** **

**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 March 31, 2008.**                                               |
|            |                                                                                                        |  |

 

**or**

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

 

**Commission file number 001-33782**

 

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**ARYxTHERAPEUTICS, INC.**

(Exact name of registrant as specified in itscharter)

 

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

 

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

(Address of Principal Executive Officesincluding zip code)

 

**(510) 585-2200**

(Registrant’s Telephone Number, Including AreaCode)

 

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

 

Indicate by check mark whetherthe registrant is a large accelerated filer, an accelerated filer, anon-accelerated filer, or a smaller reporting company. See the definitions of“large accelerated filer,” “accelerated filer,” and “smaller reporting company”in Rule 12b-2 of the Exchange Act. (Check one):

 

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

 

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

 

As of April 30, 2008,17,665,133 shares of the registrant’s common stock, $0.001 par value, wereoutstanding.

 

 

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**ARYx THERAPEUTICS, INC.**

 

**FORM 10-Q FOR THE QUARTER ENDED MARCH 31,2008**

 

**INDEX**

** **
| ** **                                   | ** **                                                                                                | **Page**   |
|----------------------------------------------|-----------------------------------------------------------------------------------------------------------|------------|
| **PART I — FINANCIAL INFORMATION** | ** **                                                                                                |
| ** **                                   | ** **                                                                                                | ** ** |
| Item 1.                                      | Financial Statements                                                                                      |       |
|                                         | Condensed Consolidated  Balance Sheets as of March 31, 2008 and December 31, 2007               | 2          |
|                                         | Condensed Consolidated  Statements of Operations for the three months ended March 31, 2008 and  2007 | 3          |
|                                         | Condensed Consolidated  Statements of Cash Flow for the three months ended March 31, 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               | 11         |
| Item 3.                                      | Quantitative and  Qualitative Disclosures About Market Risk                                               | 18         |
| Item 4.                                      | Controls and Procedures                                                                                   | 18         |
|                                         |                                                                                                      |       |
| **PART II — OTHER INFORMATION**    | ** **                                                                                                |
| Item 1.                                      | Legal Proceedings                                                                                         | 20         |
| Item 1A.                                     | Risk Factors                                                                                              | 20         |
| Item 2.                                      | Unregistered Sales of  Equity Securities and Use of Proceeds                                              | 38         |
| Item 3.                                      | Defaults Upon Senior  Securities                                                                          | 38         |
| Item 4.                                      | Submission of Matters to a  Vote of Security Holders                                                      | 38         |
| Item 5.                                      | Other Information                                                                                         | 38         |
| Item 6.                                      | Exhibits                                                                                                  | 39         |
|                                         |                                                                                                      |       |
| SIGNATURE                                    | 40                                                                                                        |
|                                              |                                                                                                           |            |  |  |  |

 

1

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**PART I— FINANCIAL INFORMATION**

 

**ITEM 1.  FINANCIALSTATEMENTS**

 

**ARYxTHERAPEUTICS, INC.**

**CONDENSEDCONSOLIDATED BALANCE SHEETS**

**(In thousands)**

 
| ** **                                          | ** ** | **March 31,** | ** ** | **December 31,** | ** ** |
|-----------------------------------------------------|------------|--------------------|------------|-----------------------|------------|
| ** **                                          | ** ** | **2008**           | ** ** | **2007**              | ** ** |
| ** **                                          | ** ** | **(unaudited)**    | ** ** | **(Note 1)**     | ** ** |
| **ASSETS**                                          |       |               |       |                  |       |
| Current assets:                                     |       |               |       |                  |       |
| Cash and cash equivalents                           |       | $                  | 58,568     |                  | $          | 55,476 |   |
| Marketable securities                               |       | 2,020              |       | 7,640                 |       |
| Restricted cash - current                           |       | 150                |       | 150                   |       |
| Prepaid research and development expenses           |       | 1,257              |       | 582                   |       |
| Other prepaid, receivable, and current  assets      |       | 736                |       | 1,051                 |       |
| Total current assets                                |       | 62,731             |       | 64,899                |       |
| Restricted cash                                     |       | 1,203              |       | 903                   |       |
| Property and equipment, net                         |       | 3,793              |       | 3,655                 |       |
| Other assets                                        |       | 305                |       | 168                   |       |
| **Total assets**                                    |       | $                  | 68,032     |                  | $          | 69,625 |   |
|                                                |       |               |       |                  |       |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**       |       |               |       |                  |       |
| Current liabilities:                                |       |               |       |                  |       |
| Accounts payable                                    |       | $                  | 1,139      |                  | $          | 1,369 |   |
| Accrued compensation                                |       | 574                |       | 1,055                 |       |
| Accrued research and development expenses           |       | 3,131              |       | 2,510                 |       |
| Current portion of notes payable                    |       | 4,946              |       | 3,536                 |       |
| Current portion of deferred revenue                 |       | 3,913              |       | 3,913                 |       |
| Other accrued liabilities                           |       | 1,165              |       | 1,074                 |       |
| Total current liabilities                           |       | 14,868             |       | 13,457                |       |
| Deferred lease credit                               |       | 1,707              |       | 1,793                 |       |
| Notes payable                                       |       | 10,274             |       | 3,444                 |       |
| Deferred revenue                                    |       | 14,610             |       | 15,584                |       |
| Commitments and contingencies                       |       |               |       |                  |       |
| Stockholders’ equity:                          |       |               |       |                  |       |
| Common stock                                        |       | 18                 |       | 18                    |       |
| Additional paid-in capital                          |       | 158,837            |       | 158,053               |       |
| Accumulated other comprehensive loss                |       | (55                | )          | —                |       |
| Accumulated deficit                                 |       | (132,227           | )          | (122,724              | )          |
| Total stockholders’ equity                     |       | 26,573             |       | 35,347                |       |
| **Total liabilities and stockholders’ equity** |       | $                  | 68,032     |                  | $          | 69,625 |   |

 

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

 

2

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**ARYx THERAPEUTICS, INC.**

**CONDENSEDCONSOLIDATED STATEMENTS OF OPERATIONS**

**(In thousands, except per share amounts)**

**(Unaudited)**

 
| ** **                                                                    | ** ** | **For the three months ended** | ** ** |
|-------------------------------------------------------------------------------|------------|----------------------------------------------------|------------|
| ** **                                                                    | ** ** | **March 31,**                                 | ** ** | **March 31,** | ** ** |
| ** **                                                                    | ** ** | **2008**                                           | ** ** | **2007** | ** ** |
| Revenue:                                                                      | ** ** | ** **                                         | ** ** | ** ** | ** ** |
| Collaboration services                                                        |       | $                                                  | 68         |   | $ | 164 |   |
| Technology license fees                                                       |       | 974                                                |       | 974 |   |
| Total revenue                                                                 |       | 1,042                                              |       | 1,138 |   |
|                                                                          |       |                                               |       |   |   |
| Costs and expenses:                                                           |       |                                               |       |   |   |
| Cost of collaboration services                                                |       | 68                                                 |       | 164 |   |
| Research and development                                                      |       | 7,600                                              |       | 4,517 |   |
| Selling, general and administrative                                           |       | 2,932                                              |       | 1,897 |   |
| Total costs and expenses                                                      |       | 10,600                                             |       | 6,578 |   |
| Loss from operations                                                          |       | (9,558                                             | )          | (5,440 | ) |
|                                                                          |       |                                               |       |   |   |
| Interest and other income, net                                                |       | 549                                                |       | 636 |   |
| Interest expense                                                              |       | (494                                               | )          | (332 | ) |
| Net loss                                                                      |       | (9,503                                             | )          | (5,136 | ) |
|                                                                          |       |                                               |       |   |   |
| Basic and diluted net loss per share                                          |       | $                                                  | (0.54      | ) | $ | (4.89 | ) |
| Weighted average shares used to compute  basic and diluted net loss per share |       | 17,631                                             |       | 1,051 |   |

 

The accompanying notes are an integral part of these financialstatements.

 

3

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**ARYx THERAPEUTICS, INC.**

**CONDENSEDCONSOLIDATED STATEMENTS OF CASH FLOW**

**(In thousands)**

**(Unaudited)**

 
| ** **                                                                     | ** ** | **For the three months ended** | ** ** |
|--------------------------------------------------------------------------------|------------|----------------------------------------------------|------------|
| ** **                                                                     | ** ** | **March 31,**                                 | ** ** | **March 31,** | ** ** |
| ** **                                                                     | ** ** | **2008**                                           | ** ** | **2007** | ** ** |
| **Cash flows from operating activities:**                                      | ** ** | ** **                                         | ** ** | ** ** | ** ** |
| Net loss                                                                       |       | $                                                  | (9,503     | ) | $ | (5,136 | ) |
| Adjustments to reconcile net loss to net  cash used in operating activities:   |       |                                               |       |   |   |
| Depreciation and amortization                                                  |       | 271                                                |       | 264 |   |
| Amortization of warrants and revaluation to  fair value                        |       | 175                                                |       | 4 |   |
| Stock-based compensation                                                       |       | 565                                                |       | 258 |   |
| Change in assets and liabilities:                                              |       |                                               |       |   |   |
| Prepaid research and development expenses                                      |       | (675                                               | )          | (19 | ) |
| Other prepaid, receivable, and assets                                          |       | 233                                                |       | (379 | ) |
| Accounts payable and other accrued  liabilities                                |       | (132                                               | )          | (68 | ) |
| Accrued compensation                                                           |       | (481                                               | )          | (275 | ) |
| Accrued research and development expenses                                      |       | 621                                                |       | 125 |   |
| Deferred lease credit                                                          |       | (86                                                | )          | (79 | ) |
| Deferred revenue                                                               |       | (974                                               | )          | (938 | ) |
| Net cash used in operating activities                                          |       | (9,986                                             | )          | (6,243 | ) |
|                                                                           |       |                                               |       |   |   |
| **Cash flows from investing activities:**                                      |       |                                               |       |   |   |
| Purchases of marketable securities                                             |       | (1,100                                             | )          | (6,494 | ) |
| Proceeds from sales of marketable  securities                                  |       | 2,575                                              |       | 3,590 |   |
| Proceeds from maturities of marketable  securities                             |       | 4,090                                              |       | 6,900 |   |
| Increase in restricted cash                                                    |       | (300                                               | )          | — |   |
| Purchases of fixed assets                                                      |       | (416                                               | )          | (133 | ) |
| Net cash provided by investing activities                                      |       | 4,849                                              |       | 3,863 |   |
|                                                                           |       |                                               |       |   |   |
| **Cash flows from financing activities:**                                      |       |                                               |       |   |   |
| Proceeds from exercise of stock options and  issuance of common stock          |       | 25                                                 |       | 23 |   |
| Offering cost in connection with our  initial public offering in November 2007 |       | (36                                                | )          | — |   |
| Proceeds from issuance of notes payable                                        |       | 9,000                                              |       | — |   |
| Principal payments on notes payable                                            |       | (760                                               | )          | (695 | ) |
| Net cash provided by (used in) financing  activities                           |       | 8,229                                              |       | (672 | ) |
|                                                                           |       |                                               |       |   |   |
| **Net increase (decrease) in cash and cash  equivalents**                      |       | 3,092                                              |       | (3,052 | ) |
| Cash and cash equivalents at beginning of  period                              |       | 55,476                                             |       | 18,660 |   |
| **Cash and cash equivalents at end of period**                                 |       | $                                                  | 58,568     |   | $ | 15,608 |   |

 

The accompanying notes are an integral part of these financialstatements.

 

4

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** **

**ARYx THERAPEUTICS, INC.**

**NOTES TOCONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

 

Inthis report, “ARYx,” “we,” “us” and “our” refer to ARYx Therapeutics, Inc.“Common Stock” refers to ARYx’s common stock, par value $0.001 per share. “PreferredStock” refers to ARYx’s convertible preferred stock, $0.001 per share.

