Table of Contents

 

 

 

**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON, D.C. 20549**

 

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**FORM 10-Q**

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

 

**FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2008**

 

**OR**

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

 

**FORTHE TRANSITION PERIOD FROM        TO        .**

 

**Commission File Number****001-33523**

 

**COMBIMATRIX CORPORATION**

(Exact Name of Registrant as Specified inIts Charter)

 

| **Delaware**                                                 | ** ** | **47-0899439**      |
|--------------------------------------------------------------|------------|---------------------|
| (State or Other  Jurisdiction of                             |       | (I.R.S. Employer    |
| Incorporation or  Organization)                              |       | Identification No.) |
|                                                         |       |                |
| **6500  Harbour Heights Pkwy, Suite 303, Mukilteo, WA** | ** ** | **98275**           |
| (Address of  Principal Executive Offices)                    |       | (Zip Code)          |

 

Registrant’s telephone number, includingarea code:  **(425) 493-2000**

 

 

(Former name, former address and formerfiscal year, if changed since last report.)

 

Indicate by check markwhether the registrant (1) has filed all reports required to be filed by Section 13or 15(d) of the Securities Exchange Act of 1934 during the preceding 12months (or for such shorter period that the registrant was required to filesuch reports), and (2) has been subject to filing requirements for thepast 90 days.      Yes xNo o

 

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

 

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

 

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

 

As of November 4, 2008, 6,286,767 shares of CombiMatrixCorporation common stock were issued and outstanding.

 

 

 

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Table of Contents

 

**COMBIMATRIX**CORPORATION

**Table of Contents**

 
| **Part I.   Financial Information** |                                                                                                                     |
|-----------------------------------------------|--------------------------------------------------------------------------------------------------------------------------|
|                                          |                                                                                                                     |   |
| Item 1.                                       | Financial Statements                                                                                                     |   |
|                                          |                                                                                                                     |   |
|                                          | CombiMatrix Corporation  Consolidated Financial Statements                                                               |   |
|                                          |                                                                                                                     |   |
|                                          | Consolidated Balance Sheets as of  September 30, 2008 (Unaudited) and December 31, 2007                        | 3 |
|                                          |                                                                                                                     |   |
|                                          | Consolidated  Statements of Operations for the Three and Nine Months Ended  September 30, 2008 and 2007 (Unaudited) | 4 |
|                                          |                                                                                                                     |   |
|                                          | Consolidated  Statements of Cash Flows for the Nine Months Ended September 30, 2008  and 2007 (Unaudited)           | 5 |
|                                          |                                                                                                                     |   |
|                                          | Notes to  Consolidated Financial Statements (Unaudited)                                                                  | 6 |
|                                          |                                                                                                                     |   |
| Item 2.                                       | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                              | 18 |
|                                          |                                                                                                                     |   |
| Item 3.                                       | Quantitative  and Qualitative Disclosures about Market Risk                                                              | 26 |
|                                          |                                                                                                                     |   |
| Item 4T.                                      | Controls and  Procedures                                                                                                 | 27 |
|                                          |                                                                                                                     |   |
| **Part II. Other  Information**          | ** **                                                                                                               |
|                                          |                                                                                                                     |   |
| Item 1.                                       | Legal Proceedings                                                                                                        | 28 |
|                                          |                                                                                                                     |   |
| Item 2.                                       | Unregistered  Sales of Equity Securities and Use of Proceeds                                                             | 28 |
|                                          |                                                                                                                     |   |
| Item  6.                                      | Exhibits                                                                                                                 | 28 |
|                                          |                                                                                                                     |   |
| **Signatures**                                | 29                                                                                                                       |
|                                          |                                                                                                                     |   |
| **Exhibit Index**                        | 30                                                                                                                       |

 

2

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**COMBIMATRIXCORPORATION**

**CONSOLIDATED BALANCE SHEETS**

**(Inthousands)**

**(Unaudited)**

 
| ** **                                                                                                                                                                                          | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                                                          | ** ** | **2008**               | ** ** | **2007**              | ** ** |
|                                                                                                                                                                                                |       |                   |       |                  |       |
| **ASSETS**                                                                                                                                                                                          |       |                   |       |                  |       |
|                                                                                                                                                                                                |       |                   |       |                  |       |
| Current assets:                                                                                                                                                                                     |       |                   |       |                  |       |
| Cash and cash equivalents                                                                                                                                                                           |       | $                      | 9,425      |                  | $          | 2,314 |   |
| Available-for-sale investments                                                                                                                                                                      |       | 958                    |       | 5,920                 |       |
| Accounts receivable, net of allowance for doubtful accounts of $280  and $33                                                                                                                        |       | 1,005                  |       | 692                   |       |
| Inventory                                                                                                                                                                                           |       | 704                    |       | 444                   |       |
| Prepaid expenses and other assets                                                                                                                                                                   |       | 344                    |       | 323                   |       |
| Total current assets                                                                                                                                                                                |       | 12,436                 |       | 9,693                 |       |
|                                                                                                                                                                                                |       |                   |       |                  |       |
| Property and equipment, net                                                                                                                                                                         |       | 817                    |       | 1,178                 |       |
| Non-current available-for-sale investments                                                                                                                                                          |       | 751                    |       | —                |       |
| Investments in unconsolidated subsidiaries                                                                                                                                                          |       | 1,240                  |       | 1,923                 |       |
| Patents and licenses, net                                                                                                                                                                           |       | 5,260                  |       | 6,131                 |       |
| Goodwill                                                                                                                                                                                            |       | 16,918                 |       | 16,918                |       |
| Total assets                                                                                                                                                                                        |       | $                      | 37,422     |                  | $          | 35,843 |   |
|                                                                                                                                                                                                |       |                   |       |                  |       |
| **LIABILITIES AND SHAREHOLDERS’  EQUITY**                                                                                                                                                      |       |                   |       |                  |       |
|                                                                                                                                                                                                |       |                   |       |                  |       |
| Current liabilities:                                                                                                                                                                                |       |                   |       |                  |       |
| Accounts payable, accrued expenses and other                                                                                                                                                        |       | $                      | 2,212      |                  | $          | 2,519 |   |
| Credit line borrowings                                                                                                                                                                              |       | 813                    |       | —                |       |
| Current portion of deferred revenues                                                                                                                                                                |       | 352                    |       | 301                   |       |
| Total current liabilities                                                                                                                                                                           |       | 3,377                  |       | 2,820                 |       |
|                                                                                                                                                                                                |       |                   |       |                  |       |
| Deferred revenues, net of current portion                                                                                                                                                           |       | 188                    |       | 375                   |       |
| Capital lease obligations, net of current portion                                                                                                                                                   |       | 46                     |       | 6                     |       |
| Secured convertible debenture                                                                                                                                                                       |       | 6,375                  |       | —                |       |
| Other liabilities                                                                                                                                                                                   |       | 768                    |       | —                |       |
| Total liabilities                                                                                                                                                                                   |       | 10,754                 |       | 3,201                 |       |
|                                                                                                                                                                                                |       |                   |       |                  |       |
| Commitments and contingencies (Note 8)                                                                                                                                                              |       |                   |       |                  |       |
|                                                                                                                                                                                                |       |                   |       |                  |       |
| Shareholders’ equity:                                                                                                                                                                          |       |                   |       |                  |       |
| Preferred stock; $0.001 par value; 5,000,000 shares authorized September 30,  2008; 30,000,000 shares authorized December 31, 2007; none issued and  outstanding                          |       | —                 |       | —                |       |
| Common stock; $0.001 par value; 25,000,000 shares authorized September 30,  2008; 180,000,000 shares authorized December 31, 2007; 6,244,671 and  5,990,915 shares issued and outstanding |       | 6                      |       | 6                     |       |
| Additional paid-in capital                                                                                                                                                                          |       | 42,314                 |       | 37,223                |       |
| Accumulated other comprehensive (loss) income                                                                                                                                                       |       | (166                   | )          | 18                    |       |
| Accumulated net losses                                                                                                                                                                              |       | (15,486                | )          | (4,605                | )          |
| Total shareholders’ equity                                                                                                                                                                     |       | 26,668                 |       | 32,642                |       |
| Total liabilities and shareholders’ equity                                                                                                                                                     |       | $                      | 37,422     |                  | $          | 35,843 |   |

** **

***The accompanyingnotes are an integral part of these consolidated financial statements.***

** **

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**Table of Contents**

** **

**COMBIMATRIXCORPORATION**

**CONSOLIDATED STATEMENTS OF OPERATIONS**

**(Inthousands, except share and per share information)**

**(Unaudited)**

** **
| ** **                                                   | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|--------------------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                                                   | ** ** | **September 30,**           | ** ** | **September 30,**          | ** ** |
| ** **                                                   | ** ** | **2008**                         | ** ** | **2007**                        | ** ** | **2008** | ** ** | **2007** | ** ** |
|                                                         |       |                             |       |                            |       |   |   |   |   |
| Revenues:                                                    |       |                             |       |                            |       |   |   |   |   |
| Government contracts                                         |       | $                                | 343        |                            | $          | 627 |   | $ | 2,380 |   | $ | 1,855 |   |
| Products                                                     |       | 140                              |       | 828                             |       | 1,292 |   | 1,726 |   |
| Services                                                     |       | 466                              |       | 164                             |       | 1,209 |   | 386 |   |
| Collaboration agreements                                     |       | 62                               |       | 62                              |       | 186 |   | 187 |   |
| Total revenues                                               |       | 1,011                            |       | 1,681                           |       | 5,067 |   | 4,154 |   |
|                                                         |       |                             |       |                            |       |   |   |   |   |
| Operating expenses:                                          |       |                             |       |                            |       |   |   |   |   |
| Cost of government contract revenues                         |       | 336                              |       | 593                             |       | 2,305 |   | 1,768 |   |
| Cost of products and services                                |       | 416                              |       | 307                             |       | 1,350 |   | 858 |   |
| Research and development expenses                            |       | 1,290                            |       | 1,924                           |       | 3,503 |   | 4,874 |   |
| Marketing, general and administrative expenses               |       | 2,301                            |       | 2,167                           |       | 6,781 |   | 6,956 |   |
| Patent amortization and royalties                            |       | 341                              |       | 332                             |       | 1,063 |   | 994 |   |
| Equity in loss of investees                                  |       | 247                              |       | 248                             |       | 737 |   | 770 |   |
| Total operating expenses                                     |       | 4,931                            |       | 5,571                           |       | 15,739 |   | 16,220 |   |
| Operating loss                                               |       | (3,920                           | )          | (3,890                          | )          | (10,672 | ) | (12,066 | ) |
|                                                         |       |                             |       |                            |       |   |   |   |   |
| Other income (expense):                                      |       |                             |       |                            |       |   |   |   |   |
| Interest income                                              |       | 58                               |       | 167                             |       | 183 |   | 448 |   |
| Interest expense                                             |       | (403                             | )          | —                          |       | (408 | ) | — |   |
| Other                                                        |       | 16                               |       | 290                             |       | 16 |   | 2,523 |   |
| Total other income                                           |       | (329                             | )          | 457                             |       | (209 | ) | 2,971 |   |
| Net loss                                                     |       | $                                | (4,249     | )                               | $          | (3,433 | ) | $ | (10,881 | ) | $ | (9,095 | ) |
|                                                         |       |                             |       |                            |       |   |   |   |   |
| Basic and diluted net loss per share                         |       | $                                | (0.70      | )                               | $          | (0.57 | ) | $ | (1.80 | ) | $ | (1.52 | ) |
|                                                         |       |                             |       |                            |       |   |   |   |   |
| Basic and diluted weighted average common shares outstanding |       | 6,097,086                        |       | 5,990,189                       |       | 6,040,214 |   | 5,990,189 |   |

** **

***The accompanyingnotes are an integral part of these consolidated financial statements.***

** **

**4**

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** **

**COMBIMATRIXCORPORATION**

**CONSOLIDATED STATEMENTS OF CASH FLOWS**

**(Inthousands)**

**(Unaudited)**

 
| ** **                                                                   | ** ** | **Nine Months Ended** | ** ** |
|------------------------------------------------------------------------------|------------|---------------------------------|------------|
| ** **                                                                   | ** ** | **September 30,**          | ** ** |
| ** **                                                                   | ** ** | **2008**                        | ** ** | **2007** | ** ** |
|                                                                         |       |                            |       |   |   |
| Operating activities:                                                        |       |                            |       |   |   |
| Net loss                                                                     |       | $                               | (10,881    | ) | $ | (9,095 | ) |
| Adjustments to reconcile net loss to net cash used in operating  activities: |       |                            |       |   |   |
| Depreciation and amortization                                                |       | 1,352                           |       | 1,420 |   |
| Non-cash stock compensation                                                  |       | 1,556                           |       | 2,163 |   |
| Warrant gains                                                                |       | —                          |       | (2,523 | ) |
| Equity in loss of investees                                                  |       | 737                             |       | 770 |   |
| Allowance for bad debt                                                       |       | 248                             |       | 241 |   |
| Equity issued to consultant                                                  |       | —                          |       | 224 |   |
| Amortization of debt discount and issuance costs                             |       | 181                             |       | — |   |
| Other                                                                        |       | (16                             | )          | 27 |   |
| Changes in assets and liabilities:                                           |       |                            |       |   |   |
| Accounts receivable                                                          |       | (561                            | )          | (152 | ) |
| Inventory, prepaid expenses and other assets                                 |       | (284                            | )          | (208 | ) |
| Accounts payable, accrued expenses and other                                 |       | (310                            | )          | (1,326 | ) |
| Deferred revenues                                                            |       | (136                            | )          | (677 | ) |
| Net cash used in operating activities                                        |       | (8,114                          | )          | (9,136 | ) |
|                                                                         |       |                            |       |   |   |
| Investing activities:                                                        |       |                            |       |   |   |
| Purchases of property and equipment                                          |       | (55                             | )          | (122 | ) |
| Purchases of available-for-sale investments                                  |       | —                          |       | (4,980 | ) |
| Sales of available-for-sale investments                                      |       | 4,030                           |       | 3,590 |   |
| Net cash provided by (used in) investing activities                          |       | 3,975                           |       | (1,512 | ) |
|                                                                         |       |                            |       |   |   |
| Financing activities:                                                        |       |                            |       |   |   |
| Proceeds from issuance of secured convertible debenture                      |       | 10,000                          |       | — |   |
| Payment of debt issuance costs                                               |       | (248                            | )          | — |   |
| Net proceeds from issuance of common stock                                   |       | 711                             |       | 5,369 |   |
| Net proceeds from credit line borrowings                                     |       | 808                             |       | — |   |
| Repayment of capital lease obligations                                       |       | (21                             | )          | — |   |
| Net cash flows transferred from Acacia Research Corporation                  |       | —                          |       | 41 |   |
| Net cash provided by financing activities                                    |       | 11,250                          |       | 5,410 |   |
|                                                                         |       |                            |       |   |   |
| Increase (decrease) in cash and cash equivalents                             |       | 7,111                           |       | (5,238 | ) |
|                                                                         |       |                            |       |   |   |
| Cash and cash equivalents, beginning                                         |       | 2,314                           |       | 7,829 |   |
|                                                                         |       |                            |       |   |   |
| Cash and cash equivalents, ending                                            |       | $                               | 9,425      |   | $ | 2,591 |   |
|                                                                         |       |                            |       |   |   |
| Noncash investing and financing activites:                                   |       |                            |       |   |   |
| Reclassification of warrant liabilities to additional paid-in capital        |       | $                               | 1,780      |   | $ | 9,089 |   |
|                                                                         |       |                            |       |   |   |
| Conversion of secured convertible debenture to common stock                  |       | $                               | 1,300      |   | $ | — |   |

