |       | 136                                               |       | (147 | ) |
| Accounts payable and other accrued  liabilities                                                                                                                   |       | (1,133                                            | )          | (511 | ) |
| Accrued compensation                                                                                                                                              |       | (325                                              | )          | (32 | ) |
| Accrued research and development expenses                                                                                                                         |       | 1,423                                             |       | 1,150 |   |
| Deferred lease credit                                                                                                                                             |       | (176                                              | )          | (163 | ) |
| Deferred revenue                                                                                                                                                  |       | (1,953                                            | )          | (1,912 | ) |
| Net cash used in operating activities                                                                                                                             |       | (22,250                                           | )          | (13,323 | ) |
|                                                                                                                                                              |       |                                              |       |   |   |
| **Cash flows from investing activities:**                                                                                                                         |       |                                              |       |   |   |
| Purchases of marketable securities                                                                                                                                |       | (13,232                                           | )          | (10,474 | ) |
| Proceeds from sales of marketable securities                                                                                                                      |       | 3,475                                             |       | 5,490 |   |
| Proceeds from maturities of marketable  securities                                                                                                                |       | 4,390                                             |       | 16,055 |   |
| Increase in restricted cash                                                                                                                                       |       | (300                                              | )          | (150 | ) |
| Purchases of fixed assets                                                                                                                                         |       | (556                                              | )          | (236 | ) |
| Net cash (used in) provided by investing  activities                                                                                                              |       | (6,223                                            | )          | 10,685 |   |
|                                                                                                                                                              |       |                                              |       |   |   |
| **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 |       | 44                                                |       | 38 |   |
| Proceeds from issuance of notes payable                                                                                                                           |       | 9,000                                             |       | — |   |
| Principal payments on notes payable                                                                                                                               |       | (1,511                                            | )          | (1,409 | ) |
| Net cash provided by (used in) financing  activities                                                                                                              |       | 7,533                                             |       | (1,371 | ) |
|                                                                                                                                                              |       |                                              |       |   |   |
| **Net increase (decrease) in cash and cash  equivalents**                                                                                                         |       | (20,940                                           | )          | (4,009 | ) |
| Cash and cash equivalents at beginning of  period                                                                                                                 |       | 55,476                                            |       | 18,660 |   |
| **Cash and cash equivalents at end of period**                                                                                                                    |       | $                                                 | 34,536     |   | $ | 14,651 |   |

 

The accompanying notes are an integral partof these financial statements.

 

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**ARYxTHERAPEUTICS, INC.**

**NOTES TOCONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

**(Unaudited)**

 

In this report, “ARYx,” “we,” “us” and “our” referto ARYx Therapeutics, Inc. “Common Stock” refers to ARYx’s common stock,par value $0.001 per share. “Preferred Stock” refers to ARYx’s convertiblepreferred stock, $0.001 per share.

 

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

 

***The Company***

 

ARYx is a biopharmaceutical company focused ondeveloping a portfolio of internally discovered product candidates designed toeliminate known safety issues associated with well-established, commerciallysuccessful drugs. We use our RetroMetabolic Drug Design technology to designstructurally unique molecules that retain the efficacy of these original drugsbut are metabolized through a potentially safer pathway to avoid specificadverse side effects associated with these compounds. Our product candidateportfolio includes an oral anticoagulant, ATI-5923, designed to have the sametherapeutic benefits as warfarin currently in Phase 2/3 clinical trials for thetreatment of patients who are at risk for the formation of dangerous bloodclots; an oral anti-arrhythmic agent, ATI-2042, designed to have the efficacyof amiodarone in Phase 2 clinical development for the treatment of atrialfibrillation, a form of irregular heartbeat; a novel, next-generation atypicalantipsychotic agent, ATI-9242, currently in Phase 1 clinical trials for the treatmentof schizophrenia 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,gastroesophageal reflux disease and symptoms associated with functionaldyspepsia. We have multiple product candidates in preclinical development.

 

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. We currently are focused on the human drug developmentbusiness and operate in a single business segment with regard to thedevelopment of human pharmaceutical products.

 

***Basis of Presentation***

 

The accompanying unaudited condensed consolidatedfinancial statements include the accounts of our wholly-owned subsidiary, ARYxTherapeutics, Ltd. All intercompany accounts and transactions have beeneliminated. These unaudited condensed consolidated financial statements havebeen prepared in accordance with U.S. generally accepted accounting principlesfor interim financial information on the same basis as the annual financialstatements and with instructions to Form 10-Q and Rule 10-01 ofRegulation S-X. Accordingly, they do not include all of the information and footnotesrequired by 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.

 

The balance sheet data at December 31, 2007 hasbeen derived from our audited consolidated financial statements for the yearended December 31, 2007, contained in our Annual Report on Form 10-K.The unaudited condensed consolidated financial statements and relateddisclosures contained in this report have been prepared with the presumptionthat users of the interim financial statements have read or have access to ouraudited financial statements for the preceding year. Accordingly, these interimfinancial statements should be read in conjunction with our audited financialstatements and notes thereto for the year ended December 31, 2007,contained in our Annual Report on Form 10-K.

 

***Use of 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.

 

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***Marketable Securities and the Adoption ofSFAS 157***

 

InSeptember 2006, the Financial Accounting Standards Board (“FASB”) issuedStatements of Financial Accounting Standards No. 157, *Fair Value Measurements* (“SFAS 157”).SFAS 157 defines fair value, establishes a framework for measuring fairvalue and expands fair value measurement disclosure. In February 2008, theFASB issued FASB Staff Position 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 FASB Staff Position 157-2, *EffectiveDate of FASB Statement No. 157* (“FSP 157-2”). FSP 157-1 amendsSFAS 157 to remove certain leasing transactions from its scope. FSP 157-2delays the effective date of SFAS 157 for all non-financial assets andnon-financial liabilities, except for items that are recognized or disclosed atfair value in the financial statements on a recurring basis (at leastannually), until fiscal year beginning after November 15, 2008. Themeasurement and disclosure requirements related to financial assets andfinancial liabilities became effective for us beginning in the first quarter of2008. The adoption of SFAS 157 for financial assets and financial liabilitiesdid not have a significant impact on our consolidated financial statements. Weare currently 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. SFAS157 describes 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.

 

Thefollowing table summarizes our available-for-sale securities portfolio as of June 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 June 30,2008:

 
| ** **                                                | ** ** | ** **              | ** ** | **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 fund                                        |       | $                       | 15,205     |                                                                                                                  | $          | 15,205 |   | $ | — |   | $ | — |   |
| U.S.  government agencies debt                            |       | 10,020                  |       | 10,020                                                                                                                |       | — |   | — |   |
| Commercial  paper                                         |       | 11,171                  |       | 11,171                                                                                                                |       | — |   | — |   |
| Corporate  debt securities                                |       | 1,562                   |       | 1,562                                                                                                                 |       | — |   | — |   |
| Auction  rate securities:                                 |       |                    |       |                                                                                                                  |       |   |   |   |   |
| Beginning  balance as of March 31, 2008              |       | 2,020                   |       | —                                                                                                                |       | 1,200 |   | 820 |   |
| Purchases                                                 |       | —                  |       | —                                                                                                                |       | — |   | — |   |
| Sales  and maturities                                     |       | (1,200                  | )          | —                                                                                                                |       | (1,200 | ) | — |   |
| Unrealized  losses included in other comprehensive income |       | (22                     | )          | —                                                                                                                |       | — |   | (22 | ) |
| Transfer  in (out) between Level 2 and 3                  |       | —                  |       | —                                                                                                                |       | — |   | — |   |
| Ending  balance as of June 30, 2008                  |       | 798                     |       | —                                                                                                                |       | — |   | 798 |   |
| Total  available-for-sale securities                      |       | $                       | 38,756     |                                                                                                                  | $          | 37,958 |   | $ | — |   | $ | 798 |   |

 

Asof June 30, 2008, we held in our marketable securities portfolio twoauction rate securities with an aggregate par value of $875,000. Beginning inearly 2008, market auctions for certain of the auction rate securities held inour portfolio began to fail causing those securities to become temporarilyilliquid. However, during the first half of 2008 we did experience liquidity inthe market for auction rate securities as all but two of our auction rateholdings were either redeemed by the original issuers or were sold at par valuein the open market. Based on our recent experience with the liquidity of ourown auction rate portfolio and our expectations regarding near-term marketconditions, we concluded that the impairment to the fair value of our auctionrate holdings as of June 30, 2008, is not other-than-temporary inaccordance with guidance 

 

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provided by FSP FAS 115-1. Accordingly, weclassify our two remaining auction rate holdings as current assets as we intendto liquidate these instruments as soon as liquidity for these instruments isavailable to us.

 

Therecent failure of some auctions and the resulting lack of liquidity requirethat certain of these securities be measured using Level 3 inputs in accordancewith guidance provided by SFAS 157. The fair value of our two remaining auctionrate securities which are classified as Level 3 instruments at June 30,2008 was determined using a discounted cash flow model that considers inputssuch as expected cash flows from the auction rate instruments, expectedinterest payments, market yields for similarly rated instruments, our estimatesof time to liquidity for those securities, and marketability discounts. Werevise our estimates for each input as of each financial statement reportingperiod based upon known and expected market conditions as well as specificinformation we have regarding each instrument. We have determined that as of June 30,2008, the aggregate fair value of our two remaining auction rate instrumentswas $798,000, net of an estimated $77,000 unrealized loss representing anaggregate 8.8% reduction in the carrying value for these instruments. Thereduction in carrying value is reflected in our condensed consolidate balancesheet as a component of other comprehensive loss as of June 30, 2008.

 

***Comprehensive Loss***

 

Comprehensive loss iscomprised of net loss and other comprehensive income/loss. The only componentof our other comprehensive income/loss is the unrealized gains and losses onour marketable securities. Comprehensive loss for the three months ended June 30,2008 and 2007 was $12.0 million and $7.0 million, respectively, and for the sixmonths ended June 30, 2008 and 2007 was $21.5 million and $12.2 million,respectively.

 

***Net Loss Per Share***

 

Basicnet loss per share is computed by dividing net loss by the weighted averagenumber of fully vested common shares outstanding during the period. Diluted netloss per share is computed by giving effect to all potential dilutive commonshares, including outstanding stock options, warrants and convertible preferredstock. Because we are in a net loss position, our computation of diluted netloss per share excludes the effects of common stock equivalents because theinclusion would have been anti-dilutive.

 

Thefollowing table presents the calculation of historical basic and diluted netloss per share:

 
| ** **                                                                             | ** ** | **Three Months Ended    June 30,**           | ** ** | **Six Months Ended    June 30,** | ** ** |
|----------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------|------------|-----------------------------------------------------------|------------|
| ** **                                                                             | ** ** | **2008**                                                              | ** ** | **2007**                                                  | ** ** | **2008** | ** ** | **2007** | ** ** |
| ** **                                                                             | ** ** | **(In thousands, except per share amounts)** | ** ** |
| *Numerator:*                                                                           | * *   | * *                                                              | * *   | * *                                                  | * *   | * * | * * | * * | * * |
| Net loss                                                                               |       | $                                                                     | (11,896    | )                                                         | $          | (7,020 | ) | $ | (21,399 | ) | $ | (12,156 | ) |
| *Denominator:*                                                                         | * *   | * *                                                              | * *   | * *                                                  | * *   | * * | * * | * * | * * |
| Weighted average common shares outstanding                                             |       | 17,668                                                                |       | 1,114                                                     |       | 17,664 |   | 1,092 |   |
| Less: Weighted average unvested restricted  common shares                              |       | (27                                                                   | )          | (34                                                       | )          | (28 | ) | (27 | ) |
| Weighted average common shares used in  computing basic and diluted net loss per share |       | 17,641                                                                |       | 1,080                                                     |       | 17,636 |   | 1,065 |   |
| Basic and diluted net loss per share                                                   |       | $                                                                     | (0.67      | )                                                         | $          | (6.50 | ) | $ | (1.21 | ) | $ | (11.41 | ) |

 

Forthe three months ended June 30, 2008, shares and per share amounts abovereflect the conversion of all of our outstanding convertible preferred stockinto common stock upon the closing of our initial public offering on November 13,2007.

 

Thefollowing common stock equivalent shares related to our convertible preferredstock, warrants and stock options were excluded from the computation of dilutednet loss per share for the periods presented because including them would havehad an antidilutive effect:

 
| ** **                                                   | ** ** | **Three Months Ended   June 30,** | ** ** | **Six Months Ended   June 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 |   |

 

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| ** **                                                                                      | ** ** | **Three Months Ended   June 30,** | ** ** | **Six Months Ended   June 30,** | ** ** |
|-------------------------------------------------------------------------------------------------|------------|-------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                                                      | ** ** | **2008**                                              | ** ** | **2007**                                            | ** ** | **2008** | ** ** | **2007** | ** ** |
| ** **                                                                                      | ** ** | **(In thousands)**                               | ** ** |
| 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                                                                |       | 2,354                                                 |       | 1,793                                               |       | 2,354 |   | 1,793 |   |
|                                                                                            |       | 2,544                                                 |       | 13,320                                              |       | 2,544 |   | 13,320 |   |

 

***Income Taxes***

 

We utilize the liabilitymethod of accounting for income taxes. Under this method, deferred tax assetsand liabilities are determined based on differences between financial reportingbases and the tax bases of assets and liabilities and are measured using theenacted tax rates and laws that will be in effect when the differences areexpected to reverse. Based on known factors, our management cannot currentlyconclude that it will be more likely than not that the deferred tax assets willbe utilized. Accordingly, the deferred tax assets have been fully offset by avaluation allowance.

 

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

 

***Recent Accounting Pronouncements***

 

In December 2007, theFASB ratified EITF 07-1, *“Accounting forCollaborative Arrangements”*(“EITF 07-1”). EITF 07-1 definescollaborative arrangements and establishes reporting requirements fortransactions between participants in a collaborative arrangement and betweenparticipants in the arrangement and third parties. EITF 07-1 also establishesthe appropriate income statement presentation and classification for jointoperating activities and payments between participants, as well as thesufficiency of the disclosures related to these arrangements. EITF 07-1 iseffective for fiscal years beginning after December 15, 2008. We arecurrently evaluating the impact of EITF 07-1 on our consolidated financialposition, results of operations and cash flows.

 

**2.  Revenue Recognition**

 

On June 30, 2006, we entered into acollaboration agreement with Procter & Gamble Pharmaceuticals, Inc.,or P&G, pursuant to which P&G would develop and commercialize ATI-7505,our product candidate for the treatment of gastrointestinal disorders such aschronic constipation, functional dyspepsia, gastroesophageal reflux disease,gastroparesis and irritable bowel syndrome with constipation. In connectionwith the collaboration agreement, P&G paid us a $25.0 millionnonrefundable upfront license fee. As of July 2, 2008, the collaborationagreement with P&G was terminated. See Note 6 – Subsequent Event forfurther discussion.

 

In accordance with our revenue recognition policy,the $25.0 million nonrefundable upfront license fee was deferred uponreceipt, as objective evidence of the fair value of the undelivered elementsunder the agreement could not be established. This fee is being recognized asrevenue on a straight-line basis over our estimated obligatory performanceperiod under the terms of the collaboration agreement. As of June 30,2008, a cumulative total of $7.5 million of the $25.0 million upfrontpayment had been recognized as revenue. In connection with the termination of the collaboration agreement, theobligatory performance period has effectively ended and accordingly, weclassify the remaining $17.5 million deferred revenue as a current liability.

 

Under the collaboration agreement, we were obligatedto provide certain transitional services to P&G which were fullyreimbursable to ARYx by P&G. These transitional services represented thepass through of actual costs billed to us by third party vendors, were standardsupport services for the biopharmaceutical industry and were readily availablefrom multiple vendors. We were also entitled to compensation from P&G forcertain pre-determined development services, such as formulation, developmentand manufacturing of drug substance and products, as well as other activitiesrelated to the licensed technology. As of June 30, 2008, we haverecognized a cumulative total of $2.6 million as collaboration servicerevenue since the commencement of our collaboration arrangement with P&Gand costs associated with these services are included in the cost ofcollaboration service revenue.

 

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

 

InMarch 2005, we entered into a loan agreement with Lighthouse CapitalPartners V, L.P. (“Lighthouse”) that was amended on October 19, 2007.The original agreement provided for up to $10.0 million in debt financing.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 June 30, 2008, these warrantsare exercisable for an aggregate of 100,704 shares of our common stock at anexercise price of $9.93 per share and 83,332 shares of our common stock at anexercise price of $10.80.

 

InFebruary 2008, we borrowed the additional $9.0 million available tous under the loan facility pursuant to the terms of the amended loan agreementdated October 19, 2007. The amended loan agreement provides for aseven-month interest-only period and a 36 month repayment term which will beginon October 1, 2008. The related promissory note provides for monthly cashpayments of principal and interest at an interest rate equal to the higher of7.75% or the prime rate plus 200 basis points per annum to be fixed as of October 1,2008, and a balloon 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 terminal interest payment isaccelerated and due at the time of prepayment of the loan balance.