 

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

 

***The Company***

 

ARYxis a biopharmaceutical company focused on developing a portfolio of internallydiscovered product candidates designed to eliminate known safety issuesassociated with well-established, commercially successful drugs. We use ourRetroMetabolic Drug Design technology to design structurally unique moleculesthat retain the efficacy of these original drugs but are metabolized through apotentially safer pathway to avoid specific adverse side effects associatedwith these compounds. Our most advanced product candidate, ATI-7505, is basedon cisapride and has successfully completed Phase 2 clinical trials forthe treatment of gastroesophageal reflux disease and symptoms associated withfunctional dyspepsia. Our second product candidate, ATI-5923, is based onwarfarin and is currently in Phase 2 clinical trials for use as ananticoagulant to treat patients at risk for the formation of dangerous bloodclots. Our third product candidate, ATI-2042, is based on amiodarone and is inPhase 2 clinical trials for the treatment of atrial fibrillation, a formof irregular heartbeat. Our fourth product candidate, ATI-9242, is a novelantipsychotic agent currently in Phase 1 clinical trials for the treatment ofschizophrenia and other psychiatric disorders. We have multiple productcandidates in preclinical development.

 

Wewere incorporated in the State of California on February 28, 1997 andreincorporated in the State of Delaware on August 29, 2007. We maintain awholly-owned subsidiary, ARYx Therapeutics Limited, with registered offices inthe United Kingdom, which has had no operations since its inception in September 2004.We currently are focused on the human drug development business and operate ina single business segment with regard to the development of humanpharmaceutical products.

 

***Basis of Presentation***

 

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

 

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

 

***Use of Estimates***

 

Thepreparation of financial statements in conformity with U.S. generally acceptedaccounting principles requires management to make estimates and assumptionsthat affect the reported amounts in the condensed consolidated financialstatements and accompanying notes. Management bases its estimates on historicalexperience and on assumptions believed to be reasonable under thecircumstances. Actual results could differ from those estimates.

 

***Marketable Securities and the Adoption of SFAS 157***

 

In September 2006, theFinancial Accounting Standards Board (“FASB”) issued Statements of FinancialAccounting Standards No. 157, *Fair ValueMeasurements* (“SFAS 157”). SFAS 157 defines fair value,establishes a framework for measuring fair value and expands fair valuemeasurement disclosure. In February 2008, the FASB issued FASB StaffPosition 157-1,*Application of FASB Statement No. 157 toFASB Statement No. 13 and Other Accounting Pronouncements That AddressFair Value Measurements for Purposes of Lease Classification or Measurementunder Statement 13* (“FSP 157-1”)*,*and FASBStaff Position 157-2, *Effective Date of FASBStatement No. 157* (“FSP 157-2”). FSP 157-1 amends SFAS 157 toremove certain leasing transactions from its scope. 

 

5

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FSP 157-2 delays the effective date ofSFAS 157 for all non-financial assets and non-financial liabilities, except foritems that are recognized or disclosed at fair value in the financialstatements on a recurring basis (at least annually), until fiscal yearbeginning after November 15, 2008. The measurement and disclosurerequirements related to financial assets and financial liabilities areeffective for us beginning in the first quarter of 2008. The adoption of SFAS157 for financial assets and financial liabilities did not have a significantimpact on our consolidated financial statements. We are currently evaluatingthe impact that SFAS 157 may have on our consolidated financial statements whenit is applied to non-financial assets and non-financial liabilities beginningin the first quarter of 2009. SFAS 157 describes three levels of inputsthat may be used to measure fair value, as follows:

 

·                  Level1 inputs which include quoted prices in active markets for identical assets orliabilities;

 

·                  Level2 inputs which include observable inputs other than Level 1 inputs, such asquoted prices 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

 

·                  Level3 inputs which include unobservable inputs that are supported by little or nomarket activity and that are significant to the fair value of the underlyingasset or liability.  Level 3 assets andliabilities include those whose fair value measurements are determined usingpricing models, discounted cash flow methodologies or similar valuationtechniques, as well as significant management judgment or estimation.

 

The following tablesummarizes our available-for-sale securities portfolio as of March 31,2008, 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 March 31,2008:

 
| ** **                                                | ** ** | ** **          | ** ** | **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                                        |       | $                   | 11,635     |                                                                                                                  | $          | 11,635 |   | $ | — |   | $ | — |   |
| Auction  rate securities:                                 |       |                |       |                                                                                                                  |       |   |   |   |   |
| Beginning  balance as of January 1, 2008             |       | 4,740               |       | —                                                                                                                |       | 4,740 |   | — |   |
| Purchases                                                 |       | 1,100               |       | —                                                                                                                |       | 1,100 |   | — |   |
| Sales  and maturities                                     |       | (3,765              | )          | —                                                                                                                |       | (3,140 | ) | (625 | ) |
| Unrealized  losses included in other comprehensive income |       | (55                 | )          | —                                                                                                                |       | — |   | (55 | ) |
| Transfer  in (out) between Level 2 and 3                  |       | —              |       | —                                                                                                                |       | (1,500 | ) | 1,500 |   |
| Ending  balance as of March 31, 2008                 |       | 2,020               |       | —                                                                                                                |       | 1,200 |   | 820 |   |
|                                                      |       | $                   | 13,655     |                                                                                                                  | $          | 11,635 |   | $ | 1,200 |   | $ | 820 |   |

 

Asof March 31, 2008, we held $2.0 million of auction rate securities in ourmarketable securities portfolio. Since the beginning of 2008, we haveexperienced failed auctions of certain of the auction rate securities held inour portfolio. We believe that the failed auctions that we have experiencedthus far in 2008 are the result of temporary market conditions. Althoughauction rate securities would typically be measured using Level 2 inputs, therecent failure of certain auctions and the resultant lack of marketabilityrequire that certain of these securities be measured using Level 3 inputs inaccordance with guidance provided by SFAS 157. The fair value of two of ourauction rate holdings classified as Level 3 instruments at March 31, 2008was determined using a discounted cash flow model that considered projectedcash flows for the auction rate instruments and market yields. We determinedthat the carrying value of these two auction rate instruments should be reducedby an estimated $55,000 below their par value, representing a 6.3% reduction inthe carrying value for these instruments. Our auction rate holdings that wereeither liquidated at par value subsequent to March 31, 2008 or that weresubject to an announced tender offer by the issuers remained classified asLevel 2 instruments.

 

All of ourauction rate securities are recorded as current assets in our condensedconsolidated balance sheet. We have estimated the fair value of theauction rate securities in our portfolio to be approximately $2.0 million, netof an estimated $55,000 in unrealized losses recorded as a component of othercomprehensive lossas of March 31,2008. Subsequent to March 31, 2008, we liquidated an additional$1.1 million of our auction rate holdings and as of May 1, 2008,$950,000 of auction rate securities, at par value, remained in our portfolio.

 

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***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 March 31,2008 and 2007 was $9.6 million and $5.1 million, respectively.

 

***Net Loss Per Share***

 

Basic net loss per share iscomputed by dividing net loss by the weighted average number of fully vestedcommon shares outstanding during the period. Diluted net loss per share iscomputed by giving effect to all potential dilutive common shares, includingoutstanding stock options, warrants and convertible preferred stock. Because weare in a net loss position, our computation of diluted net loss per shareexcludes the effects of common stock equivalents because the inclusion wouldhave been anti-dilutive.

 

The following table presentsthe calculation of historical basic and diluted net loss per share:

 
| ** **                                                                      | ** ** | **Three Months Ended March 31,**                  | ** ** |
|---------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------|------------|
| ** **                                                                      | ** ** | **2008**                                                              | ** ** | **2007** | ** ** |
| ** **                                                                      | ** ** | **(in thousands, except per share amounts)** | ** ** |
| *Numerator:*                                                                    | * *   | * *                                                              | * *   | * * | * * |
| Net loss                                                                        |       | $                                                                     | (9,503     | ) | $ | (5,136 | ) |
| *Denominator:*                                                                  | * *   | * *                                                              | * *   | * * | * * |
| Weighted average common shares outstanding                                      |       | 17,659                                                                |       | 1,070 |   |
| Less: Weighted average unvested restricted  common shares                       |       | (28                                                                   | )          | (19 | ) |
| Weighted average shares used in computing  basic and diluted net loss per share |       | 17,631                                                                |       | 1,051 |   |
| Basic and diluted net loss per share                                            |       | $                                                                     | (0.54      | ) | $ | (4.89 | ) |

 

For the three months ended March 31,2008, shares and per share amounts above reflect the conversion of all of ouroutstanding convertible preferred stock into common stock upon the closing ofour initial public offering on November 13, 2007.

 

The following common stockequivalent shares related to our convertible preferred stock, warrants andstock options were excluded from the computation of diluted net loss per sharefor the periods presented because including them would have had an antidilutiveeffect:

 
| ** **                                                                                      | ** ** | **As of March 31,** | ** ** |
|-------------------------------------------------------------------------------------------------|------------|------------------------------------|------------|
| ** **                                                                                      | ** ** | **2008**                           | ** ** | **2007** | ** ** |
| ** **                                                                                      | ** ** | **(in thousands)**            | ** ** |
| Series A convertible preferred stock  (as if converted)                                    |       | —                             |       | 126 |   |
| Series B convertible preferred stock  (as if converted)                                    |       | —                             |       | 105 |   |
| Series C convertible preferred stock  (as if converted)                                    |       | —                             |       | 2,825 |   |
| Series D convertible preferred stock  (as if converted)                                    |       | —                             |       | 5,539 |   |
| Series E convertible preferred stock  (as if converted)                                    |       | —                             |       | 2,818 |   |
| Warrants to purchase Series C  convertible preferred stock (as if exercised and converted) |       | —                             |       | 17 |   |
| Warrants to purchase Series D  convertible preferred stock (as if exercised and converted) |       | —                             |       | 101 |   |
| Warrants to purchase common stock (as if  exercised)                                            |       | 190                                |       | — |   |
| Outstanding common stock options                                                                |       | 2,342                              |       | 1,823 |   |
|                                                                                            |       | 2,532                              |       | 13,354 |   |

 

***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.

 

In June 2007, the FASBratified Emerging Issues Task Force Issue (“EITF”) No. 07-3, “*Accounting for Nonrefundable Advance Payments forGoods or Services Received for Use in Future Research and DevelopmentActivities*” (“EITF 07-3”). EITF 07-3 requires that nonrefundableadvance payments for goods and services that will be used or rendered in futureR&D activities pursuant to executory contractual arrangements be deferredand recognized as an expense in the period that the related goods are deliveredor 

 

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services are performed. Effective January 1, 2008, we adopted EITF07-3 and the adoption had no material impact on our consolidated financialposition, results of operations and cash flows.

 

In February 2007, the FASBissued Statements of Financial Accounting Standards No. 159, *The Fair Value Option for Financial Assets andFinancial Liabilities- Including an amendment of FASB Statement No. 115*(“SFAS 159”). SFAS 159 provides companies with an option to report selectedfinancial assets and liabilities at fair value (the “fair value option”). Ifan entity elects the fair value option to measure a financial instrument, theunrealized gains and losses on that instrument must be reported in earnings ateach reporting date. We electednot to measure our financial assets and liabilities under the fair valueoption.

 

**2. Collaboration with Procter & Gamble Pharmaceuticals**

 

OnJune 30, 2006, we entered into a collaboration agreement with Procter &Gamble Pharmaceuticals, Inc., or P&G, pursuant to which P&G willdevelop and commercialize ATI-7505, our product candidate for the treatment ofgastrointestinal disorders such as chronic constipation, functional dyspepsia,gastroesophageal reflux disease, gastroparesis and irritable bowel syndromewith constipation. In connection with this agreement, P&G paid us a$25.0 million nonrefundable upfront license fee and has agreed to pay usadditional potential milestone payments and royalties on product sales.Additional license fee revenue could reach approximately $391.0 millionover the life of the collaboration, of which approximately $216.0 millioncould be earned prior to commercialization. Under our agreement with P&G,we have the option, but not the obligation, to co-promote and/or co-developATI-7505. On February 29, 2008, we amended the collaboration agreement toextend the milestone date set for analysis of the final data and results fromour QT study for ATI-7505.

 

Inaccordance with our revenue recognition policy, we have concluded that we havethree units of accounting: (i) the up front license fee and our jointsteering committee obligation; (ii) our commitment to provide transitionalservices; and (iii) our rights to royalty payments on sales, if any, ofATI-7505. The $25.0 million nonrefundable upfront license fee was deferredupon receipt, as objective evidence of the fair value of the undeliveredelements under the agreement could not be established. This fee is beingrecognized as revenue on a straight-line basis over our estimated obligatoryperformance period under the terms of the agreement. We estimate on an on-goingbasis the expected duration of the obligatory performance period and adjust ourrecognition of deferred revenue accordingly. As of March, 31, 2008 and at present,we estimate that our obligatory performance period under the agreement willcontinue through January 2013. For the three months ended March 31,2008 and 2007, we recognized $974,000 and $974,000, respectively, as licensefee revenue. As of March 31, 2008, a cumulative total of $6.5 million ofthe $25.0 million upfront payment had been recognized as revenue.

