Table of Contents

 

 

 

**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON, D.C. 20549**

 

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**FORM 10-Q**

 

**x****  ****QUARTERLYREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACTOF 1934**

 

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

 

**OR**

 

**o****     ****TRANSITION REPORT PURSUANT TO SECTION 13 OR15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**

 

**FOR THE TRANSITION PERIODFROM            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.)

 

Indicateby check mark whether the registrant (1) has filed all reports required tobe filed by Section 13 or 15(d) of the Securities Exchange Act of1934 during the preceding 12 months (or for such shorter period that theregistrant was required to file such reports), and (2) has been subject tofiling requirements for the past 90 days.     Yes xNo o

 

Indicateby check mark whether the registrant is a large accelerated filer, anaccelerated filer, a non-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 |
|---------------------------------------|---------------------------------|-----------------------------------------------------------------------------------|----------------------------------------|

 

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

 

As of August 8, 2008, 6,037,643 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  June 30, 2008 (Unaudited) and December 31,  2007 | 3 |
|                                   |       |   |   |
|                                   |       | Consolidated Statements of Operations for the Three and Six Months Ended  June 30, 2008 and 2007 (Unaudited) | 4 |
|                                   |       |   |   |
|                                   |       | Consolidated Statements of Cash Flows for the Six Months Ended  June 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 | 17 |
|                                   |       |   |   |
| Item 3.                                |       | Quantitative  and Qualitative Disclosures about Market Risk | 24 |
|                                   |       |   |   |
| Item 4T.                               |       | Controls and  Procedures | 25 |
|                                   |       |   |   |
| **Part II.  Other Information**   | ** ** |
|                                   |       |   |   |
| Item 1.                                |       | Legal Proceedings | 26 |
|                                   |       |   |   |
| Item 2.                                |       | Unregistered  Sales of Equity Securities and Use of Proceeds | 26 |
|                                   |       |   |   |
| Item 6.                                |       | Exhibits | 26 |
|                                   |       |   |   |
| **Signatures**                         | 27         |
|                                   |       |   |   |
| **Exhibit Index**                 | 28         |

 

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**COMBIMATRIXCORPORATION**

**CONSOLIDATED BALANCE SHEETS**

**(Inthousands)**

**(Unaudited)**

** **
| ** **                                                                                                                                                                                     | ** ** | **June 30,** | ** ** | **December 31,** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                                                     | ** ** | **2008**          | ** ** | **2007**              | ** ** |
|                                                                                                                                                                                           |       |              |       |                  |       |
| **ASSETS**                                                                                                                                                                                     |       |              |       |                  |       |
|                                                                                                                                                                                           |       |              |       |                  |       |
| Current assets:                                                                                                                                                                                |       |              |       |                  |       |
| Cash and cash equivalents                                                                                                                                                                      |       | $                 | 2,016      |                  | $          | 2,314 |   |
| Available-for-sale investments                                                                                                                                                                 |       | 958               |       | 5,920                 |       |
| Accounts receivable, net of allowance for  doubtful accounts of $117 and $33                                                                                                                   |       | 1,506             |       | 692                   |       |
| Inventory                                                                                                                                                                                      |       | 723               |       | 444                   |       |
| Prepaid expenses and other assets                                                                                                                                                              |       | 202               |       | 323                   |       |
| Total current assets                                                                                                                                                                           |       | 5,405             |       | 9,693                 |       |
|                                                                                                                                                                                           |       |              |       |                  |       |
| Property and equipment, net                                                                                                                                                                    |       | 958               |       | 1,178                 |       |
| Non-current available-for-sale investments                                                                                                                                                     |       | 782               |       | —                |       |
| Investments in unconsolidated subsidiaries                                                                                                                                                     |       | 1,434             |       | 1,923                 |       |
| Patents and licenses, net                                                                                                                                                                      |       | 5,550             |       | 6,131                 |       |
| Goodwill                                                                                                                                                                                       |       | 16,918            |       | 16,918                |       |
| Total assets                                                                                                                                                                                   |       | $                 | 31,047     |                  | $          | 35,843 |   |
|                                                                                                                                                                                           |       |              |       |                  |       |
| **LIABILITIES  AND SHAREHOLDERS’ EQUITY**                                                                                                                                                 | ** ** | ** **        | ** ** | ** **            | ** ** |
| ** **                                                                                                                                                                                     | ** ** | ** **        | ** ** | ** **            | ** ** |
| Current liabilities:                                                                                                                                                                           |       |              |       |                  |       |
| Accounts payable, accrued expenses and  other                                                                                                                                                  |       | $                 | 2,930      |                  | $          | 2,519 |   |
| Credit line borrowings                                                                                                                                                                         |       | 810               |       | —                |       |
| Current portion of deferred revenues                                                                                                                                                           |       | 271               |       | 301                   |       |
| Total current liabilities                                                                                                                                                                      |       | 4,011             |       | 2,820                 |       |
|                                                                                                                                                                                           |       |              |       |                  |       |
| Deferred revenues, net of current portion                                                                                                                                                      |       | 250               |       | 375                   |       |
| Capital lease obligations, net of current  portion                                                                                                                                             |       | 49                |       | 6                     |       |
| Total liabilities                                                                                                                                                                              |       | 4,310             |       | 3,201                 |       |
|                                                                                                                                                                                           |       |              |       |                  |       |
| Commitments and contingencies (Note 7)                                                                                                                                                         |       |              |       |                  |       |
|                                                                                                                                                                                           |       |              |       |                  |       |
| Shareholders’ equity:                                                                                                                                                                     |       |              |       |                  |       |
| Preferred stock; $0.001 par value;  5,000,000 shares authorized June 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 June 30, 2008; 180,000,000 shares authorized  December 31, 2007; 6,037,643 and 5,990,915 shares issued and outstanding |       | 6                 |       | 6                     |       |
| Additional paid-in capital                                                                                                                                                                     |       | 38,103            |       | 37,223                |       |
| Accumulated other comprehensive (loss)  income                                                                                                                                                 |       | (135              | )          | 18                    |       |
| Accumulated net losses                                                                                                                                                                         |       | (11,237           | )          | (4,605                | )          |
| Total shareholders’ equity                                                                                                                                                                |       | 26,737            |       | 32,642                |       |
| Total liabilities and shareholders’ equity                                                                                                                                                |       | $                 | 31,047     |                  | $          | 35,843 |   |

** **

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

 

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**COMBIMATRIXCORPORATION**

**CONSOLIDATED STATEMENTS OF OPERATIONS**

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

**(Unaudited)**

** **
| ** **                                                    | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|---------------------------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                                                    | ** ** | **June 30,**                | ** ** | **June 30,**              | ** ** |
| ** **                                                    | ** ** | **2008**                         | ** ** | **2007**                       | ** ** | **2008** | ** ** | **2007** | ** ** |
|                                                          |       |                             |       |                           |       |   |   |   |   |
| Revenues:                                                     |       |                             |       |                           |       |   |   |   |   |
| Government contracts                                          |       | $                                | 968        |                           | $          | 679 |   | $ | 2,037 |   | $ | 1,228 |   |
| Products                                                      |       | 597                              |       | 458                            |       | 1,152 |   | 898 |   |
| Services                                                      |       | 440                              |       | 137                            |       | 743 |   | 222 |   |
| Collaboration agreements                                      |       | 62                               |       | 62                             |       | 124 |   | 125 |   |
| Total revenues                                                |       | 2,067                            |       | 1,336                          |       | 4,056 |   | 2,473 |   |
|                                                          |       |                             |       |                           |       |   |   |   |   |
| Operating expenses:                                           |       |                             |       |                           |       |   |   |   |   |
| Cost of government contract revenues                          |       | 955                              |       | 641                            |       | 1,969 |   | 1,175 |   |
| Cost of products and services                                 |       | 507                              |       | 248                            |       | 934 |   | 551 |   |
| Research and development expenses                             |       | 890                              |       | 1,102                          |       | 2,213 |   | 2,950 |   |
| Marketing, general and administrative  expenses               |       | 2,397                            |       | 2,304                          |       | 4,480 |   | 4,789 |   |
| Patent amortization and royalties                             |       | 361                              |       | 344                            |       | 722 |   | 662 |   |
| Equity in loss of investees                                   |       | 241                              |       | 250                            |       | 490 |   | 522 |   |
| Total operating expenses                                      |       | 5,351                            |       | 4,889                          |       | 10,808 |   | 10,649 |   |
| Operating loss                                                |       | (3,284                           | )          | (3,553                         | )          | (6,752 | ) | (8,176 | ) |
|                                                          |       |                             |       |                           |       |   |   |   |   |
| Other income (expense):                                       |       |                             |       |                           |       |   |   |   |   |
| Interest income                                               |       | 25                               |       | 131                            |       | 125 |   | 281 |   |
| Interest expense                                              |       | (4                               | )          | —                         |       | (5 | ) | — |   |
| Warrant (charges) gains                                       |       | —                           |       | (145                           | )          | — |   | 2,233 |   |
| Total other income                                            |       | 21                               |       | (14                            | )          | 120 |   | 2,514 |   |
| Net loss                                                      |       | $                                | (3,263     | )                              | $          | (3,567 | ) | $ | (6,632 | ) | $ | (5,662 | ) |
|                                                          |       |                             |       |                           |       |   |   |   |   |
| Basic and diluted net loss per share                          |       | $                                | (0.54      | )                              |       |   | $ | (1.10 | ) |   |   |
|                                                          |       |                             |       |                           |       |   |   |   |   |
| Basic and diluted weighted average common  shares outstanding |       | 6,025,844                        |       |                           |       | 6,011,465 |   |   |   |

