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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, DC 20549



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FORM 10-Q



Mark One

|x | QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES ACT OF 1934
|- | ------------------------------------------------------------------------------



FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2005



Or



| ̈ | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934
|- | ----------------------------------------------------------------------------------------



FOR THE TRANSITION PERIOD FROM
 TO



Commission File Number: 000-31255



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ISTA PHARMACEUTICALS, INC.

(Exact name of registrant as specified in its charter)



|                                                               |  |                                  
|-------------------------------------------------------------- |  | ---------------------------------
|DELAWARE                                                       |  | 33-0511729                       
|(State or other jurisdiction of incorporation or organization) |  | (IRS Employer Identification No.)



15295 Alton Parkway,
Irvine, California 92618

(Address of principal executive offices)



(949) 788-6000

(Registrants telephone number, including area code)



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Indicate by check mark whether the registrant (1) has filed all reports required to be
filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for
the past 90 days. x  Yes ̈No



Indicate by check mark whether the registrant is an accelerated filer (as defined in Exchange
Act Rule 12b-2) ̈Yes x No



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



The number of shares of the registrants common stock, $.001 par value, outstanding as of October 18, 2005 was 25,866,562.



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##### Table of Contents

TABLE OF CONTENTS



|         |  |                                                                                                                            |  |        
|-------- |  | -------------------------------------------------------------------------------------------------------------------------- |  | -------
|         |  |                                                                                                                            |  | Page No
|PART I.  |  | FINANCIAL INFORMATION                                                                                                      |  | 1      
|         |  |                                                                                                                           
|Item 1   |  | Financial Statements                                                                                                       |  | 1      
|         |  |                                                                                                                           
|         |  | Unaudited Condensed Consolidated Balance Sheets  September 30, 2005 and December 31, 2004                                 |  | 1      
|         |  |                                                                                                                           
|         |  | Unaudited Condensed Consolidated Statements of Operations  Three and Nine Month Periods Ended September 30, 2005 and 2004 |  | 2      
|         |  |                                                                                                                           
|         |  | Unaudited Condensed Consolidated Statements of Cash Flows  Nine Month Periods Ended September 30, 2005 and 2004           |  | 3      
|         |  |                                                                                                                           
|         |  | Notes to Unaudited Condensed Consolidated Financial Statements                                                             |  | 4      
|         |  |                                                                                                                           
|Item 2   |  | Managements Discussion and Analysis of Financial Condition and Results of Operations                                      |  | 7      
|         |  |                                                                                                                           
|Item 3   |  | Quantitative and Qualitative Disclosure About Market Risk                                                                  |  | 25     
|         |  |                                                                                                                           
|Item 4   |  | Controls and Procedures                                                                                                    |  | 25     
|         |  |                                                                                                                           
|PART II. |  | OTHER INFORMATION                                                                                                          |  | 25     
|         |  |                                                                                                                           
|Item 1   |  | Legal Proceedings                                                                                                          |  | 25     
|         |  |                                                                                                                           
|Item 6   |  | Exhibits                                                                                                                   |  | 25     
|         |  |                                                                                                                           
|         |  | Signatures                                                                                                                 |  | 26     
|         |  |                                                                                                                           
|         |  | Index to Exhibits                                                                                                          |  | 27     



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##### Table of Contents



PART I. FINANCIAL INFORMATION



|Item 1 | Financial Statements
|------ | --------------------



ISTA Pharmaceuticals, Inc.

Unaudited Condensed Consolidated Balance Sheets

(In thousands, except share data)



|                                                                                                                                                                                                                                                                                                |  |                    |          |   |                   |   |          |  
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ------------------ | -------- | - | ----------------- | - | -------- | -
|                                                                                                                                                                                                                                                                                                |  | September 30, 2005 |          |   | December 31, 2004 |  
|ASSETS                                                                                                                                                                                                                                                                                          |  |                    |          |   |                   |   |          |  
|Current assets:                                                                                                                                                                                                                                                                                 |  |                    |          |   |                   |   |          |  
|Cash and cash equivalents                                                                                                                                                                                                                                                                       |  | $                  | 2,378    |   |                   | $ | 9,506    |  
|Short-term investments                                                                                                                                                                                                                                                                          |  |                    | 41,695   |   |                   |   | 18,242   |  
|Accounts receivable, net of allowances of $56 in 2005 and $4 in 2004                                                                                                                                                                                                                            |  |                    | 3,559    |   |                   |   | 18       |  
|Inventory, net of allowances of $944 in 2005 and $785 in 2004                                                                                                                                                                                                                                   |  |                    | 1,970    |   |                   |   | 756      |  
|Other current assets                                                                                                                                                                                                                                                                            |  |                    | 1,911    |   |                   |   | 784      |  
|                                                                                                                                                                                                                                                                                                |  |                    |          |   |                   |   |          |  
|Total current assets                                                                                                                                                                                                                                                                            |  |                    | 51,513   |   |                   |   | 29,306   |  
|Property and equipment, net                                                                                                                                                                                                                                                                     |  |                    | 1,257    |   |                   |   | 911      |  
|Deposits and other assets                                                                                                                                                                                                                                                                       |  |                    | 289      |   |                   |   | 156      |  
|                                                                                                                                                                                                                                                                                                |  |                    |          |   |                   |   |          |  
|Total Assets                                                                                                                                                                                                                                                                                    |  | $                  | 53,059   |   |                   | $ | 30,373   |  
|                                                                                                                                                                                                                                                                                                |  |                    |          |   |                   |   |          |  
|LIABILITIES AND STOCKHOLDERS EQUITY                                                                                                                                                                                                                                                            |  |                    |          |   |                   |   |          |  
|Current liabilities:                                                                                                                                                                                                                                                                            |  |                    |          |   |                   |   |          |  
|Accounts payable                                                                                                                                                                                                                                                                                |  | $                  | 948      |   |                   | $ | 1,707    |  
|Accrued compensation and related expenses                                                                                                                                                                                                                                                       |  |                    | 1,146    |   |                   |   | 1,379    |  
|Accrued expenses  clinical trials                                                                                                                                                                                                                                                              |  |                    | 211      |   |                   |   | 28       |  
|Current portion of long-term liabilities                                                                                                                                                                                                                                                        |  |                    | 366      |   |                   |   | 3,866    |  
|Current portion of obligation under capital lease                                                                                                                                                                                                                                               |  |                    | 6        |   |                   |   |         |  
|Other accrued expenses                                                                                                                                                                                                                                                                          |  |                    | 5,026    |   |                   |   | 3,454    |  
|                                                                                                                                                                                                                                                                                                |  |                    |          |   |                   |   |          |  
|Total current liabilities                                                                                                                                                                                                                                                                       |  |                    | 7,703    |   |                   |   | 10,434   |  
|Deferred rent                                                                                                                                                                                                                                                                                   |  |                    | 193      |   |                   |   | 89       |  
|Deferred revenue                                                                                                                                                                                                                                                                                |  |                    | 4,063    |   |                   |   | 4,166    |  
|Long-term liabilities                                                                                                                                                                                                                                                                           |  |                    | 91       |   |                   |   | 366      |  
|Obligation under capital lease                                                                                                                                                                                                                                                                  |  |                    | 43       |   |                   |   |         |  
|Commitments and contingencies                                                                                                                                                                                                                                                                   |  |                    |          |   |                   |   |          |  
|Stockholders equity:                                                                                                                                                                                                                                                                           |  |                    |          |   |                   |   |          |  
|Preferred stock, $0.001 par value; 5,000,000 shares authorized of which 1,000,000 shares have been designated as Series A Participating
Preferred Stock at September 30, 2005 and December 31, 2004; no shares issued and outstanding at September 30, 2005 and December 31, 2004, respectively |  |                    |         |   |                   |   |         |  
|Common stock, $0.001 par value; 100,000,000 shares authorized at September 30, 2005 and December 31, 2004; 25,858,962 and 19,350,715
shares issued and outstanding at September 30, 2005 and December 31, 2004, respectively                                                                    |  |                    | 26       |   |                   |   | 19       |  
|Additional paid in capital                                                                                                                                                                                                                                                                      |  |                    | 256,882  |   |                   |   | 203,611  |  
|Deferred compensation                                                                                                                                                                                                                                                                           |  |                    | (36      | ) |                   |   | (167     | )
|Accumulated other comprehensive income                                                                                                                                                                                                                                                          |  |                    | (98      | ) |                   |   | (82      | )
|Deficit accumulated                                                                                                                                                                                                                                                                             |  |                    | (215,808 | ) |                   |   | (188,063 | )
|                                                                                                                                                                                                                                                                                                |  |                    |          |   |                   |   |          |  
|Total stockholders equity                                                                                                                                                                                                                                                                      |  |                    | 40,966   |   |                   |   | 15,318   |  
|                                                                                                                                                                                                                                                                                                |  |                    |          |   |                   |   |          |  
|Total Liabilities and Stockholders Equity                                                                                                                                                                                                                                                      |  | $                  | 53,059   |   |                   | $ | 30,373   |  
|                                                                                                                                                                                                                                                                                                |  |                    |          |   |                   |   |          |  



Note: The balance sheet at
December 31, 2004 has been derived from the audited financial statements at that date, but does not include all of the information and footnotes required by U.S. generally accepted accounting principles for complete financial statements.



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ISTA Pharmaceuticals, Inc.

Unaudited Condensed Consolidated Statements of Operations

(In thousands, except per share amounts)



|                                                                      |  |                                 |        |   |                                 |   |         |      |  |   |         |   |  |   |         |  
|--------------------------------------------------------------------- |  | ------------------------------- | ------ | - | ------------------------------- | - | ------- | ---- |  | - | ------- | - |  | - | ------- | -
|                                                                      |  | Three Months EndedSeptember 30, |        |   | Nine Months Ended September 30, |  
|                                                                      |  | 2005                            |        |   | 2004                            |   |         | 2005 |  |   | 2004    |  
|Revenue:                                                              |  |                                 |        |   |                                 |   |         |      |  |   |         |   |  |   |         |  
|Product sales, net                                                    |  | $                               | 3,518  |   |                                 | $ | 1,784   |      |  | $ | 6,769   |   |  | $ | 1,784   |  
|License revenue                                                       |  |                                 | 69     |   |                                 |   | 69      |      |  |   | 208     |   |  |   | 208     |  
|                                                                      |  |                                 |        |   |                                 |   |         |      |  |   |         |   |  |   |         |  
|Total revenue                                                         |  |                                 | 3,587  |   |                                 |   | 1,853   |      |  |   | 6,977   |   |  |   | 1,992   |  
|Cost of products sold                                                 |  |                                 | 968    |   |                                 |   | 639     |      |  |   | 2,311   |   |  |   | 639     |  
|                                                                      |  |                                 |        |   |                                 |   |         |      |  |   |         |   |  |   |         |  
|Gross profit margin                                                   |  |                                 | 2,619  |   |                                 |   | 1,214   |      |  |   | 4,666   |   |  |   | 1,353   |  
|Operating expenses:                                                   |  |                                 |        |   |                                 |   |         |      |  |   |         |   |  |   |         |  
|Research and development                                              |  |                                 | 4,842  |   |                                 |   | 3,502   |      |  |   | 11,704  |   |  |   | 12,091  |  
|Selling, general and administrative                                   |  |                                 | 7,286  |   |                                 |   | 15,081  |      |  |   | 21,937  |   |  |   | 20,461  |  
|                                                                      |  |                                 |        |   |                                 |   |         |      |  |   |         |   |  |   |         |  
|Total operating expenses                                              |  |                                 | 12,128 |   |                                 |   | 18,583  |      |  |   | 33,641  |   |  |   | 32,552  |  
|                                                                      |  |                                 |        |   |                                 |   |         |      |  |   |         |   |  |   |         |  
|Loss from operations                                                  |  |                                 | (9,509 | ) |                                 |   | (17,369 | )    |  |   | (28,975 | ) |  |   | (31,199 | )
|Interest income                                                       |  |                                 | 412    |   |                                 |   | 156     |      |  |   | 1,250   |   |  |   | 436     |  
|Interest expense                                                      |  |                                 | (3     | ) |                                 |   | (1      | )    |  |   | (20     | ) |  |   | (3      | )
|                                                                      |  |                                 |        |   |                                 |   |         |      |  |   |         |   |  |   |         |  
|Net loss                                                              |  | $                               | (9,100 | ) |                                 | $ | (17,214 | )    |  | $ | (27,745 | ) |  | $ | (30,766 | )
|                                                                      |  |                                 |        |   |                                 |   |         |      |  |   |         |   |  |   |         |  
|Net loss per common share, basic and diluted                          |  | $                               | (0.35  | ) |                                 | $ | (0.93   | )    |  | $ | (1.09   | ) |  | $ | (1.73   | )
|                                                                      |  |                                 |        |   |                                 |   |         |      |  |   |         |   |  |   |         |  
|Shares used in computing net loss per common share, basic and diluted |  |                                 | 25,858 |   |                                 |   | 18,519  |      |  |   | 25,356  |   |  |   | 17,810  |  



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ISTA Pharmaceuticals, Inc.