 

**4.  Warrants**

 

Upon completion of ourinitial public offering in November 2007, all outstanding warrants topurchase our convertible preferred stock were converted into warrants topurchase our common stock in accordance with their original terms.

 

As of June 30, 2008,the following warrants were issued and outstanding:

 
| ** **               | ** ** | ** **          | ** ** | ** **                       | ** ** | ** **                        | ** ** | ** **              | ** ** | **Exercise**         | ** ** | ** **     | ** ** |
|--------------------------|------------|---------------------|------------|----------------------------------|------------|-----------------------------------|------------|-------------------------|------------|----------------------|------------|----------------|------------|
| ** **               | ** ** | ** **          | ** ** | ** **                       | ** ** | ** **                        | ** ** | **Shares**              | ** ** | **Price**            | ** ** | **Expiration** | ** ** |
| **Warrant Holder**  | ** ** | **Issue Date** | ** ** | **In Connection With** | ** ** | **Warrant to Purchase** | ** ** | **(in thousands)** | ** ** | **(per share)** | ** ** | **Date**       | ** ** |
| 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                     |       |                 |       |           |       |

 

----

| (1) | Exercisable, in whole or  in part, until the earlier of the 10th anniversary of the issue date or  the 5th anniversary of the closing of an initial public offering.                                                                                                                                                                                                                                           |
|-----|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| (2) | Exercisable, in whole or  in part, prior to or upon the closing of an initial public offering, a  merger, change in control, or sale of substantially all of our assets;  expires at the earlier of (i) the close of business on March 28,  2012, (ii) two years following the effective date of an initial public  offering, or (iii) the effective date of a merger, as defined in the  agreement. |
| (3) | Exercisable, in whole or  in part, at anytime at the option of the holder or deemed to have been  automatically exercised in full immediately prior to the expiration of the  warrant; expires at the earlier of (i) the close of business on  October 19, 2014, or (ii) the effective date of a merger, as  defined in the agreement.                                                                    |

 

We follow guidance underSFAS 150, and EITF 96-18 prior, to measure the fair value of thesewarrants on the date of issuance using the Black-Scholes option valuation modelwith the following assumptions: risk-free interest rate ranging from 3.27% to4.10%, contractual life according to the remaining terms of the arrangements,no dividend yield and volatility of 73%. The fair value of the warrant issuedto ATEL was fully amortized as of December 31, 2005. The fair value of thefirst warrant issued to Lighthouse was recorded in three separate tranches asdebt issuance cost with the first tranche amortized to interest expense overthe funding commitment period ended December 31, 2005, and the remainderamortized to interest expense over the duration of the interest-only periodplus the term of the loan over 42 months. The fair value of the secondwarrant issued to Lighthouse was recorded in two separate tranches as debtissuance cost with the first tranche amortized to interest expense over thefunding commitment period ended March 1, 2008, and the remainder amortizedto interest expense over the duration of the interest-only period plus the termof the loan over 36 months. Amortization of the fair value of the warrantswas charged to interest expense as follows:

 
| ** **                  | ** ** | **Three Months Ended   June 30,** | ** ** | **Six Months Ended   June 30,** | ** ** |
|-----------------------------|------------|-------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                  | ** ** | **2008**                                              | ** ** | **2007**                                            | ** ** | **2008** | ** ** | **2007** | ** ** |
| ** **                  | ** ** | **(In thousands)**                               | ** ** |
| Lighthouse – Warrant 1 |       | $                                                     | 23         |                                                | $          | 23 |   | $ | 47 |   | $ | 47 |   |
| Lighthouse – Warrant 2 |       | 16                                                    |       | —                                              |       | 167 |   | — |   |
|                        |       | $                                                     | 39         |                                                | $          | 23 |   | $ | 214 |   | $ | 47 |   |

 

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The warrants may beexercised using the net exercise method. Under this method, the number ofshares issued upon exercise is reduced by an amount equal to the product of thenumber of shares subject to the exercise and the exercise price per share,divided by the fair value of convertible preferred stock on the date of theexercise. The number of shares issued upon exercise of the warrants, and theexercise price per share, are adjustable in the event of stock splits,dividends and similar fundamental changes. No warrant was exercised during thethree and six month periods ended June 30, 2008.  In June 2007, Life Science Group, Inc.exercised their first warrant on a net exercise basis which resulted in theissuance of 1,055 shares of our Series C convertible preferred stock priorto the conversion to an equal number of common shares.

 

Before conversion of theconvertible preferred stock warrants into common stock warrants, we followedguidance under SFAS 150 and re-measured the fair value of these warrantson each subsequent balance sheet date until the date of conversion using theBlack-Scholes option valuation model with the following assumptions: risk-freeinterest rate between 3.78% and 4.96%, contractual life according to theremaining terms of the arrangements, no dividend yield and volatility of 73%.Accordingly, we recorded interest and other income of $21,000 and $40,000 toreflect the decrease in fair value of the then preferred stock warrantliability for the three and six months ended June 30, 2007, respectively,before the conversion of the warrants.

 

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

 

We account for employee stock-based compensationunder SFAS No. 123(R), *Share-BasedPayment* (“SFAS 123R”), which requires compensation expense relatedto stock-based payments, including stock options and awards granted toemployees and directors, to be measured based on grant date fair value andrecognized as expense in the financial statements over the requisite serviceperiod. We estimate the fair value of our share-based award to employees anddirectors using the Black-Scholes option valuation model. Option valuationmodels require the input of highly subjective assumptions and these assumptionscan vary over time. Due to the fact that we are a newly public company, thereis limited historical information available to support our estimate of expectedvolatility required to value our stock-based awards. We, therefore, followguidance discussed in SAB No. 107 basing our estimate of expectedvolatility on the expected volatility of a group of similar entities whosestock prices are publicly available. We will continue to consistently applythis process using the similar entities until a sufficient amount of historicalinformation regarding the volatility of our own stock price becomes available.The fair value of our stock-based awards was estimated at the date of grantusing the following assumptions:

 
| ** **                                        | ** ** | **Three Months Ended   June 30,** | ** ** | **Six Months Ended   June 30,** | ** ** |
|---------------------------------------------------|------------|-------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                        | ** ** | **2008**                                              | ** ** | **2007**                                            | ** ** | **2008** | ** ** | **2007** | ** ** |
| Expected volatility                               |       | 73                                                    | %          | 73                                                  | %          | 73 | % | 73 | % |
| Expected term (in years)                          |       | 4.6                                                   |       | 4.0                                                 |       | 4.6 |   | 4.1 |   |
| Weighted-average risk-free interest rate          |       | 3.27                                                  | %          | 4.44                                                | %          | 2.66 | % | 4.63 | % |
| Expected dividends                                |       | —                                                |       | —                                              |       | — |   | — |   |
| Weighted-average grant date fair value per  share |       | $                                                     | 3.83       |                                                | $          | 1.88 |   | $ | 4.35 |   | $ | 1.90 |   |
|                                                   |            |                                                       |            |                                                     |            |  |  |  |  |  |  |  |  |

 

SFAS 123R requires forfeitures to be estimatedat the time of grant and revised, if necessary, in subsequent periods if actualforfeitures differ from estimates. Forfeitures are estimated based on ourhistorical experience and separate groups of employees that have similarhistorical forfeiture behavior are separately considered for expenserecognition.

 

Totalcompensation cost that has been recorded in the statement of operations, whichincludes stock-based compensation expense under SFAS 123R and the value ofoptions issued to non-employees for services rendered, are allocated asfollows:

 
| ** **                           | ** ** | **Three Months Ended   June 30,** | ** ** | **Six Months Ended   June 30,** | ** ** |
|--------------------------------------|------------|-------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                           | ** ** | **2008**                                              | ** ** | **2007**                                            | ** ** | **2008** | ** ** | **2007** | ** ** |
| ** **                           | ** ** | **(In thousands)**                               | ** ** |
| Research and development:            |       |                                                  |       |                                                |       |   |   |   |   |
| Officer compensation                 |       | $                                                     | 84         |                                                | $          | 42 |   | $ | 160 |   | $ | 77 |   |
| Employee and consultant compensation |       | 161                                                   |       | 71                                                  |       | 332 |   | 128 |   |
| Selling, general and administrative: |       |                                                  |       |                                                |       |   |   |   |   |
| Director and officer compensation    |       | 279                                                   |       | 92                                                  |       | 555 |   | 245 |   |
| Employee and consultant compensation |       | 48                                                    |       | 16                                                  |       | 90 |   | 29 |   |
|                                 |       | $                                                     | 572        |                                                | $          | 221 |   | $ | 1,137 |   | $ | 479 |   |

 

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Asof June 30, 2008, total compensation cost related to unvested stockoptions not yet recognized was $2.7 million, which is expected to be allocatedto expense over a weighted-average period of 1.45 years. As a result of stockoption exercises, we issued 16,278 shares and 8,360 shares of common stockduring the three months ended June 30, 2008 and 2007, respectively, and27,343 shares and 21,771 shares of common stock during the six months ended June 30,2008 and 2007, respectively.

 

**6. ****Subsequent Event**

 

On July 2, 2008, we received notice fromP&G that it elected to exercise its option to terminate the collaborationagreement between P&G and ARYx, effective July 2, 2008. In connectionwith the termination of the collaboration agreement, the obligatory performanceperiod has effectively ended and pursuant to the terms of the collaborationagreement, we are under no obligation to return any portion of the $25 millionupfront license fee to P&G. Accordingly, we classify the remaining $17.5million deferred revenue as a current liability. In addition, effective with P&G’snotice of termination, we no longer provide support services to P&G for thedevelopment of ATI-7505 and therefore those services will no longer be a sourceof revenue for us.

 

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

 

*The following discussion of ourfinancial condition and the results of operations should be read in conjunctionwith the condensed consolidated financial statements and notes to condensedconsolidated  financial statementsincluded elsewhere in this quarterly report on Form 10-Q. This discussioncontains forward looking statements that involve risks and uncertainties. Whenreviewing the discussion below, you should keep in mind the substantial risksand uncertainties that characterize our business. In particular, we encourageyou to review the risks and uncertainties described in Part II -Item 1A. “RISK FACTORS” elsewhere in this report. These risks anduncertainties could cause actual results to differ materially from thoseprojected in forward-looking statements contained in this report or implied bypast results and trends. Forward-looking statements are statements that attemptto forecast or anticipate future developments in our business; we encourage youto review the 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**

 

ARYx Therapeutics, Inc. is a biopharmaceuticalcompany focused on developing a portfolio of internally discovered productcandidates designed to eliminate known safety issues associated withwell-established, commercially successful drugs. We were incorporated in theState of California on February 28, 1997 and reincorporated in the Stateof Delaware on August 29, 2007. We maintain a wholly-owned subsidiary,ARYx Therapeutics Limited, with registered offices in the United Kingdom, whichhas had no operations since its inception in September 2004 and wasestablished to serve as a legal entity in support of our clinical trialactivities conducted in Europe.

 

We use our RetroMetabolic Drug Design technology todesign structurally unique molecules that retain the efficacy of these originaldrugs but are metabolized through a potentially safer pathway to avoid specificadverse side effects associated with these compounds. The following is asummary of our product candidates that are currently in clinical development:

 

***ATI-5923***

 

ATI-5923 is an oral anticoagulant in Phase 2/3clinical trials for the treatment of patients who are at risk for the formationof dangerous blood clots, such as those with atrial fibrillation or those atrisk of venous thromboembolism. ATI-5923 was designed to have the sametherapeutic benefits as the drug warfarin, which for over 50 years hasbeen the treatment of choice as an oral anticoagulant. Despite its widespreaduse, warfarin has several significant limitations. It is metabolized by CYP450and has many drug-drug interactions that often lead to serious side effects. Wedesigned ATI-5923 to be metabolized through the esterase pathway, eliminatingmetabolism through CYP450 and avoiding drug-drug interactions. Warfarin alsohas a very steep dose response curve which means that a small change in dosemay lead to a substantial change in the anticoagulation status of the patient.This can put patients at risk for either life-threatening clotting or bleeding.In preclinical testing, it appears that ATI-5923 may have a more predictablerate of anticoagulation than warfarin, although confirmation of thisobservation will require substantial additional clinical data. We completed aPhase 2 clinical trial with ATI-5923 involving 66 patients. In this study,ATI-5923 achieved a significant improvement in the maintenance of thesepatients at the targeted level of anticoagulation and also demonstrated asignificant reduction in the occurrence of dangerously low levels of anticoagulationcompared to these patients’ historical levels of anticoagulation when onwarfarin. We have also completed a pilot study of 50 patients to prepare for arecently-initiated large Phase 2/3 trial. In the pilot trial, we successfullyestablished the trial methodologies for the blinded Phase 2/3 trial, and, eventhough the primary purpose of the pilot trial was not to measure theeffectiveness of ATI-5923 in achieving the patient’s target INR, the efficacyresults essentially matched those of the earlier 66 patient study. In June 2008,we initiated a double-blinded, placebo-controlled Phase 2/3 clinical trialinvolving approximately 600 patients that will study the efficacy of ATI-5923in a head-to-head comparison to warfarin. In preliminary discussions,the U.S. Food and Drug Administration, or FDA, indicated that the standardizedmeasurement of anticoagulation status known as the International NormalizedRatio, or INR, will likely be an acceptable surrogate and primary endpoint forATI-5923’s clinical development. Using INR as a surrogate and primary endpointshould reduce both the size of and time to complete our planned clinical trialsfor ATI-5923 compared to clinical trials based on survival rates or otheroutcomes. Based upon other discussions with the FDA, we will request that theFDA consider the current Phase 2/3 trial part of the patient population neededto seek commercial approval in order to qualify it as a Phase 3 trial.

 

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***ATI-2042***

 

ATI-2042 is an oral anti-arrhythmic agent inPhase 2 clinical development for the treatment of patients with atrialfibrillation. ATI-2042 was designed to have the efficacy of amiodarone, a drugthat has been used for many years, despite its adverse side effects, becausephysicians consider it to be the most effective drug for treating patients withatrial fibrillation. Amiodarone accumulates in many different organs and canonly be metabolized by CYP450, potentially leading to serious side effects thatare not immediately reversible upon withdrawal of the drug. Since ATI-2042 ispredominantly metabolized through the esterase pathway, accumulation in theorgans and drug-drug interactions are expected to be reduced. We have completeda Phase 2 clinical trial with ATI-2042 involving six atrial fibrillationpatients with implanted recordable pacemakers who failed previous drug therapy.ATI-2042 quickly reduced the amount of time these patients were in atrialfibrillation by up to 87%. We are conducting an additional Phase 2clinical trial to further demonstrate the efficacy of ATI-2042 in patients withatrial fibrillation. Enrollment in this trial is complete and we currentlyexpect to have top-line efficacy results by the end of 2008.

 

***ATI-9242***

 

ATI-9242 is a novelantipsychotic agent in Phase 1 clinical development for the treatment ofschizophrenia and other psychiatric disorders. ATI-9242’s receptor profile istargeted at the treatment of both the positive and the negative symptoms ofschizophrenia as well as the improvement of cognitive function. To date,preclinical work has supported this profile. ATI-9242 is also designed to avoidcertain drug-drug interactions by avoiding CYP450 enzymes for metabolism, aswell as reduce certain metabolic problems associated with this class oftherapy, including weight gain and type 2 diabetes. We received clearance fromthe FDA to initiate a Phase 1 clinical trial for ATI-9242 in April 2008,which is designed to test ATI-9242’s safety and tolerability. We currentlyexpect to complete this clinical trial by the end of 2008.

 

***ATI-7505***

 

ATI-7505 is an oral prokinetic drug or an agent thatspeeds up the motion of contents through the gut, which has successfullycompleted Phase 2 clinical trials for the treatment of multiplegastrointestinal disorders including gastroesophageal reflux disease, or GERD,and functional dyspepsia. 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 reached sales ofover $1.0 billion before it was withdrawn from the market in 2000 due toserious cardiovascular side effects. These side effects occurred as bloodlevels of the drug rose significantly when CYP450 clearance was blocked becauseof the presence of other drugs cleared by the same metabolic pathway. Wedesigned ATI-7505 to be metabolized through the esterase pathway, eliminatingmetabolism through CYP450 as well as off-target cardiovascular effects. We havetreated more than 500 patients with ATI-7505 as part of our clinical trialprogram, including three Phase 2 trials. Based upon the data generated inthese clinical trials, in June 2006 we entered into a collaborationagreement with Procter & Gamble Pharmaceuticals, Inc., orP&G, to develop and commercialize ATI-7505. On July 2, 2008, we announced the overall successful results of aQT study (TQT) on ATI-7505, which we believe support the favorable cardiacsafety profile of the agent. On July 2, 2008, we received notice fromP&G that it elected to exercise its option to terminate the collaborationagreement between P&G and ARYx, effective July 2, 2008. Upontermination of the agreement by P&G, all rights to ATI-7505 reverted toARYx. We intend to submit the results of the TQT study to the FDA andsubsequently seek a new collaboration partner for ATI-7505.