** **

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

 

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**COMBIMATRIXCORPORATION**

**CONSOLIDATED STATEMENTS OF CASH FLOWS**

**(Inthousands)**

**(Unaudited)**

** **
| ** **                                                                   | ** ** | **Six Months Ended** | ** ** |
|------------------------------------------------------------------------------|------------|--------------------------------|------------|
| ** **                                                                   | ** ** | **June 30,**              | ** ** |
| ** **                                                                   | ** ** | **2008**                       | ** ** | **2007** | ** ** |
|                                                                         |       |                           |       |   |   |
| Operating activities:                                                        |       |                           |       |   |   |
| Net loss                                                                     |       | $                              | (6,632     | ) | $ | (5,662 | ) |
| Adjustments to reconcile net loss to net  cash used in operating activities: |       |                           |       |   |   |
| Depreciation and amortization                                                |       | 908                            |       | 947 |   |
| Non-cash stock compensation                                                  |       | 769                            |       | 736 |   |
| Warrant gains                                                                |       | —                         |       | (2,233 | ) |
| Equity in loss of investees                                                  |       | 490                            |       | 522 |   |
| Allowance for bad debt                                                       |       | 84                             |       | 225 |   |
| Equity issued to consultant                                                  |       | —                         |       | 209 |   |
| Other                                                                        |       | —                         |       | 27 |   |
| Changes in assets and liabilities:                                           |       |                           |       |   |   |
| Accounts receivable                                                          |       | (898                           | )          | (101 | ) |
| Inventory, prepaid expenses and other  assets                                |       | (162                           | )          | (98 | ) |
| Accounts payable, accrued expenses and  other                                |       | 405                            |       | (1,286 | ) |
| Deferred revenues                                                            |       | (155                           | )          | (176 | ) |
| Net cash used in operating activities                                        |       | (5,191                         | )          | (6,890 | ) |
|                                                                         |       |                           |       |   |   |
| Investing activities:                                                        |       |                           |       |   |   |
| Purchases of property and equipment                                          |       | (42                            | )          | (69 | ) |
| Purchases of available-for-sale investments                                  |       | —                         |       | (4,980 | ) |
| Sales of available-for-sale investments                                      |       | 4,030                          |       | 1,089 |   |
| Net cash provided by (used in) investing  activities                         |       | 3,988                          |       | (3,960 | ) |
|                                                                         |       |                           |       |   |   |
| Financing activities:                                                        |       |                           |       |   |   |
| Net proceeds from issuance of common stock                                   |       | 111                            |       | — |   |
| Net proceeds from credit line borrowings                                     |       | 808                            |       | — |   |
| Repayment of capital lease obligations                                       |       | (14                            | )          | — |   |
| Net cash flows transferred from Acacia  Research Corporation                 |       | —                         |       | 5,404 |   |
| Net cash provided by financing activities                                    |       | 905                            |       | 5,404 |   |
|                                                                         |       |                           |       |   |   |
| Decrease in cash and cash equivalents                                        |       | (298                           | )          | (5,446 | ) |
|                                                                         |       |                           |       |   |   |
| Cash and cash equivalents, beginning                                         |       | 2,314                          |       | 7,829 |   |
|                                                                         |       |                           |       |   |   |
| Cash and cash equivalents, ending                                            |       | $                              | 2,016      |   | $ | 2,383 |   |

** **

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

 

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**COMBIMATRIXCORPORATION**

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS (CONTINUED)**

**(Unaudited)**

 

****1.********             ********OVERVIEW ANDBACKGROUND****

 

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 subsidiary ofAcacia 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 of the Company*****

 

We are a diversifiedbiotechnology 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,combinatorial chemistry, material sciences and nanotechnology.  We have also developed the capabilities ofproducing arrays that utilize bacterial artificial chromosomes on our arrays,also enabling 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.

 

CombiMatrix MolecularDiagnostics, Inc. (“CMDX”), our wholly owned subsidiary located in Irvine,California, has developed capabilities of producing arrays that utilizebacterial artificial chromosomes, which also enable genetic analysis.  CMDX functions primarily as a diagnosticsreference laboratory.

 

*****Basis of Presentation*****

 

Through the RedemptionDate, the consolidated financial statements include allocations of certainAcacia corporate expenses, including governance, legal, accounting, insuranceservices, management of treasury and other Acacia corporate and infrastructurecosts.  The expense allocations weredetermined on bases that Acacia and the Company considered to be a reasonablereflection of the utilization of services provided or the benefit received byus.  However, the financial informationincluded herein may not reflect the consolidated financial position, operatingresults, changes in shareholders’ equity and cash flows of the Company in thefuture or what they would have been had we been a separate, stand-alone entityduring the periods presented.  Acaciaceased allocating overhead charges to us following the Redemption Date.  For the three and six months ended June 30,2007, corporate expenses totaling $31,000 and $87,000, respectively, wereallocated to us by Acacia.

 

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** **

**COMBIMATRIXCORPORATION**

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS (CONTINUED)**

**(Unaudited)**

 

Theaccompanying consolidated financial statements have been prepared in accordancewith generally accepted accounting principles for interim financial informationand with 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 June 30,2008, and results of operations and cash flows for the interim periodspresented.  The results of operations forthe three and six months ended June 30, 2008, are not necessarilyindicative of the results to be expected for the entire year.

 

*****Liquidity and Risks*****

 

We have a history ofincurring net losses and net operating cash flow deficits.  We are also deploying new and unproventechnologies and continue to develop commercial products. We have severalongoing long-term development projects that involve experimental technology andmay require several years and substantial expenditures to complete.  Based on our cash and investment balances asof December 31, 2007, we believed that our cash and cash equivalentbalances, anticipated cash flows from operations and other external sources ofavailable credit would be sufficient to meet our cash requirements through September 30,2008, which raised substantial doubt about our ability to continue as a goingconcern beyond this point.  See Note 3below regarding additional liquidity risks due to certain of ouravailable-for-sale investments held in auction rate securities (“ARS”) as of December 31,2007 and June 30, 2008.  See Notes 5and 8 below regarding recent financing developments.

 

We will continue torequire capital from external sources, and there can be no assurances thatadditional sources of financing, including the issuance of debt and/or equitysecurities will be available at times and at terms acceptable to us.  The issuance of equity securities will also causedilution to our shareholders.  Ifexternal sources of financing are not available or are inadequate to fund ouroperations, we will be required to reduce operating costs including researchprojects and personnel, which could jeopardize the future strategic initiativesand business plans of the Company.  Forexample, reductions in research and development activities and/or personnel atour Mukilteo, Washington facility could result in the inability to invest the resourcesnecessary to continue to develop next-generation products and improve existingproduct lines in order to remain competitive in the marketplace, resulting inreduced revenues and cash flows from the sales of our CustomArrayTMproducts and services.  Also, reductionin operating 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.

 

Ourbusiness operations are also subject to certain risks and uncertainties,including:

 

·                  market acceptance of products and services;

 

·                  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 restrict ourbusiness.

 

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**COMBIMATRIXCORPORATION**

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS (CONTINUED)**

**(Unaudited)**

 

Historically, we havebeen dependent on arrangements with strategic partners and have relied uponpayments by our partners for a significant component of our workingcapital.  We intend to enter intoadditional strategic partnerships to develop and commercialize futureproducts.  However, there can be noassurance that we will be able to implement our future plans.  Failure 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.

 

Our products and servicesare concentrated in a highly competitive market that is characterized by rapidtechnological advances, frequent changes in customer requirements and evolvingregulatory requirements and industry standards. Failure to anticipate or respond adequately to technological advances,changes in customer requirements, changes in regulatory requirements orindustry standards, or any significant delays in the development orintroduction of planned products or services, could have a material adverseeffect on our business and operating results. The accompanying consolidated financial statements have been preparedassuming that the Company continues as a going concern.  The financial statements do not include anyadjustments to reflect the possible future effects on the recoverability andclassification of assets or the amounts and classification of liabilities thatmay result from the matters discussed herein.

 

In addition to seekingadditional capital from outside sources, our plans in regard to these mattersinclude reductions in overhead costs as well as research and development coststhat are not considered strategically vital to our business.  Also, we are focusing our sales and productdevelopment efforts on our core diagnostic array platform as well as our fundedresearch and development projects for the DoD.

 

****2.********             ********SUMMARY OFSIGNIFICANT 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 expenses are recognized in the period thatwork is performed based on the percentage of actual incurred costs to total estimatedcontract costs.  Actual contract costsinclude direct charges for labor and materials and indirect charges for labor,overhead and certain general and administrative charges.  Contract change orders and claims areincluded when they can be reliably estimated and are considered probable.  For contracts that extend over a one-yearperiod, revisions in contract cost estimates, if they occur, have the effect ofadjusting current period earnings applicable to performance in priorperiods.  Should current contractestimates indicate an overall future loss to be incurred, a provision is madefor the total anticipated loss in the current period.  Historically, contract revenue recognizedapproximates the amounts invoiced, resulting in no estimated costs and earningsin excess of billings or billings in excess of estimated costs and earnings.