** **

***The accompanyingnotes are an integral part of these consolidated financial statements.***

** **

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**COMBIMATRIX CORPORATION**

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS**

**(Unaudited)**

 

****1.    OVERVIEW AND BACKGROUND****

 

CombiMatrixCorporation (the “Company” “we” “us” and “our”) was originally incorporated in October 1995as a California corporation and later reincorporated as a Delaware corporationin September 2000.  On December 13,2002 (the “Merger Date”), we merged with and became a wholly owned subsidiaryof Acacia Research Corporation (“Acacia”). Also on the Merger Date, Acacia entered into a recapitalizationtransaction whereby Acacia created two classes of registered common stockcalled Acacia Research-CombiMatrix common stock (“AR-CombiMatrix stock”) andAcacia Research-Acacia Technologies common stock (“AR-Acacia Technologies stock”)and divided its existing Acacia common stock into shares of the two new classesof common stock.  The AR-CombiMatrixstock was intended to reflect separately the performance of CombiMatrixCorporation and our subsidiaries, referred to as “the CombiMatrix group,”whereas the AR-Acacia Technologies stock was intended to reflect separately theperformance of Acacia’s technology business, referred to as “the AcaciaTechnologies group.” Immediately following the Merger Date, the Company had1,000 shares of common stock authorized and 100 shares issued and outstanding,all of which were owned by Acacia.

 

In2006, Acacia announced its intent to split off the Company as an independentpublic company.  On December 26,2006, we filed a registration statement with the U.S. Securities and ExchangeCommission (“SEC”) in order to register our common stock under the SecuritiesAct of 1933 to be redeemed for AR-CombiMatrix stock.  On June 8, 2007, the SEC declared ourregistration statement effective.  On August 15,2007 (the “Redemption Date”), all currently issued and outstanding shares ofAR-CombiMatrix were redeemed and exchanged for shares of CombiMatrix commonstock at a redemption ratio of ten shares of AR-CombiMatrix common stock forone share of CombiMatrix common stock (the “Redemption Ratio”), which ispublicly traded on the Nasdaq Global Market exchange.  Also, warrants to purchase AR-CombiMatrixstock became exercisable to purchase CombiMatrix common stock, adjusted for theRedemption Ratio.  As of the RedemptionDate, we ceased to be a subsidiary of, or affiliated with, Acacia.

 

*****Description ofthe Company*****

 

We area diversified biotechnology business, through the development of proprietary technologies,products and services in the areas of drug development, genetic analysis,molecular diagnostics, nanotechnology research, defense and homeland securitymarkets, as well as other potential markets where our products and servicescould be utilized. The technologies we have developed include a platformtechnology to rapidly produce oligonucleotide arrays for use in identifying anddetermining the roles of genes, gene mutations and proteins.  We make the arrays using our patented in situelectrochemical synthesis process, which provides the ability to easily changearray content to stay current with new developments and to meet the evolvingneeds of our customers.  This technologyhas a wide range of potential applications in the areas of genomics, proteomics,biosensors, drug discovery, drug development, diagnostics, combinatorialchemistry, material sciences and nanotechnology.  We have also developed the capabilities ofproducing arrays that utilize bacterial artificial chromosomes on our arrays, alsoenabling genetic analysis.  Othertechnologies include proprietary molecular synthesis and screening methods forthe discovery of potential new drugs.  Wecurrently recognize revenues from selling these products and services andproviding research and development services for organizations including theU.S. Department of Defense (“DoD”) and other strategic partners.

 

CombiMatrixMolecular Diagnostics, Inc. (“CMDX”), our wholly owned subsidiary locatedin Irvine, California, has developed capabilities of producing arrays thatutilize bacterial artificial chromosomes, which also enable geneticanalysis.  CMDX functions primarily as adiagnostics reference laboratory.

 

*****Basis ofPresentation*****

 

Throughthe Redemption Date, the consolidated financial statements include allocationsof certain Acacia corporate expenses, including governance, legal, accounting,insurance services, management of treasury and other Acacia corporate andinfrastructure costs.  The expense allocationswere determined on bases that Acacia and the Company considered to be areasonable reflection of the utilization of services provided or the benefitreceived by us.  However, the financialinformation included herein may not reflect the consolidated financialposition, operating results, changes in shareholders’ equity and cash flows ofthe Company in the future or what they would have been had we been a separate,stand-alone entity during the periods presented.  Acacia ceased allocating overhead charges tous following the Redemption Date.

 

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**COMBIMATRIX CORPORATION**

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS (CONTINUED)**

**(Unaudited)**

 

Forthe three and nine months ended September 30, 2007, corporate expensestotaling $15,000 and $102,000, respectively, were allocated to us by Acacia.

 

The accompanyingconsolidated financial statements have been prepared in accordance withgenerally accepted accounting principles for interim financial information andwith the instructions to Form 10-Q and Rule 10-01 of RegulationS-X.  Accordingly, certain informationand footnotes required by generally accepted accounting principles in annualfinancial statements have been omitted or condensed in accordance withquarterly reporting requirements of the SEC. These interim consolidated financial statements should be read inconjunction with the consolidated financial statements and notes thereto forthe year ended December 31, 2007, as reported by us in our Annual Reporton Form 10-K filed on March 19, 2008. The year-end consolidated balance sheet data was derived from auditedfinancial statements but does not include all disclosures required byaccounting principles generally accepted in the United States of America.  The consolidated financial statements includeall adjustments of a normal recurring nature which, in the opinion ofmanagement, are necessary for a fair statement of our financial position as of September 30,2008, and results of operations and cash flows for the interim periodspresented.  The results of operations forthe three and nine months ended September 30, 2008, are not necessarilyindicative of the results to be expected for the entire year.

 

*****Liquidity andRisks*****

 

Wehave a history of incurring net losses and net operating cash flowdeficits.  We are also deploying new andunproven technologies and continue to develop commercial products. We haveseveral ongoing long-term development projects that involve experimentaltechnology and may require several years and substantial expenditures tocomplete.  Based on our cash andinvestment balances as of December 31, 2007, we believed that our cash andcash equivalent balances, anticipated cash flows from operations and otherexternal sources of available credit would be sufficient to meet our cashrequirements through September 30, 2008, which raised substantial doubtabout our ability to continue as a going concern beyond this point.  See Note 3 below regarding additionalliquidity risks due to certain of our available-for-sale investments held inauction rate securities (“ARS”) as of December 31, 2007 and September 30,2008.  See Notes 5 and 6 below regardingrecent financing developments.

 

Wewill continue to require capital from external sources, and there can be noassurances that additional sources of financing, including the issuance of debtand/or equity securities will be available at times and at terms acceptable tous.  The issuance of equity securities,should that occur, will cause dilution to our shareholders.  If external sources of financing are notavailable or are inadequate to fund our operations, we will be required toreduce operating costs including research projects and personnel, which couldjeopardize the future strategic initiatives and business plans of theCompany.  For example, reductions inresearch and development activities and/or personnel at our Mukilteo,Washington facility could result in the inability to invest the resources necessaryto continue to develop next-generation products and improve existing productlines in order to remain competitive in the marketplace, resulting in reducedrevenues and cash flows from the sales of our CustomArrayTM productsand services.  Also, reduction inoperating costs at CMDX, should they occur, could jeopardize its ability tolaunch, market and sell additional products and services necessary in order togrow and sustain its operations and eventually achieve profitability.

 

Our business operationsare also subject to certain risks and uncertainties, including:

 

·                  market acceptance of products andservices;

 

·                  technological advances that may make ourproducts and services obsolete or less competitive;

 

·                  increases in operating costs, including costsfor supplies, personnel and equipment;

 

·                  the availability and cost of capital;

 

·                  general economic conditions; and

 

·                  governmental regulation that may restrictour business.

 

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**COMBIMATRIX CORPORATION**

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS (CONTINUED)**

**(Unaudited)**

 

Historically,we have been dependent on arrangements with strategic partners and have reliedupon payments by our partners for a significant component of our workingcapital.  We intend to enter intoadditional strategic partnerships to develop and commercialize future products.  However, there can be no assurance that wewill be able to implement our future plans. Failure or delays in our efforts to achieve our plans would have amaterial adverse effect on our ability to achieve our intended businessobjectives.  Our success also depends onour ability to protect our intellectual property, the loss thereof or ourfailure to secure the issuance of additional patents covering elements of ourbusiness processes could materially harm our business and financialcondition.  The patents covering our coretechnology begin to expire in 2018.

 

Ourproducts and services are concentrated in a highly competitive market that ischaracterized by rapid technological advances, frequent changes in customerrequirements and evolving regulatory requirements and industry standards.  Failure to anticipate or respond adequatelyto technological advances, changes in customer requirements, changes inregulatory requirements or industry standards, or any significant delays in thedevelopment or introduction of planned products or services, could have amaterial adverse effect on our business and operating results.  The accompanying consolidated financialstatements have been prepared assuming that the Company continues as a goingconcern.  The financial statements do notinclude any adjustments to reflect the possible future effects on therecoverability and classification of assets or the amounts and classificationof liabilities that may result from the matters discussed herein.

 

Inaddition to seeking additional capital from outside sources, our plans inregard to these matters include reductions in overhead costs as well asresearch and development costs that are not considered strategically vital toour business.  Also, we are focusing oursales and product development efforts on our core diagnostic array platform aswell as our funded research and development projects for the DoD.

 

****2.    SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES****

 

*Use of Estimates. *The preparation of financial statements in conformity withgenerally accepted accounting principles in the United States of Americarequires management to make estimates and assumptions that affect the reportedamount of assets and liabilities and disclosure of contingent assets andliabilities at the date of the consolidated financial statements and thereported amounts of revenues and expenses during the reporting period. Actualresults could differ from these estimates.

 

**RevenueRecognition**. We recognize revenue in accordancewith Staff Accounting Bulletin No. 104, “Revenue Recognition” and relatedauthoritative pronouncements.  Revenuesfrom multiple-element arrangements are accounted for in accordance withEmerging Issues Task Force (“EITF”) Issue 00-21, “Revenue Arrangements withMultiple Deliverables.”  Revenue isrecognized when (i) persuasive evidence of an arrangement exists, (ii) deliveryhas occurred or services have been performed, (iii) amounts are fixed ordeterminable and (iv) collectibility of amounts is reasonably assured.

 

Revenuesfrom multiple-element arrangements involving license fees, up-front payments,milestone payments, products and/or services, which are received and/orbillable by us in connection with other rights and services that representcontinuing obligations of ours, are deferred until all of the elements havebeen delivered or until we have established objective and verifiable evidenceof the fair value of the undelivered elements.

 

Revenuesfrom government grants and contracts are recognized in accordance withAccounting Research Bulletin No. 43, “Government Contracts,” and relatedpronouncements, such as Statement of Position 81-1, “Accounting for Performanceof Construction-Type and Certain Production-Type Contracts.”  Accordingly, revenues are recognized underthe percentage-of-completion method of accounting, using the cost-to-costapproach to measure completeness at each reporting period.  Under the percentage-of-completion method ofaccounting, contract revenues and costs are recognized in the period that workis performed based on the percentage of actual incurred costs to total contractcosts.  Actual contract costs includedirect charges for labor and materials and indirect charges for labor, overheadand certain general and administrative charges. Contract change orders and claims are included when they can be reliablyestimated and are considered probable. For contracts that extend over a one-year period, revisions in contractcost estimates, if they occur, have the effect of adjusting current periodearnings applicable to performance in prior periods.  Should current contract estimates indicate anoverall future loss to be incurred, a provision is made for the totalanticipated loss in the current period. Historically, contract revenue recognized approximates the amountsinvoiced, resulting in no estimated costs and earnings in excess of billings orbillings in excess of estimated costs and earnings.