 

Underthe terms of the agreement, we are obligated to provide certain transitionalservices to P&G. These transitional services represent the pass through ofactual costs billed to us by third party vendors, are standard support servicesfor the biopharmaceutical industry and are readily available from multiplevendors. We are also entitled to compensation from P&G for certainpre-determined development services, such as formulation, development andmanufacturing of drug substance and products, as well as other activitiesrelated to the licensed technology. Under the agreement, we have no obligationto perform any development activities nor do we have any manufacturingobligations. For the three months ended March 31, 2008 and 2007, werecognized $68,000 and $164,000, respectively, as collaboration servicesrevenue related to these activities and costs associated with these servicesare included in the cost of collaboration service revenue. P&G has theright to terminate our collaboration agreement at any time upon written noticepursuant to its terms.

 

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

 

In March 2005, weentered into a loan agreement with Lighthouse Capital Partners V, L.P. (“Lighthouse”)that was amended on October 19, 2007. The original agreement provided forup to $10.0 million in debt financing. The amended agreement provides forup to $9.0 million in additional financing for a total of$19.0 million made available over the life of the facility. We issued twowarrants to Lighthouse in connection with the original agreement and theamended agreement. As of March 31, 2008, these warrants are exercisablefor an aggregate of 100,704 shares of our common stock at an exercise price of$9.93 per share and 83,332 shares of our common stock at an exercise price of$10.80.

 

In February 2008, weborrowed the additional $9.0 million available to us under the loanfacility pursuant to the terms of the amended loan agreement dated October 19,2007. The amended loan agreement provides for a seven-month interest-onlyperiod and a 36 month repayment term which will begin on October 1, 2008.The related promissory note provides for monthly cash payments of principal andinterest at an interest rate equal to the higher of 7.75% or the prime rateplus 200 basis points per annum to be fixed as of October 1, 2008, and aballoon interest payment of $675,000 to be made in September 2011.The agreement allows for prepayment of principal with respect to the promissorynote whereupon the $675,000 terminal interest payment is accelerated anddue at the time of prepayment of the loan balance.

 

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**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 March 31, 2008, the following warrantswere 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                     |       |                 |       |           |       |

 

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(1)          Exercisable, in whole or in part, until the earlier of the10th anniversary of the issue date or the 5th anniversary of theclosing of an initial public offering.

(2)          Exercisable, in whole or in part, prior to or upon the closing of aninitial public offering, a merger, change in control, or sale of substantiallyall 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 publicoffering, or (iii) the effective date of a merger, as defined in theagreement.

(3)          Exercisable, in whole or in part, at anytime at the option of theholder or deemed to have been automatically exercised in full immediately priorto the expiration of the warrant; expires at the earlier of (i) the closeof business on October 19, 2014, or (ii) the effective date of amerger, 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 ending March 1, 2008, and the remainderamortized to interest expense over the duration of the interest-only periodplus the term of the loan over 36 months. Amortization of the fair valueof the warrants was charged to interest expense as follows:

 
| ** **                  | ** ** | **Three Months Ended March 31,** | ** ** |
|-----------------------------|------------|------------------------------------------------------|------------|
| ** **                  | ** ** | **2008**                                             | ** ** | **2007** | ** ** |
| ** **                  | ** ** | **(in thousands)**                              | ** ** |
| Lighthouse – Warrant 1 |       | $                                                    | 23         |   | $ | 23 |   |
| Lighthouse – Warrant 2 |       | 152                                                  |       | — |   |
|                        |       | $                                                    | 175        |   | $ | 23 |   |

 

The warrants may be exercisedusing the net exercise method. Under this method, the number of shares issuedupon exercise is reduced by an amount equal to the product of the number ofshares subject to the exercise and the exercise price per share, divided by thefair value of convertible preferred stock on the date of the exercise. Thenumber of shares issued upon exercise of the warrants, and the exercise priceper share, are adjustable in the event of stock splits, dividends and similarfundamental changes. No warrant was exercised during the three months ended March 31,2008 and 2007.

 

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 $19,000 to reflect thedecrease in fair value of the then preferred stock warrant liability for thethree months ended March 31, 2007 before the conversion of the warrants.

 

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

 

Weaccount for employee stock-based compensation under SFAS No. 123(R), *Share-Based Payment* (“SFAS 123R”), whichrequires compensation expense related to stock-based payments, including stockoptions and awards granted to employees and directors, to be measured based ongrant date fair value and recognized as expense in the financial statementsover the requisite service 

 

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period. We estimate the fairvalue of our share-based award to employees and directors using theBlack-Scholes option valuation model. Option valuation models require the inputof highly subjective assumptions and these assumptions can vary over time. Dueto the fact that we are a newly public company, there is limited historicalinformation available to support our estimate of expected volatility requiredto value our stock-based awards. We, therefore, follow guidance discussed inSAB No. 107 basing our estimate of expected volatility on the expectedvolatility of a group of similar entities whose stock prices are publiclyavailable. We will continue to consistently apply this process using thesimilar entities until a sufficient amount of historical information regardingthe volatility of our own stock price becomes available. The fair value of ourstock-based awards was estimated at the date of grant using the followingassumptions:

 
| ** **                                        | ** ** | **Three Months Ended March 31,** | ** ** |
|---------------------------------------------------|------------|------------------------------------------------------|------------|
| ** **                                        | ** ** | **2008**                                             | ** ** | **2007** | ** ** |
| Expected volatility                               |       | 73                                                   | %          | 73 | % |
| Expected term (in years)                          |       | 4.5                                                  |       | 4.1 |   |
| Weighted-average risk-free interest rate          |       | 2.61                                                 | %          | 4.64 | % |
| Expected dividends                                |       | —                                               |       | — |   |
| Weighted-average grant date fair value per  share |       | $                                                    | 4.40       |   | $ | 1.90 |   |
|                                                   |            |                                                      |            |  |  |  |  |

 

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

 

Total compensation cost thathas been recorded in the statement of operations, which includes stock-basedcompensation expense under SFAS 123R and the value of options issued tonon-employees for services rendered, are allocated as follows:

 
| ** **                           | ** ** | **Three Months Ended March 31,** | ** ** |
|--------------------------------------|------------|------------------------------------------------------|------------|
| ** **                           | ** ** | **2008**                                             | ** ** | **2007** | ** ** |
| ** **                           | ** ** | **(in thousands)**                              | ** ** |
| Research and development:            |       |                                                 |       |   |   |
| Officer compensation                 |       | $                                                    | 76         |   | $ | 36 |   |
| Employee and consultant compensation |       | 170                                                  |       | 57 |   |
| Selling, general and administrative: |       |                                                 |       |   |   |
| Director and officer compensation    |       | 276                                                  |       | 153 |   |
| Employee and consultant compensation |       | 43                                                   |       | 12 |   |
|                                 |       | $                                                    | 565        |   | $ | 258 |   |

 

As of March 31, 2008,total compensation cost related to unvested stock options not yet recognizedwas $3.1 million, which is expected to be allocated to expense over aweighted-average period of 1.52 years. We issued 11,065 shares and 13,411shares of common stock as a result of stock option exercises during the threemonths ended March 31, 2008 and 2007, respectively.

 

**6. ****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.

 

We adopted the provisions ofFASB Interpretation No. 48, *Accountingfor Uncertainty in Income Taxes – an interpretation of FASB Statement No. 109*(“FIN 48”) on January 1, 2007. FIN 48 requires us to recognize thefinancial statement effects of a tax position when it is more likely than not,based on the technical merits, that the position will be sustained uponexamination. As permitted under the provisions of FIN 48, we will classifyinterest and penalties related to unrecognized tax benefits as part of ourincome tax provision, although there have been no such interest or penaltiesrecognized to-date.

 

As of December 31,2007, we had approximately $500,000 of unrecognized tax benefits, none of whichwould affect our effective tax rate if recognized. There has been nosignificant change to our unrecognized tax benefits as of March 31, 2008.We currently have a full valuation allowance against our net deferred tax assetwhich would impact the timing of the effective tax rate benefit should any ofthese uncertain tax positions be favorably settled in the future. We do notanticipate that the amount of existing unrecognized tax benefits willsignificantly increase or decrease within the next 12 months. Because ofour net operating loss carryforwards, substantially all of our tax years remainopen to federal tax examination. We file income tax returns in the UnitedStates and in California, which typically have three and four tax years open,respectively, at any point in time.

 

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

 

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

 

**Overview**

 

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

 

Weuse our RetroMetabolic Drug Design technology to design structurally uniquemolecules that retain the efficacy of these original drugs but are metabolizedthrough a potentially safer pathway to avoid specific adverse side effectsassociated with these compounds. The following is a summary of our productcandidates that are currently in clinical development:

 

***ATI-7505***

 

Ourmost advanced product is ATI-7505, an oral prokinetic drug or an agent thatspeeds up the motion of contents through the gut, that 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, according to a 2005 article in the New York Times,before it was withdrawn from the market in 2000 due to serious cardiovascularside effects. These side effects occurred as blood levels of the drug rosesignificantly when CYP450 clearance was blocked because of the presence ofother drugs cleared by the same metabolic pathway. We designed ATI-7505 to bemetabolized through the esterase pathway, eliminating metabolism through CYP450as well as off-target cardiovascular effects. The gastrointestinal disordersfor which ATI-7505 can be developed include chronic constipation, functionaldyspepsia, GERD, gastroparesis and irritable bowel syndrome, or IBS, withconstipation. While some patients may suffer from more than one of thesedisorders, it is estimated that there are more than 100 million cases ofgastrointestinal disorders in the United States based on various sources,primarily the American Journal of Gastroenterology and the AlimentaryPharmacology and Therapeutics journal. We have treated more than 500 patientswith ATI-7505 as part of our clinical trial program, including three Phase 2trials. In these trials, dosing with ATI-7505 showed a reduction in acidreflux, and in some measurements of nighttime heartburn, nighttime acidregurgitation, and multiple functional dyspepsia symptoms, as well as adose-related increase in GERD erosion healing rates in patients with lesssevere erosions. In addition, we have shown statistically significantimprovement in some measures of both upper and lower gastrointestinal motilityin healthy volunteers. Based upon the data generated in these clinical trials,we entered into a collaboration agreement with Procter & GamblePharmaceuticals, Inc., or P&G, under which they will develop andcommercialize ATI-7505. P&G has initiated two Phase 2 clinical trialswith ATI-7505 in chronic constipation and in functional dyspepsia. P&G isalso completing their analysis of the results of a thorough Qt study (TQT)testing, an important element of the cardiac safety of ATI-7505.

 

***ATI-5923***

 

ATI-5923is an oral anticoagulant in Phase 2 clinical trials for the treatment ofpatients who are at risk for the formation of dangerous blood clots, such asthose with atrial fibrillation or those at risk of venous thromboembolism.ATI-5923 was designed to have the same therapeutic benefits as the drugwarfarin, which for over 50 years has been the treatment of choice as anoral anticoagulant. Despite its widespread use, warfarin has severalsignificant limitations. It is metabolized by CYP450 and has many drug-druginteractions that often lead to serious side effects. We designed ATI-5923 tobe metabolized through the esterase pathway, eliminating metabolism throughCYP450 and avoiding drug-drug interactions. Warfarin also has a very steep doseresponse curve which means that a small change in dose may lead to asubstantial change in the anticoagulation status of the patient. This can put 

 

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patients at risk for eitherlife-threatening clotting or bleeding. In preclinical testing, it appears thatATI-5923 may have a flatter dose response curve than warfarin, althoughconfirmation of this observation will require substantial additional clinicaldata. According to a 2006 report by Datamonitor, atrial fibrillation is themost common form of cardiac arrhythmia, or abnormal heart rhythm, with approximately2.4 million people in the United States currently diagnosed with thiscondition. According to the 2005 Decision Resource Cardium Thromboembolism(Treatment) Forecast Tool report, there were approximately 510,000 patientsbeing treated for venous thromboembolism in the U.S in 2005. We recentlycompleted a Phase 2 clinical trial with ATI-5923 involving 66 patients. Inthis study, ATI-5923 achieved a significant improvement in the maintenance ofthese patients at the targeted level of anticoagulation and also demonstrated asignificant reduction in the occurrence of dangerously low levels ofanticoagulation compared to these patients’ historical levels ofanticoagulation when on warfarin. In preliminary discussions, the U.S. Food andDrug Administration, or FDA, indicated that the standardized measurement ofanticoagulation status known as the International Normalized Ratio, or INR,will likely be an acceptable surrogate and primary endpoint for ATI-5923’sclinical development. Using INR as a surrogate and primary endpoint shouldreduce both the size of and time to complete our planned clinical trials forATI-5923 compared to clinical trials based on survival rates or other outcomes.In June 2008, we plan to initiate a double-blinded,placebo-controlled Phase 2 clinical trial involving approximately 600 patientsthat will study the efficacy of ATI-5923 in a head-to-head comparison towarfarin.

