Table of Contents

 

 

 

**UNITED STATES**

**SECURITIES AND EXCHANGECOMMISSION**

**WASHINGTON, D.C. 20549**

 

----

 

**FORM 10-Q**

 

**x****  ****QUARTERLY REPORTPURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF1934**

 

**FOR THE QUARTERLY PERIOD ENDED MARCH 31, 2009**

 

**OR**

 

**o****  ****TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THESECURITIES 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.)

 

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

 

Indicate by check mark whether the registranthas submitted electronically and posted on its corporate Website, if any, everyInteractive Data File required to be submitted and posted pursuant to Rule 405of Regulation S-T during the preceding 12 months (or for such shorter periodthat the registrant was required to submit and post such files).  Yeso  No o

 

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

 

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

 

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

 

As of May 6, 2009, 7,464,408 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 March 31, 2009 (Unaudited) and December 31, 2008 | 3 |
|                                    |       |   |   |
|                                    |       | Consolidated  Statements of Operations for the Three Months Ended March 31, 2009 and  2008 (Unaudited) | 4 |
|                                    |       |   |   |
|                                    |       | Consolidated  Statements of Cash Flows for the Three Months Ended March 31, 2009 and  2008 (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 | 23 |
|                                    |       |   |   |
| Item 4T.                                |       | Controls and  Procedures | 23 |
|                                    |       |   |
| **Part II. Other  Information**    | ** ** |
| ** **                              | ** ** |
| Item 1.                                 |       | Legal Proceedings | 25 |
|                                    |       |   |   |
| Item 2.                                 |       | Unregistered  Sales of Equity Securities and Use of Proceeds | 25 |
|                                    |       |   |   |
| Item 6.                                 |       | Exhibits | 25 |
|                                    |       |   |
| **Signatures**                          | 26         |
| ** **                              |       |
| **Exhibit Index**                  | 26         |

 

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**Table of Contents**

** **

**COMBIMATRIX CORPORATIONCONSOLIDATED BALANCE SHEETS**

**(Inthousands)**

**(Unaudited)**

 
| ** **                                                                                                           | ** ** | **March 31,** | ** ** | **December 31,** | ** ** |
|----------------------------------------------------------------------------------------------------------------------|------------|--------------------|------------|-----------------------|------------|
| ** **                                                                                                           | ** ** | **2009**           | ** ** | **2008**              | ** ** |
| ** **                                                                                                           | ** ** | **(unaudited)**    | ** ** | ** **            | ** ** |
| ** **                                                                                                           | ** ** | ** **         | ** ** | ** **            | ** ** |
| **ASSETS**                                                                                                           |       |               |       |                  |       |
|                                                                                                                 |       |               |       |                  |       |
| Current assets:                                                                                                      |       |               |       |                  |       |
| Cash and cash equivalents                                                                                            |       | $                  | 5,948      |                  | $          | 7,579 |   |
| Available-for-sale investments                                                                                       |       | —             |       | 1,526                 |       |
| Accounts receivable, net of allowance for doubtful accounts of $488  and $378                                        |       | 1,208              |       | 916                   |       |
| Inventory                                                                                                            |       | 598                |       | 725                   |       |
| Prepaid expenses and other assets                                                                                    |       | 239                |       | 219                   |       |
| Total current assets                                                                                                 |       | 7,993              |       | 10,965                |       |
|                                                                                                                 |       |               |       |                  |       |
| Property and equipment, net                                                                                          |       | 661                |       | 743                   |       |
| Investments in unconsolidated subsidiaries                                                                           |       | 681                |       | 938                   |       |
| Patents and licenses, net                                                                                            |       | 4,679              |       | 4,970                 |       |
| Goodwill                                                                                                             |       | 16,918             |       | 16,918                |       |
| Total assets                                                                                                         |       | $                  | 30,932     |                  | $          | 34,534 |   |
|                                                                                                                 |       |               |       |                  |       |
| **LIABILITIES AND SHAREHOLDERS’  EQUITY**                                                                       |       |               |       |                  |       |
|                                                                                                                 | ** ** | ** **         | ** ** | ** **            | ** ** |
| Current liabilities:                                                                                                 |       |               |       |                  |       |
| Accounts payable, accrued expenses and other                                                                         |       | $                  | 2,541      |                  | $          | 2,130 |   |
| Credit line borrowings                                                                                               |       | —             |       | 820                   |       |
| Current portion of deferred revenues                                                                                 |       | 411                |       | 418                   |       |
| Total current liabilities                                                                                            |       | 2,952              |       | 3,368                 |       |
|                                                                                                                 |       |               |       |                  |       |
| Deferred revenues, net of current portion                                                                            |       | 87                 |       | 125                   |       |
| Capital lease obligation, net of current portion                                                                     |       | 40                 |       | 43                    |       |
| Secured convertible debenture                                                                                        |       | 6,751              |       | 6,483                 |       |
| Other liabilities                                                                                                    |       | 1,990              |       | 469                   |       |
| Total liabilities                                                                                                    |       | 11,820             |       | 10,488                |       |
|                                                                                                                 |       |               |       |                  |       |
| Commitments and contingencies (Note 8)                                                                               |       |               |       |                  |       |
|                                                                                                                 |       |               |       |                  |       |
| Shareholders’ equity:                                                                                           |       |               |       |                  |       |
| Preferred stock; $0.001 par value; 5,000,000 shares authorized; none  issued and outstanding                         |       | —             |       | —                |       |
| Common stock; $0.001 par value; 25,000,000 shares authorized; 6,336,794  and 6,288,033 shares issued and outstanding |       | 6                  |       | 6                     |       |
| Additional paid-in capital                                                                                           |       | 44,848             |       | 43,650                |       |
| Accumulated net losses                                                                                               |       | (25,742            | )          | (19,610               | )          |
| Total shareholders’ equity                                                                                      |       | 19,112             |       | 24,046                |       |
| Total liabilities and shareholders’ equity                                                                      |       | $                  | 30,932     |                  | $          | 34,534 |   |