Unaudited Condensed Consolidated Statements of Cash Flows

(In thousands)



|                                                                            |  |                                 |         |   |      |   |         |  
|--------------------------------------------------------------------------- |  | ------------------------------- | ------- | - | ---- | - | ------- | -
|                                                                            |  | Nine Months Ended September 30, |        
|                                                                            |  | 2005                            |         |   | 2004 |  
|Operating Activities                                                        |  |                                 |         |   |      |   |         |  
|Net loss                                                                    |  | $                               | (27,745 | ) |      | $ | (30,766 | )
|Adjustments to reconcile net loss to net cash used in operating activities: |  |                                 |         |   |      |   |         |  
|Amortization of deferred compensation                                       |  |                                 | 131     |   |      |   | 623     |  
|Amortization of financing costs                                             |  |                                 |        |   |      |   | (331    | )
|Depreciation and amortization                                               |  |                                 | 265     |   |      |   | 181     |  
|Transfer of equipment for technology                                        |  |                                 |        |   |      |   | 214     |  
|Deferred rent                                                               |  |                                 | 104     |   |      |   | (7      | )
|Deferred revenue                                                            |  |                                 | (103    | ) |      |   | (208    | )
|Changes in operating assets and liabilities:                                |  |                                 |         |   |      |   |         |  
|Accounts receivable, net                                                    |  |                                 | (3,541  | ) |      |   | (2,120  | )
|Other current assets                                                        |  |                                 | (1,127  | ) |      |   | 91      |  
|Inventory, net                                                              |  |                                 | (1,214  | ) |      |   | (1,715  | )
|Accounts payable                                                            |  |                                 | (759    | ) |      |   | 363     |  
|Accrued compensation and related expenses                                   |  |                                 | (233    | ) |      |   | 567     |  
|Accrued expenses  clinical trials and other accrued expenses               |  |                                 | 1,755   |   |      |   | 2,239   |  
|Other liabilities                                                           |  |                                 | (3,775  | ) |      |   | 10,732  |  
|                                                                            |  |                                 |         |   |      |   |         |  
|Net cash used in operating activities                                       |  |                                 | (36,242 | ) |      |   | (20,137 | )
|                                                                            |  |                                 |         |   |      |   |         |  
|Investing Activities                                                        |  |                                 |         |   |      |   |         |  
|Purchase of short-term investment securities                                |  |                                 | (56,357 | ) |      |   | (10,362 | )
|Sale of short-term investment securities                                    |  |                                 | 32,888  |   |      |   | 10,352  |  
|Purchase of equipment                                                       |  |                                 | (562    | ) |      |   | (146    | )
|Deposits and other assets                                                   |  |                                 | (133    | ) |      |   | (274    | )
|                                                                            |  |                                 |         |   |      |   |         |  
|Net cash used in investing activities                                       |  |                                 | (24,164 | ) |      |   | (430    | )
|                                                                            |  |                                 |         |   |      |   |         |  
|Financing Activities                                                        |  |                                 |         |   |      |   |         |  
|Proceeds from exercise of stock options                                     |  |                                 | 276     |   |      |   | 121     |  
|Proceeds from issuance of common stock                                      |  |                                 | 53,002  |   |      |   | 14,793  |  
|                                                                            |  |                                 |         |   |      |   |         |  
|Net cash provided by financing activities                                   |  |                                 | 53,278  |   |      |   | 14,914  |  
|                                                                            |  |                                 |         |   |      |   |         |  
|Effect of exchange rate changes on cash                                     |  |                                 |        |   |      |   | 1       |  
|                                                                            |  |                                 |         |   |      |   |         |  
|Decrease in Cash and Cash Equivalents                                       |  |                                 | (7,128  | ) |      |   | (5,652  | )
|Cash and cash equivalents at beginning of period                            |  |                                 | 9,506   |   |      |   | 16,988  |  
|                                                                            |  |                                 |         |   |      |   |         |  
|Cash and Cash Equivalents At End of Period                                  |  | $                               | 2,378   |   |      | $ | 11,336  |  
|                                                                            |  |                                 |         |   |      |   |         |  



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ISTA Pharmaceuticals, Inc.

Notes to Unaudited Condensed Consolidated Financial Statements

September 30, 2005



1. The Company



ISTA Pharmaceuticals, Inc. (ISTA or the Company) was incorporated in the state of California on February 13, 1992 to
discover, develop and market new remedies for diseases and conditions of the eye. The Company reincorporated in Delaware on August 4, 2000. Vitrase®, Istalol®, Xibrom, Caprogel®, ISTA®, ISTA Pharmaceuticals®and the ISTA logo
are our trademarks, either owned or under license.



ISTA is a
specialty pharmaceutical company focused on the development and commercialization of unique and uniquely improved ophthalmic products for serious diseases and conditions of the eye. Since the Companys inception, it has devoted its resources
primarily to fund research and development programs, late-stage product acquisitions and product commercial launches. In December 2001, ISTA announced its strategic plan to transition from a development-stage organization to a specialty
pharmaceutical company with a primary focus on ophthalmology. In July 2004, the Company transitioned from a development-stage organization to a commercial entity.



As of September 30, 2005, the Company had approximately $44.1 million in cash and cash equivalents and short-term
investments. The Company incurred a net loss of $27.7 million for the nine months ended September 30, 2005 and had an accumulated deficit of $215.8 million at September 30, 2005. The ability of ISTA to continue as a going concern is
dependent upon its ability to obtain additional capital and achieve profitable operations. ISTAs ability to attain profitable operations is dependent upon the successful development of its products, approval by the United States Food and Drug
Administration, or FDA, of its products, achieving market acceptance of such approved products and achievement of sufficient levels of revenue to support ISTAs cost structure and growth.



ISTA believes that its current cash and cash equivalents and short-term
investments on hand will be sufficient to finance its anticipated capital and operating requirements for at least the next twelve months. If ISTA engages in acquisitions of companies, products, or technology in order to execute its business
strategy, ISTA may need to raise additional capital. ISTA may be required to raise additional capital in the future through collaborative agreements, private investment in public equity, or PIPE, financings, and various other equity or debt
financings. If ISTA is required to raise additional capital in the future, there can be no assurance that the additional financing will be available on favorable terms, or at all.



The unaudited condensed consolidated financial statements contained in this Form 10-Q do not include any adjustments to the
specific amounts and classifications of assets and liabilities that might be necessary should the Company be unable to continue as a going concern.



2. Basis of Presentation



General



The unaudited condensed consolidated financial statements included herein have been prepared by the Company pursuant to the rules and regulations of the U.S. Securities and Exchange Commission, or SEC. Certain
information and footnote disclosures normally included in financial statements prepared in accordance with U.S. generally accepted accounting principles have been condensed or omitted pursuant to such rules and regulations. In managements
opinion, the accompanying financial statements have been prepared on a basis consistent with the audited financial statements and contain adjustments, consisting of only normal, recurring accruals, necessary to present fairly the Companys
financial position and results of operations. Interim financial results are not necessarily indicative of results anticipated for the full year.



The preparation of financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates and
assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates.



For further information, refer to the consolidated financial statements and footnotes thereto included in the Companys Annual Report on Form 10-K
for the year ended December 31, 2004.



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3. Revenue Recognition



Product revenue.The Company recognizes revenue from product sales, in accordance with Statement of Financial Accounting Standard, or SFAS,
No. 48 Revenue Recognition When Right of Return Exists, when there is persuasive evidence that an arrangement exists, when title has passed, the price is fixed or determinable, and the Company is reasonably assured of collecting the
resulting receivable. The Company recognizes product revenue net of estimated allowances for discounts, returns, rebates and chargebacks. Such estimates require the most subjective and complex judgment due to the need to make estimates about matters
that are inherently uncertain. Actual results may differ significantly from the Companys estimates. Changes in estimates and assumptions based upon actual results may have a material impact on the Companys results of operations and/or
financial condition.



In general, the Company is obligated to
accept from its customers the return of pharmaceuticals that have reached their expiration date. The Company authorizes returns for damaged products and exchanges for expired products in accordance with its return goods policy and procedures, and
has established reserves for such amounts at the time of sale. The Company launched its first marketed product, Istalol for the treatment of glaucoma, in the third quarter of 2004, its second product, Vitrase for use as a spreading agent, in the
first quarter of 2005 and its third product, Xibrom for the treatment of ocular inflammation following cataract surgery, in the second quarter of 2005. Actual Istalol, Vitrase and Xibrom returns have not exceeded the Companys estimated
allowances for returns.



License revenue.The Company
recognizes revenue consistent with the provisions of the SECs Staff Accounting Bulletin, or SAB, No. 104, Revenue Recognition, which sets forth guidelines in the timing of revenue recognition based upon factors such as passage
of title, installation, payments and customer acceptance. Amounts received for product and technology license fees under multiple-element arrangements are deferred and recognized over the period of such services or performance if such arrangements
require on-going services or performance. Amounts received for milestones are recognized upon achievement of the milestone, unless the amounts received are creditable against royalties or the Company has ongoing performance obligations. Royalty
revenue will be recognized upon sale of the related products, provided the royalty amounts are fixed and determinable and collection of the related receivable is probable. Any amounts received prior to satisfying the Companys revenue
recognition criteria will be recorded as deferred revenue in the accompanying balance sheets.



4. Inventory



Inventory
at September 30, 2005 consisted of $484,000 of raw materials and $2.4 million of finished goods. Additionally, the Company recorded $944,000 in inventory reserves. Inventory at September 30, 2004 consisted of $93,000 in raw materials and
$1.0 million of finished goods and $622,000 of in-transit inventory.



Inventory consists of currently marketed products. Inventory primarily represents raw materials used in production and finished goods inventory on hand, valued at standard cost. Inventories are reviewed periodically for slow-moving or
obsolete status. If a launch of a new product is delayed, inventory may not be fully utilized and could be subject to impairment, at which point the Company would record a reserve to adjust inventory to its net realizable value.



Inventory relates to Istalol, for the treatment of glaucoma; Vitrase,
lyophilized 6,200 USP units multi-purpose vial and Vitrase 200 USP units/mL for use as a spreading agent to facilitate the absorption and dispersion of other injected drugs; and Xibrom, a topical non-steroidal anti-inflammatory formulation of
bromfenac for the treatment of ocular inflammation following cataract surgery. Inventories, net of allowances, are stated at the lower of cost or market. Cost is determined by the first-in, first-to-expire method.



5. Comprehensive Income (Loss)



Statement of Financial Accounting Standard, or SFAS, No. 130,
Reporting Comprehensive Income, requires reporting and displaying comprehensive income (loss) and its components, which, for ISTA, includes net loss and unrealized gains and losses on investments and foreign currency translation gains
and losses. Total comprehensive loss for the nine-month period ended September 30, 2005 and 2004 was $27,761,000 and $30,808,000, respectively. In accordance with SFAS No. 130, the accumulated balance of unrealized gains (losses) on
investments and the accumulated balance of foreign currency translation adjustments are disclosed as separate components of stockholders equity.



6. Stock-Based Compensation



As permitted by SFAS No. 123, Accounting for Stock-Based Compensation, the Company has elected to follow Accounting Principals Board, or
APB, Opinion No. 25, Accounting for Stock Issued to Employees, and related interpretations in accounting for stock-based employee compensation. Under APB 25, if the exercise price of the Companys employee and director stock
options equals or exceeds the estimated fair value of the underlying stock on the date of grant, no compensation expense is recognized.



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When the exercise price of the employee or director stock options is less than the estimated fair value
of the underlying stock on the grant date, the Company records deferred compensation for the difference and amortizes this amount to expense in accordance with Financial Accounting Standards Board, or FASB, Interpretation No. 28,
Accounting for Stock Appreciation Rights and Other Variable Stock Option or Award Plans, over the vesting period of the options.



Options or stock awards issued to non-employees are recorded at their fair value as determined in accordance with SFAS No. 123 and Emerging Issues
Task Force, or EITF, No. 96-18, Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring or in Conjunction With Selling Goods or Services, and recognized over the related service period. Deferred
charges for options granted to non-employees are periodically re-measured as the options vest.



As required under SFAS No. 123 and SFAS No. 148, Accounting for Stock-Based Compensation - Transition and Disclosure, the pro forma effects of stock-based compensation on net loss have been
estimated at the date of grant using the Black-Scholes option-pricing model. The Black-Scholes option valuation model was developed for use in estimating the fair value of traded options that have no vesting restrictions and are fully transferable.
In addition, option valuation models require the input of highly subjective assumptions including the expected stock price volatility. Because the Companys employee stock options have characteristics significantly different from those of
traded options, and because changes in the subjective input assumptions can materially affect the fair value estimate, in managements opinion, the existing models do not necessarily provide a reliable single measure of the fair value of its
employee stock options.



SFAS No. 148 was issued in
December 2002 as an amendment to SFAS No. 123, providing alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation and also provides additional disclosures about
the method of accounting for stock-based employee compensation. Amendments are effective for financial statements for the Company beginning January 1, 2003. The Company has currently chosen to not adopt the voluntary change to the fair value
based method of accounting for stock-based employee compensation. If the Company should choose to adopt such a method, its implementation pursuant to SFAS No. 148 could have a material effect on the Companys consolidated financial
position and results of operations.



The fair value of the
employee stock options was estimated at the date of grant using the minimum value pricing model for grants prior to the initial public offering and the Black Scholes method for grants after the initial public offering with the following weighted
average assumptions: risk-free interest rate of 3.0%, zero dividend yield, volatility of 73%; and a weighted-average life of the option of four years.



For purposes of adjusted pro forma disclosures, the estimated fair value of the options is amortized to expense over the options vesting period. The
effect of applying SFAS No. 123 for purposes of providing pro forma disclosures is not likely to be representative of the effects on the Companys operating results for future years because changes in the subjective input assumptions can
materially affect future value estimates. Pro forma information is as follows:



|                                                                                                                           |  |                    |         |   |                    |   |         |  
|-------------------------------------------------------------------------------------------------------------------------- |  | ------------------ | ------- | - | ------------------ | - | ------- | -
|                                                                                                                           |  | Nine Months Ended  |        
|                                                                                                                           |  | September 30, 2005 |         |   | September 30, 2004 |  
|Net loss, as reported                                                                                                      |  | $                  | (27,745 | ) |                    | $ | (30,766 | )
|Add: Stock-based employee compensation expense included in net loss determined under intrinsic-value method for all awards |  |                    | 131     |   |                    |   | 358     |  
|Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards            |  |                    | (2,275  | ) |                    |   | (1,632  | )
|                                                                                                                           |  |                    |         |   |                    |   |         |  
|Pro forma net loss                                                                                                         |  | $                  | (29,889 | ) |                    | $ | (32,040 | )
|                                                                                                                           |  |                    |         |   |                    |   |         |  
|Net loss per share, basic and diluted, as reported                                                                         |  | $                  | (1.09   | ) |                    | $ | (1.73   | )
|                                                                                                                           |  |                    |         |   |                    |   |         |  
|Pro form net loss per share, basic and diluted                                                                             |  | $                  | (1.18   | ) |                    | $ | (1.80   | )
|                                                                                                                           |  |                    |         |   |                    |   |         |  



7. Net Loss Per Share



In accordance with SFAS No. 128, Earnings Per
Share, and SEC SAB No. 98, basic net loss per common share is computed by dividing the net loss for the period by the weighted average number of common shares outstanding during the period. Under SFAS No. 128, diluted net income
(loss) per share is computed by dividing the net income (loss) for the period by the weighted average number of common and common equivalent shares, such as stock options, outstanding during the period. Such common equivalent shares have not been
included in the Companys computation of net loss per share as their effect would be anti-dilutive.