 

***ATI-2042***

 

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

 

***ATI-9242***

 

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

 

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

 

***Revenue and Collaboration with Procter & Gamble Pharmaceuticals***

 

  In connectionwith our collaboration agreement with P&G, we received a $25.0 millionnonrefundable upfront license fee in August 2006. The $25.0 millionpayment was recorded in our balance sheet as deferred revenue upon receipt andrecognized in our consolidated statement of operations as revenue on astraight-line basis over the performance and service period. We estimate on anon-going basis the expected duration of the performance and service period andadjust our recognition of deferred revenue accordingly. At present, we estimatethat our performance period under the agreement will continue through January 2013.As of March 31, 2008, we have recognized a cumulative total of $6.5million of the $25.0 million nonrefundable upfront license fee.

 

Underthe terms of the agreement, we are obligated to provide certain transitionalservices to P&G. These transitional services represent the pass through ofactual costs billed to ARYx by third party vendors, are standard supportservices for the biopharmaceutical industry and are readily available frommultiple vendors. We are also entitled to compensation from P&G forspecified development services provided by us. These services include productformulation and manufacturing, patent filing and 

 

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maintenance, and otherdevelopment services related to the ATI-7505 program. Reimbursements we receivefor these services are recorded as collaboration service revenue. Pursuant tothe agreement, we are under no obligation to perform any such services. As of March 31,2008, we have recognized a cumulative total of $2.4 million ascollaboration service revenue. We anticipate that revenue related to theseservices in the future will be minimal and will decline as we transition toP&G direct responsibility for all development costs related to our ATI-7505product candidate.

 

OnFebruary 29, 2008, we entered into an Amendment to the License,Development and Commercialization Agreement with P&G (the “Amendment”). TheAmendment amends our existing License, Development and CommercializationAgreement between the parties, dated June 30, 2006 (the “OriginalAgreement”). Pursuant to the Original Agreement, P&G is obligated todeliver the final results of the thorough QT study (the “Study”) to us within adefined time period following the locking of the database.  The Amendment sets a new milestone date toextend the period of time for an analysis of the data and results from theStudy. The large size of the Study produced at least 20,000 electrocardiogram (“ECG”)data points that require analysis. We have mutually agreed to use a third-partyfirm to perform a manual analysis of the ECGs which cannot be completed in thetime period originally anticipated.  Toallow for sufficient time to complete this analysis, the Original Agreementbetween us and P&G has been amended to extend the timeline for finalresults.  The original target set by usto receive the Study results in the first half of 2008 remains unchanged.

 

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

 

***Cost of Collaboration Service Revenue***

 

Relatedto the service revenue we generate in connection with our collaborationagreement with P&G, we incur costs for certain services provided includingcosts for pharmaceutical development, patent filing and maintenance and otheractivities related to the ATI-7505 program. These expenses are reportedseparately in our income statement as cost of collaboration service revenue. Asof March 31, 2008, we have recorded a cumulative total of$2.4 million of expense related to these activities.

 

***Research and Development***

 

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

 

Clinicaltrial costs are a significant component of our research and developmentexpense. Currently, we conduct our clinical trials primarily throughcoordination with contract research organizations and other third-party serviceproviders. We recognize research and development expense for these activitiesbased upon a variety of factors, including actual and estimated patientenrollment, clinical site initiation activities, direct pass-through costs andother activity-based factors.

 

Thefollowing table summarizes our research and development expense for the threemonths ended March 31, 2008 and 2007:

 
| ** **                                                                           | ** ** | **Three Months Ended  March 31,** | ** ** |
|--------------------------------------------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                                                           | ** ** | **2008**                                         | ** ** | **2007** | ** ** |
|                                                                                 |       |                                             |       |   |   |
| Direct research and development expense by  program:                                 |       |                                             |       |   |   |
| ATI-7505                                                                             |       | $                                                | 75         |   | $ | 8 |   |
| ATI-5923                                                                             |       | 1,586                                            |       | 467 |   |
| ATI-2042                                                                             |       | 1,949                                            |       | 664 |   |
| ATI-9242                                                                             |       | 546                                              |       | 307 |   |
| Other research programs                                                              |       | 254                                              |       | 74 |   |
| Total direct research and development  program expense                               |       | 4,410                                            |       | 1,520 |   |
| Personnel, administrative and other expense                                          |       | 3,216                                            |       | 3,124 |   |
| Less: Research and development portion of  the cost of collaboration service revenue |       | (26                                              | )          | (127 | ) |
| Total research and development expense                                               |       | $                                                | 7,600      |   | $ | 4,517 |   |

 

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From our inception through March 31, 2008, weincurred total research and development expense of approximately$110.0 million. During the period from our inception through March 31,2008, we estimate that approximately $22.3 million was incurred for our ATI-7505program, approximately $16.3 million was incurred for our ATI-5923program, approximately $19.5 million was incurred for our ATI-2042 program,approximately $4.3 million was incurred for our ATI-9242 program, andapproximately $47.6 million was incurred (including internal and externalactivities) for our other programs that include research and developmentprogram expense, personnel, administrative and other expense.

 

 We designate development programs to which wehave allocated 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 condensedconsolidated financial statements.

 

        Atthis time, due to the risks inherent in the clinical trial process and giventhe various stages of development of our product candidates, we are unable toestimate with any certainty the costs we will incur in the continueddevelopment of our product candidates, except for ATI-7505 for which costs willbe negligible due to the provisions of our collaboration agreement withP&G. Clinical development timelines, the probability of success anddevelopment costs can differ materially from expectations. While we arecurrently focused on advancing each of our product development programs, ourfuture research and development expense will depend on the clinical success ofeach product candidate, as well as ongoing assessments as to each productcandidate’s commercial potential. In addition, we cannot forecast with anydegree of certainty which product candidates will be subject to futurecollaborations, when such arrangements will be secured, if at all, and to whatdegree such arrangements would affect our development plans and capitalrequirements.

 

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

 

        Ifwe fail to complete the development of any of our product candidates in atimely manner, it could have a material effect on our operations, financialposition and liquidity. In addition, any failure by us or our partners toobtain, or any delay in obtaining, regulatory approvals for our productcandidates could have a material effect on our results of operations. A furtherdiscussion of the risks and uncertainties associated with completing ourprograms on schedule, or at all, and certain consequences of failing to do soare discussed further in the “Risk Factors” section of this report.

 

**Critical Accounting Policies and Significant Estimates**

 

Ourcritical accounting policies are more fully described in Note 1 of the auditedfinancial statements for the year ended December 31, 2007, which areincluded in our Annual Report on Form 10-K filed with the Securities andExchange Commission on March 17, 2008. There have been no material changesin our critical accounting policies during the three months ended March 31,2008.

 

Thediscussion of our financial condition and results of operations is based uponour financial statements, which have been prepared in accordance with U.S.generally accepted accounting principles. The preparation of these financialstatements requires us to make estimates, judgments and assumptions that affectthe reported amount of assets, liabilities, revenues and expenses. On an ongoingbasis, we evaluate our estimates. These estimates, assumptions and judgmentsabout future events and their effects on our results cannot be determined withcertainty, and are made based upon our historical experience and on otherassumptions that are believed to be reasonable under the circumstances.Different estimates that we could have used, or changes in the estimates thatare reasonably likely to occur, may have a material impact on our financialcondition or results of operations. Management has discussed the development,selection and disclosure of these estimates with the audit committee of ourboard of directors. Our actual results may differ from these estimates underdifferent assumptions or conditions.

 

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**Results of Operations**

 

***Comparison of Three Months Ended March 31,2008 and 2007***

 

***Revenue***

 
| ** **              | ** ** | **Three Months Ended** | ** ** | ** **              | ** ** | ** ** | ** ** |
|-------------------------|------------|----------------------------------|------------|-------------------------|------------|------------|------------|
| ** **              | ** ** | **March 31,**               | ** ** | **Change**              | ** ** |
| ** **              | ** ** | **2008**                         | ** ** | **2007**                | ** ** | **$**      | ** ** | **%** | ** ** |
| ** **              | ** ** | ** **                       | ** ** | **(in thousands)** | ** ** | ** ** | ** ** |
| Collaboration services  |       | $                                | 68         |                    | $          | 164        |       | $ | (96 | ) | (59 | )% |
| Technology license fees |       | 974                              |       | 974                     |       | —     |       | — |   |
| Total revenue           |       | $                                | 1,042      |                    | $          | 1,138      |       | $ | (96 | ) | (8 | )% |

 

Revenuefor the three months ended March 31, 2008, as compared to the same periodin 2007, decreased by 96,000, or 8%.  Thedecrease was due to a decrease in our collaboration service revenue consistingprimarily of revenues billed to P&G for third party pass-through costsrelated to the pharmaceutical development of ATI-7505 and patent maintenancefor ATI-7505.

 

***Cost ofCollaboration Service Revenue***

 
| ** **                            | ** ** | **Three Months Ended** | ** ** | ** **              | ** ** | ** ** | ** ** |
|---------------------------------------|------------|----------------------------------|------------|-------------------------|------------|------------|------------|
| ** **                            | ** ** | **March 31,**               | ** ** | **Change**              | ** ** |
| ** **                            | ** ** | **2008**                         | ** ** | **2007**                | ** ** | **$**      | ** ** | **%** | ** ** |
| ** **                            | ** ** | ** **                       | ** ** | **(in thousands)** | ** ** | ** ** | ** ** |
| Cost of collaboration service revenue |       | $                                | 68         |                    | $          | 164        |       | $ | (96 | ) | (59 | )% |
|                                       |            |                                  |            |                         |            |            |            |  |  |  |  |  |

 

Cost of revenue was associated with ourcollaboration agreement with P&G. The decrease in cost of revenue for thethree months ended March 31, 2008 as compared to the same period in 2007was directly associated with the decrease in collaboration service revenue inthe same period.

 

***Research and Development Expense***

 
| ** **                       | ** ** | **Three Months Ended** | ** ** | ** **              | ** ** | ** ** | ** ** |
|----------------------------------|------------|----------------------------------|------------|-------------------------|------------|------------|------------|
| ** **                       | ** ** | **March 31,**               | ** ** | **Change**              | ** ** |
| ** **                       | ** ** | **2008**                         | ** ** | **2007**                | ** ** | **$**      | ** ** | **%** | ** ** |
| ** **                       | ** ** | ** **                       | ** ** | **(in thousands)** | ** ** | ** ** | ** ** |
| Research and development expense |       | $                                | 7,600      |                    | $          | 4,517      |       | $ | 3,083 |   | 68 | % |
|                                  |            |                                  |            |                         |            |            |            |  |  |  |  |  |

 

For the three months ended March 31, 2008, ascompared to the same period in 2007, our research and development expenseincreased by approximately $3.1 million. The increase was primarily due to:

 

·                  a $1.0 million increase in externalexpenditures related to the completion of a Phase 2 clinical study on ATI-5923,and higher external pharmaceutical manufacturing and start-up costs inpreparation for additional clinical studies on our ATI-5923 program;

 

·                  a $1.3 million increase in externalexpenditures related to a clinical study for our ATI-2042 program; and

 

·                  a $200,000 increase in externalpharmaceutical manufacturing costs for clinical trial materials in preparationfor clinical development of our ATI-9242 program and a $300,000 increase inspending on our other research programs.