** **

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

** **

**3**

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** **

**COMBIMATRIX CORPORATIONCONSOLIDATED STATEMENTS OF OPERATIONS**

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

**(Unaudited)**

** **
| ** **                                                   | ** ** | **Three Months Ended  March 31,** | ** ** |
|--------------------------------------------------------------|------------|----------------------------------------|------------|
| ** **                                                   | ** ** | **2009**                               | ** ** | **2008** | ** ** |
|                                                         |       |                                   |       |   |   |
| Revenues:                                                    |       |                                   |       |   |   |
| Government contracts                                         |       | $                                      | 525        |   | $ | 1,069 |   |
| Products                                                     |       | 257                                    |       | 575 |   |
| Services                                                     |       | 696                                    |       | 283 |   |
| Collaboration agreements                                     |       | 62                                     |       | 62 |   |
| Total revenues                                               |       | 1,540                                  |       | 1,989 |   |
|                                                         |       |                                   |       |   |   |
| Operating expenses:                                          |       |                                   |       |   |   |
| Cost of government contract revenues                         |       | 495                                    |       | 1,014 |   |
| Cost of products and services                                |       | 657                                    |       | 405 |   |
| Research and development expenses                            |       | 1,131                                  |       | 1,345 |   |
| Marketing, general and administrative expenses               |       | 2,769                                  |       | 2,083 |   |
| Patent amortization and royalties                            |       | 346                                    |       | 361 |   |
| Equity in loss of investee                                   |       | 250                                    |       | 249 |   |
| Total operating expenses                                     |       | 5,648                                  |       | 5,457 |   |
| Operating loss                                               |       | (4,108                                 | )          | (3,468 | ) |
|                                                         |       |                                   |       |   |   |
| Other income (expense):                                      |       |                                   |       |   |   |
| Interest income                                              |       | 10                                     |       | 100 |   |
| Interest expense                                             |       | (513                                   | )          | (1 | ) |
| Derivatives charges                                          |       | (1,521                                 | )          | — |   |
| Total other income (expense)                                 |       | (2,024                                 | )          | 99 |   |
|                                                         |       |                                   |       |   |   |
| Net loss                                                     |       | $                                      | (6,132     | ) | $ | (3,369 | ) |
|                                                         |       |                                   |       |   |   |
| Basic and diluted net loss per share                         |       | $                                      | (0.97      | ) | $ | (0.56 | ) |
|                                                         |       |                                   |       |   |   |
| Basic and diluted weighted average common shares outstanding |       | 6,320,644                              |       | 5,997,087 |   |