 

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**COMBIMATRIXCORPORATION**

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS (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 toend-users.  Our standard agreements donot provide for credits, returns or exchanges with our customers ordistributors.  Our distributionagreements include fixed pricing arrangements for our products and aftercustomer acceptance, there is no written or implied right to return or exchangethe 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 compensation expense for all periods presentedattributable to our functional expense categories were as follows (in thousands;unaudited):

 
| ** **                            | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|---------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                            | ** ** | **June 30,**                | ** ** | **June 30,**              | ** ** |
| ** **                            | ** ** | **2008**                         | ** ** | **2007**                       | ** ** | **2008** | ** ** | **2007** | ** ** |
| ** **                            | ** ** | ** **                       | ** ** | ** **                     | ** ** | ** ** | ** ** | ** ** | ** ** |
| Cost of product sales                 |       | $                                | 29         |                           | $          | — |   | $ | 57 |   | $ | — |   |
| Research and development              |       | 48                               |       | 144                            |       | 94 |   | 402 |   |
| Marketing, general and administrative |       | 331                              |       | 117                            |       | 618 |   | 334 |   |
| Total non-cash stock compensation     |       | $                                | 408        |                           | $          | 261 |   | $ | 769 |   | $ | 736 |   |

 

**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 amaterial impact on our consolidated financial position, results of operationsor cash flows.

 

**NetLoss Per Share**. As discussed in Note 1, we were a wholly owned subsidiary of Acacia andhad 100 shares of common stock outstanding for all periods presented prior tothe Redemption Date.  Therefore,historical net loss per share for the periods prior to the Redemption Date havenot been presented in the consolidated financial statements as this informationis not considered meaningful.  Net lossper share has only been presented for the current financial periods in order toreflect our capital structure subsequent to the Redemption Date.

 

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**COMBIMATRIXCORPORATION**

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS (CONTINUED)**

**(Unaudited)**

 

Basicand diluted net loss per share subsequent to the Redemption Date has beencomputed by dividing the net loss by the weighted average number of commonshares issued and outstanding during the period.  Options and warrants to purchase CombiMatrixstock are anti-dilutive and therefore are not included in the determination ofthe diluted net loss per share.  Thefollowing table presents a reconciliation of basic and diluted loss per sharefor the three and six months ended June 30, 2008 (in thousands, exceptshare and per-share data; unaudited):

 

| ** **                                 | ** ** | **Three Months**       | ** ** | **Six Months**         | ** ** |
|--------------------------------------------|------------|-----------------------------|------------|-----------------------------|------------|
| ** **                                 | ** ** | **Ended**                   | ** ** | **Ended**                   | ** ** |
| ** **                                 | ** ** | **June 30, 2008** | ** ** | **June 30, 2008** | ** ** |
| Numerator:                                 |       |                        |       |                        |       |
| Loss applicable to common shareholders     |       | $                           | (3,263     | )                           | $          | (6,632 | ) |
| Denominator:                               |       |                        |       |                        |       |
| Weighted-average common shares outstanding |       | 6,025,844                   |       | 6,011,465                   |       |
| Basic and diluted loss per share           |       | $                           | (0.54      | )                           | $          | (1.10 | ) |
|                                       |       |                        |       |                        |       |
| Common stock options                       |       | 1,010,229                   |       | 1,010,229                   |       |
| Common stock warrants                      |       | 2,305,274                   |       | 2,305,274                   |       |
| Excluded potentially dilutive securities   |       | 3,315,503                   |       | 3,315,503                   |       |

 

**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 are classified as available-for-sale, which are reportedat fair value with related unrealized gains and losses in the value of suchsecurities recorded as a component of accumulated other comprehensive incomeuntil realized.  The fair value of our available-for-saleinvestments was determined by quoted market prices at December 31, 2007and in accordance with SFAS No. 157 (see “Fair Value Measurements” belowand in Note 3) subsequent to year-end. We account for investments with fair values less than historical cost inaccordance with FASB Staff Position 115-1, “The Meaning of Other-Than-TemporaryImpairment and Its Application to Certain Investments” (“FSP 115-1”).  Under FSP 115-1, an impairment is deemedother than temporary based on a variety of factors including:  (a) the duration and severity of theimpairment; (b) the ability and intent to hold an investment for a periodof time sufficient for recovery of its carrying amount; and (c) thefinancial condition of the issuer.  Allavailable evidence, both positive and negative, is considered to determinewhether the carrying amount of the investment is recoverable within areasonable period of time.  In general,management does not consider an investment impairment to beother-than-temporary if the duration and amount of the impairment is less thantwelve months and five percent of the historical cost of the investment,respectively.

 

*****Fair Value Measurements. *****We adopted SFAS No. 157, “Fair ValueMeasurements” (“SFAS 157”), which applies to certain accounting standards thatrequire or permit fair value measurements, on January 1, 2008.  The adoption of SFAS 157 did not have amaterial impact on our consolidated financial statements.  In February 2008, the FASB issued astaff position that delays the effective date of SFAS 157 for all non-financialassets and liabilities, except those recognized or disclosed at leastannually.  Therefore, we have adopted theprovision of SFAS 157 with respect to financial assets and liabilities only.

 

SFAS 157 defines fair value, establishes aconsistent framework for measuring fair value and expands disclosures for eachmajor asset and liability category measured at fair value on either a recurringor nonrecurring basis.  SFAS 157 clarifiesthat fair value is an exit price, representing the amount that would bereceived to sell an asset or paid to transfer a liability in an orderlytransaction between market participants. As such, fair value is a market-based measurement that should bedetermined based on assumptions that market participants would use in pricingan asset or liability.  As a basis forconsidering such assumptions, SFAS 157 establishes a three-tier fair valuehierarchy, which prioritizes the inputs used in measuring fair value asfollows:

 

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**COMBIMATRIXCORPORATION**

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS (CONTINUED)**

**(Unaudited)**

 
| · |   | Level 1: |   | Observable market inputs such as quoted prices in active markets;                                                                 |
|--------|--------|----------|--------|-----------------------------------------------------------------------------------------------------------------------------------|
|   |   |     |   |                                                                                                                              |
| · |   | Level 2: |   | Observable market inputs, other than the quoted prices in active  markets, that are observable either directly or indirectly; and |
|   |   |     |   |                                                                                                                              |
| · |   | Level 3: |   | Unobservable inputs where there is little or no market data, which  require the reporting entity to develop its own assumptions.  |

 

We adopted SFAS No. 159, “The Fair Value Optionfor Financial Assets and Financial Liabilities,” which provides entities theoption to measure many financial instruments and certain other items at fairvalue.  We have currently chosen not toelect the fair value option for any items that are not already required to bemeasured at fair value in accordance with generally accepted accountingprinciples.

 

*****Recent Accounting Pronouncements.********* ****In March 2008, the FASB issuedSFAS No. 161, “Disclosures about Derivative Instruments and HedgingActivities, an amendment of FASB Statement No. 133” (“SFAS 161”).  SFAS 161 requires enhanced disclosures aboutan entity’s derivative instruments and hedging activities including: (1) howand why an entity uses derivative instruments; (2) how derivativeinstruments and related hedged items are accounted for under SFAS 133 andits related interpretations; and (3) how derivative instruments andrelated hedged items affect an entity’s financial position, financialperformance, and cash flows. SFAS 161 is effective for financial statements issued for fiscalyears and interim periods beginning after November 15, 2008, with earlierapplication encouraged.  We do notbelieve the implementation of SFAS 161 will have a material effect on ourconsolidated financial position, results of operations and cash flows.

 

In May 2008, the FASB issued FASB FSPAccounting Principles Board (“APB”) 14-1, “Accounting for Convertible DebtInstruments That May Be Settled in Cash upon Conversion (Including PartialCash Settlement).” FSP APB 14-1 applies to convertible debt instruments that,by their stated terms, may be settled in cash (or other assets) uponconversion, including partial cash settlement of the conversion option.  FSP APB 14-1 requires bifurcation of theinstrument into a debt component that is initially recorded at fair value andan equity component.  The differencebetween the fair value of the debt component and the initial proceeds fromissuance of the instrument is recorded as a component of equity.  The liability component of the debtinstrument is accreted to par using the effective yield method; accretion isreported 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. Though we do not believe FSP APB 14-1 will have an effect on our currentfinancial position, we are currently evaluating the requirements of FSP APB14-1 with respect to our recent convertible debt financing (see Note 8 below)and have not yet determined the impact on our consolidated financialstatements.

 

In June 2008, the FASB issued FSP EITF 03-6-1, “DeterminingWhether Instruments Granted in Share-Based Payment Transactions AreParticipating Securities.” FSP EITF 03-6-1 provides that unvested share-basedpayment awards that contain nonforfeitable rights to dividends or dividend equivalents(whether paid or unpaid) are participating securities and shall be included inthe computation of earnings per share pursuant to the two-class method.  FSP ETIF 03-6-1 is effective for fiscal yearsbeginning after December 15, 2008, and interim periods within thoseyears.  Upon adoption, a company isrequired to retrospectively adjust its earnings per share data (including anyamounts related to interim periods, summaries of earnings and selectedfinancial data) to conform with the provisions of FSP EITF 03-6-1.  We do not believe the implementation of FSPEITF 03-6-1 will have a material effect on our consolidated financial position,results of operations and cash flows.