 

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**COMBIMATRIXCORPORATION**

**NOTESTO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)**

**(Unaudited)**

 

Revenuefrom the sale of products and services, including shipping and handling feesbut excluding statutory taxes collected from customers, as applicable, arerecognized when delivery has occurred or services have been rendered.  We sell our products and services directly tocustomers and also through distributors, and our right to collection is notdependent upon installation or a subsequent sale of our products to end-users.  Our standard agreements do not provide forcredits, returns or exchanges with our customers or distributors.  Our distribution agreements include fixedpricing arrangements for our products and after customer acceptance, there isno written or implied right to return or exchange the products.

 

Deferredrevenues arise from payments received in advance of the culmination of theearnings process.  Deferred revenuesexpected to be recognized within the next twelve months are classified withincurrent liabilities.  Deferred revenueswill be recognized as revenue in future periods when the applicable revenuerecognition criteria as described above are met.

 

**Stock-basedCompensation**. Prior to the Redemption Date, employees ofCombiMatrix Corporation had been granted options to purchase AR-CombiMatrixcommon stock.  As a result, the followingdisclosures prior to the Redemption Date relate to AR-CombiMatrix stock optionawards, which became fully vested as of the Redemption Date and were ultimatelycancelled.  Subsequent to the RedemptionDate, we began issuing stock option awards under the CombiMatrix Corporation2006 Stock Incentive Plan (the “CombiMatrix Plan”), which provides forequity-based awards in CombiMatrix Corporation common stock.

 

Thecompensation cost for all stock-based awards is measured at the grant date,based on the fair value of the award, and is recognized as an expense, on astraight-line basis, over the employee’s requisite service period (generallythe vesting period of the equity award) which is generally two to fouryears.  The fair value of each optionaward is estimated on the date of grant using a Black-Scholes option valuationmodel.  SFAS 123R requires stock-basedcompensation expense to be recorded only for those awards expected to vestusing an estimated forfeiture rate.  Weestimate pre-vesting option forfeitures at the time of grant and reflect theimpact of estimated pre-vesting option forfeitures in compensation expenserecognized.  Stock-based compensationexpense for all periods presented attributable to our functional expensecategories were as follows (in thousands; unaudited):

 
| ** **                            | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|---------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                            | ** ** | **September 30,**           | ** ** | **September 30,**          | ** ** |
| ** **                            | ** ** | **2008**                         | ** ** | **2007**                        | ** ** | **2008** | ** ** | **2007** | ** ** |
| Cost of product sales                 |       | $                                | 58         |                            | $          | 5 |   | $ | 115 |   | $ | 5 |   |
| Research and development              |       | 75                               |       | 793                             |       | 169 |   | 1,195 |   |
| Marketing, general and administrative |       | 654                              |       | 629                             |       | 1,272 |   | 963 |   |
| Total non-cash stock compensation     |       | $                                | 787        |                            | $          | 1,427 |   | $ | 1,556 |   | $ | 2,163 |   |

 

**IncomeTaxes**.  Effective January 1,2007, we adopted Financial Accounting Standards Board (“FASB”) Interpretation No. 48(“FIN 48”), “Accounting for Uncertainty in Income Taxes,” which clarifies theaccounting for uncertainty in income taxes recognized in the financialstatements in accordance with FASB Statement No. 109, “Accounting forIncome Taxes.”  FIN 48 provides guidanceon the financial statement recognition and measurement of a tax position takenor expected to be taken in a tax return. FIN 48 also provides guidance on derecognition, classification, interestand penalties, accounting in interim periods, disclosures, and transition.  In accordance with FIN 48, a tax position isa position in a previously filed tax return or a position expected to be takenin a future tax filing that is reflected in measuring current or deferredincome tax assets and liabilities.  Taxpositions shall be recognized only when it is more likely than not (likelihoodof greater than 50%), based on technical merits, that the position would besustained upon examination.  Taxpositions that meet the more likely than not threshold should be measured usinga probability-weighted approach as the largest amount of tax benefit that isgreater than 50% likely of being realized upon settlement.  The adoption of FIN 48 did not have a materialimpact on our consolidated financial position, results of operations or cashflows.

 

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**COMBIMATRIXCORPORATION**

**NOTESTO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)**

**(Unaudited)**

 

**NetLoss Per Share**. Basic and diluted net loss per share has been computed by dividing thenet loss by the weighted average number of common shares issued and outstandingduring the periods presented.  Optionsand warrants to purchase CombiMatrix stock are anti-dilutive and therefore arenot included in the determination of the diluted net loss per share.  The following table presents a reconciliationof basic and diluted loss per share for all periods presented (in thousands, exceptshare and per-share data; unaudited):

 
| ** **                                 | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|--------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                                 | ** ** | **September 30,**           | ** ** | **September 30,**          | ** ** |
| ** **                                 | ** ** | **2008**                         | ** ** | **2007**                        | ** ** | **2008** | ** ** | **2007** | ** ** |
| Numerator:                                 |       |                             |       |                            |       |   |   |   |   |
| Loss applicable to common shareholders     |       | $                                | (4,249     | )                               | $          | (3,433 | ) | $ | (10,881 | ) | $ | (9,095 | ) |
| Denominator:                               |       |                             |       |                            |       |   |   |   |   |
| Weighted-average common shares outstanding |       | 6,097,086                        |       | 5,990,189                       |       | 6,040,214 |   | 5,990,189 |   |
| Basic and diluted loss per share           |       | $                                | (0.70      | )                               | $          | (0.57 | ) | $ | (1.80 | ) | $ | (1.52 | ) |
|                                       |       |                             |       |                            |       |   |   |   |   |
| Common stock options                       |       | 1,579,490                        |       | 1,006,120                       |       | 1,579,490 |   | 1,006,120 |   |
| Common stock warrants                      |       | 2,593,958                        |       | 2,383,865                       |       | 2,593,958 |   | 2,383,865 |   |
| Excluded potentially dilutive securities   |       | 4,173,448                        |       | 3,389,985                       |       | 4,173,448 |   | 3,389,985 |   |

 

**Available-For-SaleInvestments**. Investments in marketable securities are accounted for and classified inaccordance with the provisions of SFAS No. 115, “Accounting for CertainInvestments in Debt and Equity Securities” (“SFAS 115”).  Investments in securities with originalmaturities of less than three months are included in cash and cash equivalents,and investments with original maturities of greater than three months and lessthan one year are classified as short-term. Our investments in securities are classified as available-for-sale,which are reported at fair value with related unrealized gains and losses inthe value of such securities recorded as a component of accumulated othercomprehensive income until realized.  Thefair value of our available-for-sale investments was determined by quotedmarket prices at December 31, 2007 and in accordance with SFAS No. 157(see “Fair Value Measurements” below and Note 3) subsequent to year-end.  We account for investments with fair valuesless than historical cost in accordance with FASB Staff Position 115-1, “TheMeaning of Other-Than-Temporary Impairment and Its Application to CertainInvestments” (“FSP 115-1”).  Under FSP115-1, an impairment is deemed other than temporary based on a variety offactors including:  (a) the durationand severity of the impairment; (b) the ability and intent to hold aninvestment for a period of time sufficient for recovery of its carrying amount;and (c) the financial condition of the issuer.  All available evidence, both positive andnegative, is considered to determine whether the carrying amount of theinvestment is recoverable within a reasonable period of time.  In general, management does not consider aninvestment impairment to be other-than-temporary if the duration and amount ofthe impairment is less than twelve months and five percent of the historicalcost of the investment, respectively.

 

*****Fair Value Measurements. *****Weadopted SFAS No. 157, “Fair Value Measurements” (“SFAS 157”), whichapplies to certain accounting standards that require or permit fair valuemeasurements, on January 1, 2008. The adoption of SFAS 157 did not have a material impact on ourconsolidated financial statements.  In February 2008,the FASB issued a staff position that delays the effective date of SFAS 157 forall non-financial assets and liabilities, except those recognized or disclosedat least annually.  Therefore, we haveadopted the provision of SFAS 157 with respect to financial assets andliabilities only.

 

SFAS157 defines fair value, establishes a consistent framework for measuring fairvalue and expands disclosures for each major asset and liability categorymeasured at fair value on either a recurring or nonrecurring basis.  SFAS 157 clarifies that fair value is an exitprice, representing the amount that would be received to sell an asset or paidto transfer a liability in an orderly transaction between marketparticipants.  As such, fair value is amarket-based measurement that should be determined based on assumptions thatmarket participants would use in pricing an asset or liability.  As a basis for considering such assumptions,SFAS 157 establishes a three-tier fair value hierarchy, which prioritizes theinputs used in measuring fair value as follows:

 

·      Level 1:          Observable market inputs such as quotedprices in active markets;

 

·      Level 2:          Observable market inputs, other than thequoted prices in active markets, that are observable either directly orindirectly; and

 

·      Level 3:          Unobservable inputs where there is littleor no market data, which require the reporting entity to develop its ownassumptions.

 

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**COMBIMATRIX CORPORATION**

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS (CONTINUED)**

**(Unaudited)**

 

Weadopted SFAS No. 159, “The Fair Value Option for Financial Assets andFinancial Liabilities,” which provides entities the option to measure manyfinancial instruments and certain other items at fair value.  We have currently chosen not to elect thefair value option for any items that are not already required to be measured atfair value in accordance with generally accepted accounting principles.

 

*Derivatives Embedded in Certain Debt Securities. *We evaluate financial instruments forfreestanding or embedded derivatives in accordance with SFAS No. 133, “Accountingfor Derivative Instruments and Hedging Activities” (“SFAS 133”), and relatedguidance.  Derivative instruments thathave been separated from the host contract and do not qualify for hedgeaccounting are recorded at fair value with changes in value recognized in asother income (expense) in the consolidated statements of operations in theperiod of change.

 

*****Recent Accounting Pronouncements.*****In June 2008, the FASB ratified EITFIssue No. 07-5, “Determining Whether an Instrument (or an EmbeddedFeature) is Indexed to an Entity’s Own Stock” (“EITF 07-5”).  EITF 07-5 provides that an entity should usea two-step approach to evaluate whether an equity-linked financial instrument(or embedded feature) is indexed to its own stock, including evaluating theinstrument’s contingent exercise and settlement provisions.  EITF 07-5 is effective for fiscal yearsbeginning after December 15, 2008, although early adoption isallowed.  We have chosen to early-adoptEITF 07-5.  See Note 6 below fordiscussion of the impact on EITF 07-5 to our consolidated financial statements.

 

In June 2008,the FASB issued EITF Issue No. 08-4, “Transition Guidance for ConformingChanges to Issue No. 98-5” (“EITF 08-4”). The objective of EITF 08-4 is to provide transition guidance forconforming changes made to EITF Issue No. 98-5, “Accounting forConvertible Securities with Beneficial Conversion Features or ContingentlyAdjustable Conversion Ratios that result from EITF Issue No. 00-27,Application of Issue No. 98-5 to Certain Convertible Instruments, and SFASIssue No. 150, Accounting for Certain Financial Instruments withCharacteristics of both Liabilities and Equity.”  EITF 08-4 is effective for financialstatements issued for fiscal years ending after December 15, 2008 andearly application is permitted.  We donot believe the implementation of EITF 08-4 will have a material effect on ourconsolidated financial position, results of operations and cash flows.

 

In June 2008,the FASB issued FSP EITF 03-6-1, “Determining Whether Instruments Granted inShare-Based Payment Transactions Are Participating Securities.” FSP EITF 03-6-1provides that unvested share-based payment awards that contain nonforfeitablerights to dividends or dividend equivalents (whether paid or unpaid) areparticipating securities and shall be included in the computation of earningsper share pursuant to the two-class method. FSP ETIF 03-6-1 is effective for fiscal years beginning after December 15,2008, and interim periods within those years. Upon adoption, a company is required to retrospectively adjust itsearnings per share data (including any amounts related to interim periods,summaries of earnings and selected financial data) to conform with theprovisions of FSP EITF 03-6-1.  We do notbelieve the implementation of FSP EITF 03-6-1 will have a material effect onour consolidated financial position, results of operations and cash flows.

 

In May 2008,the FASB issued FSP Accounting Principles Board (“APB”) 14-1, “Accounting forConvertible Debt Instruments That May Be Settled in Cash upon Conversion(Including Partial Cash Settlement)” (“FSP APB 14-1”).  FSP APB 14-1 applies to convertible debtinstruments that, by their stated terms, may be settled in cash (or otherassets) upon conversion, including partial cash settlement of the conversionoption.  FSP APB 14-1 requiresbifurcation of the instrument into a debt component that is initially recordedat fair value and an equity component. The difference between the fair value of the debt component and theinitial proceeds from issuance of the instrument is recorded as a component ofequity.  The liability component of thedebt instrument is accreted to par using the effective yield method; accretionis reported as a component of interest expense. The equity component is not subsequently re-valued as long as itcontinues to qualify for equity treatment. FSP APB 14-1 must be applied retrospectively to previously issuedcash-settleable convertible instruments as well as prospectively to newlyissued instruments.  FSP APB 14-1 iseffective for fiscal years beginning after December 15, 2008, and interimperiods within those fiscal years.  We donot believe the implementation of FSP APB 14-1 will have a material effect onour consolidated financial position, results of operations and cash flows.

 

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**COMBIMATRIXCORPORATION**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)**

**(Unaudited)**

 

In March 2008,the FASB issued SFAS No. 161, “Disclosures about DerivativeInstruments and Hedging Activities, an amendment of FASB Statement No. 133”(“SFAS 161”).  SFAS 161requires enhanced disclosures about an entity’s derivative instruments andhedging activities including: (1) how and why an entity uses derivativeinstruments; (2) how derivative instruments and related hedged items areaccounted for under SFAS 133 and its related interpretations; and (3) howderivative instruments and related hedged items affect an entity’s financialposition, financial performance, and cash flows.  SFAS 161 is effective for financialstatements issued for fiscal years and interim periods beginning after November 15,2008, with earlier application encouraged. We are currently evaluating the impact this standard will have on ourconsolidated financial statements.