 

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

 
| ** **                                  | ** ** | **Three Months Ended** | ** ** | ** **              | ** ** | ** ** | ** ** |
|---------------------------------------------|------------|----------------------------------|------------|-------------------------|------------|------------|------------|
| ** **                                  | ** ** | **March 31,**               | ** ** | **Change**              | ** ** |
| ** **                                  | ** ** | **2008**                         | ** ** | **2007**                | ** ** | **$**      | ** ** | **%** | ** ** |
| ** **                                  | ** ** | ** **                       | ** ** | **(in thousands)** | ** ** | ** ** | ** ** |
| Selling, general and administrative expense |       | $                                | 2,932      |                    | $          | 1,897      |       | $ | 1,035 |   | 55 | % |
|                                             |            |                                  |            |                         |            |            |            |  |  |  |  |  |

 

The higher selling, general and administrativeexpense for the three months ended March 31, 2008 as compared to the sameperiod in 2007 was primarily due to increases in personnel and personnelrelated costs, including stock compensation expense, higher 

 

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compensation cost fornon-employee directors, and increases in our legal, professional services andinsurance costs, some of which was attributable to our transition as a publiccompany.

 

***Interestand Other Income, Net***

 
| ** **                     | ** ** | **Three Months Ended** | ** ** | ** **              | ** ** | ** ** | ** ** |
|--------------------------------|------------|----------------------------------|------------|-------------------------|------------|------------|------------|
| ** **                     | ** ** | **March 31,**               | ** ** | **Change**              | ** ** |
| ** **                     | ** ** | **2008**                         | ** ** | **2007**                | ** ** | **$**      | ** ** | **%** | ** ** |
| ** **                     | ** ** | ** **                       | ** ** | **(in thousands)** | ** ** | ** ** | ** ** |
| Interest and other income, net |       | $                                | 549        |                    | $          | 636        |       | $ | (87 | ) | (14 | )% |
|                                |            |                                  |            |                         |            |            |            |  |  |  |  |  |

 

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 months ended March 31, 2008 as compared tothe same period in 2007 wasprimarily attributable to lower average cash and investment balances and ageneral decline in yields for investments held in our investment portfolio.

 

***InterestExpense***

 
| ** **       | ** ** | **Three Months Ended** | ** ** | ** **              | ** ** | ** ** | ** ** |
|------------------|------------|----------------------------------|------------|-------------------------|------------|------------|------------|
| ** **       | ** ** | **March 31,**               | ** ** | **Change**              | ** ** |
| ** **       | ** ** | **2008**                         | ** ** | **2007**                | ** ** | **$**      | ** ** | **%** | ** ** |
| ** **       | ** ** | ** **                       | ** ** | **(in thousands)** | ** ** | ** ** | ** ** |
| Interest expense |       | $                                | 494        |                    | 332        |       | $          | 162 |   | 49 | % |
|                  |            |                                  |            |                         |            |            |            |  |  |  |  |

 

Theincrease in interest expense for three months ended March 31, 2008 ascompared to the same period in 2007 was primarily due to additional interestexpense related to the amortization of warrants and the utilization of theadditional $9.0 million loan facility extended to us by Lighthouse CapitalPartners.

 

**Liquidity and Capital Resources**

 
| ** **                  | ** ** | **Three Months Ended  March 31,** | ** ** |
|-----------------------------|------------|--------------------------------------------------|------------|
| ** **                  | ** ** | **2008**                                         | ** ** | **2007** | ** ** |
| ** **                  | ** ** | **(In thousands)**                          | ** ** |
| Cash (used in) provided by: |       |                                             |       |   |   |
| Operating activities        |       | (9,986                                           | )          | (6,243 | ) |
| Investing activities        |       | 4,849                                            |       | 3,863 |   |
| Financing activities        |       | 8,229                                            |       | (672 | ) |
| Total cash (used) provided  |       | 3,092                                            |       | (3,052 | ) |

 

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 March 31,2008, we had $60.6 million in cash, cash equivalents and marketable securitiesand a $68,000 receivable from P&G. Since inception, we have incurredsignificant net operating losses and, as of March 31, 2008, we had anaccumulated deficit of $132.2 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 the next twelve months.

 

Net cash used in operating activities for the threemonths ended March 31, 2008 was $10.0 million as compared to $6.2million for the same period in 2007. Net cash used in each of these periods wasdue to the funding of our operating costs and expenses in connection with theconduct of our research, development and administrative activities.

 

Net cash provided by investing activities was$4.8 million for the three months ended March 31, 2008 as compared to$3.9 million for the same period in 2007. Investing activities consistprimarily of purchases and sales of marketable securities and property andequipment purchases. Purchases of property and equipment were $416,000 and$133,000 for the three months ended March 31, 2008 and 2007, respectively.Net sale of our marketable securities provided $5.6 million and $4.0 million tofund our operations for the three months ended March 31, 2008 and 2007,respectively.

 

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Net cash provided by financing activities was $8.2million during the three months ended March 31, 2008 and was primarily dueto theutilization of the additional $9.0 million loan facility extended to us byLighthouse Capital Partners, partially offset by $760,000 in principal paymenton our long-term debt. Net cash used in financing activities was$672,000 during the three months ended March 31, 2007 due to principalpayments on our long-term debt.

 

On March 28, 2005, we entered into a loanagreement with 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 agreement provides that additional amounts borrowed under a newpromissory 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 agreement contains no financialcovenants. Default terms under the 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, LighthouseCapitalPartners 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 March 31, 2008, we had fully utilized the total debtcommitment available under the loan agreement, as amended, and had a totalunpaid principal balance outstanding of $13.7 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 agreement with statedinterest rates ranging from 11.73% to 12.89%. Under the agreement, events ofdefault include non-payment of amounts owed, a non-permitted sale or transferof collateral, misrepresentations under the agreement, bankruptcy and otherstandard provisions. Funds borrowed under the agreement are secured by specificequipment assets and GE has a first priority security interest in those assets.The agreement contains no financial covenants and no warrants to purchaseshares of our capital stock were issued to GE in connection with the debtfinancing. The arrangement provides for monthly payments of principal andinterest through July 2010. As of March 31, 2008, the total unpaidprincipal balance outstanding under our existing GE equipment loans was$787,000.

 

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.

 

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, we maynot be able to continue development of our product candidates or we could berequired to delay, scale back or eliminate some or all of our research anddevelopment programs. We may 

 

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

 

**Contractual Obligations**

 

In February 2008, wefully utilized the additional $9.0 million loan facility pursuant to the termsof the amended loan agreement with Lighthouse Capital Partners dated October 19,2007. The amended loan agreement provides for a seven-month interest-only periodand a 36 month repayment term which will begin on October 1, 2008. Therewere no additional material changes in our contractual obligations from thosedisclosed in our annual report on Form 10-K filed with the SEC on March 17,2008, other than scheduled payments made through March 31, 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 March 31, 2008, we held $2.0million of auction rate securities in our marketable securities portfolio.Since the beginning of 2008, we have experienced failed auctions of certain ofthe auction rate securities held in our portfolio. While we believe the failedauctions that we have experienced thus far in 2008 are the result of temporarymarket conditions, we have reevaluated the fair value of the auction ratesecurities in our portfolio in light of current market conditions. Based onthis reevaluation, we recorded $55,000 in unrealized losses as a component ofother comprehensive loss as of March 31, 2008, representing a 6.3%reduction to the carrying value of two of our auction rate holdings.

 

Subsequentto March 31, 2008, we liquidated $1.1 million of our auction rateholdings and as of May 1, 2008, $950,000 of auction rate securities, atpar value, remained in our portfolio.

 

**ITEM 4. CONTROLS AND PROCEDURES**

 

***Evaluationof Disclosure Controls and Procedures***

 

As of March 31, 2008, an evaluation wasperformed by management, with the participation of our Chief Executive Officer(“CEO”) and our Chief Financial Officer (“CFO”), of the effectiveness of ourdisclosure controls and procedures (as defined in Rules 13a-15(e) and15-d and 15(e) under the Securities Exchange Act of 1934, as amended).Disclosure controls and procedures are controls and procedures that aredesigned to ensure that information required to be disclosed in our reportsfiled or submitted under the Securities Exchange Act of 1934, as amended, isrecorded, processed, summarized and reported within the time periods specifiedin the Securities and Exchange Commission’s rules and forms. Based on thatevaluation, our CEO and CFO have concluded that, subject to the limitationsdescribed below, our disclosure controls and procedures were effective as of March 31,2008.

 

***Limitationson the Effectiveness of Controls***

 

Our management, including our CEO and CFO, does notexpect that our disclosure controls and procedures or our internal controlswill prevent all error and all fraud. A control system, no matter how wellconceived and operated, can provide only 

 

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reasonable, not absolute,assurance that the objectives of the control system are met. Because of theinherent limitations in all control systems, no evaluation of controls canprovide absolute assurance that all control issues and instances of fraud, ifany, within the company have been detected. These inherent limitations includethe realities that judgments in decision-making can be faulty, and thatbreakdowns can occur because of simple error or mistake. Additionally, controlscan be circumvented by the individual acts of some persons, by collusion of twoor more people, or by management override of the control. The design of anysystem of controls also is based in part upon certain assumptions about thelikelihood of future events, and there can be no assurance that any design willsucceed in achieving its stated goals under all potential future conditions.Over time, control may become inadequate because of changes in conditions, orthe degree of compliance with the policies or procedures may deteriorate.Because of the inherent limitations in a cost-effective control system,misstatements due to error or fraud may occur and not be detected.

 

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

 

No change was made in our internal control overfinancial reporting during the quarter ended March 31, 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 following risks anduncertainties that may have a material adverse effect on our business,financial condition or results of operations. The risks described below are notthe only ones we face. Additional risks not presently known to us or that wecurrently believe are immaterial may also significantly impair our businessoperations. 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 March 31, 2008, we had an accumulated deficit ofapproximately $132.2 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, we estimate our cost of establishing a 100-person specialtysales force to co-promote ATI-7505 to amount to approximately$20.0 million. As a result, we expect to continue to incur substantial andincreasing losses for the foreseeable future. These losses have had and willcontinue to have an adverse effect on our stockholders’ equity and workingcapital.

 

        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. We have devoted substantially allof our efforts to research and development, including clinical trials. If weare unable to develop and commercialize any of our product candidates, if developmentis delayed or if sales revenue from any product candidate that receivesmarketing approval is insufficient, we may never become profitable. Even if wedo become profitable, we may not be able to sustain or increase ourprofitability 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;

 

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

 

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

 

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        Wedo not expect any of our current product candidates to be commerciallyavailable before 2012, if at all. If we are unable to make our productcandidates commercially available, we will not generate product revenues and wewill not be successful. The results of our clinical trials to date do notprovide assurance that acceptable efficacy or safety will be shown uponcompletion of Phase 3 clinical trials.

 

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

 

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

 

·                  we may not complete a 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 beterminated or allowed to expire, which would delay the development and mayincrease the cost of developing our product candidates.

 

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

 

        ***To date, we have established asingle corporate partnership with P&G to develop and commercializeATI-7505. Collaborative arrangements do not currently exist for our otherproduct candidates. If we do not establish collaborations for each of ourATI-5923, ATI-2042 and ATI-9242 product candidates or future productcandidates, we may have to alter our development and commercialization plans.****

 

        Ourstrategy includes selectively collaborating with leading pharmaceutical andbiotechnology companies to assist us in furthering the development andpotential commercialization of some of our product candidates, includingATI-7505 (in place with P&G), ATI-5923, ATI-2042 and ATI-9242. We intend toseek partners because the commercialization of each of our first four productcandidates involves a large, primary care market that must be served by largesales and marketing organizations and because we do not currently have thecapabilities to perform Phase 3 clinical trials. We face significantcompetition in seeking appropriate 

 

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collaborators,and these collaborations are complex and time-consuming to negotiate anddocument. We may not be able to negotiate collaborations on acceptable terms,if at all. We are unable to predict when, if ever, we will enter into anycollaborations because of the numerous risks and uncertainties associated withestablishing collaborations. If we are unable to negotiate an acceptablecollaboration, we may have to curtail the development of a particular productcandidate, reduce or delay its development program or one or more of our otherdevelopment programs, delay its potential commercialization or reduce the scopeof our sales or marketing activities or increase our expenditures and undertakedevelopment or commercialization activities at our own expense. If we elect toincrease our expenditures to fund development or commercialization activitieson our own, we may need to obtain additional capital, which may not beavailable to us on acceptable terms, if at all. If we do not have sufficientfunds, we will not be able to bring our product candidates to market andgenerate product revenues.