 

# **3.**              FAIR VALUE

 

The following table summarizes, for each majorcategory of assets or liabilities, the respective fair value at June 30,2008 and the classification by level of input within the fair value hierarchydefined in SFAS 157 (in thousands, unaudited):

 

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**COMBIMATRIXCORPORATION**

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS (CONTINUED)**

**(Unaudited)**

 
| ** **                     | ** ** | **June 30,** | ** ** | **Fair Value Measurements at  June 30, 2008 Using:** | ** ** |
|--------------------------------|------------|-------------------|------------|------------------------------------------------------------------------------------|------------|
| ** **                     | ** ** | **2008**          | ** ** | **Level 1**                                                                   | ** ** | **Level 2** | ** ** | **Level 3** | ** ** |
| Assets:                        |       |              |       |                                                                               |       |   |   |   |   |
| Cash equivalents               |       | $                 | 1,539      |                                                                               | $          | 1,539 |   | $ | — |   | $ | — |   |
| Available-for-sale investments |       | 1,740             |       | —                                                                             |       | — |   | 1,740 |   |
| Total                          |       | $                 | 3,279      |                                                                               | $          | 1,539 |   | $ | — |   | $ | 1,740 |   |

 

The following table is a reconciliation of financialassets measured at fair value using significant unobservable inputs (Level 3)during the six months ended June 30, 2008 (in thousands, unaudited):

 

| ** **                    | ** ** | **June 30,** | ** ** |
|-------------------------------|------------|-------------------|------------|
| ** **                    | ** ** | **2008**          | ** ** |
|                          |       |              |       |
| Balance, January 1, 2008 |       | $                 | —     |   |
| Transfers of ARS to Level 3   |       | 3,375             |       |
| Purchases and sales of ARS    |       | (1,500            | )          |
| Unrealized losses             |       | (135              | )          |
| Balance, June 30, 2008   |       | $                 | 1,740      |   |

 

At June 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 June 30, 2008, $900,000 are issued by astate student-loan lending organization, carry an A2/A rating and are insuredby the Federal Family Education Loan Program. The remaining $975,000 of ARS are AAA-rated auction market preferredstock issued by publicly traded mutual funds that are required to maintain atleast 200% of asset coverage for issued ARS. All of our ARS continue to pay interest at the maximum contractual rate,which currently exceeds market interest rates for short-term securities.

 

At June 30, 2008, the fair values of our ARSwere 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 $66,000 and $135,000 for the three andsix months ended June 30, 2008, respectively, which is reflected inaccumulated other comprehensive (loss) income in our June 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 $782,000 as a non-currentinvestment in our June 30, 2008 consolidated balance sheet.

 

We continue to monitor the market for ARS and considerits impact (if any) on the fair value of our investments.  If the current market conditions deterioratefurther, or the anticipated recovery in fair values does not occur, we may berequired to record additional unrealized losses in other comprehensive (loss)income or realized losses for other-than-temporary impairment charges in futureperiods.

 

# **4.**              COMPREHENSIVE LOSS

 

Prior to the Redemption Date, comprehensive loss was included as acomponent of net allocations from Acacia and was not separately reported in ourconsolidated financial statements.  Thefollowing table shows our comprehensive net loss in accordance with SFAS No. 130,“Reporting Comprehensive Income,” subsequent to the Redemption Date (inthousands; unaudited):

 

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**COMBIMATRIXCORPORATION**

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

**(Unaudited)**

 
| ** **                                             | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|--------------------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                                             | ** ** | **June 30, 2008**      | ** ** | **June 30, 2008**    | ** ** |
| ** **                                             | ** ** | ** **                       | ** ** | ** **                     | ** ** |
| Net unrealized loss on available-for-sale  investments |       | $                                | (66        | )                              | $          | (135 | ) |
| Net loss                                               |       | (3,263                           | )          | (6,632                         | )          |
| Comprehensive loss                                     |       | $                                | (3,329     | )                              | $          | (6,767 | ) |

 

# **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 $807,500 from the Lender, secured by our current holdings inARS.  The LMA is similar to a revolvingline of credit borrowing facility.  TheLMA provides that we are to pay monthly interest-only payments at an annual,variable rate of 1% plus the 30-day LIBOR rate (resulting in a rate of 3.47% atJune 30, 2008).  The total amountavailable under the LMA ranges from 50% to 92% of investments pledged ascollateral, based upon the amount and security type, up to a maximum amount of$2.8 million.  However, based on theamount and type of securities currently held by us with the financial institution,the maximum borrowing ceiling is currently limited to $807,500.  The LMA has no stated maturity for theprincipal amount borrowed by us. However, because Lender has the ability under the terms of the LMA tocall in the principal amount of the borrowings at any time, we have classifiedthis liability as a component of current liabilities in the accompanying June 30,2008 consolidated balance sheet.

 

# **6.**              COMMON STOCK 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 Ratiodiscussed above.

 

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

 
| ** **                  | ** ** | **Number of Warrants Outstanding** | ** ** | ** **            | ** ** | ** **     | ** ** |
|-----------------------------|------------|---------------------------------------------------|------------|-----------------------|------------|----------------|------------|
| ** **                  | ** ** | **June 30,**                                 | ** ** | **December 31,** | ** ** | **Exercise**   | ** ** | ** ** | ** ** |
| **Date of Issue** | ** ** | **2008**                                          | ** ** | **2007**              | ** ** | **Price**      | ** ** | **Expiration** | ** ** |
| ** **                  | ** ** | **(unaudited)**                                   | ** ** | ** **            | ** ** | ** **     | ** ** | ** ** | ** ** |
| ** **                  | ** ** | ** **                                        | ** ** | ** **            | ** ** | ** **     | ** ** | ** ** | ** ** |
| May 2007               |       | 966,890                                           |       | 1,017,140             |       | $5.50          |       | May 2012 |   |
| December 2006          |       | 1,178,736                                         |       | 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                       |       | 2,305,274                                         |       | 2,383,865             |       |           |       |   |   |

 

Acacia’s classes ofcommon stock were subject to certain redemption provisions in the event thatAcacia were to sell, transfer, assign or otherwise dispose of, in onetransaction or a series of related transactions, all or substantially all ofthe 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, 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 six months ended June 30,2007, adjusting the warrant liabilities to their fair values resulted in netwarrant (charges) gains of $(145,000) and $2.2 million, respectively, to ourconsolidated statements of operations.  We have not incurredwarrant gains or charges since the Redemption Date from our existing warrantsas a result of achieving permanent equity classification as of the RedemptionDate.

 

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**COMBIMATRIXCORPORATION**

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS (CONTINUED)**

**(Unaudited)**

 

The fair value ofAR-CombiMatrix stock purchase warrants at June 30, 2007 was determinedusing the Black-Scholes option-pricing model, using weighted-averageassumptions as follows (unaudited):

 

| ** **              | ** ** | **June 30,** | ** ** |
|-------------------------|------------|-------------------|------------|
| ** **              | ** ** | **2007**          | ** ** |
| ** **              | ** ** | ** **        | ** ** |
| Risk free interest rate |       | 4.90              | %          |
| Volatility              |       | 80                | %          |
| Expected term           |       | 4.5 years         |       |
| Expected dividends      |       | 0                 | %          |

 

**7.**              COMMITMENTS ANDCONTINGENCIES

 

**Collaboration andResearch Agreements**

 

On July 26, 2007, we executed aone-year, $2.2 million contract with the DoD to further development of ourmicroarray technologies.  The primaryobjectives of the contract are to continue development of a multipathogen andchemical detection system.  Under theterms 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 these obligations, plus a fixed fee, of up to $2.2 million.  As of June 30, 2008, we had incurred$1.6 million in actual contract costs for the chemical detection contract,which was 96% complete.

 

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 will perform research and development activities, asdescribed under the contract, and will be 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 incursignificant costs or revenues from this contract beyond June 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 June 30,2008, we had incurred $1.3 million in actual costs for the microfluidicscontract, which was approximately 90% complete.

 

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 was reimbursed on a periodic basis for actual costs incurred to perform ourobligations, 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**

 

Weprovide certain severance benefits such that if an executive who is a vicepresident or higher is terminated for other than cause, death or disability,the executive will receive payments equal to three months’ base salary plusmedical and dental benefits.  Iftermination occurs as a result of a change in control transaction, thesebenefits will be extended by three months.

 

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**COMBIMATRIXCORPORATION**

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS (CONTINUED)**

**(Unaudited)**

 

**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 of $1.5million.  The minimum quarterly paymentsunder the settlement agreement are $25,000 per quarter until the patents expirein 2018.  Royalty expenses recognizedunder the agreement for the three and six months ended June 30, 2008 and2007 were $48,000, $91,000, $45,000 and $70,000, respectively, and are includedin patent amortization and royalties in the accompanying consolidatedstatements of operations.

 

In July 2007,Mr. Jeffrey Oster, a former employee of the Company, filed a complaintagainst CombiMatrix and others alleging that Mr. Oster’s employment withus was terminated in violation of federal law and was a breach of hisemployment contract.  Mr. Oster’scomplaint requested damages for back pay, front pay in lieu of reinstatementunder his employment agreement, damages for adverse tax consequences, andattorney’s fees and costs.  We filedcounterclaims against Mr. Oster for breach of employment contract, breachof common law duties of loyalty and confidentiality, and misappropriation oftrade secrets, with a demand for unspecified damages.  Although we believe Mr. Oster’s claimsare without merit, we executed a settlement agreement with Mr. Oster in June 2008,thereby ending the lawsuit by releasing all claims and counterclaims.  We did not incur a financial obligation as aresult of executing the settlement.

 

In September of2005, Ms. Jennifer Dent and Mr. Michael Strathmann (a marriedcouple), who are both former employees of the Company, filed a complaintagainst the Company asserting claims arising out of the resignation of theiremployment with CombiMatrix and were seeking alleged unpaid bonuses and salescommissions.  They also raised other claimsregarding certain intellectual property rights. We believe that these claims are without merit and have vigorouslydefended against them.  We assertedintellectual property counterclaims against Mr. Strathmann and asked forcertain injunctive relief and damages based on those counterclaims.  A trial was held and concluded at the KingCounty Superior Court of Washington (the “State Court”) during the firstquarter of 2008.  The State Court issuedfindings and conclusions in May 2008 in which the State Court found thatCombiMatrix did not owe plaintiffs any monetary damages.  The State Court found that Mr. Strathmannheld certain intellectual property rights; however, we believe that thoserights do not materially impact our intellectual property portfolio or freedomto operate with respect to our current and planned products and services.  The findings and conclusions are subject topost-trial motions, which will likely be concluded during the third quarter of2008.  After final judgment, which willlikely be entered by the end of October 2008, both parties will have anopportunity to appeal.