** **

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

** **

**4**

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** **

**COMBIMATRIX CORPORATIONCONSOLIDATED STATEMENTS OF CASH FLOWS**

**(Inthousands)**

**(Unaudited)**

 
| ** **                                                                      | ** ** | **Three Months Ended** | ** ** |
|---------------------------------------------------------------------------------|------------|------------------------|------------|
| ** **                                                                      | ** ** | **March 31,**     | ** ** |
| ** **                                                                      | ** ** | **2009**               | ** ** | **2008** | ** ** |
|                                                                            |       |                   |       |   |   |
| Operating activities:                                                           |       |                   |       |   |   |
| Net loss                                                                        |       | $                      | (6,132     | ) | $ | (3,369 | ) |
| Adjustments to reconcile net loss to net cash flows from operating  activities: |       |                   |       |   |   |
| Depreciation and amortization                                                   |       | 386                    |       | 460 |   |
| Non-cash stock compensation                                                     |       | 816                    |       | 361 |   |
| Derivatives charges                                                             |       | 1,521                  |       | — |   |
| Equity in loss of investees                                                     |       | 250                    |       | 249 |   |
| Warrants issued to consultant                                                   |       | 61                     |       | — |   |
| Allowance for bad debt                                                          |       | 110                    |       | 16 |   |
| Amortization of debt discount and issuance costs                                |       | 275                    |       | — |   |
| Changes in assets and liabilities:                                              |       |                   |       |   |   |
| Accounts receivable                                                             |       | (402                   | )          | (514 | ) |
| Inventory, prepaid expenses and other assets                                    |       | 107                    |       | (250 | ) |
| Accounts payable, accrued expenses and other                                    |       | 656                    |       | 451 |   |
| Deferred revenues                                                               |       | (45                    | )          | (68 | ) |
| Net cash flows from operating activities                                        |       | (2,397                 | )          | (2,664 | ) |
| Investing activities:                                                           |       |                   |       |   |   |
| Purchase of property and equipment                                              |       | (13                    | )          | (18 | ) |
| Sale of available-for-sale investments                                          |       | 1,526                  |       | 4,030 |   |
| Net cash flows from investing activities                                        |       | 1,513                  |       | 4,012 |   |
| Financing activities:                                                           |       |                   |       |   |   |
| Net proceeds from issuance of common stock                                      |       | 81                     |       | 31 |   |
| Repayment of line of credit                                                     |       | (820                   | )          | — |   |
| Repayment of capital lease obligations                                          |       | (8                     | )          | (7 | ) |
| Net cash flows from financing activities                                        |       | (747                   | )          | 24 |   |
|                                                                            |       |                   |       |   |   |
| Increase (decrease) in cash and cash equivalents                                |       | (1,631                 | )          | 1,372 |   |
| Cash and cash equivalents, beginning                                            |       | 7,579                  |       | 2,314 |   |
| Cash and cash equivalents, ending                                               |       | $                      | 5,948      |   | $ | 3,686 |   |
|                                                                            |       |                   |       |   |   |
| Non-cash financing activities:                                                  |       |                   |       |   |   |
| Accrued interest paid in common stock                                           |       | $                      | 240        |   | $ | — |   |

** **

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

 

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**COMBIMATRIX CORPORATION**

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS**

**(Unaudited)**

 

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

 

CombiMatrixCorporation (the “Company” “we” “us” and “our”) was originally incorporated in October 1995as a California corporation and later reincorporated as a Delaware corporationin September 2000.  On December 13,2002 (the “Merger Date”), we merged with and became a wholly owned subsidiaryof Acacia Research Corporation (“Acacia”). Also on the Merger Date, Acacia entered into a recapitalizationtransaction whereby Acacia created two classes of registered common stockcalled Acacia Research-CombiMatrix common stock (“AR-CombiMatrix stock”) andAcacia Research-Acacia Technologies common stock (“AR-Acacia Technologies stock”)and divided its existing Acacia common stock into shares of the two new classesof common stock.  In 2006, Acaciaannounced its intent to split off the Company as an independent publiccompany.  On August 15, 2007 (the “RedemptionDate”), all currently issued and outstanding shares of AR-CombiMatrix stockwere redeemed and exchanged for shares of CombiMatrix common stock at aredemption ratio of ten shares of AR-CombiMatrix stock for one share ofCombiMatrix common stock (the “Redemption Ratio”), which is publicly traded onthe Nasdaq Global Market exchange.  Also,warrants to purchase AR-CombiMatrix stock became exercisable to purchaseCombiMatrix common stock, adjusted for the Redemption Ratio.  As of the Redemption Date, we ceased to be asubsidiary of, or affiliated with, Acacia.

 

*****Description of the Company*****

 

****Weare a diversified biotechnology business that develops proprietarytechnologies, including products and services in the areas of drug development,genetic analysis, molecular diagnostics, nanotechnology and defense andhomeland security markets, as well as in other potential markets where ourproducts and services could be utilized. The technologies we have developedinclude a platform technology to rapidly produce user-defined, in-situsynthesized, oligonucleotide arrays for use in identifying and determining theroles of genes, gene mutations and proteins. This technology has a wide rangeof potential applications in the areas of genomics, proteomics, biosensors,drug discovery, drug development, diagnostics, combinatorial chemistry,material sciences and nanotechnology. Other technologies include proprietarymolecular synthesis and screening methods for the discovery of potential newdrugs****.  Wecurrently recognize revenues from selling these products and services andproviding research and development services for organizations including theU.S. Department of Defense (“DoD”) and other strategic partners.

 

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

 

LeuchemixInc. (“Leuchemix”), a minority owned subsidiary, is developing a series ofcompounds to address a number of oncology-related diseases.

 

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

 

The accompanyingconsolidated financial statements have been prepared in accordance withgenerally accepted accounting principles for interim financial information andwith the instructions to Form 10-Q and Rule 10-01 of RegulationS-X.  Accordingly, certain informationand footnotes required by generally accepted accounting principles in annualfinancial statements have been omitted or condensed in accordance withquarterly reporting requirements of the SEC. These interim consolidated financial statements should be read inconjunction with the consolidated financial statements and notes thereto forthe year ended December 31, 2008, as reported by us in our Annual Reporton Form 10-K filed on March 27, 2009. 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 March 31,2009, and results of operations and cash flows for the interim periodspresented.  The results of operations forthe three months ended March 31, 2009 are not necessarily indicative ofthe results to be expected for the entire year.