 

# **3.     FAIR VALUE**

# ** **

The following table summarizes, for each majorcategory of financial assets or liabilities measured on a recurring basis, therespective fair value at September 30, 2008 and the classification bylevel of input within the fair value hierarchy defined by SFAS 157 (inthousands, unaudited):

 
| ** **                     | ** ** | **Sept. 30,** | ** ** | **Fair Value Measurements at  September 30, 2008 Using:** | ** ** |
|--------------------------------|------------|--------------------|------------|-----------------------------------------------------------------------------------------|------------|
| ** **                     | ** ** | **2008**           | ** ** | **Level 1**                                                                        | ** ** | **Level 2** | ** ** | **Level 3** | ** ** |
| Assets:                        |       |               |       |                                                                                    |       |   |   |   |   |
| Cash equivalents               |       | $                  | 7,337      |                                                                                    | $          | 7,337 |   | $ | — |   | $ | — |   |
| Available-for-sale investments |       | 1,709              |       | —                                                                                  |       | — |   | 1,709 |   |
| Total                          |       | $                  | 9,046      |                                                                                    | $          | 7,337 |   | $ | — |   | $ | 1,709 |   |
|                           |       |               |       |                                                                                    |       |   |   |   |   |
| Liabilities:                   |       |               |       |                                                                                    |       |   |   |   |   |
| Embedded derivatives (1)       |       | $                  | (768       | )                                                                                       | $          | — |   | $ | — |   | $ | (768 | ) |

 

----

(1)   Included in “otherliabilities” in the accompanying September 30, 2008 consolidated balancesheet.  See Note 6 below for discussionof fair value measurements relating to embedded derivatives.

 

The following table is a reconciliation of financialassets and liabilities measured at fair value on a recurring basis usingsignificant unobservable inputs (Level 3) during the nine months ended September 30,2008 (in thousands, unaudited):

 
| ** **                        | ** ** | **Available-**  | ** ** | ** **      | ** ** |
|-----------------------------------|------------|-----------------|------------|-----------------|------------|
| ** **                        | ** ** | **For-Sale**    | ** ** | **Embedded**    | ** ** |
| ** **                        | ** ** | **Investments** | ** ** | **Derivatives** | ** ** |
|                              |       |            |       |            |       |
| Balances, December 31, 2007  |       | $               | —     |            | $          | — |   |
| Transfers of to Level 3           |       | 3,375           |       | —          |       |
| Sales of ARS                      |       | (1,500          | )          | —          |       |
| Issuance of embedded derivatives  |       | —          |       | (927            | )          |
| Conversions to common stock       |       | —          |       | 143             |       |
| Realized gains                    |       | —          |       | 16              |       |
| Unrealized losses                 |       | (166            | )          | —          |       |
| Balances, September 30, 2008 |       | $               | 1,709      |            | $          | (768 | ) |

 

At September 30, 2008and December 31, 2007, our available-for-sale investments included $1.9million and $3.4 million, respectively, of ARS at par value.  Historically, the carrying value of our ARSapproximated fair value due to active, liquid markets for these securities aswell as the frequent resetting of the interest rates at auction, whichtypically occurred every 7 to 30 days. However, in mid-February 2008, the market for ARS collapsed and asa result, our ARS have experienced multiple failed auctions since this time andare currently illiquid.  Of the $1.9million in par-value ARS held at September 30, 2008, $900,000 are issuedby a state student-loan lending organization, carry an A2/A rating and areinsured by the Federal Family Education Loan Program.  The remaining $975,000 of ARS are AAA-ratedauction market preferred stock (“AMPS”) issued by publicly traded mutual funds thatare required to maintain at least 200% of asset coverage for issued ARS.  All of our ARS continue to pay interest atthe maximum contractual rate, which currently exceeds market interest rates forshort-term securities.

 

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**COMBIMATRIX CORPORATION**

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS****(CONTINUED)**

**(Unaudited)**

 

At September 30, 2008, the fair values ofour ARS were estimated using discounted cash flow models.  These models consider, among other things,the timing of expected future successful auctions, estimated future cash flows,collateralization and credit worthiness of underlying security investments anddiscount rates applied to the estimated future cash flows.  Since these inputs were not observable, theyare classified as Level 3 inputs under SFAS 157.  As a result of the lack of liquidity in theARS market and not as a result of the quality of the underlying collateral, werecorded unrealized losses on our ARS of $31,000 and $166,000 for the three andnine months ended September 30, 2008, respectively, which is reflectedin accumulated other comprehensive (loss) income in our September 30, 2008consolidated balance sheet.  Ourvaluation models assume an average maturity of one year for our ARS issued inpreferred stock and greater than one year for our ARS that are backed bystudent-loans.  As a result, we haveclassified the student-loan ARS with a fair value of $751,000 as a non-currentinvestment in our September 30, 2008 consolidated balance sheet.

 

During the third quarter of 2008, one of the issuersof our AMPS announced that they would redeem approximately one-half of theiroutstanding AMPS during the fourth quarter, at par value.  Subsequent to September 30, 2008 andthrough the date of this report, we have received $325,000 from the partialredemption of one of our AMPS, at par value. We continue to monitor the market for ARS and consider its impact (ifany) on the fair value of our investments. If the current market conditions deteriorate further, or the anticipatedrecovery in fair values does not occur, we may be required to record additionalunrealized losses in other comprehensive (loss) income or realized losses forother-than-temporary impairment charges in future periods.

 

# **4.     COMPREHENSIVE LOSS**

 

The following table shows ourcomprehensive net loss in accordance with SFAS No. 130, “ReportingComprehensive Income,” for all periods presented (in thousands; unaudited):

 
| ** **                                                   | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|--------------------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                                                   | ** ** | **September 30,**           | ** ** | **September 30,**          | ** ** |
| ** **                                                   | ** ** | **2008**                         | ** ** | **2007**                        | ** ** | **2008** | ** ** | **2007** | ** ** |
| Net unrealized (loss) gain on available-for-sale investments |       | $                                | (31        | )                               | $          | 9 |   | $ | (166 | ) | $ | 4 |   |
| Net loss                                                     |       | (4,249                           | )          | (3,433                          | )          | (10,881 | ) | (9,095 | ) |
| Comprehensive loss                                           |       | $                                | (4,280     | )                               | $          | (3,424 | ) | $ | (11,047 | ) | $ | (9,091 | ) |

 

# **5.     CREDIT LINE BORROWINGS**

# ** **

On May 9, 2008 and pursuant to a LoanManagement Account agreement (the “LMA”) with a financial institution (the “Lender”),we borrowed $808,000 from the Lender, secured by our holdings in ARS.  The LMA is similar to a revolving line ofcredit borrowing facility.  The LMAprovides that we accrue monthly interest charges at an annual, variable rate of1% plus the 30-day LIBOR rate (resulting in a rate of approximately 4.8% at September 30,2008).  The total amount available underthe LMA ranges from 50% to 92% of investments pledged as collateral, based uponthe amount and security type in our investment portfolio, up to a maximumamount of $2.8 million.  However, basedon the amount and type of securities currently held by us with the Lender, themaximum borrowing ceiling is currently limited to $808,000, plus accruedinterest.  The LMA has no stated maturityfor the principal and interest amounts borrowed by us.  However, because the Lender has the abilityunder the terms of the LMA to call in the principal amount of the borrowings atany time, we have classified this liability as a component of currentliabilities in the accompanying September 30, 2008 consolidated balancesheet.

 

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# **COMBIMATRIX CORPORATION**

# **NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)**

# **(Unaudited)**

 

# **6.**     SECURED CONVERTIBLE DEBENTURE

# ** **

# ***Description***

# ** **

# **OnJuly 10, 2008 (the “Closing Date”), we issued to YA Global Investments,L.P. (“YA”): (i) a secured convertible debenture (the “Debenture”) with anaggregate principal amount of $10 million, which is convertible into shares ofour common stock**at a fixed conversion price of $11.87 per share; and (ii) warrants (the “Warrants”) to purchaseup to 336,984 shares of our common stock. TheDebenture is due on the earlier of July 10, 2010 (the “Term”) or withinfour months after receipt of payment of judgment or settlement proceeds from National Union Fire Ins. Co. of Pittsburgh, PA (“NationalUnion”)inaccordance with the $35.7 million judgment (the “Judgment”) issued by the U.S. District Court for the Central District ofCalifornia (the“Federal Court”).  The Debenture bearsinterest at an annual rate of 10%, with interest payments due quarterly ineither cash or our common stock, beginning October 2008. We have the rightto force conversion of the Debenture into our common stock if thevolume-weighted average price (“VWAP”) of our stock exceeds between 125% and135% of the fixed conversion price for a period of thirty consecutive tradingdays, among other conditions and restrictions. We also have a cash redemption option whereby we have the right topre-pay the Debenture during the Term, but only if our common stock is tradingbelow the fixed conversion price, among other conditions.  Prepayment penalties range between 0% and 10%of the principal amount due, depending upon when the cash redemption occursduring the Term.  The number of shares issuable to YA upon conversionof the Debenture may increase due to certain anti-dilution adjustments,including if we issue common stock at a price lower than the $11.87 fixedconversion price while the outstanding principal amount of the Debenture is atleast $5 million, or if we fail to generate at least $6 million in grossrevenues for our fiscal year ended December 31, 2008 (subject toadjustment in the event we sell or dispose of a division or line ofbusiness).  The Debenture is secured bythe Judgment as well as our intellectual property.  The Warrants have a five-year term and allowYA to purchase: (i) 168,492 shares of common stock at an exercise price of$11.87; and (ii) 168,492 shares of common stock at an exercise price of$13.65.  We have the right to call theWarrants, but only if the VWAP of our common stock is at or greater than 130%of the Warrants’ exercise price for at least twenty consecutive trading days,among other conditions.  We filed aresale registration statement on Form S-3 with the SEC to register1,179,444 shares of our common stock that are issuable to YA upon conversion ofthe Debenture and exercise of the Warrants, as required by certain agreementswith YA that we executed in connection with this transaction  This registration statement was declaredeffective during the third quarter of 2008. Total costs incurred by us relating to issuing the Debenture andWarrants were $248,000, of which $180,000 were paid to YA and classified as acontra-liability to the Debenture, with the remaining costs classified as along-term, asset, which is being amortized as additional interest expense overthe Term.

# ** **

# ***Accounting atClosing***

# ** **

# **On the Closing Date, we recognized the Debenture andWarrants based on their relative fair values of $8.2 million and $1.8 million,respectively, in accordance with**APB Opinion No. 14, “Accounting for Convertible Debt and DebtIssued with Stock Purchase Warrants.”  The fair value ofthe Debenture was determined using the convertible bond model, assuming a 15%yield.  The relative fair value of theWarrants was classified as a component of additional paid-in capital inaccordance with SFAS No. 150, “Accountingfor Certain Financial Instruments with Characteristics of both Liabilities andEquity” and EITF 00-19, “Accounting for Derivative Financial InstrumentsIndexed to, and Potentially Settled in, a Company’s Own Stock” (“EITF 00-19”),with the corresponding amount reflected as a contra-liability to the Debenture.  The fair value of the warrants was determinedusing the Black Scholes model, assuming a term of five years, volatility of75%, no dividends, and a risk-free interest rate of 3.1%.

# ** **

# ** In accordancewith SFAS 133,**DerivativeImplementation Group Statement 133 Implementation Issue No. B16, “EmbeddedDerivatives: Calls and Puts in Debt Instruments” and related guidance as well as the early adoptionof EITF 07-5, the conversion feature, cash redemption option, potentialacceleration of maturity of the Debenture upon payment of the Judgment proceedsand potential adjustments to the fixed conversion price all represent embeddedderivatives, that as of the Closing Date, were valued in aggregate at $927,000and recorded separately from the Debenture as other liabilities, with acorresponding amount reflected as an additional contra-liability to theDebenture.  The fair value of theembedded derivatives was determined using the convertible bond model,discounted cash flows and binomial lattice models.

 

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# **COMBIMATRIX CORPORATION**

# **NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)**

**(Unaudited)**

 

# **As a result of separating the Warrants and embeddedderivatives from the Debenture, the aggregate contra-liability totaling $2.9million was recognized as of the Closing Date and was netted against theDebenture, which will accrete to the face amount due YA over the Term using theeffective interest method, with the corresponding charges recorded as interestexpense.**

# ** **

# ***TransactionsSubsequent to Closing***

# ** **

# **During the third quarter of 2008, YA converted $1.3million of the Debenture into common stock. As a result, portions of the aggregate contra-liability and derivativeliabilities were reclassified to additional paid-in capital in proportion tothe amount of the Debenture that was converted into common stock, resulting inreductions to the aggregate contra-liability and derivative liabilities of$355,000 and $143,000, respectively.  Asof September 30, 2008, the remaining amount of the Debenture, net of theaggregate contra-liability, was $6.4 million. The embedded derivative liabilities were marked to fair value of$768,000 as of September 30, 2008, resulting in a net benefit of $16,000recognized as other income (expense) in the accompanying consolidatedstatements of operations.**

# ** **

# **Subsequent to September 30, 2008 and through thedate of this report, YA had converted an additional $200,000 of the Debentureinto common stock.  Also, in early October 2008,accrued interest to YA in the amount of $213,000 was paid by issuing 14,405shares of our common stock.**

# ** **

# **7.    COMMONSTOCK WARRANTS**

# ** **

Prior to theRedemption Date, Acacia had issued warrants to purchase approximately 23.8million shares of AR-CombiMatrix stock in connection with various financingtransactions.  As of the Redemption Date,all previously outstanding AR-CombiMatrix common stock warrants becameexercisable for CombiMatrix common stock, adjusted for the Redemption Ratio discussedabove.