 

Since our inception, we have incurred significantnet losses, and we expect to continue to incur net losses for the next severalyears as we develop, acquire or in-license additional products or productcandidates, conduct clinical trials, manufacture materials for use innonclinical studies and clinical trials, expand our research and developmentactivities, seek regulatory approvals and engage in commercializationpreparation activities. It is very expensive to gain approval of and launch apharmaceutical product, and many expenses are incurred before revenue isreceived. We are unable to predict the extent of any future losses or when wewill become profitable, if at all.

 

***Revenue***

 

  Inconnection with our collaboration agreement with P&G, we received a$25.0 million nonrefundable upfront license fee in August 2006. The$25.0 million payment was recorded in our balance sheet as deferredrevenue upon receipt and recognized in our consolidated statement of operationsas revenue on a straight-line basis over the performance and service period.Upon termination of the collaboration agreement on July 2, 2008, theperformance and service period effectively ended and pursuant to the terms ofthe collaboration agreement, we are under no obligation to return any portionof the upfront license fee to P&G. As of June 30, 2008, we haverecognized a cumulative total of $7.5 million of the $25.0 million 

 

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nonrefundable upfront license fee. Followingthe termination of the collaboration agreement, the remaining $17.5 million isdeemed fully earned and we expect that we will recognize the remaining deferredrevenue in the third quarter of 2008.

 

Under the terms of the collaboration agreement, wewere obligated to provide certain transitional services to P&G. Thesetransitional services represented the pass through of actual costs billed toARYx by third party vendors, were standard support services for thebiopharmaceutical industry and were readily available from multiple vendors. Wewere also entitled to compensation from P&G for specified developmentservices provided by us. These services included product formulation andmanufacturing, patent filing and maintenance, and other development servicesrelated to the ATI-7505 program. Reimbursements we received for these serviceshave been recorded as collaboration service revenue. As of June 30, 2008,we have recognized a cumulative total of $2.6 million as collaborationservice revenue since the beginning of our collaboration with P&G.Effective with P&G’s notice of termination on July 2, 2008, we nolonger provide support services to P&G for the development of ATI-7505 andtherefore those services will no longer be a source of revenue for us.

 

Revenue generated from the P&G agreement was ouronly source of revenue. While we intend to seek partners for each of the fourproduct candidates in our portfolio, there is no assurance that partneringarrangements will be available to us or on terms acceptable to us. See Part II– Item 1A.Risk Factors of this report for further discussion.

 

***Cost of Collaboration Service Revenue***

 

We incurred costs for certain services provided toP&G, including costs for pharmaceutical development, patent filing andmaintenance and other activities related to the ATI-7505 program, which arerelated to the service revenue we generated in connection with ourcollaboration agreement with P&G. These expenses are reported separately inour income statement as cost of collaboration service revenue. As of June 30,2008, we have recorded a cumulative total of $2.6 million of expenserelated to these activities since the commencement of our collaborationarrangement with P&G in June 2006.

 

***Research and Development***

 

Our research and development expense consists ofexpenses incurred in identifying, testing and developing our productcandidates. These expenses consist primarily of fees paid to contract researchorganizations and other third parties to assist us in managing, monitoring andanalyzing our clinical trials, clinical trial costs paid to sites andinvestigators’ fees, costs of nonclinical studies including toxicity studies inanimals, costs of contract manufacturing services, costs of materials used inclinical trials and nonclinical studies, laboratory related expenses, researchand development support costs including certain regulatory, quality assurance,project management and administration, allocated expenses such as facilitiesand information technology that are used to support our research anddevelopment activities and related personnel expenses, including stock-basedcompensation. Research and development costs are expensed as incurred.

 

Clinical trial costs are a significant component ofour research and development expense. Currently, we conduct our clinical trialsprimarily through coordination with contract research organizations and otherthird-party service providers. We recognize research and development expensefor these activities based upon a variety of factors, including actual andestimated patient enrollment, clinical site initiation activities, directpass-through costs and other activity-based factors.

 

The following table summarizes our research anddevelopment expense for the three and six months ended June 30, 2008 and2007:

 
| ** **                                                                           | ** ** | **Three Months Ended   June 30,** | ** ** | **Six Months Ended   June 30,** | ** ** |
|--------------------------------------------------------------------------------------|------------|-------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                                           | ** ** | **2008**                                              | ** ** | **2007**                                            | ** ** | **2008** | ** ** | **2007** | ** ** |
| ** **                                                                           | ** ** | **(In thousands)**                               | ** ** |
| Direct research and development expense by  program:                                 |       |                                                  |       |                                                |       |   |   |   |   |
| ATI-5923                                                                             |       | $                                                     | 4,494      |                                                | 1,027      |   | $ | 6,081 |   | $ | 1,494 |   |
| ATI-2042                                                                             |       | 1,389                                                 |       | 1,435                                               |       | 3,338 |   | 2,099 |   |
| ATI-9242                                                                             |       | 546                                                   |       | 645                                                 |       | 1,092 |   | 952 |   |
| ATI-7505                                                                             |       | 57                                                    |       | 19                                                  |       | 133 |   | 8 |   |
| Other research programs                                                              |       | 394                                                   |       | 173                                                 |       | 648 |   | 246 |   |
| Total direct research and development  program expense                               |       | 6,880                                                 |       | 3,299                                               |       | 11,292 |   | 4,799 |   |
| Personnel, administrative and other expense                                          |       | 3,178                                                 |       | 3,207                                               |       | 6,392 |   | 6,347 |   |
| Less: Research and development portion of  the cost of collaboration service revenue |       | (13                                                   | )          | (7                                                  | )          | (39 | ) | (130 | ) |
| Total research and development expense                                               |       | $                                                     | 10,045     |                                                | $          | 6,499 |   | $ | 17,645 |   | $ | 11,016 |   |
|                                                                                      |            |                                                       |            |                                                     |            |  |  |  |  |  |  |  |  |

 

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From our inception through June 30, 2008, weincurred total research and development expense of approximately$120.0 million. During the period from our inception through June 30,2008, we estimate that approximately $20.8 million was directly incurred forour ATI-5923 program, approximately $20.9 million was directly incurredfor our ATI-2042 program, approximately $4.8 million was directly incurred forour ATI-9242 program, approximately $22.3 million was directly incurred for ourATI-7505 program, and approximately $51.2 million was incurred (includinginternal and external activities) for our other research and development programexpense, personnel, administrative and other expense.

 

We designate development programs to which we haveallocated significant research and development resources with the term “ATI”and a unique number. All of the product candidates designated with “ATI” arecurrently in development. The expenditures summarized in the above tablereflect costs directly attributable to each development candidate and to ourother research programs. We do not allocate salaries, employee benefits, orother indirect costs to our development candidates or other research programsand have included those expenses in “Personnel, administrative and otherexpense” in the above table. The portion of our research and developmentexpense that is identified as cost of collaboration service revenue is includedwithin a separate category of expense in our condensed consolidated financialstatements and is subtracted from total expenses in the above table to derivetotal research and development expense as reported in our condensed consolidatedfinancial statements.

 

At this time, due to the risks inherent in theclinical trial process and given the various stages of development of ourproduct candidates, we are unable to estimate with any certainty the costs wewill incur in the continued development of our product candidates. Clinicaldevelopment timelines, the probability of success and development costs candiffer materially from expectations. While we are currently focused onadvancing each of our product development programs, our future research anddevelopment expense will depend on the clinical success of each productcandidate, as well as ongoing assessments as to each product candidate’scommercial potential. In addition, we cannot forecast with any degree ofcertainty which product candidates will be subject to future collaborations,when such arrangements will be secured, if at all, and to what degree sucharrangements would affect our development plans and capital requirements.

 

The process of developing and obtaining FDA approvalof products is costly and time consuming. Development activities and clinicaltrials can take years to complete, and failure can occur at any time during thedevelopment and clinical trial process. In addition, the results from earlyclinical trials may not be predictive of results obtained in subsequent andlarger clinical trials, and product candidates in later stages of clinicaltrials may fail to show the desired safety and efficacy despite havingprogressed successfully through initial clinical testing. Although our programfor identifying and developing new product candidates is designed to mitigaterisk, the successful development of our product candidates is highly uncertain.Further, even if our product candidates are approved for sale, they may not be successfullycommercialized and therefore the future revenue we anticipate may notmaterialize.

 

If we fail to complete the development of any of ourproduct candidates in a timely manner, it could have a material effect on ouroperations, financial position and liquidity. In addition, any failure by us orour partners to obtain, or any delay in obtaining, regulatory approvals for ourproduct candidates could have a material effect on our results of operations. Afurther discussion of the risks and uncertainties associated with completingour programs on schedule, or at all, and certain consequences of failing to doso are discussed further in the “Risk Factors” section of this report.

 

**Critical Accounting Policies and Significant Estimates**

 

Thediscussion of our financial condition and results of operations is based uponour condensed consolidated financial statements, which have been prepared inaccordance with U.S. generally accepted accounting principles. The preparationof these financial statements requires us to make estimates, judgments andassumptions that affect the reported amount of assets, liabilities, revenuesand expenses. On an ongoing basis, we evaluate our estimates. These estimates,assumptions and judgments about future events and their effects on our resultscannot be determined with certainty, and are made based upon our historicalexperience and on other assumptions that are believed to be reasonable underthe circumstances. Different estimates that we could have used, or changes inthe estimates that are reasonably likely to occur, may have a material impacton our financial condition or results of operations. Management has discussedthe development, 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.

 

Ourcritical accounting policies are more fully described in Note 1 of the auditedconsolidated financial statements for the year ended December 31, 2007,which are included in our Annual Report on Form 10-K filed with theSecurities and Exchange Commission on March 17, 2008. There have been nomaterial changes in our critical accounting policies and significant estimatesduring the three and six months ended June 30, 2008 except for the fairvalue estimates on our auction rate securities as discussed below.

 

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***Fair Value Estimates of Auction Rate Securities***

 

InSeptember 2006, the Financial Accounting Standards Board (“FASB”) issuedStatements of Financial Accounting Standards No. 157, *Fair Value Measurements* (“SFAS 157”).SFAS 157 defines fair value, establishes a framework for measuring fairvalue and expands fair value measurement disclosure. The measurement anddisclosure requirements related to financial assets and financial liabilitiesbecame effective for us beginning in the first quarter of 2008. Accordingly, webegan to measure the fair value of financial assets in our available-for-salesecurities portfolio beginning in the first quarter of 2008 and began to valueour auction rate securities using significant other observable and unobservableinputs.

 

Inearly 2008, market auctions for certain of the auction rate securities held inour portfolio began to fail causing those securities to become temporarilyilliquid. We believe that the failed auctions are the result of temporarycredit market conditions. During the first half of 2008, we did experienceliquidity in the auction rate market as all but two of our auction rateholdings were either redeemed by the original issuers or were sold at par valuein the open market. Based on our recent experience with the liquidity of ourown auction rate portfolio and our expectations regarding near-term marketconditions, we concluded that the impairment to the fair value of our auctionrate holdings as of June 30, 2008, is not other-than-temporary inaccordance with guidance provided by FSP FAS 115-1. Accordingly, we classifyour two remaining auction rate holdings as current assets as we intend toliquidate these instruments as soon as liquidity for these instruments isavailable to us and due to our expectation that there is a greater likelihoodthan not that liquidity will be made available to us in these instrumentswithin a twelve month period. However, in future reporting periods, ifwe see that market conditions are such that we determine it to be less likelythan not that these instruments will become liquid to us within a twelve monthperiod, we may be required to classify these instruments as non-current assets.

 

Thefair value of our two remaining auction rate securities which are classified asLevel 3 instruments at June 30, 2008 was determined using a discountedcash flow model that considers inputs such as expected cash flows from theauction rate instruments including expected interest payments, market yieldsfor similarly rated instruments, our estimates of time to liquidity for thosesecurities, and marketability discounts. We revise our estimates for each inputas of each financial statement reporting period based upon known and expectedmarket conditions as well as specific information we have regarding eachinstrument. We have determined that as of June 30, 2008, the aggregatefair value of our two remaining auction rate instruments was $798,000, net ofan estimated $77,000 unrealized loss representing an aggregate 8.8% reductionin the carrying value for these instruments. The two remaining auction ratesecurities in our portfolio reset every 28 days with recent interest paymentreset rates ranging from 3.46% to 4.23% and final maturities in 2030 and 2045,respectively. As of June 30, 2008, our auction rate instruments werecurrent with respect to their 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.

 

**Results of Operations**

 

***Comparison of Three and Six MonthsEnded June 30, 2008 and 2007***

 

***Revenue***

 
| ** **                    | ** ** | **Three Months Ended**            | ** ** | ** ** | ** ** | ** **        | ** ** | **Six Months Ended** | ** ** | ** ** | ** ** | ** ** | ** ** |
|-------------------------------|------------|---------------------------------------------|------------|------------|------------|-------------------|------------|--------------------------------|------------|------------|------------|------------|------------|
| ** **                    | ** ** | **June 30,**                           | ** ** | **Change** | ** ** | **June 30,** | ** ** | **Change**                     | ** ** |
| ** **                    | ** ** | **2008**                                    | ** ** | **2007**   | ** ** | **$**             | ** ** | **%**                          | ** ** | **2008**   | ** ** | **2007**   | ** ** | **$** | ** ** | **%** | ** ** |
| ** **                    | ** ** | **(In thousands, except %)** | ** ** |
| Collaboration service revenue |       | $                                           | 164        |       | $          | 22                |       | $                              | 142        |       | 645%       |       | $          | 232 |   | $ | 186 |   | $ | 46 |   | 25% |   |
| Technology license fees       |       | 974                                         |       | 974        |       | —            |       | —                         |       | 1,948      |       | 1,948      |       | — |   | — |   |
| Total revenue                 |       | $                                           | 1,138      |       | $          | 996               |       | $                              | 142        |       | 14%        |       | $          | 2,180 |   | $ | 2,134 |   | $ | 46 |   | 2% |   |

 

Revenue for the three months ended June 30, 2008, as compared tothe same period in 2007, increased by $142,000, or 14%.  Revenue for the six months ended June 30,2008, as compared to the same period in 2007, increased by $46,000, or 2%.  The increase to the three and six monthperiods was due to third party pass-through costs billed to P&G primarilyrelated to ATI-7505 patent filings and maintenance that were partially offsetby a reduction in manufacturing activities for the program.

 

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***Cost of Collaboration Service Revenue***

 
| ** **                            | ** ** | **Three Months Ended**            | ** ** | ** ** | ** ** | ** **        | ** ** | **Six Months Ended** | ** ** | ** ** | ** ** | ** ** | ** ** |
|---------------------------------------|------------|---------------------------------------------|------------|------------|------------|-------------------|------------|--------------------------------|------------|------------|------------|------------|------------|
| ** **                            | ** ** | **June 30,**                           | ** ** | **Change** | ** ** | **June 30,** | ** ** | **Change**                     | ** ** |
| ** **                            | ** ** | **2008**                                    | ** ** | **2007**   | ** ** | **$**             | ** ** | **%**                          | ** ** | **2008**   | ** ** | **2007**   | ** ** | **$** | ** ** | **%** | ** ** |
| ** **                            | ** ** | **(In thousands, except %)** | ** ** |
| Cost of collaboration service revenue |       | $                                           | 164        |       | $          | 22                |       | $                              | 142        |       | 645%       |       | $          | 232 |   | $ | 186 |   | $ | 46 |   | 25% |   |
|                                       |            |                                             |            |            |            |                   |            |                                |            |            |            |            |            |  |  |  |  |  |  |  |  |  |  |

 

Cost of revenue was associated with ourcollaboration agreement with P&G. The increase in cost of revenue for boththe three and six months ended June 30, 2008, as compared to the sameperiods in 2007, was directly associated with the increase in collaborationservice revenue in the same periods. These were costs that were incurreddirectly by us and were passed through to P&G.