 

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**COMBIMATRIX CORPORATION**

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

**(Unaudited)**

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

 

Wehave a history of incurring net losses and net operating cash flowdeficits.  We are also deploying new andunproven technologies and continue to develop commercial products. We haveseveral ongoing long-term development projects that involve experimentaltechnology and may require several years and substantial expenditures tocomplete.  Based on our cash andinvestment balances as of December 31, 2008, we believed that our cash andcash equivalent balances, anticipated cash flows from operations and otherexternal sources of available credit would be sufficient to meet our cashrequirements to September 2009, which raised substantial doubt about ourability to continue as a going concern beyond this point.  See Note 9 below regarding recent financingdevelopments, which management believes extents our going concern into 2010.

 

Inorder for us to continue operating as a going concern beyond 2010, we will berequired to increase revenues, reduce operating costs and possibly to obtaincapital from external sources.  However,there can be no assurances that additional sources of financing, including theissuance of debt and/or equity securities will be available at times and atterms acceptable to us.  The issuance ofequity securities, should that occur, will cause dilution to ourshareholders.  If external sources offinancing are not available or are inadequate to fund our operations, we willbe required to reduce operating costs including research projects andpersonnel, which could jeopardize the future strategic initiatives and businessplans of the Company.  For example,reductions in research and development activities and/or personnel at ourMukilteo, Washington facility could result in the inability to invest theresources necessary to continue to develop next-generation products and improveexisting product lines in order to remain competitive in the marketplace,resulting in reduced revenues and cash flows from the sales of our CustomArrayTM products and services.  Also, reduction in operating costs at CMDX,should they occur, could jeopardize its ability to launch, market and selladditional products and services necessary in order to grow and sustain itsoperations and eventually achieve profitability.

 

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

 

·      marketacceptance of products and services;

 

·      technologicaladvances that may make our products and services obsolete or less competitive;

 

·      increasesin operating costs, including costs for supplies, personnel and equipment;

 

·      theavailability and cost of capital;

 

·      thefinancial crisis affecting the global banking system and financial markets; and

 

·      governmentalregulation that may restrict our business.

 

Oursuccess also depends on our ability to protect our intellectual property, theloss thereof or our failure to secure the issuance of additional patentscovering elements of our business processes could materially harm our businessand financial condition.  The patentscovering our core technology begin to expire in 2018.

 

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

 

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**COMBIMATRIXCORPORATION**

**NOTESTO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)**

**(Unaudited)**

 

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

 

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

 

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

 

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.

 

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

 

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.

 

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**.  The compensation cost for allstock-based awards is measured at the grant date, based on the fair value ofthe award, and is recognized as an expense, on a straight-line basis, over theemployee’s requisite service period (generally the vesting period of the equityaward) which is generally two to four years. The fair value of each option award is estimated on the date of grantusing a Black-Scholes option valuation model. SFAS No. 123 (revised 2004), “Share-Based Payment” (“SFAS 123R”)requires stock-based compensation expense to be recorded only for those awardsexpected to vest using an estimated forfeiture rate.  We estimate pre-vesting option forfeitures atthe time of grant and reflect the impact of estimated pre-vesting optionforfeitures in compensation expense recognized. Stock-based compensation expense for all periods presented attributableto our functional expense categories were as follows (in thousands; unaudited):

 

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**COMBIMATRIX CORPORATION**

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

**(Unaudited)**

 
| ** **                            | ** ** | **Three Months Ended** | ** ** |
|---------------------------------------|------------|------------------------|------------|
| ** **                            | ** ** | **March 31,**     | ** ** |
| ** **                            | ** ** | **2009**               | ** ** | **2008** | ** ** |
|                                  |       |                   |       |   |   |
| Cost of products and services         |       | $                      | 25         |   | $ | 6 |   |
| Research and development              |       | 137                    |       | 68 |   |
| Marketing, general and administrative |       | 654                    |       | 287 |   |
| Total non-cash stock compensation     |       | $                      | 816        |   | $ | 361 |   |

 

 

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

 
| ** **                                 | ** ** | **March 31,** | ** ** |
|--------------------------------------------|------------|--------------------|------------|
| ** **                                 | ** ** | **2009**           | ** ** | **2008** | ** ** |
| Numerator:                                 |       |               |       |   |   |
| Loss applicable to common shareholders     |       | $                  | (6,132     | ) | $ | (3,369 | ) |
| Denominator:                               |       |               |       |   |   |
| Weighted-average common shares outstanding |       | 6,320,644          |       | 5,997,087 |   |
| Basic and diluted loss per share           |       | $                  | (0.97      | ) | $ | (0.56 | ) |
|                                       |       |               |       |   |   |
| Common stock options                       |       | 1,664,067          |       | 1,014,963 |   |
| Common stock warrants                      |       | 2,583,958          |       | 2,337,479 |   |
| Convertible debenture                      |       | 716,091            |       | — |   |
| Excluded potentially dilutive securities   |       | 4,964,116          |       | 3,352,442 |   |

 