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Under the provisions of SAB No. 98, common shares issued for nominal consideration, if any, would be
included in the per share calculations as if they were outstanding for all periods presented. In October 2004, the Company granted restricted stock awards to non-employee directors to purchase a total of 7,500 shares of common stock at a purchase
price of $0.001 per share.



8. Commitments and Contingencies



The Company is subject to routine claims and litigation incidental to its
business. In the opinion of management, the resolution of such claims is not expected to have a material adverse effect on the operating results or financial position of the Company.



9. Recent Accounting Pronouncements



In December 2004, the FASB issued Statement No. 123R (Revised 2004), Share-Based Payment. The revisions to SFAS No. 123 require
compensation costs related to share-based payment transactions to be recognized in the financial statements. With limited exceptions, the amount of compensation cost will be measured based on the grant-date fair value of the equity or liability
instruments issued. In addition, liability awards will be re-measured each reporting period. Compensation cost will be recognized over the period that an employee provides service in exchange for the award. SFAS No. 123R replaces SFAS
No. 123 and supersedes APB Opinion No. 25. For public entities, the provisions of the statement are effective as of the beginning of the first annual reporting period that begins after December 15, 2005, however early adoption is
allowed. The Company expects to adopt the provisions of the new statement in the first fiscal quarter of 2006. Although the Company will continue to evaluate the application of SFAS No. 123R, management expects the adoption to have a material
impact on its results of operations in amounts not yet determinable.



In November 2004, the FASB issued SFAS No. 151, Inventory Costsan amendment of ARB No. 43, Chapter 4. SFAS No. 151 amends the guidance in Accounting Research Bulletin, or ARB, No. 43, Chapter 4,
Inventory Pricing, to clarify that abnormal amounts of idle facility expense, freight, handling costs and wasted material (spoilage) are to be recognized as current-period charges. SFAS No. 151 is effective for fiscal years
beginning after June 15, 2005. SFAS No. 151 is not expected to have a material impact on the Companys financial statements.



In May 2005, the FASB issue SFAS No. 154, Accounting Changes and Error Corrections, which replaced APB Opinion No. 20, Accounting
Changes, and SFAS No. 3, Reporting Changes in Interim Financial Statements. SFAS No. 154 requires retrospective application to prior periods financial statements of voluntary changes in accounting principles and changes
required by a new accounting standard when the standard does not include specific transition provisions. Previous guidance required most voluntary change in accounting principle to be recognized by including in net income of the period in which the
change was made the cumulative effect of changing to the new accounting principle. SFAS No. 154 carries forward existing guidance regarding the reporting of the correction of an error and a change in accounting estimate. SFAS No. 154 is effective
for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005. Adoption of SFAS No. 154 as of January 1, 2006 is not expected to have a material effect on our consolidated financial position or results of
operations.



|Item 2. | Managements Discussion and Analysis of Financial Condition and Results of Operations
|------- | -------------------------------------------------------------------------------------



This Quarterly Report on Form 10-Q contains forward-looking statements within the meaning of Section 27A of the
Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, that concern matters that involve risks and uncertainties that could cause actual results to differ materially from those projected in the
forward-looking statements. Discussions containing forward-looking statements may be found in the material set forth under Managements Discussion and Analysis of Financial Condition and Results of Operations and in other sections
of this Form 10-Q. Words such as may, will, should, could, expect, plan, anticipate, believe, estimate, predict,
potential or continue or similar words are intended to identify forward-looking statements, although not all forward-looking statements contain these words. Although we believe that our opinions and expectations reflected in
the forward-looking statements are reasonable as of the date of this Report, we cannot guarantee future results, levels of activity, performance or achievements, and our actual results may differ substantially from the views and expectations set
forth in this Report. We expressly disclaim any intent or obligation to update any forward-looking statements after the date hereof to conform such statements to actual results or to changes in our opinions or expectations. Readers are urged to
carefully review and consider the various disclosures made by us which attempt to advise interested parties of the factors which affect our business, including without limitation Factors That May Affect Results of Operations and Financial
Condition set forth in this Form 10-Q, and the audited financial statements and the notes thereto and disclosures made under the captions, Management Discussion and Analysis of Financial Condition and Results of Operations,
Factors that May Affect Results of Operations and Financial Condition, Consolidated Financial Statements and Notes to Consolidated Financial Statements, included in the Companys Annual Report on Form 10-K
for the year ended December 31, 2004.



Overview



We are a specialty pharmaceutical company focused on the commercialization
and development of unique and uniquely improved products for serious conditions of the eye. We currently have three products available for sale in the United States: (i) Istalol for the treatment of glaucoma, (ii)) Vitrase for use as a
spreading agent, and (iii) Xibrom for the treatment of ocular inflammation following cataract surgery. We also have several product candidates in various stages of development. While we currently have three products available for sale, we have
not generated any significant revenues from sales of our products. We have incurred losses since inception and had an accumulated deficit of $215.8 million through September 30, 2005.



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Our Products and Product Pipeline



We have launched three products in the United States and are pursuing the development of several late-stage product
candidates. Our marketed products and selected product development activities include:



Xibrom (bromfenac)



Xibrom is a topical
non-steroidal anti-inflammatory formulation of bromfenac for the treatment of ocular inflammation following cataract surgery. The product was first developed by Senju Pharmaceuticals, Co. Ltd. and launched in the Japanese market in 2000. We believe
its sales growth in Japan is principally due to its superior potency and twice-daily dosing regimen, as compared to the requirement of three or four doses-per-day for most other anti-inflammatory products. In May 2002, we acquired marketing rights
for Xibrom in the United States under a license agreement with Senju. We received approval from the FDA for Xibrom for the treatment of ocular inflammation following cataract surgery in March 2005 and launched Xibrom in the United States in the
second quarter of 2005.



Ocular Inflammation



Market opportunity.Based upon 2004 data from IMS Health, we estimate
that 2004 sales in the U.S. topical ophthalmic anti-inflammatory market were approximately $400 million, with total prescriptions of 8.6 million. Currently available non-steroid treatments must be dosed three or four times a day as compared to
Xibroms twice-daily dosing.



We launched Xibrom in the
second quarter of 2005, and we currently promote it through our specialty sales force. In order to support the launch of Xibrom, we have expanded our sales force from 50 to over 70 people as of September 30, 2005.



Clinical/regulatory status.Senju completed clinical development of
bromfenac in Japan and launched the product in Japan in 2000. In March 2005, we received FDA approval for Xibrom for the treatment of ocular inflammation following cataract surgery.



Istalol (timolol)



Istalol is our once-a-day, eye drop solution of timolol, a beta-blocking agent for the treatment of glaucoma. The product was developed by Senju in Japan.
In May 2002, we acquired marketing rights for Istalol in the United States under a license agreement with Senju. We received FDA approval of Istalol in June 2004 and launched Istalol in the United States in the third quarter of 2004.



Glaucoma



Glaucoma is a chronic disease that gradually reduces eyesight without warning and often without symptoms. If undetected and
untreated, glaucoma can lead to irreversible eye damage and eventual blindness. According to the Glaucoma Research Foundation, in the United States, glaucoma is the cause of an estimated 9-12% of all blindness cases and is the second leading cause
of blindness. Currently, its causes are not well understood and there is no cure.



Market opportunity.According to the Glaucoma Research Foundation, three million people in the United States suffer from the disease, with 120,000 new cases documented annually. According to prescription data
compiled by IMS Health for 2004, we estimate that the U.S. pharmaceutical market for the treatment of glaucoma exceeds $1.4 billion per year. Of this, the ophthalmic beta-blocker market exceeds $165 million per year, primarily at generic prices,
with over 5.2 million prescriptions written annually. Timolol maleate, which is currently available from several manufacturers in either a twice-a-day eye drop solution or once-a-day gel formulation, is the leading beta-blocker to treat
glaucoma in the United States. In clinical trials, Istalol, given once-a-day, has shown efficacy and safety comparable to timolol maleate solution, given twice-a-day. Other than Istalol, the only available formulations of timolol maleate that have
demonstrated efficacy with once-a-day dosing are gels, which have been known to cause blurring of patients vision.



We launched Istalol in the United States in July 2004, and currently promote it through our specialty sales force. Istalol promotion is now focused on the
7,000 ophthalmologists whom we believe account for more than two-thirds of all glaucoma prescriptions.



Clinical/regulatory status.Senju submitted a New Drug Application (NDA) for Istalol for the treatment of glaucoma to the FDA in
September 2002 that was accepted for review in November 2002. In June 2004, the FDA approved the NDA for Istalol. In October 2004, the FDA granted Istalol a BT rating, which means that prescriptions of Istalol cannot be legally
substituted at pharmacies with generic timolol maleate solutions.



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Vitrase (ovine hyaluronidase)



We launched Vitrase, our proprietary formulation of ovine hyaluronidase, for use as a spreading agent, in the first quarter
of 2005. We also are developing Vitrase for the treatment of vitreous hemorrhage and diabetic retinopathy. In the third quarter of 2005, we filed an application for the approval of Vitrase for vitreous hemorrhage in Europe. We are also exploring
other uses of Vitrase, including use as a spreading agent in oncology radiation therapy to enhance the penetration of contrast agents in solid tumors. The term hyaluronidase describes a group of naturally occurring enzymes that can digest certain
forms of carbohydrate molecules called proteoglycans. Vitrase, when used as a spreading agent, is injected into connective tissue, where it modifies the permeability of such tissues and promotes diffusion of injected drugs, thus accelerating their
absorption. When injected into the vitreous humor, Vitrase breaks down the proteoglycan matrix, causing the vitreous humor to liquefy. We believe that this also results in the separation of the vitreous humor from the retina and that, together,
these effects are beneficial for the treatment of vitreous hemorrhage and diabetic retinopathy. Vitrase may be administered directly into the vitreous humor through a single-dose injection. The procedure will be performed in several minutes in an
ophthalmologists office and is virtually painless due to the application of a topical anesthetic.



Spreading Agent



Hyaluronidase has been found to be a spreading or diffusing substance, which modifies the permeability of connective tissue through the hydrolysis of hyaluronic acid, a polysaccharide found in the intercellular ground substance of
connective tissue, and of certain specialized tissues, such as the umbilical cord and vitreous humor. Hyaluronidase temporarily decreases the viscosity of the cellular cement and promotes diffusion of injected drugs, thus facilitating their
absorption.



When no spreading agent is present, material
injected subcutaneously spreads very slowly, but hyaluronidase causes rapid spreading, provided local interstitial pressure is adequate to furnish the necessary mechanical impulse. Such an impulse is normally initiated by injected solutions. The
rate of diffusion is proportionate to the amount of enzyme, and the extent is proportionate to the volume of solution. When a spreading agent is administered with anesthesia, it speeds the onset of the anesthetic effect thereby reducing the time
required for ocular surgery.



Market opportunity.Based
on published reports, we believe the potential annual market opportunity for Vitrase as a spreading agent consists of the 3,000,000 ophthalmic surgeries in the United States each year, of which 2,600,000 are cataract surgeries. In addition to uses
in ophthalmology, potential uses for spreading agents include oncology, plastic surgery, pain management and pediatrics.



We launched Vitrase in the United States for use as a spreading agent and are currently promoting it through our specialty sales force. We target the top
ophthalmic surgeons, most of whom are also high prescribers of anti-inflammatory medications that we currently target for Xibrom. In November 2005, the Center for Medicare and Medicaid Services, or CMS, established two new national Healthcare Common
Procedure Coding Systems, or HCPCS, J-Codes covering the injection of preservative free ovine hyaluronidase, Vitrase. Physicians will be able to use these new J-Codes beginning January 2006. HCPCS Codes are used by healthcare insurers to process
reimbursement claims. We believe that these two new J-Codes will help facilitate third-party reimbursement for Vitrase.



Clinical/regulatory status.In May 2004, the FDA approved our NDA for Vitrase, in a lyophilized 6,200 USP units multi-purpose vial, for use as a
spreading agent to facilitate the absorption and dispersion of other injected drugs. In October 2004, the FDA informed us that Vitrase for use as a spreading agent was entitled to five-year new chemical market exclusivity under the federal Food,
Drug and Cosmetic Act. In December 2004, the FDA approved our supplemental NDA for Vitrase for use as a spreading agent at a concentration of 200 USP units/mL in sterile solution.



Ecabet Sodium



We are developing ecabet sodium as a prescription eye drop for the treatment of dry eye syndrome. Ecabet sodium represents a new class of molecules that
increases the quantity and quality of mucin produced by conjunctival goblet cells and corneal epithelia. Mucin is a glycoprotein component of tear film that lubricates while retarding moisture loss from tear evaporation. Ecabet sodium is currently
marketed in Japan as an oral agent for treatment of gastric ulcers and gastritis. In November 2004, we acquired U.S. marketing rights to ecabet sodium for the treatment of dry eye syndrome in the United States under a license agreement with Senju.