 

        ***The commercial success of ourcollaboration with P&G depends in part on the development and marketingefforts of P&G, over which we have limited control. If our collaborationwith P&G is unsuccessful, our ability to develop and commercialize and togenerate future revenue from the sale of ATI-7505 would be significantlyreduced.***

 

        Ourdependence on our collaboration arrangement with P&G subjects our companyto a number of risks. Our ability to develop and commercialize ATI-7505 withour collaboration partner depends on our and P&G’s ability to establish thesafety and efficacy of ATI-7505, obtain and maintain regulatory approvals andachieve market acceptance of ATI-7505 once commercialized. Our collaborationpartner may elect to delay or terminate development of ATI-7505, independentlydevelop products that compete with ATI-7505, or fail to commit sufficientresources to the marketing and distribution of ATI-7505. Competing products,either developed by P&G or to which they have rights or acquire such rightsin the future, may result in their withdrawal of support for ATI-7505.

 

        Inthe event that P&G fails to use commercially reasonable efforts todiligently develop or commercialize ATI-7505 under our collaboration agreement,we have the right to terminate their rights to ATI-7505, but we will notreceive any future revenue from that product candidate unless we are ableeither to find another partner or to commercialize the product candidate on ourown, which is likely to result in significant additional expense. Businesscombinations, significant changes in business strategy, litigation and/orfinancial difficulties may also adversely affect the willingness or ability ofP&G to fulfill their obligations under our collaboration agreement. IfP&G fails to perform in the manner we expect, our potential to develop andcommercialize ATI-7505 through other collaborations and to generate futurerevenue from the sale of ATI-7505 would be significantly reduced. If a conflictof interest arises between us and P&G, they may act in their ownself-interest and not in the interest of our company or our stockholders.P&G may terminate our collaboration agreement at any time pursuant to itsterms. If P&G breaches or terminates their collaboration agreement with usor otherwise fails to perform their obligations thereunder in a timely manner,the clinical development or commercialization of ATI-7505 could be delayed orterminated.

 

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

 

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

 

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

 

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

 

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        TheFDA has substantial discretion in the approval process and may refuse to acceptany application or decide that our data are insufficient for approval andrequire additional preclinical, clinical or other studies. For example, varyinginterpretations of the data obtained from preclinical and clinical testingcould delay, limit or prevent regulatory approval of a product candidate.Moreover, the FDA may not agree that certain target indications are approvable.For instance, the FDA has never approved a drug for postprandial distresssyndrome, or PDS, and we cannot be certain that the FDA will recognize PDS asan indication for which ATI-7505 or other drugs can be approved. As anotherexample, while we believe we have clear direction from the FDA as to thedevelopment path for ATI-5923 based on our initial discussions, the FDA maychange their judgment on the appropriate development pathway for ATI-5923 atany time.

 

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

 

        ***Safety issues relating to ourproduct candidates or the original drugs upon which our product candidates havebeen modeled, or relating to approved products of third parties that aresimilar to our product candidates, could give rise to delays in the regulatoryapproval process.****

 

        Discoveryof previously unknown problems with an approved product may result inrestrictions on its permissible uses, including withdrawal of the medicine fromthe market. Each of the opportunities upon which we have chosen to focus isbased upon our belief that our RetroMetabolic Drug Design technology can beused to create a new product based upon an existing product which isefficacious in treating a specific condition, but which has a known safetyproblem. Each of our four lead product candidates is modeled on drugs whichhave significant safety problems. ATI-7505 is modeled on cisapride which waswithdrawn from the market due to fatal cardiac problems. ATI-5923 is modeled onwarfarin which is known to have safety risks because of its potential for bleedingand for drug-drug interactions with numerous other drugs as listed on thepackage insert for the product. ATI-2042 is modeled on amiodarone which isused, but not approved, for atrial fibrillation in spite of known safetyproblems due to its accumulation in the body and interaction with other drugs.Both amiodarone and ATI-2042 contain iodine which can accumulate in the thyroidand must be monitored for safety purposes. As will be required with each of ourproduct candidates, P&G is performing the standard regulatory studydesigned to more definitively determine what effect, if any, ATI-7505 has on Qtinterval, or a measure of the relaxation phase of the heart which occurs aftereach beat. In addition, ATI-2042 is partially metabolized by CYP450 and, athigh dose levels has caused drug-drug interactions with warfarin whichincreased INR and could increase the risk of hemorrhage complications. ATI-9242is modeled to retain certain of the positive features of the class of atypicalantipsychotic drugs while lessening certain of the safety issues that vary butexist within the class. The receptor profile which yields the positive andavoids the negative features of this class of drugs is a matter of greatdebate. While we have designed ATI-9242 to have an appropriate balance across avery complex set of receptors, we may have targeted an inappropriate profile orthe profile attained may result in an unanticipated lack of efficacy or safetyproblems. Although we have designed our drugs to largely address each of theoriginal drugs’ key safety problems, we will need to continue to demonstratethis through continued clinical testing. It is possible that the FDA may imposeadditional requirements on the development or approval of our products becauseof its concern about the original drug’s safety problems. These potentialadditional barriers could delay, increase the cost of, or prevent thecommercialization of our product candidates.

 

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

 

        Additionally,problems with approved products marketed by third parties that utilize the sametherapeutic target as our product candidates could adversely affect thedevelopment of our product candidates. For example, the recent productwithdrawals of Vioxx by Merck & Co., Inc. and Bextra byPfizer because of safety issues caused other drugs that have the sametherapeutic 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 we may be required by regulatory agencies to perform tests, inaddition to those we have planned, in order to demonstrate that ATI-7505 doesnot have the safety problems associated with Zelnorm. Any failure or delay incommencing or completing clinical trials or obtaining regulatory approvals forour product candidates would delay commercialization of our product candidatesand severely harm our business and financial condition.

 

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        ***We will need substantial additionalfunding and may be unable to raise capital when needed, which would force us todelay, reduce or eliminate our product development programs orcommercialization efforts.****

 

        Ouroperations have consumed substantial amounts of cash since inception. We expectto continue to spend substantial amounts of cash to fund our operations,including research and development expenses and costs associated with theconduct of clinical trials for our product candidates. Net cash used inoperating activities was $10.0 million and $6.3 million in the threemonths ended March 31, 2008 and 2007, respectively. We expect that our netcash used in operations will increase significantly in each of the next severalyears in order to support our operations and complete the development andcommercialization of our product candidates. We will need to raise additionalcapital to fund our operations and complete the development of our productcandidates. It is our intention to enter into collaborations to commercializeour products, but we retained the commercial right to co-promote ATI-7505 toselected physicians through a specialty sales force. If ATI-7505 or any otherproduct candidates receive regulatory approval for commercial sale, we willneed to 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.

 

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

 

        Ifwe raise additional funds by issuing equity securities, our stockholders willexperience dilution. Any debt financing or additional equity that we raise maycontain terms that are not favorable to our stockholders or us. If we raiseadditional funds through collaboration and licensing arrangements with thirdparties, we may be required to relinquish some rights to our technologies orour product candidates or grant licenses on terms that are not favorable to us.

 

        Wedo not expect our existing capital resources to be sufficient to enable us tofund the completion of the development of any of our product candidates. Weexpect that our existing capital resources will enable us to maintain currentlyplanned operations into the fourth quarter of 2009. However, our operating planmay change, and we may need additional funds sooner than planned to meetoperational needs and capital requirements for product development andcommercialization.

 

        Additionalfunds may not be available when we need them on terms that are acceptable tous, or at all. If adequate funds are not 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.

 

        ***Any failure or delay in commencingor completing clinical trials for our product candidates could severely harmour business.***

 

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

 

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·                  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.

 

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

 

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

 

        Wedo not have the ability to independently conduct clinical trials for ourproduct candidates, and we must rely on our existing corporate partner forATI-7505, and for each of our other product candidates we must rely on thirdparties such as contract research organizations, medical institutions, clinicalinvestigators and contract laboratories, to conduct our clinical trials. Wehave, in the ordinary course of business, entered into agreements with thesethird parties. To date, we have utilized more than 15 vendors to provideclinical trial management, data collection and analysis, laboratory and safetyanalysis services to us in the conduct of our clinical trials. In addition, todate we have conducted our clinical trials at more than 105 sites in NorthAmerica and Europe. Our corporate partner for ATI-7505, P&G, also engagesthird parties to conduct clinical trials. Nonetheless, we or our corporatepartner are responsible for confirming that each of our clinical trials isconducted in accordance with its general investigational plan and protocol.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 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 of our patentsexpire, are invalidated or are unenforceable, or if some or all of our patentapplications do not yield issued patents or yield patents with narrow claims,competitors may develop competing products using our intellectual property andour business will suffer.****

 

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

 

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

 

·                  we might not have been the first to make 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;

 

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·                  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.

 

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

 

        Ourability and our collaborators’ ability to obtain patents is highly uncertainbecause, to date, some legal principles remain unresolved, there has not been aconsistent policy regarding the breadth or interpretation of claims allowed inpatents in the United States and the specific content of patents and patentapplications that are necessary to support and interpret patent claims ishighly uncertain due to the complex nature of the relevant legal, scientificand factual issues. Recent patent-related decisions in the United StatesFederal Courts may make protection of patents in our industry even moredifficult. Similarly, the U.S. Patent and Trademark Office, or USPTO, recentlyattempted to promulgate changes to patent rules that could have materiallyaffected the ability of companies in our industry to obtain patents. An April 1,2008 decision by the U.S. District Court for the Eastern District of Virginiaset aside the new rules, but the USPTO has indicated that they intend to appealthe decision. The USPTO has further proposed rule changes that could beenacted at any time. While such rule changes may also be challenged, thereis no guarantee of a decision 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 is uncertainwhether 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.

 

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

 

        Asof March 31 2008, we held 41 issued or allowed U.S. patents and had 17patent applications pending before the U.S. Patent and Trademark Office, orUSPTO. For some of our inventions, corresponding foreign patent protection ispending. Of the 41 U.S. patents that we hold, 37 patents are compound- andcomposition-related, having expiration dates from 2013 to 2025.  The composition of matter patent for our leadcompound ATI-7505 for the treatment of gastrointestinal disorders issued in February 2007,and has an expiration date in 2025. Our composition of matter patent forATI-5923, our compound for anticoagulation, issued in August 2007 and hasan expiration date in 2025. Our composition of matter patent for ATI-2042, ourcompound for the treatment of atrial fibrillation, issued in April 2002and has an expiration date in 2020. Although third parties may challenge ourrights to, or the scope or validity of, our patents, to date we have notreceived any communications from third parties challenging our patents orpatent applications covering our clinical candidates.

 

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

 

        Ourresearch and development collaborators may have rights to publish data andother information in which we have rights. In addition, we sometimes engageindividuals or entities to conduct research that may be relevant to ourbusiness. The ability of these individuals or entities to publish or otherwisepublicly disclose data and other information generated during the course oftheir research is subject to certain contractual limitations. In most cases,these individuals or entities are, at the least, precluded from 

 

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publiclydisclosing our confidential information and are only allowed to disclose otherdata or information generated during the course of the research after we havebeen afforded an opportunity to consider whether patent and/or otherproprietary protection should be sought. If we do not apply for patentprotection prior to such publication or if we cannot otherwise maintain theconfidentiality of our technology and other confidential information, then ourability to receive patent protection or protect our proprietary information maybe jeopardized.

 

        ***Failure to adequately protect ourtrade secrets and other intellectual property could substantially harm ourbusiness and results of operations.***

 

        Wealso rely on trade secrets to protect our technology, especially where we donot believe that patent protection is appropriate or obtainable. This isparticularly true for our RetroMetabolic Drug Design technology. However, tradesecrets are difficult to protect. Our employees, consultants, contractors,outside scientific collaborators and other advisors are required to signconfidential disclosure agreements but they may unintentionally or willfullydisclose our confidential information to competitors. Enforcing a claim that athird party illegally obtained and is using our trade secrets is expensive andtime-consuming, and the outcome is unpredictable. Failure to obtain or maintaintrade secret protection could adversely affect our competitive businessposition.