**Available-For-SaleInvestments**. Investments in marketable securities are accounted for and classified inaccordance with the provisions of SFAS No. 115, “Accounting for CertainInvestments in Debt and Equity Securities” (“SFAS 115”).  Investments in securities with originalmaturities of less than three months are included in cash and cash equivalents,and investments with original maturities of greater than three months and lessthan one year are classified as short-term. Our investments in securities are classified as available-for-sale,which are reported at fair value with related unrealized gains and losses inthe value of such securities recorded as a component of accumulated othercomprehensive income until realized.  Thefair value of our available-for-sale investments was determined in accordance withSFAS No. 157 (see “Fair Value Measurements” below and Note 3) for allperiods presented.  We account forinvestments with fair values less than historical cost in accordance with FASBStaff Position 115-1, “The Meaning of Other-Than-Temporary Impairment and ItsApplication to Certain Investments” (“FSP 115-1”), as amended.  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. *****Weadopted SFAS No. 157, “Fair Value Measurements” (“SFAS 157”), whichapplies to certain accounting standards that require or permit fair valuemeasurements, on January 1, 2008. SFAS 157 defines fair value, establishes a consistent framework formeasuring fair value and expands disclosures for each major asset and liabilitycategory measured at fair value on either a recurring or nonrecurringbasis.  SFAS 157 clarifies that fairvalue is an exit price, representing the amount that would be received to sellan asset or paid to transfer a liability in an orderly transaction betweenmarket participants.  As such, fair valueis a market-based measurement that should be determined based on assumptionsthat market participants would use in pricing an asset or liability.

 

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**COMBIMATRIXCORPORATION**

**NOTESTO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)**

**(Unaudited)**

 

As a basis forconsidering such assumptions, SFAS 157 establishes a three-tier fair valuehierarchy, which prioritizes the inputs used in measuring fair value asfollows:

 

·      Level 1:     Observablemarket inputs such as quoted prices in active markets;

 

·      Level2:     Observable market inputs, other than the quoted pricesin active markets, that are observable either directly or indirectly; and

 

·      Level 3:     Unobservableinputs where there is little or no market data, which require the reportingentity to develop its own assumptions.

 

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

 

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

 

*****Recent Accounting Pronouncements.********* ****In April 2009, the FASB issued three StaffPositions (“FSPs”) that are intended to provide additional application guidanceand enhance disclosures about fair value measurements and impairments ofsecurities. FSP FAS 157-4 clarifies the objective and method of fair valuemeasurement even when there has been a significant decrease in market activityfor the asset being measured. FSP FAS 115-2 and FAS 124-2 establishes a newmodel for measuring other-than-temporary impairments for debt securities,including establishing criteria for when to recognize a write-down throughearnings versus other comprehensive income. FSP FAS 107-1 and APB 28-1expands the fair value disclosures required for all financial instruments withinthe scope of SFAS No. 107, “Disclosures about Fair Value of FinancialInstruments,” to interim periods. All of these FSPs are effective for usbeginning April 1, 2009, and we are currently assessing the potentialimpact that the adoption of these pronouncements may have on our consolidatedfinancial statements.

 

In June 2008, the FASB ratified EITF Issue No. 07-5,“Determining Whether an Instrument (or an Embedded Feature) is Indexed to anEntity’s Own Stock” (“EITF 07-5”).  EITF07-5 provides that an entity should use a two-step approach to evaluate whetheran equity-linked financial instrument (or embedded feature) is indexed to itsown stock, including evaluating the instrument’s contingent exercise andsettlement provisions.  EITF 07-5 iseffective for fiscal years beginning after December 15, 2008, althoughearly adoption is allowed.  We chose toearly-adopt EITF 07-5 in 2008.  See Note6 below for discussion of the impact on EITF 07-5 to our consolidated financialstatements.

 

# **3.**     FAIR VALUE MEASUREMENTS

# ** **

The following table summarizes, for each majorcategory of financial assets or liabilities measured on a recurring basis, therespective fair value at March 31, 2009 and the classification by level ofinput within the fair value hierarchy defined by SFAS 157 (in thousands;unaudited):

 

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**COMBIMATRIXCORPORATION**

**NOTESTO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)**

**(Unaudited)**

 
| ** **                         | ** ** | **March 31,** | ** ** | **Fair Value Measurements at** | ** ** |
|------------------------------------|------------|--------------------|------------|--------------------------------|------------|
| ** **                         | ** ** | **2009**           | ** ** | **Level 1**                    | ** ** | **Level 2** | ** ** | **Level 3** | ** ** |
| Assets:                            |       |               |       |                           |       |   |   |   |   |
| Cash equivalents                   |       | $                  | 5,287      |                           | $          | 5,287 |   | $ | — |   | $ | — |   |
| Available-for-sale investments (1) |       | —             |       | —                         |       | — |   | — |   |
| Total                              |       | $                  | 5,287      |                           | $          | 5,287 |   | $ | — |   | $ | — |   |
|                               |       |               |       |                           |       |   |   |   |   |
| Liabilities:                       |       |               |       |                           |       |   |   |   |   |
| Embedded derivatives (2)           |       | $                  | (1,990     | )                              | $          | — |   | $ | — |   | $ | (1,990 | ) |

 

----

(1)   Allavailable-for-sale investments previously categorized as Level 3 assets wereredeemed during the period ending March 31, 2009.