 

***Research and Development Expense***

 
| ** **                       | ** ** | **Three Months Ended**            | ** ** | ** ** | ** ** | ** **        | ** ** | **Six Months Ended** | ** ** | ** ** | ** ** | ** ** | ** ** |
|----------------------------------|------------|---------------------------------------------|------------|------------|------------|-------------------|------------|--------------------------------|------------|------------|------------|------------|------------|
| ** **                       | ** ** | **June 30,**                           | ** ** | **Change** | ** ** | **June 30,** | ** ** | **Change**                     | ** ** |
| ** **                       | ** ** | **2008**                                    | ** ** | **2007**   | ** ** | **$**             | ** ** | **%**                          | ** ** | **2008**   | ** ** | **2007**   | ** ** | **$** | ** ** | **%** | ** ** |
| ** **                       | ** ** | **(In thousands, except %)** | ** ** |
| Research and development expense |       | $                                           | 10,045     |       | $          | 6,499             |       | $                              | 3,546      |       | 55%        |       | $          | 17,645 |   | $ | 11,016 |   | $ | 6,629 |   | 60% |   |
|                                  |            |                                             |            |            |            |                   |            |                                |            |            |            |            |            |  |  |  |  |  |  |  |  |  |  |

 

For the three months ended June 30, 2008, ascompared to the same period in 2007, our research and development expenseincreased by $3.5 million, or 55%. The increase was primarily due to:

 

•                  a $2.2 million increase in clinical trialexpenditures related to the initiation of a double-blinded, placebo-controlledPhase 2/3 clinical trial involving approximately 600 patients that will studythe efficacy of ATI-5923; and

 

•                  a $1.3 million increase in externalpharmaceutical manufacturing and manufacturing start-up costs in support of thePhase 2/3 clinical studies on our ATI-5923 program.

 

For the six months ended June 30, 2008, ascompared to the same period in 2007, our research and development expense increasedby $6.6 million, or 60%. The increase was primarily due to:

 

•                  a $3.0 million increase in clinical andpre-clinical expenditures related to the 600 patient efficacy study of ATI-5923;

 

•                  a $1.1 million increase in clinical trialexpenditures related to a pilot efficacy study on ATI-5923, partially offset bya $900,000 reduction in expenditures due to the completion of aproof-of-concept study on ATI-5923 in 2007;

 

•                  a $1.7 million increase in externalpharmaceutical manufacturing and manufacturing start-up costs in support of thePhase 2/3 clinical studies on our ATI-5923 program;

 

•                  a $1.2 million increase in externalexpenditures related to a Phase 2 clinical study for our ATI-2042 program; and

 

•                  a $400,000 increase in spending on our otherresearch programs.

 

***Selling,General and Administrative Expense***

 
| ** **                                  | ** ** | **Three Months Ended**            | ** ** | ** ** | ** ** | ** **        | ** ** | **Six Months Ended** | ** ** | ** ** | ** ** | ** ** | ** ** |
|---------------------------------------------|------------|---------------------------------------------|------------|------------|------------|-------------------|------------|--------------------------------|------------|------------|------------|------------|------------|
| ** **                                  | ** ** | **June 30,**                           | ** ** | **Change** | ** ** | **June 30,** | ** ** | **Change**                     | ** ** |
| ** **                                  | ** ** | **2008**                                    | ** ** | **2007**   | ** ** | **$**             | ** ** | **%**                          | ** ** | **2008**   | ** ** | **2007**   | ** ** | **$** | ** ** | **%** | ** ** |
| ** **                                  | ** ** | **(In thousands, except %)** | ** ** |
| Selling, general and administrative expense |       | $                                           | 2,664      |       | $          | 1,727             |       | $                              | 937        |       | 54%        |       | $          | 5,596 |   | $ | 3,624 |   | $ | 1,972 |   | 54% |   |
|                                             |            |                                             |            |            |            |                   |            |                                |            |            |            |            |            |  |  |  |  |  |  |  |  |  |  |

 

The higher selling, general and administrativeexpense for the three and six months ended June 30, 2008 as compared tothe same periods in 2007 was primarily due to increases in personnel andpersonnel related costs, including stock-based compensation expense, highercompensation costs for non-employee directors, and increases in our legal,professional services and insurance costs, much of which was attributable toour transition as a public company. Non-cash stock-based compensation expenseincluded in selling, general and administrative expense was $326,000 for thethree months ended June 

 

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30, 2008, representing anincrease of $218,000 as compared to the same three month period in 2007, and$646,000 for the six months ended June 30, 2008, representing an increaseof $372,000 as compared to the same six month period in 2007.

 

***Interestand Other Income, Net***

 
| ** **                     | ** ** | **Three Months Ended**            | ** ** | ** ** | ** ** | ** **        | ** ** | **Six Months Ended** | ** ** | ** ** | ** ** | ** ** | ** ** |
|--------------------------------|------------|---------------------------------------------|------------|------------|------------|-------------------|------------|--------------------------------|------------|------------|------------|------------|------------|
| ** **                     | ** ** | **June 30,**                           | ** ** | **Change** | ** ** | **June 30,** | ** ** | **Change**                     | ** ** |
| ** **                     | ** ** | **2008**                                    | ** ** | **2007**   | ** ** | **$**             | ** ** | **%**                          | ** ** | **2008**   | ** ** | **2007**   | ** ** | **$** | ** ** | **%** | ** ** |
| ** **                     | ** ** | **(In thousands, except %)** | ** ** |
| Interest and other income, net |       | $                                           | 308        |       | $          | 543               |       | $                              | (235       | )          | (43)%      |       | $          | 857 |   | $ | 1,179 |   | $ | (322 | ) | (27)% |   |
|                                |            |                                             |            |            |            |                   |            |                                |            |            |            |            |            |  |  |  |  |  |  |  |  |  |  |

 

Interestand other income, net of other expenses, consists of interest income from ourinvestments in marketable securities and benefits related to the reassessmentof the fair value of our preferred stock warrant liability prior to theconversion of our preferred stock warrants into common stock warrants. Lowerinterest income for the three and six months ended June 30, 2008 ascompared to the same period in 2007 was primarily attributable to lower prevailing short-term interestrates as well as lower average investments in marketable securities.

 

***InterestExpense***

 
| ** **       | ** ** | **Three Months Ended**            | ** ** | ** ** | ** ** | ** **        | ** ** | **Six Months Ended** | ** ** | ** ** | ** ** | ** ** | ** ** |
|------------------|------------|---------------------------------------------|------------|------------|------------|-------------------|------------|--------------------------------|------------|------------|------------|------------|------------|
| ** **       | ** ** | **June 30,**                           | ** ** | **Change** | ** ** | **June 30,** | ** ** | **Change**                     | ** ** |
| ** **       | ** ** | **2008**                                    | ** ** | **2007**   | ** ** | **$**             | ** ** | **%**                          | ** ** | **2008**   | ** ** | **2007**   | ** ** | **$** | ** ** | **%** | ** ** |
| ** **       | ** ** | **(In thousands, except %)** | ** ** |
| Interest expense |       | $                                           | 469        |       | $          | 311               |       | $                              | 158        |       | 51%        |       | $          | 963 |   | $ | 643 |   | $ | 320 |   | 50% |   |
|                  |            |                                             |            |            |            |                   |            |                                |            |            |            |            |            |  |  |  |  |  |  |  |  |  |  |

 

Theincrease in interest expense for three and six months ended June 30, 2008as compared to the same period in 2007 was primarily due to additional interestexpense related to the amortization of warrants and debt servicing costsrelated to the utilization of the additional $9.0 million loan facility in thefirst quarter of 2008 extended to us by Lighthouse Capital Partners.

 

**Liquidity and Capital Resources**

 
| ** **                  | ** ** | **Six Months Ended** | ** ** |
|-----------------------------|------------|--------------------------------|------------|
| ** **                  | ** ** | **June 30,**              | ** ** |
| ** **                  | ** ** | **2008**                       | ** ** | **2007** | ** ** |
| ** **                  | ** ** | **(In thousands)**        | ** ** |
| Cash (used in) provided by: |       |                           |       |   |   |
| Operating activities        |       | $                              | (22,250    | ) | $ | (13,323 | ) |
| Investing activities        |       | (6,223                         | )          | 10,685 |   |
| Financing activities        |       | 7,533                          |       | (1,371 | ) |
| Total cash (used) provided  |       | $                              | (20,940    | ) | $ | (4,009 | ) |

 

In November 2007, we completed our initialpublic offering of common stock and received aggregate net proceeds ofapproximately $43.8 million. Prior to our initial public offering, we financedour operations primarily through the private placement of equity securities,receiving aggregate net proceeds from such sales totaling $110.7 million.In August 2006, we received a $25.0 million nonrefundable upfront licensefee in connection with our collaboration agreement with P&G. As of June 30,2008, we had $47.4 million in cash, cash equivalents and marketable securitiesand a $159,000 receivable from P&G. Since inception, we have incurredsignificant net operating losses and, as of June 30, 2008, we had anaccumulated deficit of $144.1 million. We have not achieved profitability andanticipate that we will continue to incur significant net losses for the nextseveral years. We believe that our current capital resources will be sufficientto fund our planned operations for at least twelve months following June 30,2008.

 

Net cash used in operating activities for the sixmonths ended June 30, 2008 was $22.3 million as compared to $13.3 millionfor the same period in 2007. Net cash used in each of these periods was due tothe funding of our operating costs and expenses in connection with the conductof our research, development and administrative activities.

 

Net cash used in investing activities was $6.2million for the six months ended June 30, 2008. Net cash provided byinvesting activities was $10.7 million for the six months ended June 30,2007. Investing activities consist primarily of purchases and sales ofmarketable securities and property and equipment purchases. Purchases ofproperty and equipment were $556,000 and $236,000 for the six months ended June 30,2008 and 2007, respectively. As a majority of the cash proceeds from ourinitial public offering remained invested in our cash and cash equivalentportfolio during most of the six- 

 

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month period ended June 30,2008, cash used in investing activities during this period reflects a nettransfer of cash into our investment portfolio.

 

Net cash provided by financing activities was $7.5million during the six months ended June 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 $1.5 million in principal payments on ourlong-term debt. Net cash used in financing activities was $1.4 millionduring the six months ended June 30, 2007 and was due to principalpayments on our long-term debt.

 

On March 28, 2005, we entered into a loan agreementwith Lighthouse Capital Partners that was amended on October 19, 2007. Theoriginal agreement provided for up to $10.0 million in debt financing. Theagreement was amended in October 2007 to provide for up to$9.0 million of additional financing. The original loan agreement providedfor a 42 month repayment term which began on April 1, 2006. Theoriginal outstanding promissory note provides for monthly cash payments ofprincipal and interest at a stated interest rate of 9.75% per annum through September 2009and a balloon 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 terminal interest payment isaccelerated and due at the time of prepayment of the outstanding loan balance.The amended loan agreement provides that additional amounts borrowed under anew promissory note will be subject to an interest-only period expiring in September 2008followed by 36 equal monthly payments of principal and interest at a fixed rateof the prime rate plus 2.0%, to be fixed as of September 2008. Inaddition, we will be obligated to make a final interest payment of 7.5% of theamount borrowed at loan maturity. The loan agreement contains no financialcovenants. Default terms under the loan agreement are standard terms includingborrower default upon nonpayment of amounts due, noncompliance with loancovenants, misrepresentations under the agreement, bankruptcy and otherstandard provisions. Under the terms of the loan agreement, as amended,Lighthouse CapitalPartners has a first priority security interest in all of our tangibleand intangible 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 June 30, 2008, we had fully utilized the total debtcommitment available under the loan agreement, as amended, and had a totalunpaid principal balance outstanding of $12.9 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 non-payment 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 specific equipment assets and GE has a firstpriority security interest in those assets. The loan agreement with GE containsno financial covenants and no warrants to purchase shares of our capital stockwere issued to GE in connection with the debt financing. The loan agreementprovides for monthly payments of principal and interest through July 2010.As of June 30, 2008, thetotal unpaid principal balance outstanding under our existing GE equipmentloans was $646,000.

 

Our future funding requirements will depend uponmany factors, including:

 

•                  the scope, rate of progress, results and costof our preclinical testing, clinical trials and other research and developmentactivities;

 

•                  the terms and timing of any collaborative,licensing and other arrangements that we may establish;

 

•                  the cost, timing and outcomes of regulatoryapprovals;

 

•                  the number and characteristics of productcandidates that we pursue;

 

•                  the cost and timing of establishing sales,marketing and distribution capabilities;

 

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

 

•                  the timing, receipt and amount of sales orroyalties generated, if any, from our product candidates; and

 

•                  the cost of preparing, filing, prosecuting,defending and enforcing any patent claims and other intellectual propertyrights.

 

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We will need to raise additional funds to supportour operations, and such funding may not be available to us on acceptableterms, or at all. If we are unable to raise additional funds when needed, wemay not be able to continue development of our product candidates or we couldbe required to delay, scale back or eliminate some or all of our research anddevelopment programs. We may seek to raise any necessary additional fundsthrough public or private equity, debt financings, collaborative arrangementswith corporate partners or other sources. If we raise additional funds throughthe issuance of debt securities, these securities could have rights that aresenior to the holders of our common stock and could contain covenants thatrestrict our operations. If we raise additional funds by issuing equitysecurities, dilution to our existing stockholders may result. In addition, ifwe raise additional funds through the sale of equity securities, new investorscould have rights superior to our existing stockholders. To the extent that weraise additional capital through licensing arrangements or arrangements withcollaborative partners, we may be required to relinquish, on terms that are notfavorable to us, rights to some of our technologies or product candidates thatwe would otherwise seek to develop or commercialize ourselves for a higherprofit margin. The terms of future financings may restrict our ability to raiseadditional capital, which could delay or prevent the further development of ourproduct candidates or commercialization of our products. Our failure to raisecapital when needed may harm our business and operating results.

 

**Contractual Obligations**

 

In February 2008, wefully utilized the additional $9.0 million loan facility pursuant to the termsof the loan agreementwith Lighthouse Capital Partners dated October 19,2007, as amended. The loan agreement, as amended, provides for a seven-monthinterest-only period and a 36 month repayment term which will begin on October 1,2008. 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 June 30,2008.

 

**Recent Accounting Pronouncements**

 

See Note 1 of the Notes to our CondensedConsolidated Financial Statements included elsewhere in this report for recentaccounting pronouncements that could have an effect on us.

 

**Off-Balance Sheet Arrangements**

 

Since inception, except for standard operatingleases, we have not engaged in any off-balance sheet arrangements, includingthe use of structured finance, special purpose entities or variable interestentities.

 

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

 

There were no material changes to our market riskfrom those disclosed in our annual report on Form 10-K filed with the SECon March 17, 2008.  As of June 30, 2008, $875,000 of auctionrate securities remained in our marketable securities portfolio. As of June 30,2008, those securities had limited market liquidity. While we believe that thelimited liquidity for these instruments is due to temporary market conditions,in light of current market conditions, we have revalued our estimate of fairvalue for the auction rate securities held in our portfolio. Based on thisrevaluation, we recorded $77,000 in unrealized losses as a component of othercomprehensive loss as of June 30, 2008, representing an 8.8% reduction tothe carrying value of our auction rate holdings.

 

**ITEM 4T. CONTROLS AND PROCEDURES**

 

***Changesin Internal Control over Financial Reporting***

 

No change was made in our internal control overfinancial reporting during the quarter ended June 30, 2008 that hasmaterially affected, or is reasonably likely to materially affect, our internalcontrol over financial reporting.

 

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**PART II — OTHERINFORMATION**

 

**ITEM 1. LEGAL PROCEEDINGS**

 

From time to time we are involved in legal proceedings arising in theordinary course of our business. We believe there is no litigation pending thatcould have, individually or in the aggregate, a material adverse effect on ourresults of operations or financial condition.

 

**ITEM 1A. RISK FACTORS**

 

*We have identified the followingrisks and uncertainties that may have a material adverse effect on ourbusiness, financial condition or results of operations. The risks describedbelow are not the only ones we face. Additional risks not presently known to usor that we currently believe are immaterial may also significantly impair ourbusiness operations. Our business could be harmed by any of these risks.**Thetrading price of our common stock could decline due to any of these risks, andour investors may lose all or part of their investment.**We have marked with anasterisk (*) those risks described below that reflect substantive changesfrom the risks 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.*

 

**RisksRelated to Our Business and Industry**

 

***We have incurred significantoperating losses since inception and expect to continue to incur substantialand increasing losses for the foreseeable future. We may never achieve orsustain profitability.****

 

Wehave a limited operating history and have incurred significant losses since ourinception. As of June 30, 2008, we had an accumulated deficit ofapproximately $144.1 million. We expect our research and developmentexpenses to continue to increase as we continue to expand our developmentprograms, and, subject to regulatory approval for any of our productcandidates, we expect to incur significant expenses associated with thepotential establishment of a North American specialty sales force and increasedmanufacturing expenses. Although it is not expected to occur in the nextseveral years, the cost of establishing a 100-person North American specialtysales force will be substantial. As a result, we expect to continue to incursubstantial and increasing losses for the foreseeable future. These losses havehad and will continue to have an adverse effect on our stockholders’ equity andworking 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 onour most advanced product candidates, which are still under development. If weare unable to bring any or all of these product candidates to market, orexperience significant delays in doing so, our ability to generate productrevenue and our likelihood of success will be harmed.****

 

Ourthree most advanced product candidates are in Phase 2 clinical trials anda fourth compound entered into Phase 1 clinical trial in April 2008. Ourability to generate product revenue in the future will depend heavily on thesuccessful development and commercialization of these product candidates. Ourother product candidates are in the discovery stage. Any of our productcandidates could be unsuccessful for a variety of reasons, including that they:

 

•                  do not demonstrate acceptable safety andefficacy in preclinical studies or clinical trials or otherwise do not meetapplicable regulatory standards for approval;

 

•                  do not offer therapeutic, safety or otherimprovements over existing or future drugs used to treat the same conditions;

 

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•                  are not capable of being produced incommercial quantities at acceptable costs; or

 

•                  are not accepted in the medical community andby third-party payors.