 

        ***Third-party claims of intellectualproperty infringement would require us to spend significant time and money andcould prevent us from developing or commercializing our products.***

 

        Ourcommercial success depends in part on not infringing the patents andproprietary rights of other parties and not breaching any licenses that we haveentered into with regard to our technologies and products. Because others mayhave filed, and in the future are likely to file, patent applications coveringproducts or other technologies of interest to us that are similar or identicalto ours, patent applications or issued patents of others may have priority overour patent applications or issued patents. There are numerous issued andapplied for patents related to the original molecules and analogs of such fromwhich our products are engineered. If the patents are determined to be validand construed to cover our products, the development and commercialization ofany or all could be affected. We do not believe that our activities infringethe patents of others or that the patents of others inhibit our freedom tooperate. However, it is possible that others may choose to challenge this positionand that a judge or jury will disagree with our conclusions, and we could incursubstantial costs in litigation if we are required to defend against patentsuits brought by third parties. Similarly, if we initiate suits to defend ourpatents, such litigation could be costly and there is no assurance we would besuccessful in such processes. Any legal action against our collaborators or usclaiming damages and seeking to enjoin commercial activities relating to theaffected products and processes could, in addition to subjecting us topotential liability for damages, require our collaborators or us to obtain alicense to continue to manufacture or market the affected products andprocesses. Licenses required under any of these patents may not be available oncommercially acceptable terms, if at all. Failure to obtain such licenses couldmaterially and adversely affect our ability to develop, commercialize and sellour product candidates. We believe that there may continue to be significantlitigation in the biotechnology and pharmaceutical industry regarding patentand other intellectual property rights. If we become involved in litigation, itcould consume a substantial portion of our management and financial resourcesand we may not prevail in any such litigation.

 

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

 

        ***If third parties do not manufactureour product candidates in sufficient quantities or at an acceptable cost,clinical development and commercialization of our product candidates would bedelayed. ****

 

        Wepresently do not have sufficient quantities of our product candidates tocomplete clinical trials of any of our lead product candidates. We do notcurrently own or operate manufacturing facilities, and we rely and expect tocontinue to rely on a small number of third-party manufacturers and activepharmaceutical ingredient formulators for the production of clinical andcommercial quantities of our product candidates. We do not have long-termagreements with any of these third parties, and our agreements with these partiesare generally terminable at will by either party at any time. If for anyreason, 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 

 

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intofavorable agreements with them. Any inability to acquire sufficient quantitiesof our product candidates in a timely manner from these third parties coulddelay clinical trials and prevent us from developing and commercializing ourproduct candidates in a cost-effective manner or on a timely basis.

 

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

 

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

 

        Thestarting materials for the production of ATI-2042 are provided by the followingvendors: SCI Pharmtech, Inc., Lexen Inc., Panchim, Julich GmbHand Weylchem Inc. To date, Ricerca, Biosciences, LLC,ScinoPharm Ltd. and SCI Pharmtech have produced all of ATI-2042’s activepharmaceutical ingredient. Historically, we have relied on Ricerca andScinoPharm as single-source suppliers for ATI-2042’s active pharmaceuticalingredients. In the event that Ricerca, Biosciences, LLC,ScinoPharm Ltd. or SCI Pharmtech could not produce ATI-2042, we would notbe able to manufacture ATI-2042’s active pharmaceutical ingredient. This coulddelay the development of, and impair our ability to, commercialize ATI-2042. Toproduce ATI-2042 drug product, drug substance is processed into 50 milligram or200 milligram capsule forms by Patheon Inc.

 

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

 

        Allof our current arrangements with third-party manufacturers and suppliers forthe production of our product candidates are on a purchase order basis. P&G’sarrangements with the third-party manufacturers and suppliers for ATI-7505 arealso on a purchase order basis. We, and P&G with respect to ATI-7505,currently do not have long-term supply contracts with any of the third-partymanufacturers and suppliers for our product candidates, and they are notrequired to supply us, or P&G in the case of ATI-7505, with products forany specified periods, in any specified quantities or at any set price, exceptas may be specified in a particular purchase order. We have no reason tobelieve any of the current manufacturers and suppliers for our productcandidates is the sole source for the materials they supply us. However, if weor P&G 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 are required to obtainalternate third-party manufacturers, it could delay or prevent the clinicaldevelopment and commercialization of our product candidates.***

 

        Wemay not be able to maintain or renew our existing or any other third-partymanufacturing arrangements on acceptable terms, if at all. If we are unable tocontinue relationships with our current suppliers, or to do so at acceptablecosts, or if these suppliers fail to meet our requirements for these productcandidates for any reason, we would be required to obtain alternativesuppliers. Any inability to obtain qualified alternative suppliers, includingan inability to obtain or delay in obtaining approval of an alternativesupplier from the FDA, would delay or prevent the clinical development andcommercialization of these product candidates.

 

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

 

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

 

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

 

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

 

        Ifwe are not able to obtain adequate supplies of our product candidates, it willbe more difficult for us to develop our product candidates and competeeffectively. Our product candidates and any products that we may develop maycompete with other product candidates and products for access to manufacturingfacilities.

 

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

 

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

 

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

 

·                  regulators or institutional review boards 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.

 

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

 

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

 

        Unforeseenevents could cause us to experience significant delays in, or the terminationof, clinical trials. Any such events would increase our costs and could delayor prevent our ability to commercialize our product candidates, which wouldadversely impact our financial results.

 

        ***We may not be successful in ourefforts to identify or discover additional candidates using our RetroMetabolicDrug Design Technology. ****

 

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

 

·                  the research methodology used may not 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.

 

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

 

        ***Our product candidates will remainsubject to ongoing regulatory review even if they receive marketing approval.If we fail to comply with continuing regulations, we could lose these approvalsand the sale of our products could be suspended.***

 

        Evenif we receive regulatory approval to market a particular product candidate, theapproval could be conditioned on our conducting additional costly post-approvalstudies or could limit the indicated uses included in our labeling. Moreover,the product may later cause adverse effects that limit or prevent itswidespread use, force us to withdraw it from the market or impede or delay ourability to obtain regulatory approvals in additional countries. In addition,the manufacturer of the product and its facilities will continue to be subjectto FDA review and periodic inspections to ensure adherence to applicable GMPAregulations. After receiving marketing approval, the manufacturing, labeling,packaging, adverse event reporting, storage, advertising, promotion and recordkeeping related to the product will remain subject to extensive regulatoryrequirements.

 

        Ifwe fail to comply with the regulatory requirements of the FDA and otherapplicable U.S. and foreign regulatory authorities or previously unknownproblems with our products, manufacturers or manufacturing processes arediscovered, we could be subject to administrative or judicially imposedsanctions, including:

 

·                  restrictions on the products, manufacturersor manufacturing processes;

 

·                  warning letters;

 

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·                  civil or criminal penalties or fines;

 

·                  injunctions;

 

·                  product seizures, detentions or import bans;

 

·                  voluntary or mandatory product recalls andpublicity requirements;

 

·                  suspension or withdrawal of regulatoryapprovals;

 

·                  total or partial suspension of production;and

 

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

 

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

 

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

 

        ***The commercial success of anyproducts that we may develop will depend upon the degree of market acceptanceamong physicians, patients, healthcare payors and the medical community.***

 

        Anyproducts that we may develop may not gain market acceptance among physicians,patients, healthcare payors and the medical community. If these products do notachieve an adequate level of acceptance, we may not generate material productrevenues and we may not become profitable. The degree of market acceptance of anyof our product candidates, if approved for commercial sale, will depend on anumber 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 unable to establish salesand marketing capabilities or enter into agreements with third parties tomarket and sell our product candidates, we may be unable to generate productrevenue.***

 

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        Wedo not have a sales and marketing organization and have no experience in thesales, marketing and distribution of pharmaceutical products. It is ourintention to use collaborative arrangements to gain access to large sales andmarketing organizations in order to commercialize our product candidates. Byexercising our co-promotion rights under our agreement with P&G, we intendto eventually build a small specialty sales force to market our productcandidates to specific physician groups. There are risks involved withestablishing our own sales and marketing capabilities and entering intoarrangements with third parties to perform these services. Developing aninternal sales force is expensive and time-consuming and could delay anyproduct launch. Importantly, our co-promotion agreement with P&G onlyprovides for a partial reimbursement of the cost of our sales force and onlyfor the cost of sales actually made. The cost to establish the sales force willnot be reimbursed by P&G. The sales force only has the potential to becomea profitable effort if additional products are obtained that could be marketedby this specialty sales force. However, there is no assurance that futureproducts will be obtained through internal or external efforts. 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.

 

        Weplan to establish our own specialty sales force and engage pharmaceutical orother healthcare companies with an existing sales and marketing organizationand distribution system to sell, market and distribute our products. We may notbe able to establish these sales and distribution relationships on acceptableterms, or at all. Factors that may inhibit our efforts to commercialize ourproducts without collaborators or licensees include:

 

·                  our inability to convince future 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.

 

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

 

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

 

        Manypatients may be unable to pay for any products that we may develop. In theUnited States, many patients will rely on Medicare, Medicaid, private healthinsurers and other third-party payors to pay for their medical needs. Ourability to achieve acceptable levels of reimbursement for drug treatments bygovernmental authorities, private health insurers and other organizations willhave an effect on our ability to successfully commercialize, and attractcollaborative partners to invest in the development of, our product candidates.We cannot be sure that reimbursement in the United States, Europe or elsewherewill be available for any products that we may develop, and any reimbursementthat may become available may be decreased or eliminated in the future.Third-party payors increasingly are challenging prices charged for medicalproducts and services, and many third-party payors may refuse to providereimbursement for particular drugs when an equivalent generic drug isavailable. Although we believe that the safety profile of any products that wemay develop will be sufficiently different from 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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        Thetrend toward managed healthcare in the United States and the changes in healthinsurance programs, as well as legislative proposals to reform healthcare orreduce government insurance programs, may result in lower prices forpharmaceutical products, including any products that may be offered by us. Inaddition, any future regulatory changes regarding the healthcare industry orthird-party coverage and reimbursement may affect demand for any products thatwe may develop and could harm our sales and profitability.

 

        ***If our competitors are able todevelop and market products that are more effective, safer or less costly thanany products that we may develop, our commercial opportunity will be reduced oreliminated. ****

 

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

 

        ATI-7505has potential use in five indications: chronic constipation, functionaldyspepsia, GERD, gastroparesis and IBS with constipation. Some of theseindications may not be recognized by the FDA as sufficiently defined to enableregulatory approval of a drug for treatment. ATI-7505 is a prokinetic which hasbeen shown to increase motility in the upper and lower gastrointestinal tract,including the ability to improve gastric emptying and colonic motility.Products which affect the gastrointestinal system’s motility could be useful inthe treatment of each of these disorders. Other prokinetics are on the marketor in development which will also be competitive to ATI-7505, includingtegaserod, marketed by Novartis Pharmaceuticals Corporation as Zelnorm, whichwas temporarily withdrawn from the market and recently re-introduced with restrictiveuse labeling, renzapride, being developed by Alizyme plc, TD-5108 beingdeveloped by Theravance, and erythromycin. Many additional prokinetics are indevelopment targeting these indications. We believe the most significantcompetition to ATI-7505 for the treatment of GERD are proton pump inhibitorsand H2 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 stomach. ATI-7505 will face competition from the prokinetics aswell as many inexpensive over-the-counter indications for the treatment ofthese gastrointestinal disorders.

 

        Competitionfor ATI-5923 for use as an oral anticoagulant will continue to come fromgeneric coumadin owing to its pricing and the years of experience physiciansand patients have with the drug. Other oral anticoagulants are in developmentthroughout the pharmaceutical and biotechnology industry. Most of thesedevelopment programs fall into either the factor Xa or direct thrombininhibitor categories. We are aware that Johnson & Johnson incollaboration with Bayer AG, Bristol-Myers Squibb Company in collaboration withPfizer, Inc., Eli Lilly and Company and Portola Pharmaceuticals, Inc.each have factor Xa programs in Phase 2 or Phase 3 testing. We areaware of a direct thrombin inhibitor program at Boehringer-Ingelheim GmbH.The first direct thrombin inhibitor presented to the FDA for approval,ximelagatran, previously marketed as Exanta by AstraZeneca plc, has notbeen recommended for approval due to idiosyncratic liver toxicity problems.Although we believe ATI-5923’s mechanism of action (VKOR inhibition as withwarfarin) and broadly available inexpensive monitoring methodology (INR)provide an advantage, these factor Xa and direct thrombin inhibitor programswill likely provide major competition in this market. In addition, there may beother compounds of which we are not aware that are at an earlier stage ofdevelopment and may compete with our product candidates. If any of thosecompounds are successfully developed and approved, they could compete directlywith our product candidates.