 

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 insurance carrier,National Union Fire Ins. Co. of Pittsburgh, PA (“National Union”), seekingreimbursement of litigation and settlement costs for a lawsuit, pursuant to ourdirectors’ and officers’ insurance policy with National Union.  A trial was held and concluded during thefourth quarter of 2007.  In March 2008,the Federal Court issued a judgment (the “Judgment”) in favor of Acacia and us,and awarded approximately $32.1 million in monetary damages to be paid byNational Union.  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 the Judgment to the U.S. Ninth CircuitCourt of Appeals, and we intend to vigorously defend against the appeal.

 

**8.****             ****SUBSEQUENT EVENTS**

 

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 at a 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 or within four monthsafter our receipt of payment from National Union in accordance with the $35.7million Judgment issued by the Federal Court. The Debenture bears interest at an annual rate of 10%, with interestpayments due quarterly beginning October 2008.

 

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**COMBIMATRIXCORPORATION**

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS (CONTINUED)**

**(Unaudited)**

 

Thenumber of shares issuable upon conversion of the Debenture may increase due tocertain anti-dilution adjustments, including if we issue common stock at aprice lower than the $11.87 conversion price while the outstanding principalamount of the Debenture is at least $5 million, or if we fail to generate atleast $6 million in gross revenues for our fiscal year ended December 31,2008 (subject to adjustment in the event we sell or dispose of a division orline of business).  The Debenture is secured by the Judgment aswell as our intellectual property.  Wehave the right to force conversion of the Debenture upon meeting certaintrading conditions of our stock.  TheWarrants have a five-year term and allow YA to purchase: (i) 168,492shares of common stock at an exercise price of $11.87; and (ii) 168,492shares of common stock at an exercise price of $13.65.  We have the right to call the Warrants uponmeeting certain trading conditions of our common stock.  On July 23, 2008, we filed a resaleregistration statement on Form S-3 with the SEC to register the 1,179,444shares of our common stock that are issuable to YA upon conversion of theDebenture and exercise of the Warrants, as required by certain agreements withYA that we executed in connection with this transaction.  This registration statement was declaredeffective on August 4, 2008.

 

On July 11, 2008, the DoD awarded us afifteen-month, $923,000 contract 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, to continue the integration of serological and genomic assays fororthogonal testing and to explore new methods of detection that expand targetidentification, 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.

 

On July 31, 2008, the DoD awarded us asix-month, $250,000 contract for the development of label-free detectiontechniques using our microarray technology.  Thesedetection techniques involve the synthesis of molecules known as “aptamers,”which are molecules with unique biological properties.  Synthesisof aptamers followed by iterative evolution of these molecules, coupled withour electrochemical detection techniques, could enable powerful, label-freedetection systems that could revolutionize analysis applications such asdiagnostics, chemical measurement, biological and chemical agent detection, andothers.

 

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**Item2.    MANAGEMENT’S DISCUSSION AND ANALYSISOF FINANCIAL CONDITION AND RESULTS OF OPERATIONS**

 

**Cautionary Statement**

 

You should read the following discussion and analysis inconjunction with the consolidated financial statements and related notesthereto contained in Part I, Item 1 of 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 carefully review and consider the variousdisclosures made by us in this report and in our other reports filed with theU.S. Securities and Exchange Commission, or SEC, including our Annual Report onForm 10-K, filed on March 19, 2008.

 

This report contains forward-looking statements within themeaning of the “safe harbor” provisions of the Private Securities LitigationReform Act of 1995. Reference is made in particular to the description of ourplans and objectives for future operations, assumptions underlying such plansand objectives, and other forward-looking statements included in this report.Such statements may be identified by the use of forward-looking terminologysuch as “may,” “will,” “expect,” “believe,” “estimate,” “anticipate,” “intend,”“continue,” or similar terms, variations of such terms or the negative of suchterms. Such statements are based on management’s current expectations and aresubject to a number of factors and uncertainties, which could cause actualresults to differ materially from those described in the forward-lookingstatements. Such statements address future events and conditions concerningproduct development, capital expenditures, earnings, litigation, regulatorymatters, markets for products and services, liquidity and capital resources andaccounting matters. Actual results in each case could differ materially fromthose anticipated in such statements by reason of factors such as futureeconomic conditions, changes in consumer demand, legislative, regulatory andcompetitive developments in markets in which we and our subsidiaries operate,results of litigation and other circumstances affecting anticipated revenuesand costs. We expressly disclaim any obligation or undertaking to releasepublicly any updates or revisions to any forward-looking statements containedherein to reflect any change in our expectations with regard thereto or anychange in events, conditions or circumstances on which any such statement isbased. Additional factors that could cause such results to differ materiallyfrom those described in the forward-looking statements are set forth inconnection with the forward-looking statements and in the “Risk Factors”described in our Annual Report on Form 10-K filed on March 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 technologies we have developed include aplatform technology to rapidly produce oligonucleotide arrays for use inidentifying and determining the roles of genes, gene mutations andproteins.  We make the arrays using ourpatented in situ electrochemical synthesis process, which provides the abilityto easily change array content to stay current with new developments and tomeet the evolving needs of our customers. This technology has a wide range of potential applications in the areasof 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 (“DoD”) andother 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.

 

## **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 separatelythe performance of CombiMatrix Corporation and its subsidiaries, referred to asthe******“CombiMatrix group****,**” whereas theAR-Acacia Technologies stock was intended to reflect separately the performanceof Acacia’s technology business, referred to as “**Acacia Technologies group**.”

 

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In December 2006,we filed a registration statement on Form S-1 with the U.S. Securities andExchange Commission (the “SEC”) to register our common stock in order to affecta split off of our Company from Acacia by redeeming shares of existingAR-CombiMatrix common stock with our common stock.  The Form S-1 was declared effective bythe SEC on June 8, 2007 and on August 15, 2007 (the “Redemption Date”),each one share of our common stock was issued in exchange for every ten sharesAR-CombiMatrix common issued and outstanding on August 15, 2007 (the “RedemptionRatio”).  Also, warrants to purchaseAR-CombiMatrix stock became exercisable to purchase CombiMatrix common stock,adjusted for the Redemption Ratio.  As ofthe Redemption Date, we ceased to be a subsidiary or an affiliate of Acacia,and the holders of AR-CombiMatrix became the stockholders of our company.  Our common stock currently trades on theNasdaq Global Market under the symbol “CBMX.”

 

## **Liquidity**

 

At December 31,2007, we had cash, cash equivalents and short- and long-term available-for-saleinvestments of $8.2 million.  As aresult, we anticipated that our cash, cash equivalents and anticipated cashflows from operations would be sufficient to meet our cash requirements throughSeptember 2008.  At June 30,2008, we had cash, cash equivalents and short- and long-term available-for-saleinvestments of $3.8 million.  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 securitieswill also cause dilution to our shareholders. If external financing sources are not available or are inadequate tofund our operations, we will be required to reduce operating costs includingresearch projects and personnel, which could jeopardize our future strategicinitiatives and business plans.  See theLiquidity and Capital Resources section below as well as Notes 5 and 8 to theconsolidated financial statements included elsewhere in this report foradditional discussion of these matters.

 

As of June 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 8 to theconsolidated financial statements included elsewhere in this report foradditional discussion of these matters.

 

## **Basis OfPresentation Of Financial Statements**

 

Theconsolidated financial statements included in this Form 10-Q areconsistent with our historical financial statements included in our December 31,2007 Form 10-K.  Through theRedemption Date, the consolidated financial statements included the assets,liabilities, operating results and cash flows of CombiMatrix Corporation usingAcacia’s historical bases in the assets and liabilities and the historicalresults of operations of CombiMatrix Corporation. Also, through the RedemptionDate, the consolidated financial statements included allocations of certainAcacia corporate expenses, including governance, legal, accounting, insuranceservices, treasury and other Acacia corporate and infrastructure costs.  The expense allocations were determined onbases that we determined with Acacia to be a reasonable reflection of theutilization of services provided for the benefit received by us and arediscussed in more detail below.  Sincethe Redemption Date, Acacia is no longer allocating operating expenses to us.

 

## **Overview Of RecentBusiness Activities**

 

Forthe three and six months ended June 30, 2008, our operating activitiesincluded the recognition of $2.1 million and $4.1 million in revenues,respectively, including $968,000 and $2.0 million, respectively, in governmentcontract revenues and $1.1 million and $2.1 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 general and administrative expenses,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.