 

Outstandingwarrants to purchase CombiMatrix common stock (adjusted for the RedemptionRatio) are as follows (unaudited):

 
| ** **                  | ** ** | **Number of Warrants Outstanding** | ** ** | ** **            | ** ** | ** **       | ** ** |
|-----------------------------|------------|---------------------------------------------------|------------|-----------------------|------------|------------------|------------|
| ** **                  | ** ** | **September 30,**                            | ** ** | **December 31,** | ** ** | **Exercise**     | ** ** | ** ** | ** ** |
| **Date of Issue** | ** ** | **2008**                                          | ** ** | **2007**              | ** ** | **Price**        | ** ** | **Expiration** | ** ** |
|                        |       |                                              |       |                  |       |             |       |   |   |
| July 2008              |       | 336,984                                           |       | —                |       | $11.87  - $13.65 |       | July 2013 |   |
| May 2007               |       | 959,390                                           |       | 1,017,140             |       | $5.50            |       | May 2012 |   |
| December 2006          |       | 1,137,936                                         |       | 1,178,736             |       | $8.70  - $10.88  |       | December 2011 |   |
| September 2005         |       | 159,648                                           |       | 159,648               |       | $24.00           |       | September 2010 |   |
| May 2003               |       | —                                            |       | 28,341                |       | $27.50           |       | May 2008 |   |
| Total                       |       | 2,593,958                                         |       | 2,383,865             |       |             |       |   |   |

 

Acacia’sclasses of common stock were subject to certain redemption provisions in theevent that Acacia were to sell, transfer, assign or otherwise dispose of, inone transaction or a series of related transactions, all or substantially allof the properties and assets attributed to the CombiMatrix group, in which casethe shareholders of AR-CombiMatrix common stock would have the right to receivea dividend or a redemption of the stock equal to the net proceeds generatedfrom the sale of assets.  Pursuant toguidance set forth in FSP No. 150-5, “Issuer’s Accounting under FASBStatement No. 150 for Freestanding Warrants and Other Similar Instrumentson Shares That Are Redeemable,” EITF 00-19 and related authoritativepronouncements, we recorded a liability representing the fair value of commonstock warrants issued to investors and adjusted the warrant liability to itsmarket value at each balance sheet date. Our current capital structure does not include the redemption provisionsthat required liability classification of the warrants and as such, since theRedemption Date, we have classified all outstanding warrants to purchaseCombiMatrix common stock as a component of permanent equity.  For the three and nine months ended September 30,2007, adjusting the warrant liabilities to their fair values resulted in netwarrant gains of $290,000 and $2.5 million, respectively, to our consolidatedstatements of operations.  We have not incurred warrant gains or chargessince the Redemption Date from our existing warrants as a result of achievingpermanent equity classification as of the Redemption Date.

 

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# **COMBIMATRIX CORPORATION**

# **NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)**

**(Unaudited)**

 

The fair value ofAR-CombiMatrix stock purchase warrants at the Redemption Date was determinedusing the Black-Scholes option-pricing model, using weighted-averageassumptions as follows (unaudited):

 
| ** **              | ** ** | **August 15,** | ** ** |
|-------------------------|------------|---------------------|------------|
| ** **              | ** ** | **2007**            | ** ** |
| ** **              | ** ** | ** **          | ** ** |
| Risk free interest rate |       | 4.50                | %          |
| Volatility              |       | 78                  | %          |
| Expected term           |       | 6.5  years          |       |
| Expected dividends      |       | 0                   | %          |

 

**8.    COMMITMENTSAND CONTINGENCIES**

** **

**Collaboration and Research Agreements**

 

On July 31, 2008, we executed a six-month,$250,000 contract with the DoD for the development of label-free detectiontechniques using our microarray technology.  These detection techniques involve thesynthesis of molecules known as “aptamers,” which are molecules with uniquebiological properties.  As of September 30,2008, we had incurred $28,000 in actual costs for this contract, which wasapproximately 15% complete.

 

On July 11, 2008, we executed a fifteen-month,$923,000 contract with the DoD to further development of our microarraytechnologies for a multipathogen detection system.  The primary objectives of the contract are tocontinue development of an automated biothreat agent detection system basedupon our complementary metal oxide semiconductor microarray and electrochemicaldetection techniques, to continue the integration of serological and genomicassays for orthogonal testing and to explore new methods of detection that expandtarget identification, reduce reagent burden, and improve assay time.  Under the terms of this contract, we willperform research and development activities, as described under the contract,and will be reimbursed on a periodic basis for actual costs incurred to performthese obligations, plus a fixed fee, of up to $923,000.  As of September 30, 2008, we hadincurred $58,000 in actual costs for this contract, which was approximately 9%complete.

 

On July 26,2007, we executed a one-year, $2.2 million contract with the DoD to furtherdevelopment of our microarray technologies. The primary objectives of the contract were to continue development of amultipathogen and chemical detection system. Under the terms of this contract, we performed research and development activities, as described under thecontract, and were reimbursed on a periodic basis for actual costs incurred toperform these obligations, plus a fixed fee, of up to $2.2 million.  We substantially completedthis contract during the third quarter of 2008 and do not expect to incuradditional costs or revenues from this contract beyond September 30, 2008.

 

On March 13,2007, we executed a one-year, $869,000 contract with the DoD, focusing on thedevelopment of a field-deployable influenza genotyping system based on ourelectrochemical detection technology to be used for military and homelandsecurity applications.  Under the termsof this contract, we performed research and development activities, asdescribed under the contract, and were reimbursed on a periodic basis foractual costs incurred to perform our obligations, plus a fixed fee, of up to$869,000.  We substantially completedthis contract during the second quarter of 2008 and do not expect to incur significantcosts or revenues from this contract beyond September 30, 2008.

 

On August 9,2006, we executed a two-year, $1.9 million contract with the DoD, focusing onthe integration of our electrochemical detection technology currently underdevelopment with our microfluidics “lab-on-a-chip” technology to be used formilitary and homeland security applications. Under the terms of this contract,we will perform research and development activities, as described under thecontract, and will be reimbursed on a periodic basis for actual costs incurredto perform our obligations, plus a fixed fee, of up to $1.9 million.  As of September 30, 2008, we hadincurred $1.4 million in actual costs for the microfluidics contract, which wasapproximately 98% complete.

 

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# **COMBIMATRIX CORPORATION**

# **NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)**

**(Unaudited)**

 

On February 8,2006, we executed a one-year, $2.1 million contract with the DoD to further thedevelopment of our array technology for the electrochemical detection ofbiological and chemical threat agents. Under the terms of this contract, weperformed research and development activities as described under the contractand were reimbursed on a periodic basis for actual costs incurred to performour obligations, plus a fixed fee, of $2.1 million. We completed this contractduring the first quarter of 2007 and do not expect to incur additional costs orrevenues from this contract beyond March 31, 2007.

 

**Human Resources**

 

We provide certain severance benefits such that if anexecutive of CombiMatrix who is a vice president or higher is terminated forother than cause, death or disability, the executive will receive paymentsequal to three months’ base salary plus medical and dental benefits.  If termination occurs as a result of a changein control transaction, these benefits will be extended by three months.  Also, if our chief executive officer isterminated for other than cause or for death or disability, he will receivepayments equal to one years’ base salary plus medical and dental benefits.

 

**Litigation**

 

On September 30,2002, we entered into a settlement agreement with Nanogen, Inc. (“Nanogen”)to settle all pending litigation between the parties.  Pursuant to the terms of the settlementagreement, we agreed to make quarterly payments to Nanogen equal to 12.5% oftotal sales of products developed by us and our affiliates based on the patentsthat had been in dispute in the litigation, up to an annual maximum amount of$1.5 million.  The minimum quarterlypayments under the settlement agreement are $25,000 per quarter until thepatents expire in 2018.  Royalty expensesrecognized under the agreement for the three and nine months ended September 30,2008 and 2007 were $25,000, $116,000, $25,000 and $95,000, respectively, andare included in patent amortization and royalties in the accompanyingconsolidated statements of operations.

 

In April of2005, Acacia and CombiMatrix filed a complaint against our insurance carrier,National Union, seeking reimbursement of litigation and settlement costs for alawsuit, pursuant to our directors’ and officers’ insurance policy withNational Union.  A trial was held andconcluded during the fourth quarter of 2007. In March 2008, the Federal Court issued its Judgment in favor ofAcacia and us, and awarded approximately $32.1 million in monetary damages tobe paid by National Union.  In accordancewith the distribution agreement entered into between Acacia and us prior to ourseparation, all proceeds from the lawsuit will be paid to us.  In April 2008, the Federal Court awardedus an additional $3.6 million in attorneys’ fees and litigation costs, therebyincreasing the overall award to $35.7 million. This award was entered as a final Judgment in May 2008 and willcontinue to earn interest until paid. National Union has appealed the Judgment to the U.S. Ninth CircuitCourt of Appeals, and we intend to vigorously defend against the appeal.  The Federal Court has required, and NationalUnion has posted, an appellate bond in the amount of $39.2 million to cover theJudgment as well as accrued interest charges. The appellate bond will remain in place until the appeal process isconcluded.

 

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**Item2.****   ****MANAGEMENT’SDISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS**

 

**Cautionary Statement**

 

You shouldread the following discussion and analysis in conjunction with the consolidatedfinancial statements and related notes thereto contained in Part I, Item 1of this report.  The informationcontained in this Quarterly Report on Form 10-Q is not a completedescription of our businesses or the risks associated with an investment in ourcommon stock.  We urge you to carefullyreview and consider the various disclosures made by us in this report and inour other reports filed with the U.S. Securities and Exchange Commission, or “SEC,”including our Annual Report on Form 10-K, filed on March 19, 2008.

 

This reportcontains forward-looking statements within the meaning of the “safe harbor”provisions of the Private Securities Litigation Reform Act of 1995. Referenceis made in particular to the description of our plans and objectives for futureoperations, assumptions underlying such plans and objectives, and otherforward-looking statements included in this report. Such statements may beidentified by the use of forward-looking terminology such as “may,” “will,” “expect,”“believe,” “estimate,” “anticipate,” “intend,” “continue,” or similar terms,variations of such terms or the negative of such terms.  Such statements are based on management’scurrent expectations and are subject to a number of factors and uncertainties,which could cause actual results to differ materially from those described inthe forward-looking statements.  Suchstatements address future events and conditions concerning product development,capital expenditures, earnings, litigation, regulatory matters, markets forproducts and services, liquidity and capital resources and accountingmatters.  Actual results in each casecould differ materially from those anticipated in such statements by reason offactors such as future economic conditions, changes in consumer demand,legislative, regulatory and competitive developments in markets in which we andour subsidiaries operate, results of litigation and other circumstancesaffecting anticipated revenues and costs. We expressly disclaim any obligation or undertaking to release publiclyany updates or revisions to any forward-looking statements contained herein toreflect any change in our expectations with regard thereto or any change inevents, conditions or circumstances on which any such statement is based.  Additional factors that could cause suchresults to differ materially from those described in the forward-lookingstatements are set forth in connection with the forward-looking statements andin the “Risk Factors” described in our Annual Report on Form 10-K filed onMarch 19, 2008.

 

## **General**

## ** **

We area diversified biotechnology business, through the development of proprietarytechnologies, products and services in the areas of drug development, geneticanalysis, molecular diagnostics, nanotechnology research, defense and homelandsecurity markets, as well as other potential markets where our products andservices could be utilized.  The technologieswe have developed include a platform technology to rapidly produceoligonucleotide arrays for use in identifying and determining the roles ofgenes, gene mutations and proteins.  Wemake the arrays using our patented in situ electrochemical synthesis process,which provides the ability to easily change array content to stay current withnew developments and to meet the evolving needs of our customers.  This technology has a wide range of potentialapplications in the areas of genomics, proteomics, biosensors, drug discovery,drug development, diagnostics, combinatorial chemistry, material sciences andnanotechnology.  We have also developedthe capabilities of producing arrays that utilize bacterial artificialchromosomes on our arrays, also enabling genetic analysis.  Other technologies include proprietarymolecular synthesis and screening methods for the discovery of potential newdrugs.  We currently recognize revenuesfrom selling these products and services and providing research and developmentservices for organizations including the U.S. Department of Defense, or “DoD”and other strategic partners.

 

CombiMatrixMolecular Diagnostics, Inc., or “**CMDX,**” our wholly ownedsubsidiary located in Irvine, California, has developed capabilities ofproducing arrays that utilize bacterial artificial chromosomes, which alsoenable genetic analysis.  CMDX functionsprimarily as a diagnostics reference laboratory.

 

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## **Relationship WithAcacia Research Corporation**

## ** **

Wewere originally incorporated in October 1995 as a California corporationand later reincorporated as a Delaware corporation in September 2000. On December 13,2002, we merged with and became a wholly owned subsidiary of Acacia ResearchCorporation, or “**Acacia**.”On the same date, Acacia entered into a recapitalization transaction wherebyAcacia created two classes of registered common stock called AcaciaResearch-CombiMatrix common stock (“**AR-CombiMatrix stock**”) andAcacia Research-Acacia Technologies common stock (“**AR-Acacia Technologies stock**”)and divided its existing Acacia common stock into shares of the two new classesof common stock. The AR-CombiMatrix stock was intended to reflect separately theperformance of CombiMatrix Corporation and its subsidiaries, referred to as the******“CombiMatrix group****,**” whereas theAR-Acacia Technologies stock was intended to reflect separately the performanceof Acacia’s technology business, referred to as “**Acacia Technologies group**.”

 

In December 2006,we filed a registration statement on Form S-1 with the SEC to register ourcommon stock in order to affect a split off of our Company from Acacia byredeeming shares of existing AR-CombiMatrix common stock with our commonstock.  The Form S-1 was declaredeffective by the SEC on June 8, 2007, and on August 15, 2007 (the “RedemptionDate”), each one share of our common stock was issued in exchange for every tenshares of AR-CombiMatrix common issued and outstanding on August 15, 2007(the “Redemption Ratio”).  Also, warrantsto purchase AR-CombiMatrix stock became exercisable to purchase CombiMatrixcommon stock, adjusted for the Redemption Ratio.  As of the Redemption Date, we ceased to be asubsidiary or an affiliate of Acacia, and the holders of AR-CombiMatrix commonstock became the stockholders of our company. Our common stock currently trades on the Nasdaq Global Market under thesymbol “CBMX.”