 

(2)   Includedin “other liabilities” in the accompanying March 31, 2009 consolidatedbalance sheet.  See Note 6 below fordiscussion of fair value measurements relating to embedded derivatives.

 

Beginning January 1, 2009, SFAS 157 also requiresthat assets and liabilities measured on a nonrecurring basis to be reflected atfair value when an other-than-temporary impairment has been deemed tooccur.  We did not have any suchimpairments as of or for the three months ended March 31, 2009.

 

The following table is a reconciliation of financialassets and liabilities measured at fair value on a recurring basis usingsignificant unobservable inputs (Level 3) during the three months ended March 31,2009 (in thousands; unaudited):

 
| ** **                       | ** ** | **Available-**  | ** ** | ** **      | ** ** |
|----------------------------------|------------|-----------------|------------|-----------------|------------|
| ** **                       | ** ** | **For-Sale**    | ** ** | **Embedded**    | ** ** |
| ** **                       | ** ** | **Investments** | ** ** | **Derivatives** | ** ** |
|                             |       |            |       |            |       |
| Balances, December 31, 2008 |       | $               | 1,526      |            | $          | (469 | ) |
| Redemption of ARS                |       | (1,526          | )          | —          |       |
| Realized losses                  |       | —          |       | (1,521          | )          |
| Balances, March 31, 2009    |       | $               | —     |            | $          | (1,990 | ) |

 

At December 31, 2008,our available-for-sale investments included $1.5 million of auction ratesecurities (“ARS”) at par value. Historically, the carrying value of our ARS approximated fair value dueto active, liquid markets for these securities as well as the frequentresetting of the interest rates at auction, which typically occurred every 7 to30 days.  However, in mid-February 2008,the market for ARS collapsed and as a result, our ARS experienced multiplefailed auctions during 2008.  During thefourth quarter of 2008, one of the issuers of our holdings in ARS redeemed$350,000 at par value, bringing the total amount of ARS held by us as of December 31,2008 to $1.5 million.  On January 2,2009, all of our remaining ARS were liquidated at par value.

 

From mid-February 2008 through the third quarterof 2008, the fair values of our holdings in ARS were estimated using discountedcash flow models.  These models consider,among other things, the timing of expected future successful auctions,estimated future cash flows, collateralization and credit worthiness ofunderlying security investments and discount rates applied to the estimatedfuture cash flows.  Since these inputswere not observable, they were classified as Level 3 inputs under SFAS157.  As a result of the lack ofliquidity in the ARS market and not as a result of the quality of the underlyingcollateral, we recorded unrealized losses on our ARS of $69,000 through theperiod ended March 31, 2008. However, due to liquidations of our ARS at par value prior to andsubsequent to December 31, 2008, we reversed our previously recognized unrealizedlosses and classified our ARS as current assets at par value in our December 31, 2008consolidated balance sheet.

 

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**COMBIMATRIXCORPORATION**

**NOTESTO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)**

**(Unaudited)**

 

# **4. COMPREHENSIVE LOSS**

 

Thefollowing table shows our comprehensive net loss in accordance with SFAS No. 130,“Reporting Comprehensive Income,” for all periods presented (in thousands;unaudited):

 
| ** **                                            | ** ** | **Three Months Ended** | ** **   |
|-------------------------------------------------------|------------|------------------------|--------------|
| ** **                                            | ** ** | **March 31,**     | ** **   |
| ** **                                            | ** ** | **2009**               | ** **   | **2008** | ** ** |
| Net unrealized loss on available for sale investments |       | $                      | —       |   | $ |  (69 | ) |
| Net loss                                              |       | (6,132                 | )            | (3,369 | ) |
| Comprehensive loss                                    |       | $                      |  (6,132 | ) | $ |  (3,438 | ) |

 

# **5.  CREDIT LINE BORROWINGS**

# ** **

On May 9, 2008 and pursuant to a LoanManagement Account agreement (the “LMA”) with a financial institution (the “Lender”),we borrowed $808,000 from the Lender, secured by investments held in aninvestment account with the Lender.  TheLMA is similar to a revolving line of credit borrowing facility.  The LMA provides that we accrue monthlyinterest charges at an annual, variable rate of 1% plus the 30-day LIBORrate.  The total amount available underthe LMA ranges from 50% to 92% of investments pledged as collateral, based uponthe amount and security type in our investment portfolio, up to a maximumamount of $2.8 million.  The LMA has nostated maturity for the principal and interest amounts borrowed by us.  However, because the Lender has the abilityunder the terms of the LMA to call in the principal amount of the borrowings atany time, we have classified this liability as a component of currentliabilities in the accompanying December 31, 2008 consolidated balancesheet.  The LMA balance of $820,000 as ofDecember 31, 2008 was repaid by us during the first quarter of 2009,however the LMA remains available for future borrowings at similar terms if sochosen by management.