 

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Significantbusiness developments that occurred during and subsequent to the second quarterended June 30, 2008 were:

 
| · |   | On April 8, 2008, CMDX launched BAC HD Scan Test for over 125  genetic abnormalities that cause developmental delay in children, including  the recently published Autism-linked markers. This test represents the  highest level of multiplexing of any diagnostic ever offered.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                |
|--------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
| · |   | On April 24, 2008, we announced that the United States District Court for the Central  District of California (the “Federal Court”) had increased the award  previously issued in favor of CombiMatrix to be paid by National Union Fire  Ins. Co. of Pittsburgh, PA, a member company of American International Group  by $3.6 million, thereby increasing the overall award to a total of $35.7  million. On May 23, 2008, we announced that the Federal Court had  entered this award as a final Judgment against National Union, which has  subsequently appealed the Judgment.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
| · |   | On May 9, 2008, we borrowed $807,500 from a commercial bank  using our ARS as collateral. See the Liquidity and Capital Resources  section below as well as Note 5 to the consolidated financial statements  included elsewhere in this report for additional discussion of this  transaction.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
| · |   | On June 4, 2008, we announced that CMDX had received results from  a multi-institute evaluation of its HemeScanTM test for CLL that  were accepted for publication by the journal, *Expert Opinions in Molecular Diagnostics* (2008) 2(6):  1-10. The study, which was led by Dr. Shelly Gunn, Medical Director of  CMDX, and which included collaborators from the prestigious M.D. Anderson  Cancer Center, Texas, the Netherlands Cancer Institute, Amsterdam, and the  University of Texas Health Science Center, San Antonio, evaluated over 170  patients with chronic lymphocytic leukemia (CLL) by the HemeScan test. The  results of the study concluded that CMDX’s HemeScan test is a powerful and  cost-effective tool for genome-wide risk assessment in the clinical  evaluation of CLL. On August 12, 2008, we announced the publication of a  validation study in the Journal of Molecular Diagnostics ((2008) 10:442-451),  which augments the previous publication and provides further support for the  superiority of HemeScan for the management of CLL patients. |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
| · |   | On June 25, 2008, we announced that we had been selected to join  the Russell Microcap Index.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
| · |   | On July 10, 2008, we raised $10 million in a financing  transaction by issuing a secured convertible debenture (the “Debenture”) and  warrants to a single institutional investor. See the Liquidity and  Capital Resources section below as well as Note 8 to the consolidated  financial statements included elsewhere in this report for additional  discussion of this transaction.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
| · |   | On July 14, 2008, we announced that we had received a new contract from the  DoD to continue development of our microarray products and technologies for  military use. The new contract was for $923,000, to be executed over a  fifteen-month period.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
| · |   | On July 22, 2008, we announced that CMDX had  launched an updated version of its ATScanTM test for  pre-disposition screening for autism. The ATScan test has been updated to  encompass recent discoveries published in the journal, *Science*, which confirmed the role of  several new genomic imbalances in the etiology of Autism Spectrum Disorder  (Morrow et al., Science, 11 July 2008, Vol 321).                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
| · |   | On August 4, 2008, we announced that we were  awarded a $250,000, six-month contract from the Defense Advanced Research  Projects Administration (or “DARPA”) for the development of label-free  detection techniques using our microarray technology.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
| · |   | On August 6, 2008, we announced that  Dr. Colin Collins, a renowned expert in prostate cancer, had joined our  scientific advisory board.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   |

 

**Critical Accounting Estimates**

 

Our unauditedinterim financial statements have been prepared in accordance with accountingprinciples generally accepted in the United States of America.  Preparation of these statements requiresmanagement to make judgments and estimates. Some accounting policies have a significant impact on amounts reportedin these financial statements.  A summaryof significant accounting policies and a description of accounting policiesthat are considered critical may be found in our Annual Report on Form 10-K,filed on March 19, 2008, in the Notes to the Consolidated FinancialStatements and the Critical Accounting Estimates section.  In addition, refer to Note 2 to theconsolidated interim financial statements included in Part I, Item 1 of this report.

 

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**Comparison of the Results of Operations for the Threeand Six Months Ended June 30, 2008 and 2007**

** **

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

** **
| ** **                           | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|--------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                           | ** ** | **June 30,**                | ** ** | **June 30,**              | ** ** |
| ** **                           | ** ** | **2008**                         | ** ** | **2007**                       | ** ** | **2008** | ** ** | **2007** | ** ** |
|                                 |       |                             |       |                           |       |   |   |   |   |
| Government contracts                 |       | $                                | 968        |                           | $          | 679 |   | $ | 2,037 |   | $ | 1,228 |   |
| Cost of government contract revenues |       | (955                             | )          | (641                           | )          | (1,969 | ) | (1,175 | ) |
| Products                             |       | 597                              |       | 458                            |       | 1,152 |   | 898 |   |
| Services                             |       | 440                              |       | 137                            |       | 743 |   | 222 |   |
| Cost of products and services        |       | (507                             | )          | (248                           | )          | (934 | ) | (551 | ) |
| Collaboration agreements             |       | 62                               |       | 62                             |       | 124 |   | 125 |   |
|                                      |            |                                  |            |                                |            |  |  |  |  |  |  |  |  |

 

**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 each reportingperiod.  Cost of government contractsreflect research and development expenses incurred in connection with ourcommitments under our current contracts with the DoD.

 

Thechanges in government contract revenues for the three and six months ended June 30,2008 versus the corresponding periods in 2007 reflect ongoing performance ofour electrochemical detection, microfluidics and influenza genotypingcontracts.  Changes in the number ofcontracts underway coupled with increases in the underlying contract activitycontributed to the overall increase for the comparable periods.  These changes in contract activity alsocontribute to the change in government contract costs during the three and sixmonths ended June 30, 2008 versus the corresponding periods in 2007.  See Note 7 to our consolidated financialstatements included elsewhere in this report for a detailed description of theamounts, completion rates and estimated costs to complete of our governmentcontracts that are ongoing as well as prior contracts that were completedduring the periods presented.  As thesecontracts near completion, future contract revenues could be volatile in theshort-term and decrease in the longer term if new government contracts are notawarded or executed.

 

**Productsand Cost of Products**. Product revenues and costs of products relate to domestic andinternational sales of our array products. For all periods presented, product revenues include the sale of DNAsynthesizer instruments, CustomArray 12K, 4X2K and 90K DNA expression arrays,ElectraSense® microarray readers and related hardware.  The increase in product revenues was dueprimarily to the increase of DNA synthesizer instrument sales for the three andsix months ended June 30, 2008 versus the corresponding periods in2007.  As we expand our business focusfrom exclusively selling array-based research and development products toproviding array-based diagnostic services, we have reduced internal salesstaff, marketing and production efforts regarding sales of CustomArray productsand instead have executed product distribution and manufacturing agreementswith various third-party distributors for the sales of our suite of CustomArrayproducts into the research and development markets.  As a result, CustomArray product revenueswill likely be volatile and could decrease in future periods, depending on thesales 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 $396,000 and $669,000 for the three and six months ended June 30,2008, as compared to $76,000 and $105,000 for the three and six months ended June 30,2007, respectively.  These revenues haveincreased for all periods presented due to an increased number of diagnostictest offerings as well as increased customer demand for our suite of diagnosticservices provided by CMDX, which is due primarily to increased sales andmarketing efforts at CMDX during the 2008 versus 2007 periods presented.

 

**Operating Expenses (In thousands)**

** **
| ** **                        | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|-----------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                        | ** ** | **June 30,**                | ** ** | **June 30,**              | ** ** |
| ** **                        | ** ** | **2008**                         | ** ** | **2007**                       | ** ** | **2008** | ** ** | **2007** | ** ** |
|                              |       |                             |       |                           |       |   |   |   |   |
| Research and development expenses |       | $                                | 890        |                           | $          | 1,102 |   | $ | 2,213 |   | $ | 2,950 |   |
|                                   |            |                                  |            |                                |            |  |  |  |  |  |  |  |  |

 

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*Research and Development Expenses*.  The decrease in internal research anddevelopment expenses for all periods presented was due primarily to the impactof cost reduction efforts in the area of full-time staff and ongoing researchand development projects for the CustomArray platform while continuing todevelop microarray-based diagnostics services. In addition, for the three and six months ended June 30, 2008 and2007, research and development expenses included $48,000, $94,000, $144,000 and$402,000, respectively, of non-cash stock compensation expense recognized underSFAS No. 123R.  See Note 2 to ourconsolidated financial statements included elsewhere in this report for adetailed description of the amounts recognized and assumptions used bymanagement in determining the stock-based compensation charges incurred for theperiods 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 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 executedwith strategic partners.

 
| ** **                                      | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|-------------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                                      | ** ** | **June 30,**                | ** ** | **June 30,**              | ** ** |
| ** **                                      | ** ** | **2008**                         | ** ** | **2007**                       | ** ** | **2008** | ** ** | **2007** | ** ** |
|                                            |       |                             |       |                           |       |   |   |   |   |
| Marketing, general and administrative  expenses |       | $                                | 2,397      |                           | $          | 2,304 |   | $ | 4,480 |   | $ | 4,789 |   |
| Patent amortization and royalties               |       | 361                              |       | 344                            |       | 722 |   | 662 |   |
| Equity in loss of of investees                  |       | 241                              |       | 250                            |       | 490 |   | 522 |   |
|                                                 |            |                                  |            |                                |            |  |  |  |  |  |  |  |  |

 

**Marketing,General and Administrative Expenses.**  The decrease in marketing, general andadministrative expenses for the six months ended June 30, 2008 versus thecorresponding periods 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 six months ended June 30, 2008 and 2007,marketing, general and administrative expenses included $331,000, $618,000,$117,000 and $334,000, 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.

### * *

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

 

**Warrant(Charges) Gains. ****Prior to the RedemptionDate and**in accordance with SFAS No. 150, “Accountingfor Certain Instruments with Characteristics of Both Liabilities and Equity,”and related interpretations, the outstanding AR-CombiMatrix stock purchasewarrants were classified as long-term liabilities due to certain redemptionprovisions associated with the underlying AR-CombiMatrix stock.  Changes in the fair value of the stockpurchase warrant liabilities were reflected in the consolidated statement ofoperations, which resulted in a net, non-cash charge of $(145,000) and abenefit of $2.2 million for the three and six months ended June 30,2007.  On the Redemption Date, alloutstanding warrants to purchase AR-CombiMatrix common stock became exercisablein CombiMatrix common stock, which is not subject to the redemption provisionsthat required liability classification of the warrants prior to the RedemptionDate.