 

## **Liquidity**

## ** **

At December 31,2007, we had cash, cash equivalents and short- and long-term available-for-saleinvestments of $8.2 million.  At thattime, we anticipated that our cash, cash equivalents and anticipated cash flowsfrom operations would be sufficient to meet our cash requirements through September 2008.  In July 2008, we raised $10 million in a financingtransaction by issuing a secured convertible debenture and warrants to a singleinstitutional investor. At September 30, 2008, we had cash, cashequivalents and short- and long-term available-for-sale investments of $11.1million, which management believes will be sufficient to fund our operationsinto the third quarter of 2009.  In orderfor our company to continue as a going concern beyond this point and ultimatelyto achieve profitability, we will be required to obtain capital from externalsources, increase revenues and reduce operating costs.  However, there can be no assurance that suchcapital will be available at times and at terms acceptable to us, or thathigher levels of product and service revenues will be achieved.  The issuance of additional equity securities,should that occur, will cause dilution to our shareholders.  If external financing sources are notavailable or are inadequate to fund our operations, we will be required toreduce operating costs including research projects and personnel, which couldjeopardize our future strategic initiatives and business plans.  See the Liquidity and Capital Resourcessection below as well as Notes 1, 5 and 6 to the consolidated financialstatements included elsewhere in this report for additional discussion of thesematters.

 

As of September 30,2008, our short- and long-term available-for-sale investments (net ofunrealized losses) of $1.7 million were held in auction rate securities (“ARS”),which are currently illiquid due to the collapse of the auction rate securitiesmarket since February 2008.  Theinability to liquidate the remainder of these securities at par value in thenear future could materially jeopardize our ability to execute our businessstrategies.  See the Liquidity andCapital Resources section below as well as Notes 1, 3, 5 and 6 to theconsolidated financial statements included elsewhere in this report foradditional discussion of these matters.

 

## **Basis OfPresentation Of Financial Statements**

## ** **

The consolidatedfinancial statements included in this Form 10-Q are consistent with ourhistorical financial statements included in our Form 10-K for our fiscalyear ended December 31, 2007. Through the Redemption Date, the consolidated financial statements includedthe assets, liabilities, operating results and cash flows of CombiMatrixCorporation using Acacia’s historical bases in the assets and liabilities andthe historical results of operations of CombiMatrix Corporation. Also, throughthe Redemption Date, the consolidated financial statements included allocationsof certain Acacia corporate expenses, including governance, legal, accounting,insurance services, treasury and other Acacia corporate and infrastructurecosts.  The expense allocations were determinedon bases that we determined with Acacia to be a reasonable reflection of theutilization of services provided for the benefit received by us.  Since the Redemption Date, Acacia is nolonger allocating operating expenses to us.

 

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## **Overview Of RecentBusiness Activities**

## ** **

Forthe three and nine months ended September 30, 2008, our operatingactivities included the recognition of $1.0 million and $5.1 million inrevenues, respectively, including $343,000 and $2.4 million, respectively, ingovernment contract revenues and $668,000 and $2.7 million, respectively, inCustomArray product and diagnostics service revenues.  Research and development expenses, excludinggovernment contract costs and non-cash stock based compensation, decreased in2008 due primarily to the impact of our cost reduction efforts, which beganduring the fourth quarter of 2006 and continued during the first and secondquarter of 2007.  Such efforts alsocontributed to the overall decrease in marketing, general and administrativeexpenses, which were impacted primarily by the execution of an amendment to ourfacilities lease in Mukilteo that reduced the amount of space as well as thelease rate paid by us.

 

Significantbusiness developments that occurred during and subsequent to the third quarterended September 30, 2008 were:

 

·      On July 10, 2008, weraised $10 million in a financing transaction by issuing a secured convertibledebenture and warrants to a single institutional investor.  See the Liquidity andCapital Resources section below as well as Note 6 to the consolidated financialstatements included elsewhere in this report for additional discussion of thistransaction.

 

·      On July 14, 2008, weannounced that we had received a new contract from the DoD to continue developmentof our microarray products and technologies for military use.  A key goal of this contract is thedevelopment of a hand-held biochemical detection system.  The new contract was for $923,000, to beexecuted over a fifteen-month period.

 

·      On July 22, 2008, we announced that CMDX had launched an updatedversion of its ATScanTM test for pre-disposition screening forautism.  The ATScan test has been updatedto encompass recent discoveries published in the journal, *Science*, which confirmed the role ofseveral new genomic imbalances in the etiology of Autism Spectrum Disorder(Morrow et al., Science, 11 July 2008, Vol 321).

 

·      On August 4, 2008, weannounced that we were awarded a $250,000, six-month contract from the DefenseAdvanced Research Projects Administration for the development of label-freedetection techniques using our microarray technology.

 

·      On August 6, 2008, weannounced that Dr. Colin Collins, a renowned expert in prostate cancer,had joined our scientific advisory board.

 

·      On August 12, 2008, weannounced that a retrospective, clinical validation study of ourtest for Chronic Lymphocytic Leukemia (or “CLL”) was to be published in the September issueof the Journal of Molecular Diagnostics, augmenting an earlier publication inthe Expert Opinions in Molecular Diagnostics. The subject of both publications is the clinical evaluation andprognosis of CLL patients using our HemeScanTM test, compared toconventional testing.  The conclusionsindicate that the HemeScan test is a superior test for such evaluation andmanagement of individual patients.

 

·      On September 15, 2008,we announced that National Union Fire Insurance Co. of Pittsburg, PA (“NationalUnion”) had been ordered by the United States District Court for the CentralDistrict of California (the “Federal Court”) to increase its bond from $36.0million to $39.2 million regarding the judgment against National Union in favorof CombiMatrix.  National Union hasappealed the judgment.  By the end of September 2008,National Union had complied with this order to increase the bond, whichprovides assurance to us that regardless of the financial difficultiesexperienced by AIG (the parent company of National Union), the judgment amountwill be paid to CombiMatrix upon successful completion of the appellateprocess.

 

·      On September 22, 2008,we announced that U.S. Senator Patty Murray of Washington State had included$2.0 million in the 2009 U.S. Defense Appropriations Bill for CombiMatrixregarding the development of a Health Surveillance System.

 

·      On September 26, 2008,we announced that CombiMatrix had been named to Deloitte’s prestigiousTechnology Fast 50 program for Washington State, a ranking of the 50 fastestgrowing technology, media, telecommunications, and life sciences companies inthe area.  Rankings were based on thepercentage revenue growth over five years from 2003-2007.

 

·      On September 29, 2008, we announcedthat Leuchemix Corporation had received permission to undertake clinical safetytrials of its drug LC-1, for leukemia, and that the sponsored trial would beginshortly.  CombiMatrix owns a one-thirdvoting interest in Leuchemix.

 

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·      On September 30, 2008,we announced the launch of two new array-based diagnostic tests, adding to ourleading and growing portfolio of tests. The first test is an update of the BAC HD Scan 2500TM to theBAC HD Scan 2700TM test, which has been designed to identify up to220 genetic syndromes and disorders that are the cause of developmentalproblems in children.  The second test isthe Zoom-in TM array test, which is used in conjunction with ourother array tests to provide higher-resolution sequence analysis of the geneticaberration in question.  Both of thesetests will be provided by CMDX, our diagnostics laboratory located in Irvine,California.

 

·      On October 3, 2008, we hosted a conference callto discuss the development of our new Cancer Array (or “CCA”) test for cancerscreening, which is currently under development at CombiMatrix.

 

·      On October 15, 2008, we announced that microRNAexpert Dr. Muneesh Tewari had joined our scientific advisory board.

 

## **CriticalAccounting Estimates**

## ** **

Our unaudited interim financial statementshave been prepared in accordance with accounting principles generally acceptedin the United States of America. Preparation of these statements requires management to make judgmentsand estimates.  Some accounting policieshave a significant impact on amounts reported in these financialstatements.  A summary of significantaccounting policies and a description of accounting policies that areconsidered critical may be found in our Annual Report on Form 10-K, filedon March 19, 2008, in the Notes to the Consolidated Financial Statementsand the Critical Accounting Estimates section. In addition, refer to Note 2 to the consolidated interim financialstatements included inPart I, Item 1 of this report.

 

**Comparison of the Results of Operations for the Threeand Nine months Ended September 30, 2008 and 2007**

** **

**Revenues and Cost ofRevenues (In thousands)**

 
| ** **                           | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|--------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                           | ** ** | **September 30,**           | ** ** | **September 30,**          | ** ** |
| ** **                           | ** ** | **2008**                         | ** ** | **2007**                        | ** ** | **2008** | ** ** | **2007** | ** ** |
|                                 |       |                             |       |                            |       |   |   |   |   |
| Government contracts                 |       | $                                | 343        |                            | $          | 627 |   | $ | 2,380 |   | $ | 1,855 |   |
| Cost of government contract revenues |       | (336                             | )          | (593                            | )          | (2,305 | ) | (1,768 | ) |
| Products                             |       | 140                              |       | 828                             |       | 1,292 |   | 1,726 |   |
| Services                             |       | 466                              |       | 164                             |       | 1,209 |   | 386 |   |
| Cost of products and services        |       | (416                             | )          | (307                            | )          | (1,350 | ) | (858 | ) |
| Collaboration agreements             |       | 62                               |       | 62                              |       | 186 |   | 187 |   |
|                                      |            |                                  |            |                                 |            |  |  |  |  |  |  |  |  |

 

**GovernmentContracts and Cost of Government Contracts. **Under the terms of our contracts with the DoD, weare reimbursed on a periodic basis for actual costs incurred to perform ourobligations, plus a fixed fee.  Revenuesare recognized under the percentage-of-completion method of accounting, usingthe cost-to-cost approach to measure completeness at the end of the eachreporting period. Cost of government contracts reflect research and developmentexpenses incurred in connection with our commitments under our currentcontracts with the DoD.

 

Thechanges in government contract revenues for the three and nine months ended September 30,2008 versus the corresponding periods in 2007 reflect ongoing performance ofour government contracts, including our electrochemical, label-free andmultipathogen detection contracts as well as our microfluidics and influenzagenotyping contracts.  The recentcompletion of our multipathogen and electrochemical detection contractsresulted in a decrease in government contract activity and thus lowergovernment contract revenues recognized during the three months ended September 30,2008 versus the corresponding period in 2007. For the nine months ended September 30, 2008, government contractrevenues were higher due to the overall larger number of ongoing contracts andcontract activity in 2008 versus the corresponding period in 2007.  The changes in government contract activityalso contribute to the change in government contract costs during the three andnine months ended September 30, 2008 versus the corresponding periods in2007.  See Note 8 to our consolidatedfinancial statements included elsewhere in this report for a detaileddescription of the amounts, completion rates and estimated costs to complete ofour government contracts that are ongoing as well as prior contracts that werecompleted during the periods presented. As these contracts near completion, future contract revenues could bevolatile in the short-term and decrease in the longer term if new governmentcontracts are not awarded or executed.

 

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**Productsand Cost of Products**. Product revenues and costs of products relate to domestic andinternational sales of our array products, which include DNA synthesizerinstruments, CustomArray 12K, 4X2K and 90K DNA expression arrays, ElectraSense®microarray readers and related hardware. Product revenues decreased in the three and nine months ended September 30,2008 versus the corresponding periods in 2007 due primarily to lower DNAsynthesizer instrument sales in 2008 than 2007. As we expand our business focus from exclusively selling array-basedresearch and development products to providing array-based diagnostic services,we have reduced internal sales staff, marketing and production effortsregarding sales of CustomArray products and instead have executed productdistribution and manufacturing agreements with various third-party distributorsfor the sales of our suite of CustomArray products into the research anddevelopment markets.  As a result,CustomArray product revenues will likely be volatile and could decrease infuture periods, depending largely on the sales efforts of our distributors.

 

*Services.* Services revenues are comprised primarily of diagnostic servicesprovided by CMDX as well as the amortization of one-year equipment maintenanceand service contracts executed with certain customers of our DNAsynthesizers.  Diagnostic servicesrevenue from CMDX was $463,000 and $1.1 million for the three and nine monthsended September 30, 2008, versus $142,000 and $247,000 for the three andnine months ended September 30, 2007, respectively.  These revenues have increased for all periodspresented due to an increased number of diagnostic test offerings as well asincreased customer demand for our suite of diagnostic services provided byCMDX, which is due primarily to increased sales and marketing efforts at CMDXduring the 2008 and 2007 periods presented.

 

**Operating Expenses (Inthousands)**

 
| ** **                        | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|-----------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                        | ** ** | **September 30,**           | ** ** | **September 30,**          | ** ** |
| ** **                        | ** ** | **2008**                         | ** ** | **2007**                        | ** ** | **2008** | ** ** | **2007** | ** ** |
|                              |       |                             |       |                            |       |   |   |   |   |
| Research and development expenses |       | $                                | 1,290      |                            | $          | 1,924 |   | $ | 3,503 |   | $ | 4,874 |   |
|                                   |            |                                  |            |                                 |            |  |  |  |  |  |  |  |  |

 

*Research and Development Expenses*.  The decrease in internal research and developmentexpenses for all periods presented was due primarily to the impact of costreduction efforts in the area of full-time staff and ongoing research anddevelopment projects for the CustomArray platform while continuing to developmicroarray-based diagnostics services. In addition, for the three and nine months ended September 30, 2008and 2007, research and development expenses included $75,000, $169,000,$793,000 and $1.2 million, respectively, of non-cash stock compensation expenserecognized under SFAS No. 123R.  SeeNote 2 to our consolidated financial statements included elsewhere in thisreport for a detailed description of the amounts recognized and assumptionsused by management in determining the stock-based compensation charges incurredfor the periods presented.