Dry Eye Syndrome



According to the National Eye Institute, dry eye syndrome
(keratoconjunctivities sicca or KCS) is defined as a disorder of the tear film due to the tear deficiency or excessive tear evaporation which causes damage to the interpalpebral (the exposed area between the upper and lower eye lids) ocular surface
and is associated with symptoms of ocular discomfort. Dry eye syndrome has been linked with a number of factors, including age, hormonal changes, ocular disease, medications that disrupt tear secretion or blinking, and autoimmune diseases such as
lupus and rheumatoid arthritis. In severe cases of dry eye syndrome, scarring develops that may lead to blindness.



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Market opportunity.Based on data compiled from various publicly available sources, we estimate
that annual sales in the U.S. prescription dry eye market were approximately $95 million in 2004 and are anticipated to grow to approximately $350 to $700 million within three to five years.



Clinical/regulatory status.Senju has commenced Phase II testing of
the product in Japan for the treatment of dry eye syndrome. In March 2005, we filed an Investigation New Drug Application, or IND, with the FDA to conduct a U.S. Phase IIb study of ecabet sodium for the treatment of dry eye syndrome. We initiated
our Phase IIb study in the second quarter of 2005 and expect to complete our Phase IIb study by the end of 2005. Based on timely completion of our Phase IIb study and depending upon the results, we expect to design and initiate two Phase III studies
in 2006.



Tobramycin and Prednisolone Acetate Combination Product



We have developed a proprietary formulation of a
fixed combination product of tobramycin and prednisolone acetate, or tobra/pred product. The tobra/pred product is being developed for the treatment of steroid-responsive inflammatory ocular conditions where risk of bacterial infection exists.



Market opportunity.The tobra/pred product, if approved
by the FDA, will compete in the antibiotic steroid segment of the U.S. topical ophthalmic anti-inflammatory market. Based upon management estimates and 2004 prescription data compiled by IMS Health, we estimate that 2004 sales in the U.S. topical
ophthalmic anti-inflammatory market were approximately $400 million, with total prescriptions of 8.6 million. The combination antibiotic and steroid segment of the ophthalmic anti-inflammatory market has approximately a 45% share of the
prescriptions, or about 3.8 million prescriptions according to data compiled by IMS Health.



Clinical/regulatory status.In April 2005, we filed an IND with the FDA to initiate a U.S. Phase III study of the tobra/pred product for the
treatment of steroid-responsive inflammatory ocular conditions where risk of bacterial infection exists. We initiated our tobra/pred product Phase III study in the third quarter of 2005 and expect to complete our Phase III study by late 2005 or
early 2006. Based on timely completion of our Phase III study and depending on the results, we expect to submit to the FDA an NDA for the tobra/pred product during the first half of 2006.



Caprogel (aminocaproic acid)



Caprogel is a new topical gel formulation of aminocaproic acid for treating hyphema. Hyphema is a term used to describe bleeding in the anterior chamber,
the space between the cornea and the iris, of the eye and usually results from trauma to the eye. In May 2002, we acquired worldwide marketing rights for Caprogel, and we are currently conducting feasibility studies for its reformulation and
commercialization. Once completed, and if these studies yield promising results, we intend to pursue further clinical development consistent with such studies results.



Based on data compiled for us by Milliman U.S.A., we believe that hyphema affects an estimated 50,000 patients per year in
the United States and currently there is no available pharmaceutical agent approved for its treatment. Caprogel has received an orphan drug designation for the treatment of hyphema from the FDA, which may result in a seven year market exclusivity
privilege with respect to Caprogel, if approved.



Other Product Candidates
and Development Activities



We continually evaluate
opportunities for late-stage or currently marketed complementary product and for expansion of our existing product franchises and, if and when appropriate, intend to pursue such opportunities through further product acquisitions and related
development activities. For example, we have initiated work on a strong steroid eye drop being developed to treat ocular inflammation. Our ability to execute on such opportunities in some circumstances will be dependent upon our ability to raise
additional capital on commercially reasonable terms.



Company Information



We incorporated in California in February 1992 as
Advanced Corneal Systems, Inc. In March 2000, we changed our name to ISTA Pharmaceuticals, Inc., and we reincorporated in Delaware in August 2000. Our corporate headquarters are located at 15295 Alton Parkway, Irvine, CA 92618, and our telephone
number is (949) 788-6000.



We have incurred losses since
inception and had an accumulated deficit of $215.8 million through September 30, 2005. Our losses have resulted primarily from research and development activities, including clinical trials, general and administrative expenses and a deemed
dividend to our preferred shareholders. We expect to continue to incur operating losses for the foreseeable future as we continue to conduct research, development and clinical testing activities, to seek regulatory approval for our product
candidates, and to market our approved products.



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Critical Accounting Policies and Estimates



Managements discussion and analysis of financial condition and results of operations, as well as disclosures included
elsewhere in this Quarterly Report on Form 10-Q, are based upon our consolidated financial statements, which have been prepared in accordance with U.S. generally accepted accounting principles. Our significant accounting policies are described in
the accompanying Notes to Unaudited Condensed Consolidated Financial Statements. Included within these policies are our critical accounting policies. Critical accounting policies are those policies that are most important to the
preparation of our consolidated financial statements and require managements most subjective and complex judgment due to the need to make estimates about matters that are inherently uncertain. Although we believe that our estimates and
assumptions are reasonable, actual results may differ significantly from these estimates. Changes in estimates and assumptions based upon actual results may have a material impact on our results of operations and/or financial condition.



We believe that the critical accounting policies that most impact the
consolidated financial statements are as described below.



Revenue Recognition



Product
Revenue.We recognize revenue from product sales, in accordance with Statement of Financial Accounting Standard No. 48 Revenue Recognition When Right of Return Exists, when there is persuasive evidence that an arrangement
exists, when title has passed, the price is fixed or determinable, and we are reasonably assured of collecting the resulting receivable. We recognize product revenue net of estimated allowances for discounts, returns, rebates and chargebacks. If
actual future payments for allowances for discounts, returns, rebates and chargebacks exceed the estimates we made at the time of sale, our financial position, results of operations and cash flows would be negatively impacted. In general, we are
obligated to accept from our customers the return of pharmaceuticals that have reached their expiration date. We authorize returns for damaged products and exchanges for expired products in accordance with our return goods policy and procedures, and
have established reserves for such amounts at the time of sale. We launched our first product, Istalol, in the third quarter of 2004, our second product, Vitrase, in the first quarter of 2005, and our third product, Xibrom, in the second quarter of
2005. With the launch of each of our products, we recorded a sales return allowance, which was larger for stocking orders than subsequent re-orders. To date, actual Istalol, Vitrase and Xibrom returns have not exceeded our estimated allowances for
returns. Although we believe that our estimates and assumptions are reasonable as of the date when made, actual results may differ significantly from these estimates. Our financial position, results of operations and cash flows may be materially and
negatively impacted if actual returns exceed our estimated allowances for returns.



License Revenue.We recognize revenue consistent with the provisions of the Securities and Exchange Commissions Staff Accounting Bulletin No. 104, Revenue Recognition, which sets forth
guidelines in the timing of revenue recognition based upon factors such as passage of title, installation, payments and customer acceptance. Amounts received for product and technology license fees under multiple-element arrangements are deferred
and recognized over the period of such services or performance if such arrangements require on-going services or performance. Amounts received for milestones are recognized upon achievement of the milestone, unless the amounts received are
creditable against royalties or we have ongoing performance obligations. Royalty revenue will be recognized upon sale of the related products, provided the royalty amounts are fixed and determinable and collection of the related receivable is
probable. Any amounts received prior to satisfying our revenue recognition criteria will be recorded as deferred revenue in the accompanying balance sheets.



Inventories



Inventory consists of currently marketed products. Inventory primarily represents raw materials used in production and finished goods inventory on hand,
valued at standard cost. Inventories are reviewed periodically for slow-moving or obsolete status. If a launch of a new product is delayed, inventory may not be fully utilized and could be subject to impairment, at which point we would record a
reserve to adjust inventory to its net realizable value.



Inventory relates to Istalol, for the treatment of glaucoma; Vitrase, lyophilized 6,200 USP units multi-purpose vial and Vitrase 200 USP units/mL for use as a spreading agent to facilitate the absorption and dispersion of other injected
drugs; and Xibrom, for the treatment of ocular inflammation following cataract surgery. Inventories, net of allowances, are stated at the lower of cost or market. Cost is determined by the first-in, first-to-expire method.



Income Taxes



We record a full valuation allowance to reduce our deferred tax assets to the
amount that is more likely than not to be realized. While we have considered future taxable income and ongoing prudent and feasible tax planning strategies in assessing the need for the valuation allowance, in the event we were to determine that we
would be able to realize our deferred tax assets in the future in excess of its net recorded amount, an adjustment to the deferred tax asset would increase income in the period such determination was made.



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Results of Operations



The following discussion of our results of operations generally reflects our continuing transition from a development-stage company to a specialty
pharmaceuticals company with a primary focus on ophthalmology.



Three Months
Ended September 30, 2005 and 2004



Revenue.
Revenue was $3.6 million for the three months ended September 30, 2005, as compared to $1.9 million for the three months ended September 30, 2004. Revenue consists of net product sales and license revenue.



Net product sales for the three months ended September 30, 2005 were
$3.5 million as compared to $1.8 million for the three months ended September 30, 2004. We launched in the United States Istalol in the third quarter of 2004, Vitrase for use as a spreading agent in the first quarter of 2005 and Xibrom for the
treatment of ocular inflammation following cataract surgery in second quarter of 2005. Net product sales for the third quarter of 2005 consisted of Xibrom net sales of $1.9 million, Istalol net sales of $1.0 million and Vitrase net sales of $0.6
million. During the third quarter of 2005, we continued to experience a reduction of wholesaler inventory levels for our products. Because of increasing demand for our products during the third quarter of 2005, we decreased our sales return
allowance by $290,000 and had a corresponding increase in our net product sales during the third quarter of 2005. As of September 30, 2005, we maintained a reserve of $853,000 recorded as a sales return allowance. From time to time, we will
review, and as appropriate adjust, our sales allowance reserves based on actual results and our assessment of then current trends. Such adjustments may have a material impact on our results of operations and financial condition.



License revenue was $69,000 for both the three months ended
September 30, 2005 and 2004, respectively, which reflects the amortization for the period of deferred revenue recorded in December 2001 for the $5.0 million license fee payment made by Otsuka Pharmaceuticals Co., Ltd. in connection with the
license of Vitrase in Japan for ophthalmic uses in the posterior region of the eye.



Cost of products sold. Cost of products sold were $968,000 for the three months ended September 30, 2005, as compared to $639,000 for the three months ended September 30, 2004. Cost of products sold
for the third quarter of 2005 consisted primarily of standard costs for each of our commercial products, distribution costs, royalties and other costs of products sold. Product gross margin for the three months ended September 30, 2005 was $2.6
million, or 72% of net product sales, as compared to $1.1 million, or 64% of net product sales, for the three month period ended September 30, 2004. The percentage increase in product gross margin for the third quarter of 2005 as compared to
the prior period is due to changes in product mix and the reversal of a portion of the ISTAs sales return allowance which increased net product sales and gross margin by $290,000. From time to time, we will review, and as appropriate adjust,
our sales allowance reserves based on actual results and our assessment of then current trends. Such adjustments may cause our product gross margin to fluctuate, in some cases significantly, from quarter to quarter. Product gross margin has varied
on a quarterly basis in 2005 commensurate with our product sales mix. We expect product gross margin for the fourth quarter of 2005 to be lower than the product gross margin for the third quarter of 2005 due to changes in product mix between
quarters.



Research and development expenses.Research
and development expenses for the three months ended September 30, 2005 were $4.8 million compared to $3.5 million for the three months ended September 30, 2004. Our research and development expenses consisted primarily of costs associated
with the clinical trials of our product candidates, compensation and other expenses for research and development personnel, costs for consultants and contract research organizations and costs related to the development of commercial manufacturing
capabilities for our approved products. Research and development expenses increased by $1.3 million during the three months ended September 30, 2005 as compared to the three months ended September 30, 2004 primarily as a result of our
commencement of the ecabet sodium Phase IIb clinical study and the tobra/pred Phase III clinical study during the third quarter of 2005, offset by the completion of the Xibrom Phase III clinical study in the third quarter of 2004 and by the impact
of obtaining FDA approval for Vitrase, Istalol and Xibrom, which resulted in the capitalization of various amounts into commercial inventory as compared to the prior period.



Selling, general and administrative expenses.Selling, general and administrative expenses were $7.3 million for the
three months ended September 30, 2005 compared to $15.1 million for the three months ended September 30, 2004. In the third quarter of 2004, we recorded a one-time payment of $10.0 million upon entering an agreement with Allergan, Inc.
pursuant to which we reacquired all rights to market and sell Vitrase for all uses in the United States and other specified markets. The $7.8 million difference in selling, general and administrative expenses between the three months ended
September 30, 2005 and the prior period is primarily attributable to the above described one-time $10.0 million payment recorded in the third quarter of 2004 offset by a $2.2 million increase in selling, general and administrative expenses
during the third quarter of 2005 of which $2.1 million related to sales and marketing expenses associated with the commercial



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launch of our approved products, including an increase in sales personnel from 28 to over 70 representatives since the third quarter of 2005, and
$100,000 related to an increase in general corporate expenses.



Interest income.Interest income was $412,000 for the three months ended September 30, 2005 compared to $156,000 for the three months ended September 30, 2004. The increase in interest income was primarily attributable to
higher cash balances as a result of our receipt of $53.0 million of net proceeds from our January 2005 financing and higher rates of return for the three months ended September 30, 2005 as compared to the three months ended September 30,
2004.



Interest expense. Interest expense was $3,000 for
the three months ended September 30, 2005 compared to $1,000 for the three months ended September 30, 3004.



Nine Months Ended September 30, 2005 and 2004



Revenue. Revenue was $7.0 million for the nine months ended September 30, 2005, as compared to $2.0 million for the nine months ended
September 30, 2004. Revenue consists of net product sales and license revenue.