 

**Inflation**

 

Inflationhas not had a significant impact on our Company.

 

**Liquidity and Capital Resources**

 

At June 30,2008, cash, cash equivalents and short- and long-term available-for-saleinvestments totaled $3.8 million compared to $8.2 million at December 31,2007.  Working capital at June 30,2008 was $1.4 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):

 

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| ** **                            | ** ** | **Six Months Ended** | ** ** |
|---------------------------------------|------------|--------------------------------|------------|
| ** **                            | ** ** | **June 30,**              | ** ** |
| ** **                            | ** ** | **2008**                       | ** ** | **2007** | ** ** |
| Net cash provided by (used in):       |       |                           |       |   |   |
| Operating activities                  |       | $                              | (5,191     | ) | $ | (6,890 | ) |
| Investing activities                  |       | 3,988                          |       | (3,960 | ) |
| Financing activities                  |       | 905                            |       | 5,404 |   |
| Decrease in cash and cash equivalents |       | $                              | (298       | ) | $ | (5,446 | ) |

 

*Operating Activities.*  The overall decrease in cash used inoperating activities for the six months ended June 30, 2008 versus thecorresponding periods in 2007 was due primarily to a decrease in operating cashoutflows, which totaled $8.2 million in 2008 compared to $9.1 million in2007.  This decrease was due primarily todecreased research and development and general and administrative costsincurred as a result of the cost reduction efforts discussed above, as well asthe net impact of the timing of the payments to certain vendors.  Contributing to the overall decrease in cashused in operating activities was an increase in cash receipts from customers,which totaled $1.6 million in 2008 compared to $1.3 million in 2007.

 

*Investing Activities.*  The change in net cash flows provided byinvesting activities was due primarily to net sales of available-for-saleinvestments in connection with ongoing cash management activities during theperiods presented.  For the six months endedJune 30, 2008 and 2007, we incurred $42,000 and $69,000, respectively, ofcapital expenditures.

 

*Financing Activities.*  The decrease in net cash flows provided byfinancing activities was due primarily to the completion of a registered directoffering of AR-CombiMatrix common stock in May 2007 for $5.0 million innet proceeds to us as well as the exercise of AR-CombiMatrix common stockwarrants totaling $368,000 during February of 2007, compared with creditline borrowings of $807,500 and proceeds of $111,000 from the exercise ofcommon stock options in 2008.

 

*Future Liquidity.*  Based on our ending cash balances as of December 31,2007, we believed that our cash and cash equivalent balances, anticipated cashflows from operations and external sources of funding from the capital marketswill be sufficient to meet our cash requirements through September 2008.  In order for us to continue to meet our cashrequirements beyond this point, we will be required to obtain capital fromexternal sources.  However, there can beno assurances that we will be able to secure additional sources of financing attimes and at terms acceptable to management. The issuance of additional equity securities will also cause dilution toour shareholders.  If external financingsources are not available or are inadequate to fund our operations, managementwill be required to reduce our operating costs including research projects andpersonnel, which could jeopardize our future strategic initiatives and businessplans.  For example, reductions inresearch and development activities and/or personnel at our Mukilteo,Washington facility could result in the inability to invest the resourcesnecessary to continue to develop next-generation products and improve existingproduct lines in order to remain competitive in the marketplace, resulting inreduced revenues and cash flows from the sales of our CustomArray products andservices.  Also, reductions in operatingcosts at CMDX, should they occur, could jeopardize our ability to launch, marketand sell additional products and services necessary to grow and sustain ouroperations 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 (see below and in Notes 5 and 8 to the consolidatedfinancial statements included elsewhere in this report), we believe that theadditional cash received from these transactions will allow us to meet our cashrequirements into the third quarter of 2009.

 

*AuctionRate Securities.*  At June 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.

 

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Of the $1.9million in par-value ARS held at June 30, 2008, $900,000 are issued by astate student-loan lending organization, carry an A2/A rating and are insuredby the Federal Family Education Loan Program. The remaining $975,000 of ARS are AAA-rated auction market preferredstock issued by publicly traded mutual funds that are required to maintain atleast 200% of asset coverage for issued ARS. All of our ARS continue to pay interest at the maximum contractual rate,which currently exceeds market interest rates for short-term securities.

 

At June 30, 2008, the fair values of our ARSwere 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 the ARS market and not as aresult of the quality of the underlying collateral, we recorded an unrealizedlosses on our ARS of $66,000 and $135,000 for the three and six months ended June 30,2008, respectively, which is reflected in accumulated other comprehensive(loss) income in our June 30, 2008 consolidated balance sheet.  Our valuation models assume an average maturityof one year for our ARS issued in preferred stock and greater than one year forour ARS that are backed by student-loans. As a result, we have classified the student-loan ARS with a fair valueof $782,000 as a non-current investment in our June 30, 2008consolidated balance sheet.

 

Wecontinue to monitor the market for ARS and consider its impact (if any) on thefair value of our investments.  If thecurrent market conditions deteriorate further, or the anticipated recovery infair values does not occur, we may be required to record additional unrealizedlosses in other comprehensive income or realized, other-than-temporaryimpairment charges in future periods.

 

*Recent Financing Transactions.*  On May 9, 2008 and pursuant to a LoanManagement Account agreement (“LMA”) with a financial institution (the “Lender”),we borrowed $807,500 from the Lender, secured by our current holdings inARS.  The LMA is similar to a revolvingline of credit borrowing facility.  TheLMA provides that we are to pay monthly interest-only payments at an annual,variable rate of 1% plus the 30-day LIBOR rate (resulting in a rate of 3.47% atJune 30, 2008).  The total amountavailable under the LMA ranges from 50% to 92% of investments pledged ascollateral, based upon the amount and security type, up to a maximum amount of$2.8 million.  However, based on theamount and type of securities currently held by us with the financialinstitution, the maximum borrowing ceiling is currently limited to$807,500.  The LMA has no stated maturityfor the principal amounts borrowed.

 

On July 10,2008, we issued to YA Global Investments, L.P. (“YA”): (i) a securedconvertible debenture (the “Debenture”) with an aggregate principal amount of$10 million, which is convertible into shares of our common stock at a conversion price of $11.87 per share; and(ii) warrants (the “Warrants”) to purchase up to 336,984 shares of ourcommon stock.  The Debenture is due on the earlier of July 10, 2010 or within fourmonths after our receipt of payment from National Union in accordance with the$35.7 million Judgment issued by the Federal Court.  The Debenture bears interest at an annualrate of 10%, with interest payments due quarterly beginning October 2008.  The number of shares issuable uponconversion of the Debenture may increase due to certain anti-dilutionadjustments, including if we issue common stock at a price lower than the$11.87 conversion price while the outstanding principal amount of the Debentureis at least $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 by the Judgment as well as our intellectualproperty.  We have the right to forceconversion of the Debenture upon meeting certain trading conditions of ourstock.  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 upon meeting certain trading conditions of ourstock.  On July 23, 2008, we filed aresale registration statement on Form S-3 with the SEC to register the1,179,444 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.  The registration statement was declared effectiveon August 4, 2008.

 

*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:

 

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·                  the costs of commercialization activities,including sales and marketing, manufacturing and capital equipment;

 

·                  our continued progress in research anddevelopment programs;

 

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

 

·                  the costs involved in defending our Judgmentagainst the appeal brought by National Union;

 

·                  our ability to license technology;

 

·                  competing technological developments;

 

·                  the creation and formation of strategicpartnerships; and

 

·                  the costs associated with leasing andimproving our Irvine, California facility; and other factors that may not bewithin our control, such as the ability to liquidate our ARS.

 

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-Balance Sheet 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.  Other than as set forth below, as of June 30,2008, we have no committed funding or long-term debt (see Note 1 to the tablebelow).  The following table lists ourmaterial known future cash commitments as of June 30, 2008:

 
| ** **                             | ** ** | **Payments Due by Period (in thousands)** | ** ** |
|----------------------------------------|------------|--------------------------------------------------------------------|------------|
| ** **                             | ** ** | **2008**                                                           | ** ** | **2009** | ** ** | **2010** | ** ** | **2011** | ** ** | **2012 and  Thereafter** | ** ** |
|                                   |       |                                                               |       |   |   |   |   |   |   |   |   |
| Operating leases                       |       | $                                                                  | 287        |   | $ | 517 |   | $ | 353 |   | $ | — |   | $ | — |   |
| Capital leases                         |       | 14                                                                 |       | 18 |   | 13 |   | 14 |   | 16 |   |
| Minimum royalty payments               |       | 50                                                                 |       | 100 |   | 100 |   | 100 |   | 675 |   |
| Total contractual cash obligations (1) |       | $                                                                  | 351        |   | $ | 635 |   | $ | 466 |   | $ | 114 |   | $ | 691 |   |

 

----

(1)   Does notinclude $807,500 in credit line borrowings with no stated maturity but are dueon demand by the Lender.  Also, does notinclude $10 million Debenture issued to YA subsequent to June 30, 2008,which is due the earlier of July 10, 2010 or four months after receivingthe settlement payment from National Union.

 

**Recent Accounting Pronouncements**

 

Refer to Note 2 to our consolidatedfinancial statements included in Part I, Item 1 of this report.

 

**Item 3. ****                ****QUANTITATIVE AND QUALITATIVE DISCLOSURESABOUT 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. To minimize risk, we maintain our portfolio ofcash, cash equivalents and available-for-sale investments in a variety ofinvestment-grade securities and with a variety of issuers, including corporatenotes, commercial paper, government securities, ARS and money market funds.