 

**6.  SECURED CONVERTIBLE DEBENTURE**

** **

On July 10, 2008 (the “Closing Date”), weissued to YA Global Investments, L.P. (“YA”): (i) a secured convertibledebenture (the “Debenture”) with an aggregate principal amount of $10 million,which is convertible into shares of our common stock at a fixedconversion price of $11.87 per share; and (ii) warrants (the “Warrants”)to purchase up to 336,984 shares of our common stock.  The Debenture is due on theearlier of July 10, 2010 (the “Term”) or within four months after receiptof payment of judgment or settlement proceeds from National Union Fire Ins. Co.of Pittsburgh, PA (“National Union”) in accordance with the $35.7million judgment (the “Judgment”) issued by the U.S. District Court for theCentral District of California (the “District Court”).  The Debenture bears interest at an annualrate of 10%, with interest payments due quarterly in either cash or our commonstock, beginning October 2008.  Wehave the right to force conversion of the Debenture into our common stock ifthe volume-weighted average price (“VWAP”) of our stock exceeds between 125%and 135% of the fixed conversion price for a period of thirty consecutivetrading days, among other conditions and restrictions.  We also have a cash redemption option wherebywe have the right to pre-pay the Debenture during the Term, but only if ourcommon stock is trading below the fixed conversion price, among otherconditions.  Prepayment penalties rangebetween 0% and 10% of the principal amount due, depending upon when the cashredemption occurs during the Term.  The number ofshares issuable to YA 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 fixed conversion price while the outstandingprincipal amount of the Debenture is at least $5 million (see Note 9). Theconversion feature of the Debenture allows YA to receive shares of our commonstock only and not cash or other consideration. The Debenture is secured bythe Judgment as well as our intellectual property.  The Warrants have a five-year term and allowYA to purchase: (i) 168,492 shares of common stock at an exercise price of$11.87; and (ii) 168,492 shares of common stock at an exercise price of$13.65.  We have the right to call theWarrants, but only if the VWAP of our common stock is at or greater than 130%of the Warrants’ exercise price for at least twenty consecutive trading days,among other conditions.  We haveregistered the shares of our common stock that are issuable to YA uponconversion of the Debenture and exercise of the Warrants on Form S-3,which was declared effective by the SEC during the third quarter of 2008.

 

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**COMBIMATRIXCORPORATION**

**NOTESTO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)**

**(Unaudited)**

 

*Recognition of the Debenture andWarrants on the Closing Date*

* *

On the Closing Date, we recognized the Debenture andWarrants based on their relative fair values of $8.2 million and $1.8 million,respectively, in accordance with APB Opinion No. 14,“Accounting for Convertible Debt and Debt Issued with Stock Purchase Warrants.”  The fair value of the Debenture wasdetermined using the convertible bond model, assuming a 15% yield.  The relative fair value of the Warrants wasclassified as a component of additional paid-in capital in accordance with SFAS No. 150,“Accounting for Certain Financial Instruments with Characteristics of bothLiabilities and Equity” and EITF Issue No. 00-19, “Accounting forDerivative Financial Instruments Indexed to, and Potentially Settled in, aCompany’s Own Stock” (“EITF 00-19”), with the corresponding amount reflected asa contra-liability to the Debenture.  The fair value of the warrants was determinedusing the Black-Scholes model, assuming a term of five years, volatility of75%, no dividends, and a risk-free interest rate of 3.1%.

 

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

 

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

 

*Recognition Subsequent to theClosing Date*

* *

During the third and fourth quarters of 2008, YAconverted $1.5 million of the Debenture into common stock.  As a result, portions of the aggregatecontra-liability and derivative liabilities were reclassified to additionalpaid-in capital in proportion to the amount of the Debenture that was convertedinto common stock, resulting in reductions to the aggregate contra-liabilityand derivative liabilities of $408,000 and $157,000, respectively.  There have been no further conversions sincethe fourth quarter of 2008.  As of March 31,2009 and December 31, 2008, the remaining amount of the Debenture, net ofthe aggregate contra-liability, was $6.8 million and $6.5 million,respectively.  The embedded derivativeliabilities were marked to fair value of $2.0 million as of March 31,2009, resulting in a net expense of $1.5 million recognized as non-operatingderivative charges in the accompanying March 31, 2009 consolidatedstatement of operations.  As of March 31,2009 and December 31, 2008, the remaining principal amount of theDebenture was $8.5 million, with an estimated fair value of $8.1 million and$7.9 million, respectively.

 

Since the issuance of the Debenture through March 31,2009, accrued interest to YA in the amount of $427,000 has been paid by issuing45,458 shares of our common stock. Subsequent to March 31, 2009 but prior to the issuance of thisreport, accrued interest to YA as of March 31, 2009 in the amount of$210,000 was paid by issuing 27,614 shares of our common stock.