 

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

 

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.

 

        Manyof our competitors have significantly greater financial resources and expertisein research and development, manufacturing, preclinical testing, conductingclinical trials, obtaining regulatory approvals and marketing approved productsthan we 

 

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

 

        ***If we fail to attract and keepsenior management and key scientific personnel, we may be unable tosuccessfully develop or commercialize our product candidates.***

 

        Oursuccess depends on our continued ability to attract, retain and motivate highlyqualified management, clinical and scientific personnel and on our ability todevelop and maintain important relationships with leading clinicians. If we arenot able to retain Dr. Goddard, our Chairman and Chief Executive Officer, Dr. Milner,our President, Research and Development, Dr. Canafax, our Vice Presidentand Chief Development Officer, and Dr. Druzgala, our Vice President andChief Scientific Officer, we may not be able to successfully develop orcommercialize our product candidates. Competition for experienced scientistsmay limit our ability to hire and retain highly qualified personnel onacceptable terms. In addition, none of our employees have employment commitmentsfor any fixed period of time and could leave our employment at will. We carry “keyperson” insurance in the amount of $1 million for each of Drs. Milnerand Druzgala, but do not carry “key person” insurance covering any othermembers of senior management or key scientific personnel. If we fail toidentify, attract and retain qualified personnel, we may be unable to continueour development and commercialization activities.

 

        ***We will need to hire additionalemployees in order to commercialize our product candidates. Any inability tomanage future growth could harm our ability to commercialize our productcandidates, increase our costs and adversely impact our ability to competeeffectively.***

 

        Inorder to commercialize our product candidates, we will need to expand thenumber of our managerial, operational, financial and other employees. Wecurrently anticipate that we will need between 164 and 204 additional employeesby the time that ATI-7505 is initially commercialized, which includes 80 to 120sales representatives in the United States. Because the projected time framefor hiring these additional employees depends on the development status of ourproduct candidates and because of the numerous risks and uncertaintiesassociated with drug development, we are unable to project when we will hirethese additional employees. While to date we have not experienced difficultiesin recruiting, hiring and retaining qualified individuals, the competition forqualified personnel in the pharmaceutical and biotechnology field is intense.

 

        Futuregrowth will impose significant added responsibilities on members of management,including the need to identify, recruit, maintain and integrate additionalemployees. Our future financial performance and our ability to commercializeour product candidates and compete effectively will depend, in part, on ourability to manage any future growth effectively.

 

        ***If product liability lawsuits arebrought against us, we will incur substantial liabilities and may be requiredto limit commercialization of any products that we may develop. ****

 

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

 

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

 

·                  injury to our reputation;

 

·                  withdrawal of clinical trial participants;

 

·                  costs to defend the related litigation;

 

·                  substantial monetary awards to clinical trialparticipants or patients;

 

·                  loss of revenue; and

 

·                  the inability to commercialize any productsthat we may develop.

 

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

 

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

 

Ourresearch and development activities involve the use of potentially harmfulbiological materials as well as hazardous materials, chemicals and variousradioactive compounds. We cannot completely eliminate the risk of accidentalcontamination or injury from the use, storage, handling or disposal of thesematerials. In the event of contamination or injury, we could be held liable fordamages that result, and any liability could exceed our resources. We, thethird parties that conduct clinical trials on our behalf and the third partiesthat manufacture our product candidates are subject to federal, state and locallaws and regulations governing the use, storage, handling and disposal of thesematerials and waste products. The cost of compliance with these laws andregulations could be significant. The failure to comply with these laws andregulations could result in significant fines and work stoppages and mayharm our business.

 

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

 

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

 

Asa public reporting company, we need to comply with the Sarbanes-Oxley Act of2002 and the related rules and regulations of the Securities and ExchangeCommission, including expanded disclosures and accelerated reportingrequirements and more complex accounting rules. Compliance with Section 404of the Sarbanes-Oxley Act of 2002 and other requirements will increase ourcosts and require additional management resources. We are continuing to upgradeour finance and accounting systems, procedures and controls and may need tocontinue to implement additional finance and accounting systems, procedures andcontrols as we grow our business and organization and to satisfy new reportingrequirements. Compliance with Section 404 will first apply to our annualreport on Form 10-K for our fiscal year ending December 31, 2008. Ifwe are unable to complete the required assessment as to the adequacy of ourinternal control over financial reporting or if our independent registeredpublic accounting firm is unable to provide us with an unqualified report as tothe effectiveness of our internal controls over financial reporting as of December 31,2008, investors could lose confidence in the reliability of our internalcontrols over financial reporting, which could adversely affect our stock priceand our ability to raise capital.

 

***Our principal facility is locatednear known earthquake fault zones, and the occurrence of an earthquake,extremist attack or other catastrophic disaster could cause damage to ourfacilities and equipment, which could require us to cease or curtailoperations.***

 

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

 

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**RisksRelating to Ownership of Our Common Stock**

 

***Our stock price may be extremelyvolatile, and your investment in our common stock could suffer a decline invalue.***

 

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

 

·                  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 with respectto 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 or pharmaceuticalindustries in general;

 

·                  changes in financial estimates orrecommendations by 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.

 

Thestock markets in general, and the markets for biotechnology stocks inparticular, have experienced extreme volatility that has often been unrelatedto the operating performance of particular companies. These broad marketfluctuations may adversely affect the trading price of our common stock. In thepast, class action litigation has often been instituted against companies whosesecurities have experienced periods of volatility in market price. Any suchlitigation brought against us could result in substantial costs, which wouldhurt our financial condition and results of operations, divert management’sattention and resources, and possibly delay our clinical trials orcommercialization efforts.

 

***Fluctuations in our operatingresults could cause our stock price to decline.***

 

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

 

·                  adverse results or delays in our 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 with respectto 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; and

 

36

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

 

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

 

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

 

Basedon our outstanding shares as of February 29, 2008, our executive officers,directors and holders of 5.0% or more of our outstanding common stockbeneficially own approximately 39.2% of our common stock. As a result, thesestockholders, acting together, will be able to control all matters requiringapproval by our stockholders, including the election of directors and theapproval of mergers or other business combination transactions. The interestsof this group of stockholders may not always coincide with our interests or theinterests of other stockholders.

 

***Anti-takeover provisions in ourcharter documents and under Delaware law could make an acquisition of us, whichmay be beneficial to our stockholders, more difficult and may prevent attemptsby our stockholders to replace or remove our current management.***

 

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

 

·                  a classified board of directors;

 

·                  a prohibition on actions by our stockholdersby written consent;

 

·                  the ability of our board of directors toissue preferred stock without stockholder approval, which could be used toadopt a stockholders’ rights plan that would make it difficult for a thirdparty to acquire 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 203 of the Delaware GeneralCorporation Law, which prohibits a person who owns in excess of 15% of ouroutstanding voting stock from merging or combining with us for a period ofthree years after the date of the transaction in which the person acquired inexcess of 15% of our outstanding voting stock, unless the merger or combinationis approved in a prescribed manner.

 

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

 

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

 

Asof March 31, 2008, we had 17,664,713 shares of common stock outstanding.The five million shares of common stock sold in our initial public offering arefreely tradable without restriction in the public market unless held by anaffiliate of ours. Any common stock purchased by affiliates in the initialpublic offering is subject to the lock-up agreements relating to our initialpublic offering. Morgan Stanley & Co. Incorporated, asrepresentative of the underwriters for our initial public offering, may, in itssole discretion, permit our officers, directors, employees and currentstockholders who are subject to the 180-day contractual lock-up to sell sharesprior to the expiration of the lock-up agreements. The 180-day restrictedperiod under the lock-up agreements may be extended under specifiedcircumstances. In addition, the shares that are either subject to outstandingoptions or warrants or reserved for future issuance under our 2001 EquityIncentive Plan, 2007 Equity Incentive Plan, 2007 Non-Employee Directors’ StockOption Plan and 2007 Employee Stock Purchase Plan could become eligible forsale in the public market to the extent permitted by the provisions of variousvesting agreements, the lock-up agreements and Rules 144 and 701 under theSecurities Act. If these additional shares are sold, or if it is perceived thatthey will be sold, in the public market, the trading price of our common stockcould decline.

 

Asof March 31, 2008, the holders of approximately 11,415,130 shares ofcommon stock based on shares outstanding, including 189,647 shares underlyingoutstanding warrants, will be entitled to rights with respect to registrationof such shares under the Securities Act of 1933, as amended. If such holders,by exercising their registration rights, cause a large number of securities tobe registered and sold in the public market, these sales could have an adverseeffect on the market price for our common stock. If we 

 

37

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wereto initiate a registration and include shares held by these holders pursuant tothe exercise of their registration rights, these sales may impair our abilityto raise capital. In addition, we filed a registration statement on Form S-8under the Securities Act of 1933, as amended, to register up to 2,638,845shares of our common stock for issuance under our stock option and employeestock purchase plans, and intend to file additional registration statements on Form S-8to register the shares automatically added each year to the share reservesunder these plans.

 

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

 

None.

 

**ITEM 3. DEFAULTS UPON SENIOR SECURITIES**

 

None.

 

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

 

None.

 

**ITEM 5. OTHER INFORMATION**

 

Not applicable.

 

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** **

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

 
| **Exhibit  Number** | ** ** | **Description of Document**                                                                                                                                                                                           |
|---------------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                |       |                                                                                                                                                                                                                  |
| 3.2(1)              |       | Amended and Restated Certificate of Incorporation.                                                                                                                                                                    |
|                |       |                                                                                                                                                                                                                  |
| 3.3(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.                                                                                                              |
|                |       |                                                                                                                                                                                                                  |
| 10.22               |       | Amendment to License, Development and  Commercialization Agreement, dated June 30, 2006, by and between the  Registrant and Proctor & Gamble Pharmaceuticals, Inc., dated  February 29, 2008. |
|                |       |                                                                                                                                                                                                                  |
| 31.1                |       | Certification of the Chief Executive  Officer pursuant to Rule 13a-14(a) and Rule 15d-14(a) of  the Securities Exchange Act, as amended.                                                          |
|                |       |                                                                                                                                                                                                                  |
| 31.2                |       | Certification of the Chief Financial  Officer pursuant to Rule 13a-14(a) and Rule 15d-14(a) of the  Securities Exchange Act, as amended.                                                               |
|                |       |                                                                                                                                                                                                                  |
| 32.1                |       | Certification of the Chief Executive  Officer and Chief Financial Officer pursuant to 18U.S.C. 1350, as adopted  pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.                                      |

 

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(1)          Previously filed as the like numbered exhibit to ARYx Therapeutics, Inc.’sCurrent Report on Form 8-K (No. 001-33782), as filed with theSecurities and Exchange Commission on November 13, 2007 and incorporatedby reference herein.

 

(2)          Previously filed 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:May 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.                                                                                                              |
|                |       |                                                                                                                                                                                                                  |
| 10.22               |       | Amendment to License, Development and  Commercialization Agreement, dated June 30, 2006, by and between the  Registrant and Proctor & Gamble Pharmaceuticals, Inc., dated  February 29, 2008. |
|                |       |                                                                                                                                                                                                                  |
| 31.1                |       | Certification of the Chief Executive  Officer pursuant to Rule 13a-14(a) and Rule 15d-14(a) of  the Securities Exchange Act, as amended.                                                          |
|                |       |                                                                                                                                                                                                                  |
| 31.2                |       | Certification of the Chief Financial  Officer pursuant to Rule 13a-14(a) and Rule 15d-14(a) of  the Securities Exchange Act, as amended.                                                          |
|                |       |                                                                                                                                                                                                                  |
| 32.1                |       | Certification of the Chief Executive  Officer and Chief Financial Officer pursuant to 18U.S.C. 1350, as adopted  pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.                                      |

 

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(1)          Previously filed as the like numbered exhibit to ARYx Therapeutics, Inc.’sCurrent Report on Form 8-K (No. 001-33782), as filed with theSecurities and Exchange Commission on November 13, 2007 and incorporatedby reference herein.

 

(2)          Previously filed 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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