 

Futureresearch and development expenses will continue to be incurred in connectionwith our ongoing internal research and development efforts in the areas ofgenomics, diagnostics, drug discovery and product development.   We expect our research and developmentexpenses to continue to fluctuate and such expenses could increase in futureperiods as additional internal research and development agreements areundertaken and/or as new research and development collaborations are executed withstrategic partners.

 
| ** **                                      | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|-------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                                      | ** ** | **September 30,**           | ** ** | **September 30,**          | ** ** |
| ** **                                      | ** ** | **2008**                         | ** ** | **2007**                        | ** ** | **2008** | ** ** | **2007** | ** ** |
|                                            |       |                             |       |                            |       |   |   |   |   |
| Marketing, general and administrative  expenses |       | $                                | 2,301      |                            | $          | 2,167 |   | $ | 6,781 |   | $ | 6,956 |   |
| Patent amortization and royalties               |       | 341                              |       | 332                             |       | 1,063 |   | 994 |   |
| Equity in loss of of investees                  |       | 247                              |       | 248                             |       | 737 |   | 770 |   |
|                                                 |            |                                  |            |                                 |            |  |  |  |  |  |  |  |  |

 

**Marketing,General and Administrative Expenses.**  The increase in marketing, general andadministrative expenses for the three months ended September 30, 2008 versusthe corresponding period in 2007 was due primarily to increases in sales andmarketing expenses at CMDX.  The decreasein marketing, general and administrative expenses for the nine months ended September 30,2008 versus the corresponding period in 2007 was due primarily to a decrease infacilities-related costs from executing the February 1, 2007 leaseamendment that significantly reduced our office space and lease rates,reduction in sales and marketing staff and expenses at our Mukilteo operationsand decreases in one-time accounting and legal costs incurred during 2007 aspart of our split off from Acacia.  Inaddition, for the three and nine months ended September 30, 2008 and 2007,marketing, general and administrative expenses included $654,000, $1.3 million,$629,000 and $963,000, respectively, of non-cash stock compensation expenserecognized under SFAS No. 123R.  SeeNote 2 to our consolidated financial statements included elsewhere in thisreport for a detailed description of the amounts recognized and assumptionsused by management in determining the stock-based compensation charges incurredfor the periods presented.

 

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### *****Other Non-Operating Items*****

### * *

**InterestExpense.****  Since July 2008,interest expense is recognized from the issuance of the $10.0 million securedconvertible debenture, which accrues interest at an annual rate of 10%.  Interest expense also includes amortizationof the $2.9 million of debt discount recognized from issuance of the securedconvertible debenture and warrants using the effective interest method.**

 

**OtherIncome.****  For the threeand nine months ended September 30, 2008, other income represents the netbenefit recognized from mark-to-market adjustments to the embedded derivativesof the secured convertible debenture.**

 

**Prior to the Redemption Date**,the outstanding AR-CombiMatrix stock purchase warrants were classified aslong-term liabilities due to certain redemption provisions associated with theunderlying AR-CombiMatrix stock.  Changesin the fair value of the stock purchase warrant liabilities were reflected aswarrant gains in the consolidated statements of operations, which resulted innon-cash benefits of $290,000 and $2.5 million for the three and nine monthsended September 30, 2007, respectively. On the Redemption Date, all outstanding warrants to purchaseAR-CombiMatrix common stock became exercisable in CombiMatrix common stock,which is not subject to the redemption provisions that required liabilityclassification of the warrants prior to the Redemption Date.

 

**Inflation**

 

Inflation has not had a significant impacton our Company.

 

**Liquidity and CapitalResources**

 

At September 30,2008, cash, cash equivalents, short- and long-term available-for-saleinvestments totaled $11.1 million compared to $8.2 million at December 31,2007.  Working capital at September 30,2008 was $9.1 million, compared to $6.9 million at December 31, 2007.  The change in working capital was dueprimarily to the impact of net cash flow activities as discussed below as wellas the reclassification of certain of our ARS to long-term.  The net change in cash and cash equivalentsfor the periods presented was comprised of the following (in thousands):

 
| ** **                                        | ** ** | **Nine Months Ended** | ** ** |
|---------------------------------------------------|------------|---------------------------------|------------|
| ** **                                        | ** ** | **September 30,**          | ** ** |
| ** **                                        | ** ** | **2008**                        | ** ** | **2007** | ** ** |
| Net cash provided by (used in):                   |       |                            |       |   |   |
| Operating activities                              |       | $                               | (8,114     | ) | $ | (9,136 | ) |
| Investing activities                              |       | 3,975                           |       | (1,512 | ) |
| Financing activities                              |       | 11,250                          |       | 5,410 |   |
| Increase (decrease) in cash and cash  equivalents |       | $                               | 7,111      |   | $ | (5,238 | ) |

 

*Operating Activities.*  The overall net decrease in cash used inoperating activities for the nine months ended September 30, 2008 versusthe corresponding period in 2007 was due primarily to an increase in cashreceipts from customers, which totaled $4.4 million in 2008 compared to $3.3million in 2007.  This increase waspartially offset by an increase in operating cash outflows, which totaled $12.6million in 2008 compared to $12.4 million in 2007.  This increase was due primarily to the netimpact of the timing of the payments to certain vendors.

 

*Investing Activities.*  The change in net cash flows from investingactivities was due primarily to net sales of available-for-sale investments inconnection with ongoing cash management activities during the periodspresented.  Also, for the nine monthsended September 30, 2008 and 2007, we incurred $55,000 and $122,000,respectively, of capital expenditures.

 

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*Financing Activities.*  The increase in net cash flows from financingactivities was due primarily to the sale of a $10.0 million secured convertibledebenture in July 2008 for $9.8 million (net of issuance costs), creditline borrowings of $808,000 in May 2008 and proceeds of $711,000 from theexercise of common stock warrants and options during the nine months ended September 30,2008, versus the completion of a registered direct offering of AR-CombiMatrixcommon stock in May 2007 for $5.0 million as well as the exercise ofAR-CombiMatrix common stock warrants totaling $369,000 during the nine monthsended September 30, 2007.

 

On July 10, 2008, we issued to YA GlobalInvestments, L.P. (“YA”): (i) a secured convertible debenture (the “Debenture”)with an aggregate principal amount of $10 million, which is convertible intoshares of our common stock ata fixed conversion price of $11.87 per share; and (ii) warrants(the “Warrants”) to purchase up to 336,984 shares of our common stock.  TheDebenture is due on the earlier of July 10, 2010 (the “Term”) or withinfour months after our receipt of payment of settlement or judgment proceeds fromNational Union in accordance with the $35.7 million judgement (the “Judgment”)issued by the Federal Court.  TheDebenture bears interest at an annual rate of 10%, with interest payments duequarterly in either cash or our common stock, beginning October 2008. Wehave the right to force conversion of the Debenture into our common stock ifthe volume-weighted average price (or “VWAP”) of our stock exceeds between 125%and 135% of the fixed conversion price for a period of thirty consecutivetrading days, among other conditions and restrictions.  We also have a cash redemption option wherebywe have the right to pre-pay the Debenture during the Term, but only if ourcommon stock is trading below the fixed conversion price, among otherconditions.  Prepayment penalties rangebetween 0% and 10% of the principal amount due, depending when the cashredemption occurs during the Term.** **The number of sharesissuable upon conversion of the Debenture may increase due to certainanti-dilution adjustments, including if we issue common stock at a price lowerthan the $11.87 fixed conversion price while the outstanding principal amountof the Debenture is at least $5 million, or if we fail to generate at least $6million in gross revenues for our fiscal year ended December 31, 2008(subject to adjustment in the event we sell or dispose of a division or line ofbusiness).  The Debenture is secured by the Judgment as well as our intellectualproperty.  The Warrants have a five-yearterm and allow YA to purchase: (i) 168,492 shares of common stock at anexercise price of $11.87; and (ii) 168,492 shares of common stock at anexercise price of $13.65.  We have theright to call the Warrants, but only if the VWAP of our common stock is at orgreater than 130% of the Warrants’ exercise price for at least twentyconsecutive trading days, among other conditions.  During the third quarter of 2008, weregistered 1,179,444 shares of our common stock that are issuable to YA uponconversion of the Debenture and exercise of the Warrants on Form S-3 withthe SEC.  As of September 30, 2008,YA had converted $1.3 million of the Debenture into our common stock.

 

On May 9,2008 and pursuant to a Loan Management Account agreement (the “LMA”) with afinancial institution (the “Lender”), we borrowed $808,000 from the Lender,secured by our holdings in ARS.  The LMAis similar to a revolving line of credit borrowing facility.  The LMA provides that we accrue monthlyinterest charges at an annual, variable rate of 1% plus the 30-day LIBOR rate(resulting in a rate of approximately 4.8% at September 30, 2008).  The total amount available under the LMAranges from 50% to 92% of investments pledged as collateral, based upon theamount and security type in our investment portfolio, up to a maximum amount of$2.8 million.  However, based on theamount and type of securities currently held by us with the Lender, the maximumborrowing ceiling is currently limited to $808,000, plus accrued interest.  The LMA has no stated maturity for theprincipal and interest amounts borrowed by us. However, the Lender does havethe ability under the terms of the LMA to call in the principal amount of theborrowings at any time.

 

*Future Liquidity.*  In order for us to continue to meet our cashrequirements beyond 2009, we will be required to obtain capital from externalsources.  However, there can be noassurances that we will be able to secure additional sources of financing attimes and at terms acceptable to management. The issuance of additional equity securities, should that occur, willcause dilution to our shareholders.  Ifexternal financing sources are not available or are inadequate to fund ouroperations, management will be required to reduce our operating costs includingresearch projects and personnel, which could jeopardize our future strategicinitiatives and business plans.  Forexample, reductions in research and development activities and/or personnel atour Mukilteo, Washington facility could result in the inability to invest theresources necessary to continue to develop next-generation products and improveexisting product lines in order to remain competitive in the marketplace,resulting in reduced revenues and cash flows from the sales of our CustomArrayproducts and services.  Also, reductionsin operating costs at CMDX, should they occur, could jeopardize our ability tolaunch, market and sell additional products and services necessary to grow andsustain our operations and eventually achieve profitability.  As discussed in Note 1 to the consolidatedfinancial statements included herein, the anticipation that we would berequired to obtain additional financing in the foreseeable future raisedsubstantial doubt about our ability to continue as a going concern beyond September 2008.  In addition to seeking additional capitalfrom outside sources, our plans in regard to these matters include reductionsin overhead costs as well as research and development costs that are notconsidered strategically vital to our business. Also, we are focusing our sales and product development efforts on ourcore diagnostic array platform as well as our funded research and developmentprojects for the DoD.  Based on recentfinancing transactions discussed above, we believe that the additional cashreceived from these transactions will allow us to meet our cash requirementsinto the third quarter of 2009.

 

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*AuctionRate Securities.*  At September 30, 2008 and December 31,2007, our available-for-sale investments included $1.9 million and $3.4million, respectively, of ARS at par value.  Historically, the carrying value of our ARSapproximated fair value due to active, liquid markets for these securities aswell as the frequent resetting of the interest rates at auction, whichtypically occurred every 7 to 30 days. However, in mid-February 2008, the market for ARS collapsed and asa result, our ARS have experienced multiple failed auctions since this time andare currently illiquid.  Of the $1.9million in par-value ARS held at September 30, 2008, $900,000 are issuedby a state student-loan lending organization, carry an A2/A rating and areinsured by the Federal Family Education Loan Program.  The remaining $975,000 of ARS are AAA-ratedauction market preferred stock (or “AMPS”) issued by publicly traded mutualfunds that are required to maintain at least 200% of asset coverage for issuedARS.  All of our ARS continue to payinterest at the maximum contractual rate, which currently exceeds marketinterest rates for short-term securities.

 

At September 30, 2008, the fair values ofour ARS were estimated using discounted cash flow models.  These models consider, among other things,the timing of expected future successful auctions, estimated future cash flows,collateralization and credit worthiness of underlying security investments anddiscount rates applied to the estimated future cash flows.  Since these inputs were not observable, theyare classified as Level 3 inputs under Statement of Financial AccountingStandards No. 157, “Fair Value Measurements.”  As a result of the lack of liquidity in theARS market and not as a result of the quality of the underlying collateral, werecorded an unrealized losses on our ARS of $31,000 and $166,000 for the threeand nine months ended September 30, 2008, respectively, which is reflectedin accumulated other comprehensive (loss) income in our September 30, 2008consolidated balance sheet.  Ourvaluation models assume an average maturity of one year for our ARS issued inpreferred stock and greater than one year for our ARS that are backed bystudent-loans.  As a result, we haveclassified the student-loan ARS with a fair value of $751,000 as a non-currentinvestment in our September 30, 2008 consolidated balance sheet.

 

During the third quarter of 2008, one of the issuersof our AMPS announced that they would redeem approximately one-half of theiroutstanding AMPS during the fourth quarter, at par value.  Subsequent to September 30, 2008 andthrough the date of this report, we have received $325,000 from the partialredemption of one of our AMPS, at par value. We continue to monitor the market for ARS and consider its impact (ifany) on the fair value of our investments. If the current market conditions deteriorate further, or the anticipatedrecovery in fair values does not occur, we may be required to record additionalunrealized losses in other comprehensive income or realized,other-than-temporary impairment charges in future periods.