 

 

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We areexposed to liquidity and credit risk associated with our ARS.  In the event of a failed auction, we wouldnot have access to these funds until a future auction is successful.  If the issuers are unable to successfullyclose future auctions and their credit ratings deteriorate, we may be requiredto adjust the carrying value of these investments through an impairmentcharge.  Included within our investmentportfolio at June 30, 2008, are ARS with a par-value of $1.9 million and afair value computed by management of $1.7 million.

 

**Item 4T. ****        ****CONTROLSAND PROCEDURES**

 

*Evaluation of Disclosure Controls and Procedures*

 

We maintain disclosure controls andprocedures that are designed to ensure that information required to bedisclosed in our reports filed or submitted under the Securities Exchange Actof 1934, as amended (the “Exchange Act”) is recorded, processed, summarized andreported within the time periods specified in SEC rules and forms.  Our disclosure controls and proceduresinclude, without limitation, controls and procedures designed to ensure thatinformation required to be disclosed in our reports filed under the ExchangeAct is accumulated and communicated to management as appropriate to allowtimely decisions regarding required disclosures.  There are inherent limitations to theeffectiveness of any system of disclosure controls and procedures, includingthe possibility of human error and the circumvention or overriding of thecontrols and procedures. Accordingly, even effective disclosure controls andprocedures can only provide reasonable assurance of achieving their controlobjectives, and management necessarily is required to use its judgment inevaluating the cost-benefit relationship of possible controls andprocedures.  Our management, with theparticipation of our Chief Executive Officer and Chief Financial Officer,conducted an evaluation required by Rules 13a-15 and 15d-15 under theExchange Act of the effectiveness of our disclosure controls and procedures asdefined in Rules 13a-15 and 15d-15 under the Exchange Act as of June 30,2008.  Based on this evaluation, ourChief Executive Officer and Chief Financial Officer concluded that as of June 30,2008, the design and operation of our disclosure controls and procedures wereeffective.

 

*Changes in Internal Controls*

 

There were no changes in our internal control over financialreporting that occurred during our last fiscal quarter (the quarter ended June 30,2008) that have materially affected, or are reasonably likely to materiallyaffect, our internal control over financial reporting.

 

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**PART II—OTHER INFORMATION**

 

**Item 1.  LEGALPROCEEDINGS**

 

In July 2007,Mr. Jeffrey Oster, a former employee of the Company, filed a complaintagainst CombiMatrix and others alleging that Mr. Oster’s employment withus was terminated in violation of federal law and was a breach of hisemployment contract. Mr. Oster’s complaint requested damages for back pay,front pay in lieu of reinstatement under his employment agreement, damages foradverse tax consequences, and attorney’s fees and costs. We filed counterclaimsagainst Mr. Oster for breach of employment contract, breach of common lawduties of loyalty and confidentiality, and misappropriation of trade secrets,with a demand for unspecified damages. Although we believe Mr. Oster’sclaims are without merit, we executed a settlement agreement with Mr. Osterin June 2008, thereby ending the lawsuit by releasing all claims andcounterclaims.  We did not incur afinancial obligation as a result of executing the settlement.

 

In September of2005, Ms. Jennifer Dent and Mr. Michael Strathmann (a marriedcouple), who are both former employees of the Company, filed a complaintagainst the Company asserting claims arising out of the resignation of theiremployment with CombiMatrix and were seeking alleged unpaid bonuses and salescommissions.  They also raised otherclaims regarding certain intellectual property rights.  We believe that these claims are withoutmerit and have vigorously defended against them.  We asserted intellectual propertycounterclaims against Mr. Strathmann and asked for certain injunctiverelief and damages based on those counterclaims.  A trial was held and concluded at the KingCounty Superior Court of Washington (the “State Court”) during the firstquarter of 2008.  The State Court issuedfindings and conclusions in May 2008 in which the State Court found thatCombiMatrix did not owe plaintiffs any monetary damages.  The State Court found that Mr. Strathmannheld certain intellectual property rights; however, we believe that thoserights do not materially impact our intellectual property portfolio or freedomto operate with respect to our current and planned products and services.  The findings and conclusions are subject topost-trial motions, which will likely be concluded during the third quarter of2008.  After final judgment, which willlikely be entered by the end of October 2008, both parties will have anopportunity to appeal.

 

In April of 2005, Acacia and we filed a complaintin the U.S. District Court for the Central District of California (the “FederalCourt”) against our insurance carrier, National Union Fire Ins. Co. ofPittsburgh, PA (“National Union”), seeking reimbursement of litigation andsettlement costs for a lawsuit, pursuant to our directors’ and officers’insurance policy with National Union.  Atrial was held and 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 National Union.  In accordance with the distribution agreemententered into between Acacia and us prior to our separation, all proceeds fromthe lawsuit will be paid to us.  In April 2008,the Federal Court awarded us an additional $3.6 million in attorneys’ fees andlitigation costs, thereby increasing the overall award to $35.7 million.  This award was entered as a final Judgment inMay 2008 and will continue to earn interest until paid.  National Union has appealed theJudgment, and we intend to vigorously defend against the appeal.

 

**Item 2.  UNREGISTERED SALES OF EQUITYSECURITIES AND USE OF PROCEEDS**

 

None.

 

**Item 6. EXHIBITS**

** **
| **Exhibit  Number** | ** ** | **Description** |
|---------------------|------------|-----------------|
|                |       |            |
| 3.1                 |       |            | Amended and Restated Certificate of Incorporation  (incorporated by reference to Exhibit 3.1 to the Registration Statement  on Form S-1 (File No. 333-139679), filed December 26, 2006, as  amended) |
| 3.1                 | a          |            | Certificate of Amendment to the Amended and Restated  Certificate of Incorporation |
| 3.2                 |       |            | Amended and Restated Bylaws (incorporated by reference to  Exhibit 3.2 to the Registration Statement on Form S-1 (File  No. 333-139679), filed December 26, 2006, as amended) |
| 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) |

 

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| **Exhibit  Number** | ** ** | **Description**                                                                                                                                                                                                                                                                                                            |
|---------------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                |       |                                                                                                                                                                                                                                                                                                                       |
| 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)                                                    |
| 10.10               |       | Loan Management Account Agreement between the Registrant  and Merrill Lynch Bank, USA (incorporated by reference to Exhibit 99.2  to Current Report on Form 8-K, filed May 14, 2008)                                                                                                                        |
| 10.11               |       | Lease Agreement, dated as of October 19, 2000, with Wiredzone  Property, L.P., a Delaware limited partnership (incorporated by  reference to Exhibit 10.21 to Acacia Research Corporation’s Annual  Report on Form 10-K for the year ended December 31, 2005, filed on  March 16, 2006) |
| 10.12               |       | Third Amendment to Lease Agreement, dated as of  February 1, 2007, with Wiredzone Property, L.P., a Delaware limited  partnership (incorporated by reference to Exhibit 10.19 to the  Registration Statement on Form S-1 (File No. 333-139679), filed  December 26, 2006, as amended)        |
| 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                                                                                                                                                                                                                        |

 

**SIGNATURES**

 

 

Pursuantto the requirements of the Securities Exchange Act of 1934, the Registrant hasduly caused this report to be signed on its behalf by the undersigned,thereunto duly authorized.

 

 
|     | COMBIMATRIX CORPORATION                        |
|----------|------------------------------------------------|
|     |                                           |
|     |                                           |
|     | By:                                            | /s/ AMIT KUMAR |
|     | Amit Kumar                                     |
|     | Chief Executive Officer                        |
| * * | *(Authorized Signatory)*                       |
|     |                                           |
|     |                                           |
|     | By:                                            | /s/ SCOTT R.  BURELL |
|     | Scott R. Burell                                |
|     | Chief Financial Officer                        |
| * * | *(Principal Financial and Accounting Officer)* |

 

Date:   August 14, 2008

 

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**EXHIBIT INDEX**

** **
| **Exhibit  Number**      | ** ** | **Description**                                                                                                                                                                                                                                                                                                            |
|--------------------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                     |       |                                                                                                                                                                                                                                                                                                                       |
|    3.1              |       | Amended and Restated Certificate of Incorporation  (incorporated by reference to Exhibit 3.1 to the Registration Statement  on Form S-1 (File No. 333-139679), filed December 26, 2006, as  amended)                                                                                                   |
|      3.1a |       | Certificate of Amendment to the Amended and Restated  Certificate of Incorporation                                                                                                                                                                                                                                         |
|    3.2              |       | Amended and Restated Bylaws (incorporated by reference to  Exhibit 3.2 to the Registration Statement on Form S-1 (File  No. 333-139679), filed December 26, 2006, as amended)                                                                                                                          |
| 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)                                                    |
|    10.10            |       | Loan Management Account Agreement between the Registrant  and Merrill Lynch Bank, USA (incorporated by reference to Exhibit 99.2  to Current Report on Form 8-K, filed May 14, 2008)                                                                                                                        |
|   10.11             |       | Lease Agreement, dated as of October 19, 2000, with Wiredzone  Property, L.P., a Delaware limited partnership (incorporated by  reference to Exhibit 10.21 to Acacia Research Corporation’s Annual  Report on Form 10-K for the year ended December 31, 2005, filed on  March 16, 2006) |
|    10.12            |       | Third Amendment to Lease Agreement, dated as of  February 1, 2007, with Wiredzone Property, L.P., a Delaware limited  partnership (incorporated by reference to Exhibit 10.19 to the  Registration Statement on Form S-1 (File No. 333-139679), filed  December 26, 2006, as amended)        |
| 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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