 

We do not expect any of our current productcandidates to be commercially available before 2012, if at all. If we areunable to make our product candidates commercially available, we will notgenerate product revenues and we will not be successful. The results of ourclinical trials to date do not provide assurance that acceptable efficacy orsafety will be shown upon completion of Phase 3 clinical trials.

 

***We expect todepend on collaborative arrangements to complete the development andcommercialization of each of our product candidates. Potential collaborativearrangements will likely place the development of our product candidatesoutside of our control and will likely require us to relinquish importantrights or may otherwise be on terms unfavorable to us.****

 

We plan to enter into collaborative arrangementswith third parties to develop and commercialize each of our lead productcandidates. Dependence on collaborative arrangements for development andcommercialization of our product candidates will subject us to a number ofrisks, including:

 

•                  we may not complete a collaborativearrangement in time to avoid delays in clinical development, if at all, and ifno collaborative arrangement is achieved, product development may be haltedaltogether;

 

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

 

•                  collaborators may delay clinical trials,provide insufficient funding for a clinical trial program, stop a clinicaltrial or abandon a product candidate, repeat or conduct new clinical trials orrequire a new formulation of a product candidate for clinical testing;

 

•                  we may have limited control over our clinicaltrial design;

 

•                  disputes may arise between us and ourcollaborators that result in the delay or termination of the research,development or commercialization of our product candidates or that result incostly litigation or arbitration that diverts management’s attention andresources;

 

•                  our collaborators may experience financialdifficulties;

 

•                  collaborators may not properly maintain ordefend our intellectual property rights or may use our proprietary informationin such a way as to invite litigation that could jeopardize or invalidate ourproprietary information or expose us to potential litigation;

 

•                  business combinations or significant changesin a collaborator’s business strategy may adversely affect a collaborator’swillingness or ability to fulfill its obligations under any arrangement;

 

•                  a collaborator could independently moveforward with a competing product candidate developed either independently or incollaboration with others, including our competitors; and

 

•                  any collaborative arrangement may be terminatedor allowed to expire, which would delay the development and may increase thecost of developing our product candidates.

 

***Collaborativearrangements do not currently exist for any of our product candidates. If we donot establish collaborations for each of our ATI-5923, ATI-2042, ATI-9242 andATI-7505  product candidates or futureproduct candidates, we may have to alter our development and commercializationplans.****

 

Our strategy includes selectively collaborating withleading pharmaceutical and biotechnology companies to assist us in furtheringthe development and potential commercialization of some of our productcandidates, including  ATI-5923,ATI-2042, ATI-9242 and ATI-7505. We intend to seek partners because thecommercialization of each of our first four product candidates involves alarge, primary care market that must be served by large sales and marketingorganizations and because we do not currently have the capabilities to performPhase 3 clinical trials. We face significant competition in seeking 

 

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appropriatecollaborators, and these collaborations are complex and time-consuming tonegotiate and document. We may not be able to negotiate collaborations onacceptable terms, if at all. We are unable to predict when, if ever, we willenter into any collaborations because of the numerous risks and uncertaintiesassociated with establishing collaborations. If we are unable to negotiate anacceptable collaboration, we may have to curtail the development of aparticular product candidate, reduce or delay its development program or one ormore of our other development programs, delay its potential commercializationor reduce the scope of our sales or marketing activities or increase ourexpenditures and undertake development or commercialization activities at ourown expense. If we elect to increase our expenditures to fund development orcommercialization activities on our own, we may need to obtain additionalcapital, which may not be available to us on acceptable terms, if at all. If wedo not have sufficient funds, we will not be able to bring our productcandidates to market and generate product revenues.

 

***The commercialsuccess of our potential collaborations will depend in part on the developmentand marketing efforts of our potential partners, over which we will havelimited control. If our collaborations are unsuccessful, our ability to developand commercialize and to generate future revenue from the sale of our productswill be significantly reduced.****

 

Our dependence on future collaboration arrangementswill subject our company to a number of risks. Our ability to develop andcommercialize each of our product candidates will depend on our and ourpotential collaboration partner(s)’ ability to establish the safety andefficacy of each respective product candidate, obtain and maintain regulatoryapprovals and achieve market acceptance of the product candidate(s) oncecommercialized. Our potential collaboration partner(s) may elect to delayor terminate development of our product candidates, independently developproducts that compete with ours, or fail to commit sufficient resources to themarketing and distribution of our product candidates. The termination of acollaboration agreement may cause us to incur additional and unanticipatedcosts that may be material to our operations.

 

Business combinations, significant changes inbusiness strategy, litigation and/or financial difficulties may also adverselyaffect the willingness or ability of our potential collaboration partners tofulfill their obligations to us. If a partner fails to perform in the manner weexpect, our potential to develop and commercialize the respective productcandidate(s) through other collaborations and to generate future revenuefrom the sale of the product candidate(s) may be significantly reduced. Ifa conflict of interest arises between us and our collaboration partner(s), theymay act in their own self-interest and not in the interest of our company orour stockholders. If a collaboration partner breaches or terminates theircollaboration agreement with us or otherwise fails to perform their obligationsthereunder in a timely manner, the clinical development or commercialization ofthe respective product candidate(s) could be delayed or terminated. Forexample, our collaboration with P&G on the development andcommercialization of ATI-7505 was terminated by P&G and we may experience asimilar result with collaboration partners in the future on any of our productcandidates.

 

***If we are notable to obtain required regulatory approvals, we will not be able tocommercialize our product candidates, our ability to generate revenue will bematerially impaired and our business will not be successful.****

 

Our product candidates and the activities associatedwith their development and commercialization are subject to comprehensiveregulation by the Food and Drug Administration, or FDA, and other federal andstate regulatory agencies in the United States and by comparable authorities inother countries. The inability to obtain FDA approval or approval fromcomparable authorities in other countries would prevent us and ourcollaborative partners from commercializing our product candidates in theUnited States or other countries. Future collaborative agreements will likelycause us to give up control of interactions with the FDA and other regulatorybodies. We or our partners may never receive regulatory approval for thecommercial sale of any of our product candidates. We have only limitedexperience in preparing and filing the applications necessary to gainregulatory approvals and have not received regulatory approval to market any ofour product candidates in any jurisdiction. The process of applying forregulatory approval is expensive, often takes many years and can varysubstantially based upon the type, complexity and novelty of the productcandidates involved.

 

Because our product candidates are modeled afterdrugs which are known to have safety problems, the FDA and other regulatoryagencies may require additional safety testing which may delay our clinicalprogress, increase our expected costs or make further development unfeasible. Forinstance, because of known problems with the drug after which it was modeled,we were required to conduct significant monitoring for cardiac toxicity in ourclinical studies of ATI-7505.

 

Changes in regulatory approval policies during thedevelopment period, changes in, or the enactment of, additional regulations orstatutes or changes in the regulatory review team for each submitted productapplication may cause delays in the approval or rejection of an application.Even if the FDA or a foreign regulatory agency approves a product candidate,the approval may impose significant restrictions on the indicated uses,conditions for use, labeling, advertising, promotion, marketing and/orproduction of such product and may impose requirements for post-approval studies,including additional research and development and clinical trials. The FDA andother agencies also may impose various civil or criminal 

 

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sanctions for failure to complywith regulatory requirements, including substantial monetary penalties andwithdrawal of product approval.

 

The FDA has substantial discretion in the approvalprocess and may refuse to accept any application or decide that our data areinsufficient for approval and require additional preclinical, clinical or otherstudies. For example, varying interpretations of the data obtained frompreclinical and clinical testing could delay, limit or prevent regulatoryapproval of a product candidate. Moreover, the FDA may not agree that certaintarget indications are approvable. For instance, the FDA has never approved adrug for postprandial distress syndrome, or PDS, and we cannot be certain thatthe FDA will recognize PDS as an indication for which ATI-7505 or other drugscan be approved. As another example, while we believe we have clear directionfrom the FDA as to the development path for ATI-5923 based on our initialdiscussions, the FDA may change their judgment on the appropriate developmentpathway for ATI-5923 at any time.

 

We will need to obtain regulatory approval fromauthorities in foreign countries to market our product candidates in thosecountries. We have not yet initiated the regulatory process in any foreignjurisdictions. Approval by one regulatory authority does not ensure approval byregulatory authorities in other jurisdictions. If we fail to obtain approvalsfrom foreign jurisdictions, the geographic market for our product candidateswould be limited.

 

***Safety issuesrelating to our product candidates or the original drugs upon which our productcandidates have been modeled, or relating to approved products of third partiesthat are similar to our product candidates, could give rise to delays in theregulatory approval process.****

 

Discovery of previously unknown problems with anapproved product may result in restrictions on its permissible uses, includingwithdrawal of the medicine from the market. Each of the opportunities upon whichwe have chosen to focus is based upon our belief that our RetroMetabolic DrugDesign technology can be used to create a new product based upon an existingproduct which is efficacious in treating a specific condition, but which has aknown safety problem. Each of our four lead product candidates is modeled ondrugs which have significant safety problems. ATI-5923 is modeled on warfarinwhich is known to have safety risks because of its potential for bleeding andfor drug-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. . In addition, ATI-2042 is partially metabolizedby CYP450 and, at high dose levels has caused drug-drug interactions withwarfarin which increased INR and could increase the risk of hemorrhagecomplications. ATI-9242 is modeled to retain certain of the positive featuresof the class of atypical antipsychotic drugs while lessening certain of thesafety issues that vary but exist within the class. The receptor profile whichyields the positive and avoids the negative features of this class of drugs isa matter of great debate. While we have designed ATI-9242 to have anappropriate balance across a very complex set of receptors, we may have targetedan inappropriate profile or the profile attained may result in an unanticipatedlack of efficacy or safety problems. ATI-7505 is modeled on cisapride which waswithdrawn from the market due to fatal cardiac problems. Although we havedesigned our drugs to largely address each of the original drugs’ key safetyproblems, we will need to continue to demonstrate this through continuedclinical testing. It is possible that the FDA may impose additionalrequirements on the development or approval of our products because of itsconcern about the original drug’s safety problems. These potential additionalbarriers could delay, increase the cost of, or prevent the commercialization ofour product candidates.

 

Our product candidates are engineered to be brokendown by the body’s natural metabolic processes in a manner we believe to besafer than that of the original drug. There can be no assurance that theproducts we develop will actually be metabolized as we expect. While we havedesigned the breakdown products to be safe, it is possible that there will beunexpected toxicity associated with these breakdown products that could causeour products to be poorly tolerated by, or toxic to, humans. Additionally,while we believe we have addressed the key safety problem of each of theoriginal drugs, it is possible that our change to the chemical structure mayresult in new unforeseen safety issues. Any unexpected toxicity or suboptimaltolerance of our products would delay or prevent commercialization of these productcandidates.

 

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 associated

 

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withZelnorm. Any failure or delay in commencing or completing clinical trials orobtaining regulatory approvals for our product candidates would delaycommercialization of our product candidates and severely harm our business andfinancial condition.

 

***We will needsubstantial additional funding and may be unable to raise capital when needed,which would force us to delay, reduce or eliminate our product developmentprograms or commercialization efforts.****

 

Our operations have consumed substantial amounts ofcash since inception. We expect to continue to spend substantial amounts ofcash to fund our operations, including research and development expenses andcosts associated with the conduct of clinical trials for our productcandidates. Net cash used in operating activities was $22.3 million and$13.3 million in the six months ended June 30, 2008 and 2007,respectively. We expect that our net cash used in operations may increasesignificantly in each of the next several years in order to support ouroperations and complete the development and commercialization of our productcandidates. We will need to raise additional capital to fund our operations andcomplete the development of our product candidates. It is our intention toenter into collaboration arrangements to commercialize our products. However,within those arrangements, we may retain the commercial right to co-promote ourproducts to selected physicians through a specialty sales force. If any of ourproduct candidates receive regulatory approval for commercial sale, we may needto raise additional capital to fund our portion of the commercializationefforts. Our future funding requirements will depend on many factors,including:

 

•                  the scope, rate of progress, results and costof our preclinical testing, clinical trials and other research and developmentactivities;

 

•                  the terms and timing of any collaborative,licensing and other arrangements that we may establish;

 

•                  the cost, timing and outcomes of regulatoryapprovals;

 

•                  the number and characteristics of productcandidates that we pursue;

 

•                  the cost and timing of establishing sales,marketing and distribution capabilities for our specialty sales force;

 

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

 

•                  the timing, receipt and amount of sales orroyalties, if any, from our potential products;

 

•                  the cost of preparing, filing, prosecuting,defending and enforcing any patent claims and other intellectual propertyrights; and

 

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

 

Until we can generate a sufficient amount of productrevenue, if we ever do, we expect to finance future cash needs through publicor private equity offerings, debt financings or corporate collaboration and licensingarrangements, as well as through interest income earned on cash balances.

 

If we raise additional funds by issuing equitysecurities, our stockholders will experience dilution. Any debt financing oradditional equity that we raise may contain terms that are not favorable to ourstockholders or us. If we raise additional funds through collaboration andlicensing arrangements with third parties, we may be required to relinquishsome rights to our technologies or our product candidates or grant licenses onterms that are not favorable to us.

 

We do not expect our existing capital resources tobe sufficient to enable us to fund the completion of the development of any ofour product candidates. We expect that our existing capital resourceswill enable us to maintain currently planned operations through the secondquarter of 2009. However, our operating plan may change, and we may needadditional funds sooner than planned to meet operational needs and capitalrequirements for product development and commercialization. 

 

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Additional funds may not be available when weneed them on terms that are acceptable to us, or at all. If adequate funds arenot available on a timely basis, we may:

 

•                  terminate or delay clinical trials for one ormore of our product candidates;

 

•                  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.

 

***Globalcredit and financial market conditions could negatively impact the value of ourcurrent portfolio of cash equivalents or short-term investments and our abilityto meet our financing objectives.***

 

Our cash and cashequivalents are maintained in highly liquid investments with remainingmaturities of 90 days or less at the time of purchase. Our investments inmarketable securities consist primarily of readily marketable debt securitieswith remaining maturities of more than 90 days at the time of purchase. Whileas of the date of this filing, we are not aware of any material losses, orother significant deterioration in the fair value of our cash equivalents orinvestments in marketable securities since June 30, 2008, no assurance canbe given that further deterioration in conditions of the global credit andfinancial markets would not negatively impact our current portfolio of cashequivalents or investments in marketable securities or our ability to meet ourfinancing objectives and incur required debt to fund our operations.

 

***Any failure ordelay in commencing or completing clinical trials for our product candidatescould severely harm our business.***

 

To date, we have not completed the clinical trialprogram of any product candidate. The commencement and completion of clinicaltrials for our product candidates may be delayed or terminated as a result ofmany factors, including:

 

•                  our inability or the inability of ourcollaborators or licensees to manufacture or obtain from third partiesmaterials sufficient for use in preclinical studies and clinical trials;

 

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

 

•                  difficulty in maintaining contact withpatients after treatment, resulting in incomplete data;

 

•                  poor effectiveness of product candidatesduring clinical trials;

 

•                  unforeseen safety issues or side effects; and

 

•                  governmental or regulatory delays and changesin regulatory requirements, policies and guidelines.

 

Any delay in commencing or completing clinicaltrials for our product candidates would delay commercialization of our productcandidates and severely harm our business and financial condition. It is alsopossible that none of our product candidates will complete clinical trials inany of the markets in which our collaborators or we intend to sell thoseproduct candidates. Accordingly, our collaborators or we would not receive theregulatory approvals needed to market our product candidates, which wouldseverely harm our business and financial condition.