 

*Capital Requirements.*  We may also encounter unforeseen difficultiesthat may deplete our capital resources more rapidly than anticipated.  Any efforts to seek additional funding couldbe made through equity, debt or other external financing, and there can be noassurance that additional funding will be available on favorable terms, if atall.  Our long-term capital requirementswill be substantial and the adequacy of available funds will depend upon manyfactors, including:

 

·      the costsof commercialization activities, including sales and marketing, manufacturingand capital equipment;

 

·      ourcontinued progress in research and development programs;

 

·      the costsinvolved in filing, prosecuting, enforcing and defending any patents claims,should they arise;

 

·      the costsinvolved in defending our Judgment against the appeal brought by NationalUnion;

 

·      ourability to license technology;

 

·      competingtechnological developments;

 

·      thecreation and formation of strategic partnerships; and

 

·      the costs associated with leasing and improving our Irvine, Californiafacility; and other factors that may not be within our control, such as theability to liquidate our ARS.

 

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Pursuantto the tax allocation agreement executed between us and Acacia, we have agreednot to take certain actions for two years following the split off, unless weobtain an IRS ruling or an opinion of counsel to the effect that these actionswill not affect the tax-free nature of the split off.  These actions include certain issuances ofour stock, a liquidation or merger of our company, and dispositions of assetsoutside the ordinary course of our business. If any of these transactions were to occur, the split off could bedeemed to be a taxable distribution to Acacia. In particular, we have agreed to indemnify Acacia for any tax resultingfrom an acquisition by one or more persons of a 50% or greater interest in ourcompany.

 

#### **Off-BalanceSheet Arrangements**

 

Wehave not entered into off-balance sheet financing arrangements, other thanoperating leases for our premises.  Wehave no significant commitments for capital expenditures in 2008 orbeyond.  We have executed two capitalleases totaling $109,000 for certain laboratory equipment.  The following table lists our material knownfuture cash commitments as of September 30, 2008:

 
| ** **                             | ** ** | **Payments Due by Period (in thousands)** | ** ** |
|----------------------------------------|------------|--------------------------------------------------------------------|------------|
| ** **                             | ** ** | **2008**                                                           | ** ** | **2009** | ** ** | **2010** | ** ** | **2011** | ** ** | **2012 and  Thereafter** | ** ** |
|                                   |       |                                                               |       |   |   |   |   |   |   |   |   |
| Operating leases                       |       | $                                                                  | 144        |   | $ | 517 |   | $ | 353 |   | $ | — |   | $ | — |   |
| Capital leases                         |       | 7                                                                  |       | 18 |   | 13 |   | 14 |   | 16 |   |
| Minimum royalty payments               |       | 25                                                                 |       | 100 |   | 100 |   | 100 |   | 675 |   |
| Secured convertible debenture (1)      |       | —                                                             |       | — |   | 8,700 |   | — |   | — |   |
| Total contractual cash obligations (2) |       | $                                                                  | 176        |   | $ | 635 |   | $ | 9,166 |   | $ | 114 |   | $ | 691 |   |

 

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(1)   Theprincipal amount of the Debenture due to YA as of September 30, 2008 isdue the earlier of July 10, 2010 or four months after receiving thesettlement payment from National Union, is reflected as being due in July, 2010assuming no additional conversions occur. In October 2008, YA converted an additional $200,000 of the securedconvertible debenture to common stock, bringing the total principal amount dueYA to $8.5 million as of the date of this report.

 

(2)   Doesnot include $808,000, plus accrued interest, in credit line borrowings with nostated maturity but are due on demand by the Lender.

 

**Recent AccountingPronouncements**

 

Referto Note 2 to our consolidated financial statements included in Part I,Item 1 of this report.

 

**Item 3.****       ****QUANTITATIVE ANDQUALITATIVE DISCLOSURES ABOUT MARKET RISK**

 

Our exposure to marketrisk is limited to interest income sensitivity, which is affected by changes inthe general level of U.S. interest rates, particularly because the majority ofour investments are in short-term debt securities issued by the U.S. treasuryand by U.S. corporations as well as ARS. The primary objective of our investment activities is to preserveprincipal while at the same time maximizing the income we receive withoutsignificantly increasing risk.  Tominimize risk, we maintain our portfolio of cash, cash equivalents andavailable-for-sale investments in a variety of investment-grade securities andwith a variety of issuers, including corporate notes, commercial paper,government securities, ARS and money market funds.

 

We are exposed to liquidity and credit riskassociated with our ARS.  In the event ofa failed auction, we would not have access to these funds until a futureauction is successful.  If the issuersare unable to successfully close future auctions and their credit ratingsdeteriorate, we may be required to adjust the carrying value of these investmentsthrough an impairment charge.  Includedwithin our investment portfolio at September 30, 2008, are ARS with apar-value of $1.9 million and a fair value computed by management of $1.7million.

 

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**Item 4T.****    ****CONTROLS AND PROCEDURES**

 

*Evaluation of DisclosureControls and Procedures*

 

We maintain disclosure controls and procedures that are designed toensure that information required to be disclosed in our reports filed orsubmitted under the Securities Exchange Act of 1934, as amended (the “ExchangeAct”) is recorded, processed, summarized and reported within the time periodsspecified in SEC rules and forms. Our disclosure controls and procedures include, without limitation,controls and procedures designed to ensure that information required to bedisclosed in our reports filed under the Exchange Act is accumulated andcommunicated to management as appropriate to allow timely decisions regarding requireddisclosures.  There are inherentlimitations to the effectiveness of any system of disclosure controls andprocedures, including the possibility of human error and the circumvention oroverriding of the controls and procedures. Accordingly, even effectivedisclosure controls and procedures can only provide reasonable assurance ofachieving their control objectives, and management necessarily is required touse its judgment in evaluating the cost-benefit relationship of possiblecontrols and procedures.  Our management,with the participation of our Chief Executive Officer and Chief FinancialOfficer, conducted an evaluation required by Rules 13a-15 and 15d-15 underthe Exchange Act of the effectiveness of our disclosure controls and proceduresas defined in Rules 13a-15 and 15d-15 under the Exchange Act as of September 30,2008.  Based on this evaluation, ourChief Executive Officer and Chief Financial Officer concluded that as of September 30,2008, the design and operation of our disclosure controls and procedures wereeffective.

 

*Changes in InternalControls*

 

There wereno changes in our internal control over financial reporting that occurredduring our last fiscal quarter (the quarter ended September 30, 2008) thathave materially affected, or are reasonably likely to materially affect, ourinternal control over financial reporting.

 

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**PART II—OTHER INFORMATION**

** **

**Item 1.  LEGAL PROCEEDINGS**

 

        In April of2005, Acacia and we filed a complaint in the U.S. District Court for theCentral District of California (the “Federal Court”) against our insurancecarrier, National Union, seeking reimbursement of litigation and settlementcosts for a lawsuit, pursuant to our directors’ and officers’ insurance policywith National Union.  A trial was heldand concluded during the fourth quarter of 2007.  In March 2008, the Federal Court issueda judgment (the “Judgment”) in favor of Acacia and us, and awardedapproximately $32.1 million in monetary damages to be paid by NationalUnion.  In accordance with thedistribution agreement entered into between Acacia and us prior to ourseparation, all proceeds from the lawsuit will be paid to us.  In April 2008, the Federal Court awardedus an additional $3.6 million in attorneys’ fees and litigation costs, therebyincreasing the overall award to $35.7 million. This award was entered as a final Judgment in May 2008 and willcontinue to earn interest until paid.  National Union has appealed theJudgment to the U.S. Ninth Circuit Court of Appeals, and we intend tovigorously defend against the appeal. The Federal Court has required, and National Union has posted, anappellate bond in the amount of $39.2 million to cover the Judgment as well asaccrued interest charges.  The appellatebond will remain in place until the appeal process is concluded.

 

**Item2.  UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS**

 

During thethird quarter of 2008, we issued 109,519 shares of our common stock to YA fromthe conversion of $1.3 million of the Debenture into our common stock.  The issuance of common stock to YA was madepursuant to an exemption under Rule 506 of Regulation D.

 

**Item 6.  EXHIBITS**

** **
| **Exhibit  Number** | ** ** | **Description**                                                                                                                                                                                                                                                          |
|---------------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                |       |                                                                                                                                                                                                                                                                     |
| 10.1                |       | Securities Purchase  Agreement (incorporated by reference to Exhibit 99.1 to Current Report  on Form 8-K, filed July 11, 2008)                                                                                                                            |
| 10.2                |       | Secured Convertible  Debenture (incorporated by reference to Exhibit 99.2 to Current Report  on Form 8-K, filed July 11, 2008)                                                                                                                            |
| 10.3                |       | Warrant (exercise  price of $11.87 per share) (incorporated by reference to Exhibit 99.3 to  Current Report on Form 8-K, filed July 11, 2008)                                                                                                             |
| 10.4                |       | Warrant (exercise  price of $13.65 per share) (incorporated by reference to Exhibit 99.4 to  Current Report on Form 8-K, filed July 11, 2008)                                                                                                             |
| 10.5                |       | Registration Rights  Agreement (incorporated by reference to Exhibit 99.5 to Current Report  on Form 8-K, filed July 11, 2008)                                                                                                                            |
| 10.6                |       | Security Agreement  (incorporated by reference to Exhibit 99.6 to Current Report on  Form 8-K, filed July 11, 2008)                                                                                                                                       |
| 10.7                |       | Intellectual  Property Security Agreement (incorporated by reference to Exhibit 99.7  to Current Report on Form 8-K, filed July 11, 2008)                                                                                                                 |
| 10.8                |       | Form of  Irrevocable Voting Agreement and Proxy (incorporated by reference to  Exhibit 99.8 to Current Report on Form 8-K, filed July 11,  2008)                                                                                                     |
| 10.9                |       | Contract titled,  “Reagentless Detection on a Semiconductor Microarray for the Immunochemical  and Genomic Identification of Biothreat Agents” (incorporated by reference to  Exhibit 10.1 to Current Report on Form 8-K, filed July 14,  2008) |
| 31.1                |       | Certification of  Chief Executive Officer pursuant to section 302 of the Sarbanes-Oxley Act of  2002                                                                                                                                                                     |
| 31.2                |       | Certification of  Chief Financial Officer pursuant to section 302 of the Sarbanes-Oxley Act of  2002                                                                                                                                                                     |
| 32.1                |       | Certification of  Chief Executive Officer pursuant to section 906 of the Sarbanes-Oxley Act of  2002                                                                                                                                                                     |
| 32.2                |       | Certification of  Chief Financial Officer pursuant to section 906 of the Sarbanes-Oxley Act of  2002                                                                                                                                                                     |

 

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**SIGNATURES**

** **

Pursuant to the requirements of theSecurities Exchange Act of 1934, the Registrant has duly caused this report tobe signed on its behalf by the undersigned, thereunto duly authorized.

 

 
|                                           | COMBIMATRIX CORPORATION |
|------------------------------------------------|-------------------------|
|                                           |                    |   |
|                                           |                    |   |
|                                           | By:                     |          /s/  AMIT KUMAR, PH.D. |
|                                           |                    | Amit Kumar, Ph.D. |
|                                           |                    | Chief Executive Officer |
| * *                                       | * *                | *(Authorized Signatory)* |
|                                           |                    |   |
|                                           | By:                     |          /s/  SCOTT R. BURELL |
|                                           |                    | Scott R. Burell |
|                                           |                    | Chief Financial Officer |
| * *                                       |                    | *(Principal Financial and Accounting Officer)* |
|                                           |                    |   |
| Date:   November 10,  2008 |                    |   |

 

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**EXHIBIT INDEX**

 
| **Exhibit  Number** | ** ** | **Description**                                                                                                                                                                                                                                                          |
|---------------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                |       |                                                                                                                                                                                                                                                                     |
| 10.1                |       | Securities Purchase  Agreement (incorporated by reference to Exhibit 99.1 to Current Report  on Form 8-K, filed July 11, 2008)                                                                                                                            |
| 10.2                |       | Secured Convertible Debenture  (incorporated by reference to Exhibit 99.2 to Current Report on  Form 8-K, filed July 11, 2008)                                                                                                                            |
| 10.3                |       | Warrant (exercise  price of $11.87 per share) (incorporated by reference to Exhibit 99.3 to  Current Report on Form 8-K, filed July 11, 2008)                                                                                                             |
| 10.4                |       | Warrant (exercise  price of $13.65 per share) (incorporated by reference to Exhibit 99.4 to  Current Report on Form 8-K, filed July 11, 2008)                                                                                                             |
| 10.5                |       | Registration Rights  Agreement (incorporated by reference to Exhibit 99.5 to Current Report  on Form 8-K, filed July 11, 2008)                                                                                                                            |
| 10.6                |       | Security Agreement  (incorporated by reference to Exhibit 99.6 to Current Report on  Form 8-K, filed July 11, 2008)                                                                                                                                       |
| 10.7                |       | Intellectual  Property Security Agreement (incorporated by reference to Exhibit 99.7  to Current Report on Form 8-K, filed July 11, 2008)                                                                                                                 |
| 10.8                |       | Form of  Irrevocable Voting Agreement and Proxy (incorporated by reference to  Exhibit 99.8 to Current Report on Form 8-K, filed July 11,  2008)                                                                                                     |
| 10.9                |       | Contract titled, “Reagentless  Detection on a Semiconductor Microarray for the Immunochemical and Genomic  Identification of Biothreat Agents” (incorporated by reference to  Exhibit 10.1 to Current Report on Form 8-K, filed July 14,  2008) |
| 31.1                |       | Certification of  Chief Executive Officer pursuant to section 302 of the Sarbanes-Oxley Act of  2002                                                                                                                                                                     |
| 31.2                |       | Certification of  Chief Financial Officer pursuant to section 302 of the Sarbanes-Oxley Act of  2002                                                                                                                                                                     |
| 32.1                |       | Certification of  Chief Executive Officer pursuant to section 906 of the Sarbanes-Oxley Act of  2002                                                                                                                                                                     |
| 32.2                |       | Certification of  Chief Financial Officer pursuant to section 906 of the Sarbanes-Oxley Act of  2002                                                                                                                                                                     |

 

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