Net product sales for the nine months ended September 30, 2005 were $6.8 million, as compared to $1.8 million for the nine months ended September 30, 2004. We launched in the United States Istalol in the
third quarter of 2004, Vitrase for use as a spreading agent in the first quarter of 2005 and Xibrom in second quarter of 2005.



License revenue was $208,000 for both the nine months ended September 30, 2005 and 2004, respectively, which reflects the amortization for the period
of deferred revenue recorded in December 2001 for the $5.0 million license fee payment made by Otsuka Pharmaceuticals Co., Ltd. in connection with the license of Vitrase in Japan for ophthalmic uses in the posterior region of the eye.



Cost of products sold. Cost of products sold were $2.3 million for the
nine months ended September 30, 2005, as compared to $639,000 for the nine months ended September 30, 2004. Cost of products sold for the nine months ended September 30, 2005 consisted primarily of standard costs for each of our
commercial products, distribution costs, royalties, inventory reserves for short dating of certain Istalol lots and other costs of products sold. Product gross margin for the nine months ended September 30, 2005 was $4.5 million, or 66% of net
product sales, as compared to $1.1 million, or 64% of net product sales, for the nine month period ended September 30, 2004 which included net product sales only from the launch of our first commercial product, Istalol, in the third quarter of
2004. The percentage increase in product gross margin for the nine month period ended September 30, 2005 as compared to the prior 2004 period is primarily due to changes in our product mix resulting from launching two new products in 2005,
Xibrom for the treatment of ocular inflammation following cataract surgery, and Vitrase for the use as a spreading agent.



Research and development expenses.Research and development expenses for the nine months ended September 30, 2005 were $11.7
million compared to $12.1 million for the nine months ended September 30, 2004. Our research and development expenses have consisted primarily of costs associated with the clinical trials of our product candidates, compensation and other
expenses for research and development personnel, costs for consultants and contract research organizations and costs related to the development of commercial manufacturing capabilities for Vitrase, Istalol and Xibrom. Research and development
expenses decreased by $400,000 during the nine months ended September 30, 2005 as compared to the nine months ended September 30, 2004. This decrease is attributable to a difference in research and development project mix and related
clinical study activity as well as obtaining FDA approval for Vitrase, Istalol and Xibrom, which resulted in the capitalization of various amounts into commercial inventory, as compared to the prior period. In addition, a $1.25 million milestone to
Senju was recorded in the second quarter of 2005 upon first commercialization of Xibrom. The milestone payment was paid to Senju during the third quarter of 2005. Research and development expenses for the nine months ended September 30, 2005
included $1.25 million in milestone payments under various licensing agreements as compared to $2.6 in milestone payments for the nine months ended September 30, 2004.



Selling, general and administrative expenses.Selling, general and administrative expenses were $21.9 million for the
nine months ended September 30, 2005 compared to $20.5 million for the nine months ended September 30, 2004. Of the $1.4 million increase in selling, general and administrative expenses, $11.0 million relates to sales and marketing
expenses associated with the commercial launch of our approved products, including an increase in sales personnel from 28 to over 70 representatives since the third quarter of 2005, and $400,000 is due to increases in general corporate expenses
principally related to facility and personnel costs, offset by a reduction in deferred compensation expense and by the one-time payment during the third quarter of 2004 of $10.0 million which was recorded upon entering an agreement with Allergan
pursuant to which we reacquired all rights to market and sell Vitrase for all uses in the United States and other specified markets.



Interest income.Interest income was $1.3 million for the nine months ended September 30, 2005 compared to $436,000 for the nine months ended
September 30, 2004. The increase in interest income was primarily attributable to higher



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cash balances as a result of our receipt of $53.0 million of net proceeds from our January 2005 financing and higher rates of return for the nine months
ended September 30, 2005 compared to the nine months ended September 30, 2004.



Interest expense. Interest expense was $20,000 for the nine months ended September 30, 2005 compared to $3,000 for the nine months ended September 30, 2004. Interest expense incurred during the nine
months ended September 30, 2005 was primarily attributable to the interest accrued on the $3.5 million liability due (and fully paid during the first quarter of 2005) to Allergan as a result of our reacquisition of all rights to market and sell
Vitrase in the United States and other specified markets. The interest expense incurred during 2004 was primarily attributable to the interest paid on the financing of our directors and officers insurance premiums.



Liquidity and Capital Resources



As of September 30, 2005, we had approximately $44.1 million in cash
and equivalents and short-term investments and working capital of $43.8 million.



We have financed our operations since inception primarily through private equity sales and the sale of our common stock in our initial and follow-on public offerings. We received net proceeds of $10.0 million from the
private sale of preferred stock in March 2000, $31.7 million from our initial public offering in August 2000, $4.0 million from the private sale of common stock in December 2001, $5.0 million from a license fee payment in December 2001, $4.0 million
from the issuance of promissory notes in September 2002, $37.3 million from our PIPE transaction in November 2002, $35.7 million from our follow-on public offering in November 2003, $14.5 million from our registered direct offerings in August 2004
and $52.9 million from our follow-on public offering in January 2005. The private investment in public equity, or PIPE, transaction in November 2002 consisted of a private placement of 10,526,306 shares of our common stock for the aggregate purchase
price of approximately $40.0 million, or $3.80 per share, and warrants to purchase up to 1,578,946 shares of our common stock for an exercise price of $3.80 per share, before offering expenses and fees. The follow-on public offering in November 2003
consisted of the sale of 4,000,000 shares of our common stock for the aggregate purchase price of $38.0 million, or $9.50 per share, before offering expenses and underwriting discounts. In April 2004, we filed a universal shelf registration
statement on Form S-3 with the SEC providing for the offering from time to time of up to $75,000,000 of our securities, which may consist of common stock, preferred stock, warrants, or debt securities. On August 6, 2004 we sold 1,570,000 shares
of common stock under our universal shelf registration statement on Form S-3 for an aggregate purchase price of $13.3 million, or $8.50 per share, before placement agency fees and other offering expenses. On August 10, 2004, we sold an
additional 250,000 shares of common stock under our universal shelf registration statement for an aggregate purchase price of $2.1 million, or $8.50 per share, before offering expenses. In January 2005, we sold 6,325,000 shares of our common stock
under our universal shelf registration statement in an underwritten public offering for an aggregate purchase price of $56.2 million, or $8.88 per share, before offering expenses and underwriting discounts.



For the nine months ended September 30, 2005, we used $36.2 million of
cash for operations primarily as a result of the net loss of $27.7 million and a change in working capital of $8.9 million, which primarily includes a $3.5 million payment (including interest) incurred as a result our reacquisition of all rights to
market and sell Vitrase in the United States and other specified markets from Allergan,and a combined increase in accounts receivable, net, and inventory, net, of $4.8 million. For the nine months ended September 30, 2004, we used
approximately $20.1 million of cash for operations.



For the
nine months ended September 30, 2005, we used $24.2 million of cash from investing activities, primarily due to the purchase of our short-term investment securities. For the nine months ended September 30, 2004, we used $430,000 of cash
from investing activities, primarily due to the purchase of our short-term investment securities.



For the nine months ended September 30, 2005, we received $53.3 million from financing activities, primarily as a result of the sale of an aggregate
of 6,325,000 shares of common stock under our universal shelf registration statement in an underwritten public offering for an aggregate purchase price of $56.2 million, before offering expenses and underwriting discounts. For the nine months ended
September 30, 2004, we received $14.9 million from financing activities, primarily from the issuance of 1,820,000 shares of our common stock in two separate offerings, for an aggregate purchase price of $15.5 million, before offering expenses.



Our actual future capital requirements will depend on many
factors, including the following:



| |  |  | the success of the commercialization of our products;
| | - |  | -----------------------------------------------------



| |  |  | sales and marketing activities, and expansion of our commercial infrastructure, related to our approved products and product candidates;
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------



| |  |  | the results of our clinical trials and requirements to conduct additional clinical trials;
| | - |  | ------------------------------------------------------------------------------------------



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| |  |  | the rate of progress of our research and development programs;
| | - |  | --------------------------------------------------------------



| |  |  | the time and expense necessary to obtain regulatory approvals;
| | - |  | --------------------------------------------------------------



| |  |  | activities and payments in connection with potential acquisitions of companies, products or technology;
| | - |  | -------------------------------------------------------------------------------------------------------



| |  |  | competitive, technological, market and other developments; and
| | - |  | --------------------------------------------------------------



| |  |  | our ability to establish and maintain collaborative relationships
| | - |  | -----------------------------------------------------------------



We believe that our current cash and cash equivalents and short-term investments on hand will be sufficient to finance our anticipated capital and
operating requirements for at least the next twelve months. If we engage in acquisitions of companies, products, or technology in order to execute our business strategy, we may need to raise additional capital through public or private equity or
debt financing. If we are required to raise additional capital in the future, there can be no assurance that the additional financing will be available on favorable terms, or at all, or that such financing would not be dilutive to our existing
stockholders.



CAUTIONARY NOTE REGARDING FORWARD-LOOKING
STATEMENTS



This Quarterly Report on Form 10-Q contains
forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934 that involve risks and uncertainties. In some cases, you can identify forward-looking
statements by words like may, will, should, could, believes, intends, expects, anticipates, plans, estimates,
predicts, potential, continue and similar expressions. You should not rely on these forward-looking statements. These forward-looking statements are subject to substantial risks, uncertainties and assumptions.
Some of the factors that could cause actual results to differ materially from the forward-looking statements are described under Factors that May Affect Results of Operations and Financial Condition in this Report. These factors include,
but are not limited to:



| |  |  | our ability to successfully develop, obtain regulatory approvals for and market our products;
| | - |  | ---------------------------------------------------------------------------------------------



| |  |  | our ability to generate and maintain sufficient cash resources to increase investment in our business;
| | - |  | ------------------------------------------------------------------------------------------------------



| |  |  | the contribution to our results of new product launches;
| | - |  | --------------------------------------------------------



| |  |  | the timing or results of pending or future clinical trials;
| | - |  | -----------------------------------------------------------



| |  |  | actions by the FDA and other regulatory agencies;
| | - |  | -------------------------------------------------



| |  |  | demand and market acceptance for our approved products; and
| | - |  | -----------------------------------------------------------



| |  |  | the effect of changing economic conditions.
| | - |  | -------------------------------------------



If one or more of these risks or uncertainties materialize, or if any of our underlying assumptions proves incorrect, our actual results, performance or
achievements may vary materially from future results, performance or achievements expressed or implied by these forward-looking statements. All forward-looking statements attributable to us or persons acting on our behalf are expressly qualified in
their entirety by the cautionary statements in this section. We undertake no obligation to update or revise any forward-looking statements to reflect future events or developments.



Factors that May Affect Results of Operations and Financial Condition



Risks Related to Our Business



If we do not receive and maintain regulatory approvals for our product candidates, we will not be able to commercialize our products, which would substantially
impair our ability to generate revenues and materially harm our business and financial condition.



Three of our product candidates have received regulatory approval from the FDA. In May 2004, the FDA approved our NDA for Vitrase, in a lyophilized 6,200
USP units multi-purpose vial, for use as a spreading agent. In December 2004, the FDA approved our supplemental NDA for Vitrase for use as a spreading agent at a concentration of 200 USP units/mL in sterile solution. In June 2004, we received FDA
approval of the NDA for Istalol for the treatment of glaucoma. In March 2005, we received FDA approval of the NDA for Xibrom for the treatment of ocular inflammation following cataract surgery. Approval from the FDA is necessary to manufacture and
market pharmaceutical products in the United States.



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The regulatory approval process is extensive, time-consuming and costly, and there is no guarantee that
the FDA will approve additional NDAs for our product candidates, or that the timing of any such approval will be appropriate for our product launch schedule and other business priorities, which are subject to change.



We filed and the FDA accepted an NDA for Vitrase for the treatment of
vitreous hemorrhage. Although we have received an approvable letter from the FDA with respect to our NDA for Vitrase for the treatment of vitreous hemorrhage, the FDA has requested additional analysis of the existing data and an additional
confirmatory clinical study based upon that analysis. There can be no assurances that the FDA will approve this NDA for Vitrase, even if we decide to and are successfully able to undertake the further analysis and clinical testing requested by the
FDA. We are continuing our discussions with the FDA on this NDA and other potential uses of Vitrase, such as diabetic retinopathy.



Clinical testing of pharmaceutical products is also a long, expensive and uncertain process. Even if initial results of preclinical studies or clinical
trial results are positive, we may obtain different results in later stages of drug development, including failure to show desired safety and efficacy. The clinical trials of any of our product candidates could be unsuccessful, which would prevent
us from obtaining regulatory approval and commercializing the product. We have filed Investigation New Drug Applications, or INDs, with the FDA in March and April 2005, respectively, to conduct a U.S. Phase IIb study of ecabet sodium for the
treatment of dry eye syndrome and to conduct a U.S. Phase III study of our proprietary formulation of a fixed combination product of tobramycin and prednisolone acetate (the tobra/pred product) for the treatment of steroid-responsive
inflammatory ocular conditions where risk of bacterial infection exists. We initiated our ecabet sodium Phase IIb study in the second quarter of 2005 and our tobra/pred product Phase III study in the third quarter of 2005. We expect to complete our
ecabet sodium Phase IIb study by the end of 2005 and our tobra/pred product Phase III study by late 2005 or early 2006. However, we can provide no assurance as to whether the results of these studies, if completed, will be successful.