 

***We rely on thirdparties to conduct our clinical trials. If these third parties do not performas contractually required or expected, we may not be able to obtain regulatoryapproval for or commercialize our product candidates.****

 

We do not have the ability to independently conductclinical trials for our product candidates, and thus for each of our productcandidates we must rely on third parties such as contract researchorganizations, medical institutions, clinical investigators and contractlaboratories, to conduct our clinical trials. We have, in the ordinary courseof business, entered into agreements with these third parties. To date, we haveutilized numerous vendors to provide clinical trial management, data collectionand analysis, laboratory and safety analysis services to us in the conduct ofour clinical trials. In addition, to date we have conducted our clinical trialsat numerous sites in North America and Europe. Nonetheless, we are responsible for confirming that each of our clinicaltrials is conducted in accordance with its general investigational plan andprotocol. Moreover, the FDA requires us to comply with regulations and standards,commonly referred to as good clinical practices, for conducting and recordingand reporting the results of clinical trials to assure that data and reportedresults are credible and accurate and that the trial participants areadequately protected. Our reliance on third parties that we do not control doesnot relieve us of these responsibilities and requirements. If these thirdparties do not successfully carry out their contractual 

 

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duties or regulatoryobligations or meet expected deadlines, if the third parties need to bereplaced or if the quality or accuracy of the data they obtain is compromisedowing to the failure to adhere to our clinical protocols or regulatoryrequirements or for other reasons, our clinical trials may be extended,delayed, suspended or terminated, and we may not be able to obtain regulatoryapproval for, or successfully commercialize, our product candidates.

 

***If some or all ofour patents expire, are invalidated or are unenforceable, or if some or all ofour patent applications do not yield issued patents or yield patents withnarrow claims, competitors may develop competing products using ourintellectual property and our business will suffer.****

 

Our success will depend in part on our ability toobtain and maintain patent and trade secret protection for our technologies andproduct candidates both in the United States and other countries. We rely oncomposition of matter patents for the compounds we develop. We cannot guaranteethat any patents will issue from any of our pending or future patentapplications. Alternatively, a third party may successfully circumvent ourpatents. Our rights under any issued patents may not provide us with sufficientprotection against competitive products or otherwise cover commerciallyvaluable products or processes.

 

The degree of future protection for our proprietarytechnologies and product candidates is uncertain because legal means affordonly limited protection and may not adequately protect our rights or permit usto gain or keep our competitive advantage. For example:

 

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

 

•                  we might not have been the first to filepatent applications for these inventions;

 

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

 

•                  it is possible that none of our pendingpatent applications will result in issued patents;

 

•                  any patents issued to us or our collaboratorsmay not provide a basis for commercially viable products or may be challengedby third parties;

 

•                  the patents of others may have an adverseeffect on our ability to do business; or

 

•                  regulators or courts may retroactivelydiminish the value of our intellectual property.

 

Even if valid and enforceable patents cover ourproduct candidates and technologies, the patents will provide protection onlyfor a limited amount of time. As our patents are based on a parent drug wheremuch research has been conducted, we may encounter many competitive patentsfrom covered analogs of the parent drug. Our know-how and trade secrets mayonly provide a competitive advantage for a short amount of time.

 

Our ability and our potential collaborators’ abilityto obtain patents is highly uncertain because, to date, some legal principlesremain unresolved, there has not been a consistent policy regarding the breadthor interpretation of claims allowed in patents in the United States and thespecific content of patents and patent applications that are necessary tosupport and interpret patent claims is highly uncertain due to the complexnature of the relevant legal, scientific and factual issues. Recentpatent-related decisions in the United States Federal Courts may makeprotection of patents in our industry even more difficult. Similarly, the U.S.Patent and Trademark Office, or USPTO, recently attempted to promulgate changesto patent rules that could have materially affected the ability ofcompanies in our industry to obtain patents. An April 1, 2008 decision bythe U.S. District Court for the Eastern District of Virginia set aside the newrules, but the USPTO has indicated that they intend to appeal the decision. TheUSPTO has further proposed rule changes that could be enacted at any time.While such rule changes may also be challenged, there is no guarantee of adecision that is favorable to patent holders’ rights.  In addition to the changes originating in thecourts and the USPTO, Congress has been debating the enactment of substantialchanges to U.S. patent law, which may make obtaining new patents moredifficult, diminish the value of our intellectual property or narrow the scopeof our patent protection. The patent reform bill has passed in the House (H.R.1908) but has not yet passed in the Senate (S. 1145). At present, it isuncertain whether S.1145 will be introduced or passed in the current session ofCongress.  It is also uncertain whetherthe bills will be reintroduced in future years if not passed this year. Theabove-described changes, as well as future changes, to either patent rules,patent laws or interpretations of patent laws in the United States and othercountries may diminish the value of our intellectual property or narrow thescope of our patent protection. Furthermore, the policies governingbiotechnology patents outside the United States are even more uncertain.

 

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Even if patents are issued regarding our productcandidates or methods of using them, those patents can be challenged by our competitorswho can argue such patents are invalid and/or unenforceable. Patents also maynot protect our product candidates if competitors devise ways of making theseor similar product candidates without legally infringing our patents. TheFederal Food, Drug and Cosmetic Act and FDA regulations and policies provideincentives to manufacturers to challenge patent validity or create modified,noninfringing versions of a drug in order to facilitate the approval of genericsubstitutes. These same types of incentives encourage manufacturers to submitnew drug applications that rely on literature and clinical data not preparedfor or by the drug sponsor.

 

As of June 30, 2008, we held 43 issued orallowed U.S. patents and had 16 patent applications pending before the U.S.Patent and Trademark Office, or USPTO. For some of our inventions,corresponding foreign patent protection is pending. Of the 43 U.S. patents thatwe hold, 39 patents are compound- and composition-related, having expirationdates from 2013 to 2025.  The compositionof matter patent for ATI-5923, our compound for anticoagulation, issued in August 2007and has an expiration date in 2025. Our composition of matter patent forATI-2042, our compound for the treatment of atrial fibrillation, issued in April 2002and has an expiration date in 2020. The composition of matter patent forATI-7505 for the treatment of gastrointestinal disorders issued in February 2007and has an expiration date in 2025. Although third parties may challenge ourrights to, or the scope or validity of, our patents, to date we have notreceived any communications from third parties challenging our patents orpatent applications covering our clinical candidates.

 

While ATI-5923, ATI-2042 and ATI-7505 are allcovered in the United States by issued composition of matter patents,additional patent applications would be required to extend patent protectionbeyond 2025, 2020 and 2025, respectively (assuming the validity andenforceability of the current composition of matter patents). We cannotguarantee that any patents will be issued from our pending or future patentapplications, and any patents that issue from such pending or future patentapplications would be subject to the same risks described herein for currentlyissued patents.

 

Our research and development collaborators may haverights to publish data and other information in which we have rights. Inaddition, we sometimes engage individuals or entities to conduct research thatmay be relevant to our business. The ability of these individuals or entitiesto publish or otherwise publicly disclose data and other information generatedduring the course of their research is subject to certain contractuallimitations. In most cases, these individuals or entities are, at the least,precluded from publicly disclosing our confidential information and are onlyallowed to disclose other data or information generated during the course ofthe research after we have been afforded an opportunity to consider whetherpatent and/or other proprietary protection should be sought. If we do not applyfor patent protection prior to such publication or if we cannot otherwisemaintain the confidentiality of our technology and other confidentialinformation, then our ability to receive patent protection or protect ourproprietary information may be jeopardized.

 

***Failure toadequately protect our trade secrets and other intellectual property couldsubstantially harm our business and results of operations.***

 

We also rely on trade secrets to protect ourtechnology, especially where we do not believe that patent protection isappropriate or obtainable. This is particularly true for our RetroMetabolicDrug Design technology. However, trade secrets are difficult to protect. Ouremployees, consultants, contractors, outside scientific collaborators and otheradvisors are required to sign confidential disclosure agreements but they mayunintentionally or willfully disclose our confidential information tocompetitors. Enforcing a claim that a third party illegally obtained and isusing our trade secrets is expensive and time-consuming, and the outcome isunpredictable. Failure to obtain or maintain trade secret protection couldadversely affect our competitive business position.

 

***Third-partyclaims of intellectual property infringement would require us to spendsignificant time and money and could prevent us from developing orcommercializing our products.***

 

Our commercial success depends in part on notinfringing the patents and proprietary rights of other parties and not breachingany licenses that we have entered into with regard to our technologies andproducts. Because others may have filed, and in the future are likely to file,patent applications covering products or other technologies of interest to usthat are similar or identical to ours, patent applications or issued patents ofothers may have priority over our patent applications or issued patents. Thereare numerous issued and applied for patents related to the original moleculesand analogs of such from which our products are engineered. If the patents aredetermined to be valid and construed to cover our products, the development andcommercialization of any or all could be affected. We do not believe that ouractivities infringe the patents of others or that the patents of others inhibitour freedom to operate. However, it is possible that others may choose tochallenge this position and that a judge or jury will disagree with ourconclusions, and we could incur substantial costs in litigation if we arerequired to defend against patent suits brought by third parties. Similarly, ifwe initiate suits to defend our 

 

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patents, such litigation couldbe costly and there is no assurance we would be successful in such processes.Any legal action against our collaborators or us claiming damages and seekingto enjoin commercial activities relating to the affected products and processescould, in addition to subjecting us to potential liability for damages, requireour collaborators or us to obtain a license to continue to manufacture ormarket the affected products and processes. Licenses required under any ofthese patents may not be available on commercially acceptable terms, if at all.Failure to obtain such licenses could materially and adversely affect ourability to develop, commercialize and sell our product candidates. We believethat there may continue to be significant litigation in the biotechnology andpharmaceutical industry regarding patent and other intellectual propertyrights. If we become involved in litigation, it could consume a substantialportion of our management and financial resources and we may not prevail in anysuch litigation.

 

Furthermore, our commercial success will depend, inpart, on our ability to continue to conduct research to identify additionalproduct candidates in current indications of interest or opportunities in otherindications. Some of these activities may involve the use of genes, geneproducts, screening technologies and other research tools that are covered bythird-party patents. Court decisions have indicated that the exemption frompatent infringement afforded by Title 35, Section 271(e)(1) of theUnited States Code does not encompass all research and development activitiesassociated with product development. In some instances, we may be required toobtain licenses to such third-party patents to conduct our research anddevelopment activities, including activities that may have already occurred. Itis not known whether any license required under any of these patents would bemade available on commercially acceptable terms, if at all. Failure to obtainsuch licenses could materially and adversely affect our ability to maintain apipeline of potential product candidates and to bring new products to market.If we are required to defend against patent suits brought by third partiesrelating to third-party patents that may be relevant to our researchactivities, or if we initiate such suits, we could incur substantial costs inlitigation. Moreover, an adverse result from any legal action in which we areinvolved could subject us to damages and/or prevent us from conducting some ofour research and development activities.

 

***If third partiesdo not manufacture our product candidates in sufficient quantities or at anacceptable cost, clinical development and commercialization of our productcandidates would be delayed. ****

 

We presently do not have sufficient quantities ofour product candidates to complete clinical trials of any of our lead productcandidates. We do not currently own or operate manufacturing facilities, and werely and expect to continue to rely on a small number of third-party manufacturersand active pharmaceutical ingredient formulators for the production of clinicaland commercial 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 productcandidates in a timely manner from these third parties could delay clinicaltrials and prevent us from developing and commercializing our product candidatesin a cost-effective manner or on a timely basis.

 

The starting materials for the production ofATI-5923 are provided by Synquest Labs, Inc. and Chem Uetikon, GmbH. Todate, the active pharmaceutical ingredient for ATI-5923 has been produced byChemShop BV of the Netherlands and Corum Inc. of Taiwan on an ongoingpurchase order basis. We have also transferred the ATI-5923 manufacturingprocesses to an additional vendor, Ampac Fine Chemicals, or Ampac, and arecurrently qualifying this vendor. Should ChemShop BV or Corum Inc.cease to serve as the supplier of ATI-5923 and our current vendor qualificationefforts fail, a delay in the development of ATI-5923 could occur, impairing ourability to commercialize ATI-5923 on our existing timeline. ATI-5923’s activepharmaceutical ingredient is processed into 1 milligram, 2 milligram, 5milligram or 10 milligram tablets by QS Pharma.

 

The starting materials for the production ofATI-2042 are provided by the following vendors: SCI Pharmtech, Inc.,Lexen Inc., Panchim, Julich GmbH and Weylchem Inc. To date,Ricerca, Biosciences, LLC, ScinoPharm Ltd. and SCI Pharmtech haveproduced all of ATI-2042’s active pharmaceutical ingredient. Historically, wehave relied on Ricerca and ScinoPharm as single-source suppliers for ATI-2042’sactive pharmaceutical ingredients. In the event that Ricerca,Biosciences, LLC, ScinoPharm Ltd. or SCI Pharmtech could not produceATI-2042, we would not be able to manufacture ATI-2042’s active pharmaceuticalingredient. This could delay the development of, and impair our ability to,commercialize ATI-2042. To produce ATI-2042 drug product, drug substance isprocessed into 50 milligram or 200 milligram capsule forms by Patheon Inc.

 

The starting materials for the production ofATI-9242 are provided by the following vendors: Corum Inc., Alfa Aesar,Apollo Scientific Ltd., and SKECHEM. To date, the active pharmaceuticalingredient for ATI-9242 has been produced exclusively by Corum Inc. inTaiwan. In the event that Corum Inc. could not produce ATI-9242, we wouldnot be able to manufacture ATI-9242’s active pharmaceutical ingredient. Thiscould delay the development of, and impair our ability to, 

 

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commercialize ATI-9242. Toproduce ATI-9242 drug product, drug substance is processed into20 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 of our current arrangements with third-partymanufacturers and suppliers for the production of our product candidates are ona purchase order basis.  We currently donot have long-term supply contracts with any of the third-party manufacturersand suppliers for our product candidates, and they are not required to supplyus with products for any specified periods, in any specified quantities or atany set price, except as may be specified in a particular purchase order. Wehave no reason to believe that any of the current manufacturers and suppliersfor our product candidates is the sole source for the materials they supply us.However, if we were to lose one of these vendors and were unable to obtain analternative source on a timely basis or on terms acceptable to us, our clinicaland production schedules could be delayed. In addition, to the extent that anyof these vendors uses technology or manufacturing processes that areproprietary, we may be unable to obtain comparable materials from alternativesources.

 

***If we arerequired to obtain alternate third-party manufacturers, it could delay orprevent the clinical development and commercialization of our productcandidates.***

 

We may not be able to maintain or renew our existingor any other third-party manufacturing arrangements on acceptable terms, if atall. If we are unable to continue relationships with our current suppliers, orto do so at acceptable costs, or if these suppliers fail to meet ourrequirements for these product candidates for any reason, we would be requiredto obtain alternative suppliers. Any inability to obtain qualified alternativesuppliers, including an inability to obtain or delay in obtaining approval ofan alternative supplier from the FDA, would delay or prevent the clinicaldevelopment and commercialization of these product candidates.

 

Changes in manufacturing site, process or scale cantrigger additional regulatory requirements that could delay our ability toperform certain clinical trials or obtain product approval.

 

The manufacturing and formulation of each of ourlead product candidates that have been tested in humans to date has beenperformed by entities other than those that will likely manufacture theproducts for future clinical trials or commercial use. There is a possibilitythat analysis of future clinical trials will show that the results from ourearlier clinical trials have not been replicated. The failure to replicatethese earlier clinical trials would delay our clinical development timelines.New impurity profiles that occur as a result of changing manufacturers may leadto delays in clinical trial testing and approvals.

 

***Use ofthird-party manufacturers may increase the risk that we will not have adequatesupplies of our product candidates.***

 

Our current and anticipated future reliance onthird-party manufacturers will expose us and our future collaborative partnersto risks that could delay or prevent the initiation or completion of ourclinical trials, the submission of applications for regulatory approvals, theapproval of our product by the FDA or the commercialization of our products mayresult in higher costs or lost product revenues. In particular, our contractmanufacturers could:

 

•                  encounterdifficulties in achieving volume production, quality control and qualityassurance or suffer shortages of qualified personnel, which could result intheir inability to manufacture sufficient quantities of drugs to meet ourclinical schedules or to commercialize our product candidates;

 

•                  terminate or choose not to renewmanufacturing agreements, based on their own business priorities, at a time thatis costly or inconvenient for us;

 

•                  fail to establish and follow FDA-mandatedcurrent good manufacturing practices, or cGMPs, which are required for FDAapproval of our product candidates, or fail to document their adherence tocGMPs, either of which could lead to significant delays in the availability ofmaterial for clinical studies and delay or prevent marketing approval for ourproduct candidates; and

 

•                  breach or fail to perform as agreed undermanufacturing agreements.

 

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If we are not able to obtain adequate supplies ofour product candidates, it will be more difficult for us to develop our productcandidates and compete effectively. Our product candidates and any productsthat we may develop may compete with other product candidates and products foraccess to manufacturing facilities.

 

In addition, Lexen, SCI Pharmtech, Scinopharm,Corum Inc. and ChemShop BV are located outside of the United States.This may give rise to difficulties in importing our product candidates or theircomponents into the United States as a result of, among other things, FDAimport inspections, incomplete or inaccurate import documentation, or defectivepackaging.

 

***If ourpreclinical studies do not produce successful results or our clinical trials donot demonstrate safety and efficacy in humans, we will not be able tocommercialize our product candidates.***

 

To obtain the requisite regulatory approvals tomarket and sell any of our product candidates, we must demonstrate, throughextensive preclinical studies and clinical trials, that the product candidateis safe and effective in humans. To date, we have not completed the clinical trialsof any product candidate. Preclinical and clinical testing is expensive, cantake many years and has an uncertain outcome. A failure of one or more of ourclinical trials could occur at any stage of testing. In addition, success inpreclinical testing and early clinical trials does not ensure that laterclinical trials will be successful, and interim results of a clinical trial donot necessarily predict final results. We may experience numerous unforeseenevents during, or as a result of, preclinical testing and the clinical trialprocess, which could delay or prevent our ability to commercialize our productcandidates, including:

 

•                  regulators or institutional review boards maynot authorize us to commence a clinical trial at a prospective trial site;

 

•                  our preclinical studies or clinical trialsmay produce negative or inconclusive results, which may require us to conductadditional preclinical or clinical testing or to abandon development projects;

 

•                  we may suspend or terminate our clinicaltrials if the participating patients are being exposed to unacceptable healthrisks;

 

•                  regulators or institutional review boards maysuspend or terminate clinical research for various reasons, includingnoncompliance with regulatory requirements;

 

•                  the effects of our product candidates may notbe the desired effects or may include undesirable side effects; and

 

•                  our preclinical studies or clinical trialsmay show that our product candidates are not superior to the original drugs onwhich our product candidates are modeled.

 

For instance, our preclinical studies and clinicaltrials may indicate that our product candidates cause unexpected drug-druginteractions and result in adverse events. As another example, more extensiveand robust clinical trials of ATI-5923 will be necessary in order todemonstrate clinical superiority to warfarin. Even if we adequately demonstratethat ATI-5923 is safe and effective and obtain FDA approval, we may not bepermitted to market it as superior to warfarin. In addition, ATI-2042’spreclinical studies contain results that are currently being monitored in theclinic. Inhibition of testicular function was observed in one animal species aspart of these studies. No such effect has been observed to date in the clinicand monitoring continues. In published studies, a similar effect is thought tobe correlated with the accumulation of amiodarone in tissues. A possible renaleffect was also observed at high doses in our rat and dog toxicology studiesfor ATI-2042. While we will continue to monitor patients for these effects,there is no assurance these effects will not occur in patients as part of ourongoing and planned clinical trials for ATI-2042, and have a resulting adverseeffect on our ability to obtain requisite regulatory approval to market andsell ATI-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.

 

Even when our product candidates do not cause anyadverse effects, clinical studies of efficacy may show that our productcandidates do not have significant effects on target symptoms or may beinconclusive. For example, ATI-7505 was tested in two Phase 2 clinicaltrials in which the primary endpoints were not met in comparison to placebo.Although these studies did support ATI-7505’s efficacy against certain symptomsas secondary endpoints, if future studies show that ATI-7505 is notsufficiently efficacious to justify its use as a therapy, our business andprospects may be materially adversely affected.

 

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Unforeseen events could cause us to experiencesignificant delays in, or the termination of, clinical trials. Any such eventswould increase our costs and could delay or prevent our ability tocommercialize our product candidates, which would adversely impact ourfinancial results.

 

***We may not besuccessful in our efforts to identify or discover additional candidates usingour RetroMetabolic Drug Design Technology. ****

 

An important element of our strategy is to continueto identify existing molecules which have demonstrated efficacy, but havesafety problems that are amenable to our RetroMetabolic Drug Design technology.Other than ATI-5923, ATI-2042, ATI-9242 and ATI-7505, all of our programs arein the preclinical or discovery stage. Research programs to identify newproduct candidates require substantial technical, financial and humanresources. These programs may initially show promise in identifying potential productcandidates, yet fail to yield product candidates for clinical development for anumber of reasons, including:

 

•                  the research methodology used may not besuccessful in identifying potential product candidates; or

 

•                  potential product candidates may, on furtherstudy, be found not to retain the efficacy profile of the original molecule orbe shown to retain harmful side effects or other characteristics suggestingthat they are unlikely to be effective products. For instance, at high dosesour ATI-2042 product candidate interacts with warfarin and causes prolonged INRwhich could increase the risk of hemorrhage complications.

 

If we are unable to develop suitable productcandidates through internal research programs or otherwise, we may not be ableto increase our revenues in future periods, which could result in significantharm to our financial position and adversely impact our stock price.

 

***Our productcandidates will remain subject to ongoing regulatory review even if theyreceive marketing approval. If we fail to comply with continuing regulations,we could lose these approvals and the sale of our products could be suspended.***

 

Even if we receive regulatory approval to market aparticular product candidate, the approval could be conditioned on our conductingadditional costly post-approval studies or could limit the indicated usesincluded in our labeling. Moreover, the product may later cause adverse effectsthat limit or prevent its widespread use, force us to withdraw it from themarket or impede or delay our ability to obtain regulatory approvals inadditional countries. In addition, the manufacturer of the product and itsfacilities will continue to be subject to FDA review and periodic inspectionsto ensure adherence to applicable GMPA regulations. After receiving marketingapproval, the manufacturing, labeling, packaging, adverse event reporting,storage, advertising, promotion and record keeping related to the product willremain subject to extensive regulatory requirements.

 

If we fail to comply with the regulatoryrequirements of the FDA and other applicable U.S. and foreign regulatoryauthorities or previously unknown problems with our products, manufacturers ormanufacturing processes are discovered, we could be subject to administrativeor judicially imposed sanctions, including:

 

•                  restrictions on the products, manufacturersor manufacturing processes;

 

•                  warning letters;

 

•                  civil or criminal penalties or fines;

 

•                  injunctions;

 

•                  product seizures, detentions or import bans;

 

•                  voluntary or mandatory product recalls andpublicity requirements;

 

•                  suspension or withdrawal of regulatoryapprovals;

 

•                  total or partial suspension of production;and

 

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•                  refusal to approve pending applications formarketing approval of new drugs or supplements to approved applications.

 

***Because we have anumber of product candidates and are considering a variety of target indications,we may expend our limited resources to pursue a particular candidate orindication and fail to capitalize on candidates or indications that may be moreprofitable or for which there is a greater likelihood of success.***

 

Because we have limited financial and managerialresources, we must focus on research programs and product candidates for thespecific opportunities that we believe are the most amenable to ourRetroMetabolic Drug Design and are the most commercially promising. As aresult, we may forego or delay pursuit of opportunities with other productcandidates or other indications that later prove to have greater commercialpotential. Our resource allocation decisions may cause us to fail to capitalizeon viable commercial products or profitable market opportunities. In addition,we may spend valuable time and managerial and financial resources on researchprograms and product candidates for specific indications that ultimately do notyield any commercially viable products. If we do not accurately evaluate thetechnical feasibility and the commercial potential or target market for aparticular product candidate, we may relinquish valuable rights to that productcandidate through collaboration, licensing or other royalty arrangements insituations where it would have been more advantageous for us to retain solerights to development and commercialization.

 

***The commercialsuccess of any products that we may develop will depend upon the degree ofmarket acceptance among physicians, patients, healthcare payors and the medicalcommunity.***

 

Any products that we may develop may not gain marketacceptance among physicians, patients, healthcare payors and the medicalcommunity. If these products do not achieve an adequate level of acceptance, wemay not generate material product revenues and we may not become profitable.The degree of market acceptance of any of our product candidates, if approvedfor commercial sale, will depend on a number of factors, including:

 

•                  demonstration of efficacy and safety inclinical trials;

 

•                  demonstration that we have adequatelyaddressed the specific safety problem of the original molecule;

 

•                  the prevalence and severity of any sideeffects;

 

•                  potential or perceived advantages overalternative treatments;

 

•                  perceptions about the relationship orsimilarity between our product candidates and the original drug upon which eachRetroMetabolic Drug Design candidate was based;

 

•                  advantage over other drugs may not besufficiently great enough to obtain premium pricing;

 

•                  the timing of market entry relative tocompetitive treatments;

 

•                  the ability to offer our product candidatesfor sale at competitive prices;

 

•                  relative convenience and ease ofadministration;

 

•                  the strength of marketing and distributionsupport;

 

•                  sufficient third-party coverage orreimbursement; and

 

•                  the product labeling or product insertrequired by the FDA or regulatory authorities in other countries.

 

***If we are unableto establish sales and marketing capabilities or enter into agreements withthird parties to market and sell our product candidates, we may be unable togenerate product revenue.****

 

We do not have a sales and marketing organizationand have no experience in the sales, marketing and distribution ofpharmaceutical products. It is our intention to use collaborative arrangementsto gain access to large sales and marketing organizations in order tocommercialize our product candidates. Additionally, in the event we enter intoany collaboration arrangements for any of our product candidates, we may retainthe right to co-promote the sales of any ultimate product(s) by 

 

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establishing a small specialtysales force to market such product(s) to specific physician groups. Thereare risks involved with establishing our own sales and marketing capabilitiesand entering 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 may decide to establish our own specialty salesforce and engage pharmaceutical or other healthcare companies with an existingsales and marketing organization and distribution system to sell, market anddistribute our products. We may not be able to establish these sales anddistribution relationships on acceptable terms, or at all. Factors that mayinhibit our efforts to commercialize our products without collaborators orlicensees include:

 

•                  our inability to convince future corporatepartners to allow us to retain commercialization rights for specific physiciangroups;

 

•                  our inability to obtain financing toestablish the specialty sales force;

 

•                  our inability to recruit and retain adequatenumbers of effective sales and marketing personnel;

 

•                  the inability of sales personnel to obtainaccess to or persuade adequate numbers of physicians to prescribe our products;

 

•                  the lack of complementary products to beoffered by sales personnel, which may put us at a competitive disadvantagerelative to companies with more extensive product lines; and

 

•                  unforeseen costs and expenses associated withcreating an independent sales and marketing organization.

 

Because the establishment of sales and marketingcapabilities depends on the progress toward commercialization of our productcandidates and because of the numerous risks and uncertainties involved withestablishing our own sales and marketing capabilities, we are unable to predictwhen we will establish our own sales and marketing capabilities. If we are notable to partner with a third party and are not successful in recruiting salesand marketing personnel or in building a sales and marketing infrastructure, wewill have difficulty commercializing our product candidates, which wouldadversely affect our business and financial condition.

 

***Our ability togenerate revenue from any products that we may develop will depend onreimbursement and drug pricing policies and regulations. ****

 

Many patients may be unable to pay for any productsthat we may develop. In the United States, many patients will rely on Medicare,Medicaid, private health insurers and other third-party payors to pay for theirmedical needs. Our ability to achieve acceptable levels of reimbursement fordrug treatments by governmental authorities, private health insurers and otherorganizations will have an effect on our ability to successfully commercialize,and attract collaborative partners to invest in the development of, our productcandidates. We cannot be sure that reimbursement in the United States, Europeor elsewhere will be available for any products that we may develop, and anyreimbursement that may become available may be decreased or eliminated in thefuture. Third-party payors increasingly are challenging prices charged formedical products and services, and many third-party payors may refuse toprovide reimbursement 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 the original drugs from whichthey are modeled to be considered unique and not subject to substitution by ageneric 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.

 

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The trend toward managed healthcare in the UnitedStates and the changes in health insurance programs, as well as legislativeproposals to reform healthcare or reduce government insurance programs, mayresult in lower prices for pharmaceutical products, including any products thatmay be offered by us. In addition, any future regulatory changes regarding thehealthcare industry or third-party coverage and reimbursement may affect demandfor any products that we may develop and could harm our sales andprofitability.

 

***If ourcompetitors are able to develop and market products that are more effective,safer or less costly than any products that we may develop, our commercialopportunity will be reduced or eliminated. ****

 

We face competition from established pharmaceuticaland biotechnology companies, as well as from academic institutions, governmentagencies and private and public research institutions. Our commercialopportunity will be reduced or eliminated if our competitors develop andcommercialize products that are safer, more effective, have fewer side effectsor are less expensive than any products that we may develop. In addition,significant delays in the development of our product candidates could allow ourcompetitors to bring products to market before us and impair our ability tocommercialize our product candidates.

 

Competition for ATI-5923 for use as an oralanticoagulant will continue to come from generic coumadin owing to its pricingand the years of experience physicians and patients have with the drug. Otheroral anticoagulants are in development throughout the pharmaceutical andbiotechnology industry. Most of these development programs fall into either thefactor Xa or direct thrombin inhibitor categories. We are aware that Johnson &Johnson in collaboration with Bayer AG, Bristol-Myers Squibb Company incollaboration with Pfizer, Inc., Eli Lilly and Company and PortolaPharmaceuticals, Inc. each have factor Xa programs in Phase 2 orPhase 3 testing. We are aware of a direct thrombin inhibitor program atBoehringer-Ingelheim GmbH. The first direct thrombin inhibitor presentedto the FDA for approval, ximelagatran, previously marketed as Exanta byAstraZeneca plc, has not been recommended for approval due toidiosyncratic liver toxicity problems. Although we believe ATI-5923’s mechanismof action (VKOR inhibition as with warfarin) and broadly available inexpensivemonitoring methodology (INR) provide an advantage, these factor Xa and directthrombin inhibitor programs will likely provide major competition in thismarket. In addition, there may be other compounds of which we are not awarethat are at an earlier stage of development and may compete with our productcandidates. If any of those compounds are successfully developed and approved,they could compete directly with our product candidates.

 

We believe generic amiodarone will continue toprovide competition to ATI-2042 for the treatment of atrial fibrillation, eventhough it is not labeled for use in atrial fibrillation. Amiodarone willcontinue to be used off-label in spite of its safety problems because of itsgeneric pricing. Other treatments for atrial fibrillation, such as sotalol,marketed by Bayer HealthCare Pharmaceuticals, Inc., flecainide marketed by3M Company and propafenone, marketed by Reliant Pharmaceuticals, Inc., donot have equivalent efficacy to amiodarone, but will continue to compete in theatrial fibrillation marketplace. Cardiome Pharma Corp. is in Phase 2testing with an oral product, vernakalant, for the treatment of atrialfibrillation which they hope will have efficacy equal to or better than flecainideor sotalol, but with reduced pro-arrhythmic effects. There are other companiesdeveloping devices or procedures to treat atrial fibrillation through ablation,including CryoCor, Inc. and CryoCath Technologies, Inc.

 

Competition for ATI-9242 will likely come from thefive largest selling atypical antipsychotics: Risperdal by JanssenPharmaceutica, Seroquel by AstraZeneca Pharmaceuticals LP, Zyprexa by Eli Lillyand Company, Abilify by Bristol-Myers Squibb/Otsuka America Pharmaceutical, Inc.,and Geodon by Pfizer Inc., which sold a collective $15.7 billion in 2007. It islikely that virtually all of these would be sold as generic versions by thetime ATI-9242 could come to market. Other antipsychotics are in developmentwhich may also be competitive to ATI-9242.

 

ATI-7505 has potential use in five indications:chronic constipation, functional dyspepsia, GERD, gastroparesis and IBS withconstipation. Some of these indications may not be recognized by the FDA assufficiently defined to enable regulatory approval of a drug for treatment.ATI-7505 is a prokinetic which has been shown to increase motility in the upperand lower gastrointestinal tract, including the ability to improve gastricemptying and colonic motility. Products which affect the gastrointestinalsystem’s motility could be useful in the treatment of each of these disorders.Other prokinetics are on the market or in development which will also becompetitive to ATI-7505, including tegaserod, marketed by NovartisPharmaceuticals Corporation as Zelnorm, which was temporarily withdrawn fromthe market and recently re-introduced with restrictive use labeling, TD-5108being developed by Theravance, and erythromycin. Many additional prokineticsare in development targeting these indications. We believe the most significantcompetition to ATI-7505 for the treatment of GERD is proton pump inhibitors andH2 blockers, which are currently on the market in both prescriptionformulations and strengths as well as in over-the-counter forms. Many majorpharmaceutical companies currently market proton pump inhibitors and H2blockers generating worldwide sales of over $17.0 billion in 2006.ATI-7505 is targeted at the approximately 20-25% of GERD patients who do notreceive adequate relief from proton pump inhibitors, which reduce the creationof acid in the 

 

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stomach. ATI-7505 will facecompetition from the prokinetics as well as many inexpensive over-the-counterindications for the treatment of these gastrointestinal disorders.