FDA approval can be delayed, limited or not granted for many reasons,
including, among others:



| |  |  | FDA officials may not find a product candidate safe or effective to merit an approval;
| | - |  | --------------------------------------------------------------------------------------



| |  |  | FDA officials may not find that the data from preclinical testing and clinical trials justifies approval, or they may require additional studies that would make it commercially
unattractive to continue pursuit of approval;
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | the FDA might not approve the processes or facilities of our contract manufacturers or raw material suppliers or our manufacturing processes or facilities;
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | the FDA may change its approval policies or adopt new regulations; and
| | - |  | ----------------------------------------------------------------------



| |  |  | the FDA may approve a product candidate for indications that are narrow or under conditions that place our product at a competitive disadvantage, which may limit our sales and
marketing activities or otherwise adversely impact the commercial potential of a product.
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



If the FDA does not approve our product candidates in a timely fashion on commercially viable terms or we terminate development of any of our product
candidates due to difficulties or delays encountered in clinical testing and the regulatory approval process, it will have a material adverse impact on our business and we will be dependent on the development of our other product candidates and/or
our ability to successfully acquire other products and technologies.



In addition, we intend to market, pursuant to our collaborations, certain of our products, and perhaps have certain of our products or raw materials manufactured, in foreign countries. For example, in accordance with our agreement with
Allergan, we have filed a centralized filing with the European Medicines Evaluations Agency seeking European market approval of Vitrase for the treatment of vitreous hemorrhage. Our European Vitrase filing is based on our existing U.S. clinical
trial data. Many other countries, including major European countries and Japan, have similar requirements as the United States for the manufacture, marketing and sale of pharmaceutical products. In addition, the process of obtaining approvals in
foreign countries is subject to delay and failure for similar reasons.



If
our products do not gain market acceptance, our business will suffer because we might not be able to fund future operations.



A number of factors may affect the market acceptance of our products or any other products we develop or acquire, including, among others:



| |  |  | the price of our products relative to other therapies for the same or similar treatments;
| | - |  | -----------------------------------------------------------------------------------------



| |  |  | the perception by patients, physicians and other members of the health care community of the effectiveness and safety of our products for their prescribed treatments;
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | our ability to fund our sales and marketing efforts; and
| | - |  | --------------------------------------------------------



| |  |  | the effectiveness of our sales and marketing efforts.
| | - |  | -----------------------------------------------------



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In addition, our ability to market and promote our products is restricted to the labels approved by the
FDA. If the approved labels are restrictive, our sales and marketing efforts and market acceptance and the commercial potential of our products may be negatively affected. For example, should the market not widely accept Vitrase for usage based on
the label of the approved NDA, we may have to await approval of additional indications in order to reach the full market potential for this drug.



If our products do not gain market acceptance, we may not be able to fund future operations, including the development or acquisition of new product
candidates and/or our sales and marketing efforts for our approved products, which would cause our business to suffer.



If we are unable to sufficiently develop our sales, marketing and distribution capabilities and/or enter into agreements with third parties to perform these functions,
we will not be able to commercialize our products.



We are
continuing to develop and enhance our sales, marketing and distribution capabilities. Although we have recently expanded our capabilities, our current resources in these areas are limited. In order to commercialize any products successfully, we must
continue to develop and expand substantial sales, marketing and distribution capabilities, and/or maintain our arrangements with Ventiv and Cardinal Health or establish other collaborations or other arrangements with third parties to perform these
services. We do not have extensive experience in these areas, and we may not be able to establish adequate in-house sales, marketing and distribution capabilities or engage and effectively manage relationships with third parties to perform any or
all of such services. To the extent that we enter into co-promotion, licensing or other third party arrangements, our product revenues and returns are likely to be lower than if we directly marketed and sold our products, and any revenues we receive
will depend upon the efforts of third parties, whose efforts may not be successful.



If we fail to properly manage our anticipated growth, our business could suffer.



Rapid growth of our business is likely to place a significant strain on our managerial, operational and financial resources and systems. We have increased
our full-time employee count from 63 as of December 31, 2004 to 160 as of September 30, 2005. We expanded our sales force from 50 sales representatives as of the first quarter of 2005 to over 70 sales representatives as of
September 30, 2005 in conjunction with our commercial launch of Xibrom for the treatment of ocular inflammation following cataract surgery. To manage our anticipated growth successfully, we must attract and retain qualified personnel and manage
and train them effectively. We will be dependent on our personnel and third parties to effectively manufacture, market, sell and distribute our products. We will also depend on our personnel and third parties to successfully develop and acquire new
products. Further, our anticipated growth will place additional strain on our suppliers and manufacturers, resulting in increased need for us to carefully manage these relationships and monitor for quality assurance. Although we may not in fact grow
as we expect, if we fail to manage our growth effectively or to develop and expand a successful commercial infrastructure to support marketing and sales of our products, our business and financial results will be materially harmed.



We have generated minimal revenue from product sales to date, we have a history of net
losses and negative cash flow, and we may need to raise additional working capital.



We have generated minimal revenue from product sales to date, and we may never generate significant revenues from product sales in the future. In addition, we have never been profitable, and we might never become
profitable. In this regard, we anticipate that our operating expenses will continue to increase from historical levels as we continue to expand our commercial infrastructure in connection with our commercialization of our approved products. As of
September 30, 2005, our accumulated deficit was $215.8 million, including a net loss of approximately $27.7 million for the nine months ended September 30, 2005. As of September 30, 2005, we had approximately $44.1 million in cash and
cash equivalents and short-term investments and working capital of $43.8 million. We believe our current cash and cash equivalents and short-term investments on hand will be sufficient to finance anticipated capital and operating requirements for at
least the next twelve months.



If we are unable to generate
sufficient product revenues, we may be required to raise additional capital in the future through collaborative agreements or public or private equity or debt financings. If we are required to raise additional capital in the future such additional
financing may not be available on favorable terms, or at all, or may be dilutive to our existing stockholders. If we fail to obtain additional capital as and when required such failure could have a material adverse impact on our operating plan and
business.



If actual future payments for allowances, discounts, returns,
rebates and chargebacks exceed the estimates we made at the time of the sale of our products, our financial position, results of operations and cash flows may be materially and negatively impacted.



We recognize product revenue net of estimated allowances for discounts,
returns, rebates and chargebacks. Such estimates require our most subjective and complex judgment due to the need to make estimates about matters that are



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inherently uncertain. Based on industry practice, pharmaceutical companies, including us, have liberal return policies. Generally, we are obligated to accept
from customers the return of pharmaceuticals that have reached their expiration date. We authorize returns for damaged products and exchanges for expired products in accordance with our return goods policy and procedures. In addition, like our
competitors, we also give credits for chargebacks to wholesale customers that have contracts with us for their sales to hospitals, group purchasing organizations, pharmacies or other retail customers. A chargeback is the difference between the price
the wholesale customer pays and the price that the wholesale customers end-customer pays for a product. Actual results may differ significantly from our estimated allowances for discounts, returns, rebates and chargebacks. Changes in estimates
and assumptions based upon actual results may have a material impact on our results of operations and/or financial condition. In addition, our financial position, results of operations and cash flows may be materially and negatively impacted if
actual future payments for allowances, discounts, returns, rebates and chargebacks exceed the estimates we made at the time of the sale of our products.



If we have problems with our contract manufacturers, our product development and commercialization efforts could be delayed or stopped.



We have entered into a master services agreement with R.P. Scherer West,
Inc., which was subsequently acquired by and remains a wholly owned subsidiary of Cardinal Health, Inc., for the manufacture of commercial quantities of our Vitrase product in a lyophilized 6,200 USP units multi-purpose vial and a supply agreement
with Alliance Medical Products, Inc. for the manufacture of commercial quantities of our Vitrase product in 200 USP units/mL in sterile solution. We also have entered into a manufacturing services agreement with Bausch & Lomb Incorporated
for the manufacture of commercial quantities of Istalol and Xibrom. Before any contract manufacturer can produce commercial quantities of a product, we must demonstrate to the FDAs satisfaction that the product source for commercial quantities
is substantially equivalent to the supply of the product used in our clinical trials. Such demonstration may include the requirement to conduct additional clinical trials. In addition, the manufacturing facilities of all of our contract
manufacturers must comply with current Good Manufacturing Practice, or cGMP, regulations, which the FDA strictly enforces. Moreover, the facilities of the contract manufacturer must undergo and pass pre-approval inspections by the FDA before any of
our products can be approved for commercial manufacture and, once approved, such facilities must maintain their compliance and good standing with regulatory authorities. R.P. Scherer West, Alliance Medical Products, Bausch & Lomb, or any
other manufacturer we may contract with in the future may not be able, as applicable, to develop processes necessary to produce substantially equivalent product to those products used in our clinical trials so that regulatory authorities will
approve them as a manufacturer, or such facilities, once approved, may not produce on a timely basis enough product to meet our sales demands, or they may not maintain their compliance and good standing with regulatory authorities. Any such failures
could delay or stop our efforts to develop our product candidates and commercialize our products.



Our collaborative partners may terminate, or fail to perform their duties under, our collaboration agreements, in which case our ability to commercialize our products may be significantly impaired.



We have entered into collaborations with Senju relating to Istalol, Xibrom
and ecabet sodium. We have also entered into collaborations with Allergan and Otsuka relating to the commercialization of Vitrase in specified markets outside the United States for ophthalmic uses for the posterior region of the eye. In September
2004, we entered into a new agreement with Allergan, replacing our previous Vitrase collaboration, under which we reacquired all rights to market and sell Vitrase for all uses in the United States and other specified markets. Allergan retains an
option to commercialize Vitrase for the posterior segment of the eye in Europe upon approval. If Allergan exercises its option, we will be dependent upon Allergan for the commercialization of Vitrase for such approved uses in Europe. If Allergan
does not exercise its option, then such European rights will revert to ISTA, and we will pay Allergan a royalty on our European sales of Vitrase for use in the posterior segment of the eye. In accordance with our agreement with Allergan, we have
filed a centralized filing with the European Medicines Evaluations Agency seeking European market approval of Vitrase for the treatment of vitreous hemorrhage. Our European Vitrase filing is based on our existing U.S. clinical trial data. We depend
on Otsuka for obtaining regulatory approval of Vitrase for ophthalmic uses for the posterior region of the eye in Japan, and if such approval is obtained, we will be dependent upon Otsuka for the commercialization of Vitrase for such approved uses
in Japan. The amount and timing of resources that our partners dedicate to our collaborations is not within our control. Accordingly, any breach or termination of our agreements by, or disagreements with, these collaborators could delay or stop the
development and/or commercialization of our product candidates within the scope of these collaborations, or, in the case of Allergan and Otsuka, adversely impact our receipt of milestone payments, profit splits, royalties, and other consideration
from these collaborations. Our collaborative partners may change their strategic focus, terminate our agreements or choose not to exercise their options, on relatively short notice, or pursue alternative technologies. Our agreements with Otsuka and
Senju contain reciprocal terms providing that neither we nor they may develop products that directly compete in the same form with the products involved in the collaboration. Nonetheless, our collaborators may develop competing products in different
forms or products that compete indirectly with our products.



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If we have problems with our sole source suppliers, our product development and commercialization efforts for our
product candidates could be delayed or stopped.



Some
materials used in our products are currently obtained from a single source. For example, Biozyme Laboratories, Ltd. is currently our only source for highly purified ovine hyaluronidase, which is the active ingredient in Vitrase. Our supply agreement
with Biozyme ends in August 2007, after which any further supply of hyaluronidase by Biozyme to us would be subject to Biozymes agreement. While we are currently pursuing additional sources for this material, we may not be successful in
establishing such additional supply agreements. The active ingredient for Xibrom is also supplied to us from a sole supplier. We have also entered into supply agreements with R.P. Scherer West and Alliance Medical Products to manufacture commercial
quantities of Vitrase in a lyophilized 6,200 USP units multi-purpose vial and 200 USP units/mL in sterile solution, respectively. Currently, R.P. Scherer West and Alliance Medical Products each is our sole source for Vitrase in these respective
configurations. We also have supply agreements with Bausch & Lomb to manufacture commercial quantities of Istalol and Xibrom. Currently, Bausch & Lomb is our sole source for Istalol and Xibrom.



We have not established and may not be able to establish arrangements with
additional suppliers for these ingredients or products. Difficulties in our relationship with our suppliers or delays or interruptions in such suppliers supply of our requirements could limit or stop our ability to provide sufficient
quantities of our products, on a timely basis, for clinical trials and, for our approved products, could limit or stop commercial sales, which would have a material adverse effect on our business and financial condition.



We depend on our Chief Executive Officer, Vicente Anido, Jr., Ph.D., and other key
personnel, to execute our strategic plan.



Our success
largely depends on the skills, experience and efforts of our key personnel, including Chief Executive Officer, Vicente Anido, Jr., Ph.D. We have entered into a written employment agreement with Dr. Anido that can be terminated at any time by us
or by Dr. Anido. In the event Dr. Anidos employment is terminated, other than for cause or voluntarily by Dr. Anido, Dr. Anido will receive nine months of salary as severance compensation. In the event Dr. Anidos
employment is terminated after a change of control, other than for cause or voluntarily by Dr. Anido, then certain of Dr. Anidos stock options will immediately vest and become exercisable in full, and Dr. Anido will receive
twenty-four months of salary as severance compensation. We do not maintain key person life insurance policies covering Dr. Anido. The loss of Dr. Anido, or our failure to retain other key personnel, would jeopardize our ability
to execute our strategic plan and materially harm our business.



Risks Related to Our Industry



Compliance with extensive
government regulations to which we are subject is expensive and time consuming, and may result in the delay, cessation or cancellation of product sales, introductions or modifications.



Extensive industry regulation has had, and will continue to have, a
significant impact on our business. All pharmaceutical companies, including us, are subject to extensive, complex, costly and evolving regulation by the federal government, principally the FDA and to a lesser extent by the U.S. Drug Enforcement
Administration, or DEA, and foreign and state government agencies. The Federal Food, Drug and Cosmetic Act, the Controlled Substances Act and other domestic and foreign statutes and regulations govern or influence the testing, manufacturing,
packing, labeling, storing, record keeping, safety, approval, advertising, promotion, sale and distribution of our products. Under certain of these regulations, we and our contract suppliers and manufacturers are subject to periodic inspection of
our or their respective facilities, procedures and operations and/or the testing of our products by the FDA, the DEA and other authorities, which conduct periodic inspections to confirm that we and our contract suppliers and manufacturers are in
compliance with all applicable regulations. The FDA also conducts pre-approval and post-approval reviews and plant inspections to determine whether our systems, or our contract suppliers and manufacturers processes, are in compliance
with cGMP and other FDA regulations.



In addition, the FDA
imposes a number of complex regulatory requirements on entities that advertise and promote pharmaceuticals, including, but not limited to, standards and regulations for direct-to-consumer advertising, off-label promotion, industry sponsored
scientific and educational activities, and promotional activities involving the Internet.



We are dependent on receiving and maintaining FDA and other governmental approvals in order to manufacture, market, sell and ship our products. Consequently, there is always a risk that the FDA or other applicable
governmental authorities will not approve our products, or will take post-approval action limiting, modifying or revoking our ability to manufacture or sell our products, or that the rate, timing and cost of such approvals will adversely affect our
product introduction plans or results of operations.



To the
extent that our products are reimbursed by the Medicare, Medicaid and other federal programs, our marketing and sales activities will be subject to regulation. Federal agencies in recent years have initiated investigations against and entered into
multi-million dollar settlements with a number of pharmaceutical companies alleging violations of fraud and abuse provisions. We will need to ensure that our sales force is properly trained to comply with these laws. Even with such



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training, there is a risk that some of our marketing practices could come under scrutiny, or that we will not be able to institute or continue certain
marketing practices.



Our suppliers and manufacturers are subject to
regulation by the FDA and other agencies, and if they do not meet their commitments, we would have to find substitute suppliers or manufacturers, which could delay or prevent the supply of our products to market.



Regulatory requirements applicable to pharmaceutical products make the
substitution of suppliers and manufacturers costly and time consuming. We have no internal manufacturing capabilities and are, and expect to be in the future, entirely dependent on contract manufacturers and suppliers for the manufacture of our
products and for their active and other ingredients. The disqualification of these suppliers through their failure to comply with regulatory requirements could negatively impact our business because the delays and costs of obtaining and qualifying
alternate suppliers (if any) could delay clinical trials or otherwise inhibit our ability to bring approved products to market or could result in a delay or disruption in the manufacture, marketing or sales of our products, which would have a
material adverse affect on our business and financial condition.



We may be
required to initiate or defend against legal proceedings related to intellectual property rights, which may result in substantial expense, delay and/or cessation of our development and commercialization of our products.



We rely on patents to protect our intellectual property rights. The strength
of this protection, however, is uncertain. For example, it is not certain that:



| |  |  | our patents and pending patent applications cover products and/or technology that we invented first;
| | - |  | ----------------------------------------------------------------------------------------------------



| |  |  | we were the first to file patent applications for these inventions;
| | - |  | -------------------------------------------------------------------



| |  |  | others will not independently develop similar or alternative technologies or duplicate our technologies;
| | - |  | --------------------------------------------------------------------------------------------------------



| |  |  | any of our pending patent applications will result in issued patents; and
| | - |  | -------------------------------------------------------------------------



| |  |  | any of our issued patents, or pending patent applications that result in issued patents, will be held valid and infringed in the event the patents are asserted against others.
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



We currently own or license 75 U.S. and foreign
patents and 39 U.S. and foreign pending patent applications. Our existing patents, or any patents issued to us as a result of such applications, may not provide us a basis for commercially viable products, may not provide us with any competitive
advantages, or may face third-party challenges or be the subject of further proceedings limiting their scope or enforceability. We may become involved in interference proceedings in the U.S. Patent and Trademark Office to determine the priority of
our inventions. In addition, costly litigation could be necessary to protect our patent position. We license patent rights from the Eastern Virginia Medical School for Caprogel and from Senju for Istalol, Xibrom and ecabet sodium. Some of these
license agreements do not permit us to control the prosecution, maintenance, protection and defense of such patents. If the licensor chooses not to protect its own patent rights, we may not be able to take actions to secure our related product
marketing rights. In addition, if such patent licenses are terminated before the expiration of the licensed patents, we may no longer be able to continue to manufacture and sell such products as may be covered by the patents.



We also rely on trade secrets, unpatented proprietary know-how and continuing
technological innovation that we seek to protect with confidentiality agreements with employees, consultants and others with whom we discuss our business. Disputes may arise concerning the ownership of intellectual property or the applicability or
enforceability of these agreements, and we might not be able to resolve these disputes in our favor.



We also rely on trademarks to protect the names of our products. These trademarks may be challenged by others. If we enforce our trademarks against third
parties, such enforcement proceedings may be expensive. Some of our trademarks, including Caprogel and Xibrom, are owned by or assignable to our licensors Eastern Virginia Medical School and Senju, and upon expiration or termination of the license
agreements, we may no longer be able to use these trademarks.



In addition to protecting our own intellectual property rights, we may be required to defend against third parties who assert patent, trademark or copyright infringement or other intellectual property claims against us based on what they
believe are their own intellectual property rights. We may be required to pay substantial damages, including but not limited to treble damages, for past infringement if it is ultimately determined that our products infringe a third partys
intellectual property rights. Even if infringement claims against us are without merit, defending a lawsuit takes significant time, may be expensive and may divert managements attention from other business concerns. Further, we may be stopped
from developing, manufacturing or selling our products until we obtain a license from the owner of the relevant technology or other intellectual property rights. If such a license is available at all, it may require us to pay substantial royalties
or other fees.



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We have not conducted an extensive search of patents issued to other parties and such patents which
contain claims relating to our technology and products may exist, may have been filed, or could be issued. If such patents do exist, the owners may bring claims against us for infringement, which might have an adverse effect on our business.



If third-party reimbursement is not available, our products may not be
accepted in the market.



Our ability to earn sufficient
returns on our products will depend in part on the extent to which reimbursement for our products and related treatments will be available from government health administration authorities, private health insurers, managed care organizations and
other healthcare providers.



Both governmental and private
third-party payers are increasingly attempting to limit both the coverage and the level of reimbursement of new drug products to contain costs. Consequently, significant uncertainty exists as to the reimbursement status of newly approved healthcare
products. Third-party payers may not establish adequate levels of reimbursement for any of our approved products or products we develop or acquire in the future, which could limit their market acceptance and result in a material adverse effect on
our financial condition. In November 2005, the Center for Medicare and Medicaid Services, or CMS, established two new national Healthcare Common Procedure Coding Systems, or HCPCS, J-Codes covering the injection of preservative free ovine
hyaluronidase, Vitrase. Physicians will be able to use these new J-Codes beginning January 2006. HCPCS Codes are used by healthcare insurers to process reimbursement claims. We believe that these two new J-Codes will help facilitate third-party
reimbursement for Vitrase. However, Vitrase sales in the future maybe negatively impacted by reimbursement levels established by third-party payers.



Sales of our products may continue to be adversely affected by the continuing consolidation of our distribution network and the concentration of our customer base.



Our principal customers are wholesale drug distributors
and major retail drug store chains. These customers comprise a significant part of the distribution network for pharmaceutical products in the U.S. This distribution network is continuing to undergo significant consolidation marked by mergers and
acquisitions among wholesale distributors and the growth of large retail drug store chains. As a result, a small number of large wholesale distributors control a significant share of the market, and the number of independent drug stores and small
drug store chains has decreased. We expect that consolidation of drug wholesalers and retailers will increase pricing and other competitive pressures on drug manufacturers. We launched our first product, Istalol, in the third quarter of 2004, our
second product, Vitrase, in the first quarter of 2005 and our third product, Xibrom, in the second quarter of 2005. For the year ended December 31, 2004, our three largest customers accounted for 15%, 40% and 25%, respectively, of our net
revenues. The loss of any of our customers could materially adversely affect our business, results of operations and financial condition and our cash flows. In addition, none of our customers are party to any long-term supply agreements with us
which would enable them to change suppliers freely should they wish to do so.



The rising cost of healthcare and related pharmaceutical product pricing has lead to cost-containment pressures that could cause us to sell our products at lower prices, resulting in less revenue to us.



Any of our products that have been or in the future are approved by the FDA
may be purchased or reimbursed by state and federal government authorities, private health insurers and other organizations, such as health maintenance organizations and managed care organizations. Such third party payors increasingly challenge
pharmaceutical product pricing. The trend toward managed healthcare in the United States, the growth of such organizations, and various legislative proposals and enactments to reform healthcare and government insurance programs, including the
Medicare Prescription Drug Modernization Act of 2003, could significantly influence the manner in which pharmaceutical products are prescribed and purchased, resulting in lower prices and/or a reduction in demand. Such cost containment measures and
healthcare reforms could adversely affect our ability to sell our products. Furthermore, individual states have become increasingly aggressive in passing legislation and implementing regulations designed to control pharmaceutical product pricing,
including price or patient reimbursement constraints, discounts, restrictions on certain product access, importation from other countries and bulk purchasing. Legally mandated price controls on payment amounts by third party payors or other
restrictions could negatively and materially impact our revenues and financial condition. We anticipate that we will encounter similar regulatory and legislative issues in most other countries outside the United States.



We face intense competition and rapid technological change that could result in the
development of products by others that are superior to the products we are developing. In addition, we face competition from manufacturers of generic drugs which may have an adverse impact on our product revenues.



We have numerous competitors in the United States and abroad, including,
among others, major pharmaceutical and specialized biotechnology firms, universities and other research institutions that may be developing competing products. Such competitors may include Allergan, Alcon Laboratories, Inc., Amphastar
Pharmaceuticals, Inc., Bausch & Lomb,



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Halozyme Therapeutics, Inc., Johnson & Johnson, Novartis AG, Pfizer, Inc., Eli Lilly and Company, PrimaPharm, Inc. and Inspire Pharmaceuticals, Inc.
These competitors may develop technologies and products that are more effective or less costly than our current or future products or product candidates or that could render our technologies, products and product candidates obsolete or
noncompetitive. Many of these competitors have substantially more resources and product development, manufacturing and marketing experience and capabilities than we do. Many of our competitors also have more resources committed to and expertise in
effectively commercializing, marketing, and promoting products approved by the FDA, including communicating the effectiveness, safety and value of the products to actual and prospective customers and medical professionals. In addition, many of our
competitors have significantly greater experience than we do in undertaking preclinical testing and clinical trials of pharmaceutical product candidates and obtaining FDA and other regulatory approvals of products and therapies for use in
healthcare. In August 2005, the FDA approved Nevanac (nepafenac ophthalmic suspension) 0.1% for the treatment of pain and inflammation associated with cataract surgery. Nevanac, sold by Alcon, is marketed as an alternative to and competes
against Xibrom.



In addition, competition from generic drugs is
a major challenge in the United States to branded drug companies, like us, and may have a material adverse effect on our product revenues. In October 2004, the FDA granted Istalol a BT rating, which means that prescriptions for Istalol
cannot be substituted legally at pharmacies with generic timolol maleate products. Nonetheless, we believe that certain pharmacies may have substituted, and may be continuing to substitute, Istalol prescriptions with generic timolol maleate
solutions. We have completed an educational campaign to make our customers and pharmacies aware of Istalols BT rating and that Istalol cannot be substituted legally at pharmacies with generic timolol maleate products. In October 2004, the FDA
informed us that Vitrase (hyaluronidase for injection; lyophilized, ovine) for use as a spreading agent to facilitate the dispersion and absorption of other drugs was entitled to five-year new chemical entity market exclusivity pursuant to the
federal Food, Drug and Cosmetic Act. The FDA indicated that Vitrases new chemical entity exclusivity would bar submission to FDA of certain third party 505(b)(2) NDAs and Abbreviated New Drug Applications, or ANDAs, for drugs containing the
same active moiety as Vitrase. The submission bar would be for five years from Vitrases approval date (i.e., May 5, 2004) or for four years in the case of patent challenges. The FDA also said that Vitrases new chemical entity
exclusivity is not a prohibition on FDAs review and approval of any 505(b)(2) NDA or ANDA that was submitted to the agency before Vitrase was granted five-year exclusivity. In October 2004, the FDA approved Amphadase (hyaluronidase injection,
USP) 150 IU mL, a bovine-sourced hyaluronidase, for use as a spreading agent. Amphadase is sold by Amphastar Pharmaceuticals, Inc. and competes against Vitrase. The FDA has stated that Vitrases five year new chemical exclusivity did not bar
approval of Amphadase since Amphadase did not contain the same active moiety has Vitrase. For the purposes of market exclusivity, the FDA presumes that a product does not contain a previously approved active moiety if the agency has insufficient
information to determine whether, in fact, it contains one. Like Vitrase, FDA has also granted Amphadase five year new chemical exclusivity. The FDA has stated that the hyaluronidase in these products and other previously approved products is not
fully characterized and therefore insufficient information exists to determine whether the active moiety in any of these products was previously approved. In October 2005, the FDA approved Hydase (hyaluronidase injection, USP) 150 UI mL, a bovine
hyaluronidase, for use as a spreading agent. Hydase is manufactured by PrimaPharm, Inc. and would compete against Vitrase. In March 2005, Halozyme Therapeutics announced it had filed an NDA for Enhanze SC, a formulation of recombinant human
hyaluronidase being developed as a spreading agent. If the NDA for this product is approved, it may be marketed as an alternative to and compete against Vitrase. Our ability to secure the benefit of the Vitrase market exclusivity depends on a
variety of factors, some of which are beyond our control, including, among others, the timing, content and outcome of actions and decisions by the FDA and other regulatory authorities regarding third party products and the impact and scope of the
Vitrase market exclusivity and its affect on third party products.



We are
exposed to product liability claims, and insurance against these claims may not be available to us on reasonable terms, or at all.