 

Many of our competitors have significantly greaterfinancial resources and expertise in research and development, manufacturing,preclinical testing, conducting clinical trials, obtaining regulatory approvalsand marketing approved products than we do. Established pharmaceuticalcompanies may invest heavily to quickly discover and develop novel compoundsthat could make our product candidates obsolete. Smaller or early-stagecompanies may also prove to be significant competitors, particularly throughcollaborative arrangements with large and established companies. In addition,these third parties compete with us in recruiting and retaining qualified scientificand management personnel, establishing clinical trial sites and patientregistration for clinical trials, as well as in acquiring technologies andtechnology licenses complementary to our programs or advantageous to ourbusiness. Accordingly, our competitors may succeed in obtaining patentprotection, receiving FDA approval or discovering, developing andcommercializing medicines before we do. We are also aware of other companiesthat may currently be engaged in the discovery of medicines that will competewith the product candidates that we are developing. In addition, in the marketsthat we are targeting, we expect to compete against current market-leadingmedicines. If we are not able to compete effectively against our current andfuture competitors, our business will not grow and our financial condition willsuffer.

 

***If we fail toattract and keep senior management and key scientific personnel, we may beunable to successfully develop or commercialize our product candidates.***

 

Our success depends on our continued ability toattract, retain and motivate highly qualified management, clinical andscientific personnel and on our ability to develop and maintain importantrelationships with leading clinicians. If we are not able to retain Dr. Goddard,our Chairman and Chief Executive Officer, Dr. Milner, our President,Research and Development, Dr. Canafax, our Vice President and ChiefDevelopment Officer, and Dr. Druzgala, our Senior Vice President and ChiefScientific Officer, we may not be able to successfully develop or commercializeour product candidates. Competition for experienced scientists may limit ourability to hire and retain highly qualified personnel on acceptable terms. Inaddition, none of our employees have employment commitments for any fixedperiod of time and could leave our employment at will. We carry “key person”insurance in the amount of $1 million for each of Drs. Milner andDruzgala, but do not carry “key person” insurance covering any other members ofsenior management or key scientific personnel. If we fail to identify, attractand retain qualified personnel, we may be unable to continue our developmentand commercialization activities.

 

***We will need tohire additional employees in order to commercialize our product candidates. Anyinability to manage future growth could harm our ability to commercialize ourproduct candidates, increase our costs and adversely impact our ability tocompete effectively.****

 

In order to commercialize our product candidates, wewill need to expand the number of our managerial, operational, financial andother employees.  Because the projectedtime frame for hiring these additional employees depends on the developmentstatus of our product candidates and because of the numerous risks anduncertainties associated with drug development, we are unable to project whenwe will hire these additional employees. While to date we have not experienceddifficulties in recruiting, hiring and retaining qualified individuals, thecompetition for qualified personnel in the pharmaceutical and biotechnologyfield is intense.

 

Future growth will impose significant addedresponsibilities on members of management, including the need to identify,recruit, maintain and integrate additional employees. Our future financial performanceand our ability to commercialize our product candidates and compete effectivelywill depend, in part, on our ability to manage any future growth effectively.

 

***If productliability lawsuits are brought against us, we will incur substantial liabilitiesand may be required to limit commercialization of any products that we maydevelop. ****

 

We face an inherent risk of product liabilityexposure related to the testing of our product candidates in human clinicaltrials and will face an even greater risk if we commercially sell any productsthat we may develop. If we cannot successfully defend ourselves against claimsthat our product candidates or products that we may develop caused injuries, wewill incur substantial liabilities. Regardless of merit or eventual outcome,liability claims may result in:

 

•                  decreased demand for any product candidatesor products that we may develop;

 

•                  injury to our reputation;

 

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•                  withdrawal of clinical trial participants;

 

•                  costs to defend the related litigation;

 

•                  substantial monetary awards to clinical trialparticipants or patients;

 

•                  loss of revenue; and

 

•                  the inability to commercialize any productsthat we may develop.

 

We have product liability insurance that covers our clinical trials upto an aggregate $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 usebiological and hazardous materials in a manner that causes contamination,injury or violates laws, we may be liable for damages.***

 

Our research and development activities involve theuse of potentially harmful biological materials as well as hazardous materials,chemicals and various radioactive compounds. We cannot completely eliminate therisk of accidental contamination or injury from the use, storage, handling ordisposal of these materials. In the event of contamination or injury, we couldbe held liable for damages that result, and any liability could exceed ourresources. We, the third parties that conduct clinical trials on our behalf andthe third parties that manufacture our product candidates are subject tofederal, state and local laws and regulations governing the use, storage,handling and disposal of these materials and waste products. The cost ofcompliance with these laws and regulations could be significant. The failure tocomply with these laws and regulations could result in significant fines andwork stoppages and may harm our business.

 

Our principal facility is located in California’sSilicon Valley, in an area with a long history of industrial activity and useof hazardous substances, including chlorinated solvents. Certain environmentallaws, including the U.S. Comprehensive, Environmental Response, Compensationand Liability Act of 1980, impose strict, joint and several liabilities oncurrent operators of real property for the cost of removal or remediation ofhazardous substances. These laws often impose liability even if the owner oroperator did not know of, or was not responsible for, the release of suchhazardous substances. As a result, while we have not been notified of any claimagainst us, we are not aware of any such release, nor have we been held liablefor costs to address contamination at the property beneath our facility in thepast, we cannot rule out the possibility that this may occur in thefuture. We do not carry specific insurance against such a claim.

 

***We will need toimplement additional finance and accounting systems, procedures and controls inthe future as we grow our business and organization and to satisfy newreporting requirements.****

 

As a public reporting company, we need to complywith the Sarbanes-Oxley Act of 2002 and the related rules and regulationsof the Securities and Exchange Commission, including expanded disclosures andaccelerated reporting requirements and more complex accounting rules. Compliancewith Section 404 of the Sarbanes-Oxley Act of 2002 and other requirementswill increase our costs and require additional management resources. We arecontinuing to upgrade our finance and accounting systems, procedures andcontrols and may need to continue to implement additional finance andaccounting systems, procedures and controls as we grow our business andorganization and to satisfy new reporting requirements. Compliance with Section 404will first apply to our annual report on Form 10-K for our year ending December 31,2008. If we are unable to complete the required assessment as to the adequacyof our internal control over financial reporting as of December 31, 2008,or if our independent registered public accounting firm is unable to provide uswith an unqualified report as to the effectiveness of our internal controlsover financial reporting as of December 31, 2009, investors could loseconfidence in the reliability of our internal controls over financialreporting, which could adversely affect our stock price and our ability toraise capital.

 

***Our principalfacility is located near known earthquake fault zones, and the occurrence of anearthquake, extremist attack or other catastrophic disaster could cause damageto our facilities and equipment, which could require us to cease or curtailoperations.***

 

Our principal facility is located in California’sSilicon Valley near known earthquake fault zones and, therefore, is vulnerableto damage from earthquakes. In October 1989, a major earthquake struckthis area and caused significant property 

 

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damage and a number offatalities. We are also vulnerable to damage from other types of disasters,including power loss, attacks from extremist organizations, fire, floods andsimilar events. If any disaster were to occur, our ability to operate ourbusiness could be seriously impaired. In addition, the unique nature of ourresearch activities and of much of our equipment could make it difficult for usto recover from this type of disaster. We currently may not have adequateinsurance to cover our losses resulting from disasters or other similarsignificant business interruptions, and we do not currently plan to purchaseadditional insurance to cover such losses because of the cost of obtaining suchcoverage. Any significant losses that are not recoverable under our insurancepolicies could seriously impair our business and financial condition. Ourcurrent insurance does not specifically cover property loss or businessinterruption due to earthquake damage.

 

**RisksRelating to Ownership of Our Common Stock**

 

***Our stock pricemay be extremely volatile, and your investment in our common stock could suffera decline in value.****

 

You should consider an investment in our commonstock risky and invest only if you can withstand a significant loss and widefluctuations in the market value of your investment. Investors who purchase ourcommon stock may not be able to sell their shares at or above the purchaseprice. Security market prices for securities of biopharmaceutical companieshave been highly volatile. In addition, the volatility of biopharmaceuticalcompany stocks often does not correlate to the operating performance of thecompanies represented by such stocks. Some of the factors that may cause themarket price of our common stock to fluctuate include:

 

•                  adverse results or delays in our clinicaltrials;

 

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

 

•                  announcement of FDA approval or nonapprovalof our product candidates or delays in the FDA review process;

 

•                  actions taken by regulatory agencies withrespect to our product candidates, our clinical trials or our sales and marketingactivities;

 

•                  the commercial success of any productapproved by the FDA or its foreign counterparts;

 

•                  regulatory developments in the United Statesand foreign countries;

 

•                  changes in the structure of healthcarepayment systems;

 

•                  any intellectual property infringementlawsuit involving us;

 

•                  announcements of technological innovations ornew products by us or our competitors;

 

•                  market conditions for the biotechnology orpharmaceutical industries in general;

 

•                  changes in financial estimates or recommendationsby securities analysts;

 

•                  sales of large blocks of our common stock;

 

•                  sales of our common stock by our executiveofficers, directors and significant stockholders;

 

•                  restatements of our financial results and/ormaterial weaknesses in our internal controls; and

 

•                  the loss of any of our key scientific ormanagement personnel.

 

The stock markets in general, and the markets forbiotechnology stocks in particular, have experienced extreme volatility andprice and volume fluctuations that have often been unrelated ordisproportionate to the operating performance of particular companies. Thesebroad market and industry factors may seriously harm the market price of ourcommon stock, regardless of our operating performance. In the past, classaction litigation has often been instituted against companies whose securitieshave experienced periods of volatility in market price. Any such litigationbrought against us could result in substantial costs, which would hurt ourfinancial condition and results of operations, divert management’s attentionand resources, and possibly delay our clinical trials or commercializationefforts.

 

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***Fluctuations inour operating results could cause our stock price to decline.***

 

The following factors are likely to result influctuations of our operating results from quarter to quarter and year to year:

 

•                  adverse results or delays in our clinicaltrials;

 

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

 

•                  announcement of FDA approval or nonapprovalof our product candidates or delays in the FDA review process;

 

•                  actions taken by regulatory agencies withrespect to our product candidates, our clinical trials or our sales andmarketing activities;

 

•                  the commercial success of any productapproved by the FDA or its foreign counterparts;

 

•                  regulatory developments in the United Statesand foreign countries;

 

•                  changes in the structure of healthcarepayment systems;

 

•                  any intellectual property infringementlawsuit involving us; and

 

•                  announcements of technological innovations ornew products by us or our competitors.

 

Because of these potential fluctuations in ouroperating results, a period-to-period comparison of our results of operationsmay not be a good indication of our future performance. In any particularfinancial period the actual or anticipated fluctuations could be below theexpectations of securities analysts or investors and our stock price coulddecline.

 

***Because a small number ofexisting stockholders own a large percentage of our voting stock, they may beable to control our management and operations, acting in their best interestsand not necessarily those of other stockholders. ****

 

Based on our outstanding shares as of February 29,2008, our executive officers, directors and holders of 5.0% or more of ouroutstanding common stock beneficially own approximately 55.0% of our commonstock. As a result, these stockholders, acting together, will be able tocontrol all matters requiring approval by our stockholders, including theelection of directors and the approval of mergers or other business combinationtransactions. The interests of this group of stockholders may not always coincidewith our interests or the interests of other stockholders.

 

***Anti-takeoverprovisions in our charter documents and under Delaware law could make anacquisition of us, which may be beneficial to our stockholders, more difficultand may prevent attempts by our stockholders to replace or remove our currentmanagement.***

 

Provisions in our certificate of incorporation andour bylaws may delay or prevent an acquisition of us, a change in ourmanagement or other changes that stockholders may consider favorable. Theseprovisions include:

 

•                  a classified board of directors;

 

•                  a prohibition on actions by our stockholdersby written consent;

 

•                  the ability of our board of directors toissue preferred stock without stockholder approval, which could be used to adopta stockholders’ rights plan that would make it difficult for a third party toacquire us;

 

•                  notice requirements for nominations forelection to the board of directors; and

 

•                  limitations on the removal of directors.

 

Moreover, we are governed by the provisions of Section 203of the Delaware General Corporation Law, which prohibits a person who owns inexcess of 15% of our outstanding voting stock from merging or combining with usfor a period of three years after the date of the transaction in which theperson acquired in excess of 15% of our outstanding voting stock, unless themerger or combination is approved in a prescribed manner.

 

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***Future sales ofour common stock in the public market could cause our stock price to dropsubstantially.****

 

Sales of a substantial number of shares of ourcommon stock in the public market, or the perception that these sales might occur,could depress the market price of our common stock and could impair our abilityto raise capital through the sale of additional equity securities.

 

As of June 30, 2008, we had 17,680,991 sharesof common stock outstanding. The five million shares of common stock sold inour initial public offering are freely tradable without restriction in thepublic market unless held by an affiliate of ours. The remaining 12,680,991shares of common stock outstanding as of June 30, 2008 are now eligiblefor sale in the public market, subject in some cases to the volumelimitations and manner of sale requirements under Rule 144. Any commonstock that is either subject tooutstanding options or warrants or reserved for future issuance under our 2001Equity Incentive Plan, 2007 Equity Incentive Plan, 2007 Non-Employee Directors’Stock Option Plan and 2007 Employee Stock Purchase Plan could also becomeeligible for sale in the public market to the extent permitted by theprovisions of various vesting agreements, and Rules 144 and 701 under theSecurities Act. If these additional shares are sold, or if it is perceived thatthey will be sold, in the public market, the trading price of our common stockcould decline.

 

As of June 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,cause a large number of securities to be registered and sold in the publicmarket, these sales could have an adverse effect on the market price for ourcommon stock. If we were to initiate a registration and include shares heldby these holders pursuant to the exercise of their registration rights, thesesales may impair our ability to raise capital. In addition, we filed aregistration statement on Form S-8 under the Securities Act of 1933, asamended, to register up to 2,638,845 shares of our common stock for issuanceunder our stock option and employee stock purchase plans, and intend to fileadditional registration statements on Form S-8 to register the sharesautomatically added each year to the share reserves under 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**

 

OnMay 28, 2008, our Annual Meeting of Stockholders was held at our corporateoffices in Fremont, California. Of the 17,665,133 shares of our common stockentitled to vote at the meeting, 14,200,611 shares were represented at themeeting in person or by proxy, constituting a quorum. At this meeting, ourstockholders voted on the following two proposals:

 

(i)         Proposal to elect three directors to hold office until the 2011 AnnualMeeting of Stockholders:

 
| **Name**              | ** ** | **Shares Voted For** | ** ** | **Votes Withheld** | ** ** |
|-----------------------|------------|--------------------------------|------------|-------------------------|------------|
| Robert Adelman, M.D.  |       | 14,182,349                     |       | 18,262                  |       |
| Peter G. Milner, M.D. |       | 14,170,403                     |       | 30,208                  |       |
| Nicholas Simon        |       | 14,177,847                     |       | 22,764                  |       |

 

OurClass II directors, Lars Ekman, M.D., Ph.D., Keith R. Leonard and PaulSekhri, will each continue to serve on our Board of Directors until our 2009Annual Meeting of Stockholders and until their respective successor is electedand qualified or such director’s earlier death, resignation or removal.  Our Class III directors, Paul Goddard,Ph.D. and Herm Rosenman, will each continue to serve on our Board of Directorsuntil our 2010 Annual Meeting of Stockholders and until their respectivesuccessor is elected and qualified or such director’s earlier death,resignation or removal.

 

(ii)  Proposal to ratify the selection by the AuditCommittee of our Board of Directors of Ernst & Young LLP as ourindependent registered public accounting firm for the year ending December 31,2008:

 
| **For**    | ** ** | **Votes Against** | ** ** | **Abstain** | ** ** |
|------------|------------|------------------------|------------|-------------|------------|
| 14,193,973 |       | 2,046                  |       | 4,592       |       |

 

**ITEM 5. OTHER INFORMATION**

 

Not applicable.

 

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

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

 

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(1)             Previouslyfiled as the like numbered exhibit to ARYx Therapeutics, Inc.’s CurrentReport on Form 8-K (No. 001-33782), as filed with the Securities andExchange Commission on November 13, 2007 and incorporated by referenceherein.

 

(2)             Previouslyfiled as the like numbered exhibit to ARYx Therapeutics, Inc.’sRegistration Statement on Form S-1 (File No. 333-145813), initiallyfiled with the Securities and Exchange Commission on August 30, 2007, asamended, and incorporated by reference herein.

 

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**SIGNATURE**

 

Pursuant to the requirements of the SecuritiesExchange Act of 1934, the registrant has duly caused this report to be signedon its behalf by the undersigned thereunto duly authorized.

 

Dated:August 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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**EXHIBIT INDEX**

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

 

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(1)          Previouslyfiled as the like numbered exhibit to ARYx Therapeutics, Inc.’s CurrentReport on Form 8-K (No. 001-33782), as filed with the Securities andExchange Commission on November 13, 2007 and incorporated by referenceherein.

 

(2)          Previouslyfiled as the like numbered exhibit to ARYx Therapeutics, Inc.’sRegistration Statement on Form S-1 (File No. 333-145813), initiallyfiled with the Securities and Exchange Commission on August 30, 2007, asamended, and incorporated by reference herein.

 

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