The design, development, manufacture and sale of our products involve an inherent risk of product liability claims by consumers and other third parties.
As a commercial company, we have begun to market and promote our approved products, like Xibrom, Istalol and Vitrase, and we may be subject to various product liability claims. In addition, we may in the future recall or issue field corrections
related to our products due to manufacturing deficiencies, labeling errors or other safety or regulatory reasons. We cannot assure you that we will not experience material losses due to product liability claims, product recalls or corrections. These
events, among others, could result in additional regulatory controls, such as the performance of costly post-approval clinical studies or revisions to our approved labeling that could limit the indications or patient population for our products or
could even lead to the withdrawal of a product from the market. Furthermore, any adverse publicity associated with such an event could cause consumers to seek alternatives to our products, which may cause our sales to decline, even if our products
are ultimately determined not to have been the primary cause of the event.



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We currently maintain sold products and clinical trial liability insurance with per occurrence and
aggregate coverage limits of $10.0 million. The coverage limits of our insurance policies may be inadequate to protect us from any liabilities we might incur in connection with clinical trials or the sale of our products. Product liability insurance
is expensive and in the future may not be available on commercially acceptable terms, or at all. A successful claim or claims brought against us in excess of our insurance coverage could materially harm our business and financial condition.



Risks Related to Our Stock



Our stock price is subject to significant volatility.



Since 2001 until the present, the daily closing price per share of our
common stock has ranged from a high of $133.75 per share to a low of $2.60 per share, as adjusted for the 1-for-10 reverse stock split affected November 2002. Our stock price has been and may continue to be subject to significant volatility. The
following factors may cause the market price of our common stock to fall:



| |  |  | the scope, outcome and timeliness of any governmental, court or other regulatory action that may involve us, including, without limitation, the scope, outcome or timeliness of any
inspection or other action of the FDA;
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | market acceptance and demand for our approved products;
| | - |  | -------------------------------------------------------



| |  |  | the availability to us, on commercially reasonable terms or at all, of third-party sourced products and materials;
| | - |  | ------------------------------------------------------------------------------------------------------------------



| |  |  | timely and successful implementation of our strategic initiatives, including the expansion of our commercial infrastructure to support the marketing, sale, and distribution of our
approved products;
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | developments concerning proprietary rights, including the ability of third parties to assert patents or other intellectual property rights against us which, among other things,
could cause a delay or disruption in the development, manufacture, marketing or sale of our products;
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | competitors publicity regarding actual or potential products under development or new commercial products, and the impact of competitive products and pricing;
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | period-to-period fluctuations in our financial results;
| | - |  | -------------------------------------------------------



| |  |  | public concern as to the safety of new technologies;
| | - |  | ----------------------------------------------------



| |  |  | future sales of debt or equity securities by us;
| | - |  | ------------------------------------------------



| |  |  | sales of our securities by our directors, officers or significant shareholders;
| | - |  | -------------------------------------------------------------------------------



| |  |  | comments made by securities analysts; and
| | - |  | -----------------------------------------



| |  |  | economic and other external factors, including disasters and other crises.
| | - |  | --------------------------------------------------------------------------



We participate in a highly dynamic industry, which often results in significant volatility in the market price of our common stock irrespective of company
performance. Fluctuations in the price of our common stock may be exacerbated by conditions in the healthcare and technology industry segments or conditions in the financial markets generally.



Trading in our stock over the last 12 months has been limited, so investors may not be
able to sell as much stock as they want at prevailing prices.



The average daily trading volume in our common stock for the twelve-month period ended September 30, 2005 was approximately 138,370 shares and the average daily number of transactions was approximately 414 for the same period. If
limited trading in our stock continues, it may be difficult for investors to sell their shares in the public market at any given time at prevailing prices.



Future sales of shares of our common stock may negatively affect our stock price.



As a result of our bridge financing in September 2002, our PIPE financing transaction in November 2002, our follow-on public
offering in November 2003, our registered direct offerings in August 2004 and our follow-on public offering in January 2005, we issued approximately 23.7 million shares of our common stock. The shares of common stock issued in connection with
these transactions represent approximately 92% of our common stock outstanding as of July 25, 2005. In connection with our bridge financing and our PIPE financing transaction, we also issued warrants exercisable for the purchase of up to an
aggregate of 1,842,104 shares of our common stock based upon a purchase price of $3.80 per share. We



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filed a registration statement on Form S-3 (Registration No. 333-103820), which was declared effective on June 6, 2003, to cover sales of the
shares issued to the PIPE investors and issuable to the PIPE and bridge investors upon conversion of the warrants. The exercise of these warrants could result in significant dilution to our shareholders at the time of exercise. We also filed a
registration statement on Form S-2 (Registration No. 333-109576) in connection with our November 2003 follow-on public offering, which was declared effective on November 12, 2003, in which we issued and sold 4,000,000 shares of our common
stock. In April 2004, we filed a universal shelf registration statement on Form S-3 with the SEC, which was declared effective in May 2004, providing for the offering from time to time of up to $75 million of our securities, which may consist of
common stock, preferred stock, warrants, or debt securities. On August 6, 2004 we sold 1,570,000 shares of common stock under our shelf registration statement for an aggregate purchase price of $13.3 million, or $8.50 per share, before
placement agency fees and other offering expenses. On August 10, 2004, we sold 250,000 shares of common stock under our shelf registration statement for an aggregate purchase price of $2.1 million, or $8.50 per share, before offering expenses.
In January 2005, we sold 6,325,000 shares of our common stock under our universal shelf registration statement in an underwritten public offering for an aggregate purchase price of $56.2 million, or $8.88 per share, before offering expenses and
underwriting discounts.



In the future, we may issue additional
shares of common stock or other equity securities, including but not limited to options, warrants or other derivative securities convertible into our common stock, which could result in significant dilution to our stockholders.



Concentration of ownership and contractual board rights could delay or prevent a change in
control or otherwise influence or control most matters submitted to our stockholders and could enable certain shareholders to exert control over us and our significant corporate decisions.



As of October 18, 2005, our directors, officers, and principal
stockholders together control approximately 42% of our voting securities, a concentration of ownership that could delay or prevent a change in control. We are obligated to include a representative of Investor Growth Capital as a nominee for election
to our board of directors and Sprout has the right to designate two such nominees. As of October 18, 2005, Investor Growth Capital entities beneficially owned 3,285,409 shares of our common stock or 12.4% of our outstanding common stock and
Sprout entities beneficially owned 6,009,155 shares of our common stock or 22.6% of our outstanding common stock. Our principal stockholders, if acting together, would be able to influence and possibly control most matters submitted for approval by
our stockholders, including the election of directors, delaying or preventing a change of control, and the consideration of transactions in which stockholders might otherwise receive a premium for their shares over then-current market prices.



Our shareholder rights plan, provisions in our charter documents, and
Delaware law may inhibit a takeover of us, which could limit the price investors might be willing to pay in the future for our common stock, and could entrench management.



We have a shareholder rights plan that may have the effect of discouraging unsolicited takeover proposals, thereby
entrenching current management and possibly depressing the market price of our common stock. The rights issued under the shareholder rights plan would cause substantial dilution to a person or group that attempts to acquire us on terms not approved
in advance by our board of directors. In addition, our charter and bylaws contain provisions that may discourage unsolicited takeover proposals that stockholders may consider to be in their best interests. These provisions include:



| |  |  | a classified board of directors;
| | - |  | --------------------------------



| |  |  | the ability of the board of directors to designate the terms of and issue new series of preferred stock;
| | - |  | --------------------------------------------------------------------------------------------------------



| |  |  | advance notice requirements for nominations for election to the board of directors; and
| | - |  | ---------------------------------------------------------------------------------------



| |  |  | special voting requirements for the amendment of our charter and bylaws.
| | - |  | ------------------------------------------------------------------------



We are also subject to anti-takeover provisions under Delaware law, each of which could delay or prevent a change of control. Together these provisions
and the shareholder rights plan may make more difficult the removal of management and may discourage transactions that otherwise could involve payment of a premium over prevailing market prices for our common stock.



We do not anticipate declaring any cash dividends on our common stock.



We have never declared or paid cash dividends on our common stock and do not
plan to pay any cash dividends in the near future. Our current policy is to retain all funds and any earnings for use in the operation and expansion of our business.



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|Item 3. | Quantitative and Qualitative Disclosures About Market Risk
|------- | ----------------------------------------------------------



The primary objective of our investment activities is to preserve principal while at the same time maximizing the income we receive from our investments
without significantly increasing risk. Some of the securities that we invest in may have market risk. This means that a change in prevailing interest rates may cause the principal amount of the investment to fluctuate. For example, if we hold a
security that was issued with a fixed interest rate at the then-prevailing rate and the prevailing interest rate later rises, the principal amount of our investment will probably decline. Seeking to minimize this risk, we maintain our portfolio of
cash equivalents and short-term investments in a variety of securities, including commercial paper, money market funds, government and non-government debt securities. The average duration of all of our investments in 2004 was less than one year. Due
to the short-term nature of these investments, we believe we have no material exposure to interest rate risk arising from our investments. A hypothetical 100 basis point adverse move in interest rates along the entire interest rate yield curve would
not materially affect the fair market value of our interest sensitive financial investments. Declines in interest rates over time will, however, reduce our investment income, while increases in interest rates over time will increase our interest
expense. Historically, and as of September 30, 2005, we have not used derivative instruments or engaged in hedging activities.



We have operated primarily in the United States. Accordingly, we have not had any significant exposure to foreign currency rate fluctuations.
Visionexs functional currency is the Singapore dollar and a portion of Visionexs business was conducted in currencies other than the Singapore dollar prior to the wind down of operations in July 2002. As a result, currency fluctuations
between the Singapore dollar and the currencies in which Visionex had done business will cause foreign currency translation gains and losses. We do not expect our foreign currency translation gains or losses to be material. We do not currently
engage in foreign exchange hedging transactions to manage our foreign currency exposure.



|Item 4. | Controls and Procedures
|------- | -----------------------



Evaluation of disclosure controls and procedures



Our management, with the participation and under the supervision of our Chief Executive Officer and Chief Financial Officer, has evaluated the
effectiveness of our disclosure controls and procedures (as defined in Exchange Act Rule 13a-15(e)) as of the end of the period covered by this Quarterly Report. The Chief Executive Officer and Chief Financial Officer have concluded that our
disclosure controls and procedures are effective based on their evaluation of these controls and procedures required by paragraph (b) of Exchange Act Rules 13a-15 and 15d-15. A controls system, no matter how well designed and operated, cannot
provide absolute assurance that the objectives of the controls are met, and no evaluation of controls can provide absolute assurance that all controls and instances of fraud, if any, within a company have been detected.



Changes in internal control over financial reporting



We have not made any significant changes to our internal control over
financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) during the fiscal quarter ended September 30, 2005 that have materially affected, or are reasonably likely to materially affect, our internal control over financial
reporting.



PART II. OTHER INFORMATION



|Item 1 | Legal Proceedings
|------ | -----------------



We are involved in legal proceedings incidental to our business from time to time. We believe that pending actions, individually and in the aggregate,
will not have a material adverse effect on our financial condition, results of operations or cash flows, and that adequate provision has been made for the resolution of such actions and proceedings.



|Item 6 | Exhibits
|------ | --------



|              |  |                                                                                                                                                 
|------------- |  | ------------------------------------------------------------------------------------------------------------------------------------------------
|ExhibitNumber |  | Description                                                                                                                                     
|              | 
|31.1          |  | Certification of Chief Executive Officer Pursuant to Rule 13a-14(d)/15d-14(a) of the Securities Exchange Act of 1934.                           
|              | 
|31.2          |  | Certification of Chief Financial Officer Pursuant to Rule 13a-14(d)/15d-14(a) of the Securities Exchange Act of 1934.                           
|              | 
|32.1          |  | Certification of Chief Executive Officer Pursuant to Rule 13a-14(b)/15d-14(b) of the Securities Exchange Act of 1934 and 18 U.S.C. Section 1350.
|              | 
|32.2          |  | Certification of Chief Financial Officer Pursuant to Rule 13a-14(b)/15d-14(b) of the Securities Exchange Act of 1934 and 18 U.S.C. Section 1350.



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Signatures



Pursuant to the
requirements of the Securities Exchange Act of 1934, ISTA Pharmaceuticals, Inc. has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.



|                        |  |  |  |                               |  |                                      
|----------------------- |  |  |  | ----------------------------- |  | -------------------------------------
|                        |  |  |  | ISTA PHARMACEUTICALS, INC.   
|                        |  |  |  | (Registrant)                 
|                        |  | 
|Dated: November 9, 2005 |  |  |  | /s/ Vicente Anido, Jr., Ph.D.
|                        |  |  |  |                               |  | Vicente Anido, Jr., Ph.D.            
|                        |  |  |  |                               |  | President and Chief Executive Officer
|                        |  | 
|Dated: November 9, 2005 |  |  |  | /s/ Lauren P. Silvernail     
|                        |  |  |  |                               |  | Lauren P. Silvernail                 
|                        |  |  |  |                               |  | Chief Financial Officer,             
|                        |  |  |  |                               |  | Chief Accounting Officer and         
|                        |  |  |  |                               |  | Vice President, Corporate Development



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INDEX TO EXHIBITS



|              |  |                                                                                                                                                  
|------------- |  | -------------------------------------------------------------------------------------------------------------------------------------------------
|              | 
|ExhibitNumber |  | Description                                                                                                                                      
|31.1          |  | Certification of Chief Executive Officer Pursuant to Rule 13a-14(d) / 15d-14(a) of the SecuritiesExchange Act of 1934.                           
|              | 
|31.2          |  | Certification of Chief Financial Officer Pursuant to Rule 13a-14(d) / 15d-14(a) of the SecuritiesExchange Act of 1934.                           
|              | 
|32.1          |  | Certification of Chief Executive Officer Pursuant to Rule 13a-14(b) / 15d-14(b) of the SecuritiesExchange Act of 1934 and 18 U.S.C. Section 1350.
|              | 
|32.2          |  | Certification of Chief Financial Officer Pursuant to Rule 13a-14(b) / 15d-14(b) of the SecuritiesExchange Act of 1934 and 18 U.S.C. Section 1350.



27