 

# **7.  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.

 

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**COMBIMATRIXCORPORATION**

**NOTES TO CONSOLIDATEDFINANCIAL STATEMENTS (CONTINUED)**

**(Unaudited)**

 

Outstandingwarrants to purchase CombiMatrix common stock are as follows (unaudited):

** **
| ** **          | ** ** | **Shares of Common Stock** | ** ** | ** **            | ** ** | ** **       | ** ** |
|---------------------|------------|----------------------------|------------|-----------------------|------------|------------------|------------|
| ** **          | ** ** | **Issuable from Warrants** | ** ** | ** **            | ** ** | ** **       | ** ** |
| ** **          | ** ** | **March 31,**         | ** ** | **December 31,** | ** ** | **Exercise**     | ** ** | ** ** | ** ** |
| **Date of Issue**   | ** ** | **2009**                   | ** ** | **2008**              | ** ** | **Price**        | ** ** | **Expiration** | ** ** |
|                |       |                       |       |                  |       |             |       |   |   |
| July 2008      |       | 336,984                    |       | 336,984               |       | $11.87  - $13.65 |       | July 2013 |   |
| May 2007       |       | 959,390                    |       | 959,390               |       | $5.50            |       | May 2012 |   |
| December 2006  |       | 1,127,936                  |       | 1,127,936             |       | $8.70  - $10.88  |       | December 2011 |   |
| September 2005 |       | 159,648                    |       | 159,648               |       | $24.00           |       | September 2010 |   |
| Total               |       | 2,583,958                  |       | 2,583,958             |       |             |       |   |   |

 

**8.  COMMITMENTS AND CONTINGENCIES**

** **

**Collaboration and Research Agreements**

** **

On March 10, 2009, we executed a four-year,$858,000 contract with the NASA Ames Research Center (“NASA”)for further development of our microarray technologies.  The primary objective of the contract is todesign and test a microfluidics system that incorporates oursemiconductor-based microarray platform as part of an integrated geneticanalysis system that can be deployed in space. Under the terms of this contract, we will perform research anddevelopment activities during the first year (“Phase I”) for a fixed fee of$214,000.  If NASA chooses to continuedevelopment for each of the subsequent years two through four of the contract,we will continue development at similar funding levels to the first year, notto exceed a maximum fee of $858,000 for the entire contract period.  As of March 31, 2009, we had incurred$4,000 in actual costs for Phase I of this contract, which was approximately 2%complete.

 

On July 31, 2008, we executed a six-month,$250,000 contract with the DoD for the development of label-free detectiontechniques using our microarray technology.  These detection techniques involve thesynthesis of molecules known as “aptamers,” which are molecules with uniquebiological properties.  Wesubstantially completed this contract during the first quarter of 2009 and donot expect to incur additional costs or revenues from this contract beyond2009.

 

On July 11, 2008, we executed a fifteen-month,$923,000 contract with the DoD to further development of our microarraytechnologies for a multipathogen detection system.  The primary objectives of the contract are tocontinue development of an automated biothreat agent detection system basedupon our complementary metal oxide semiconductor microarray and electrochemicaldetection techniques, to continue the integration of serological and genomicassays for orthogonal testing and to explore new methods of detection thatexpand target identification, reduce reagent burden, and improve assaytime.  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 these obligations, plus a fixed fee, of up to $923,000.  As of March 31, 2009, we had incurred$505,000 in actual costs for this contract, which was approximately 75%complete.

 

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

 

On March 13,2007, we executed a one-year, $869,000 contract with the DoD, focusing on thedevelopment of a field-deployable influenza genotyping system based on our electrochemicaldetection technology to be used for military and homeland securityapplications.  Under the terms of thiscontract, we performed research and development activities, as described underthe contract, and were reimbursed on a periodic basis for actual costs incurredto perform our obligations, plus a fixed fee, of up to $869,000.

 

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**COMBIMATRIXCORPORATION**

**NOTES TO CONSOLIDATEDFINANCIAL STATEMENTS (CONTINUED)**

**(Unaudited)**

 

Wesubstantially completed this contract during the second quarter of 2008 and donot expect to incur significant costs or revenues from this contract beyond2008.

 

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 performed research and development activities, as described under thecontract, and were reimbursed on a periodic basis for actual costs incurred toperform our obligations, plus a fixed fee, of up to $1.9 million.  We substantially completed this contractduring the fourth quarter of 2008 and do not expect to incur significant costsor revenues from this contract beyond 2008.

 

**Human Resources**

** **

Weprovide certain severance benefits such that if an executive of CombiMatrix whois a vice president or higher is terminated for other than cause, death ordisability, the executive will receive payments equal to three months’ basesalary plus medical and dental benefits. If termination occurs as a result of a change in control transaction,these benefits will be extended by three months.  Also, if our chief executive officer isterminated for other than cause, or for death or disability, he will receivepayments equal to one year’s base salary plus medical and dental benefits.

 

**Litigation**

** **

On September 30,2002, we entered into a settlement agreement with Nanogen, Inc. (“Nanogen”)to settle all pending litigation between the parties.  Pursuant to the terms of the settlementagreement, we agreed to make quarterly payments to Nanogen equal to 12.5% oftotal sales of products developed by us and our affiliates based on the patentsthat had been in dispute in the litigation, up to an annual maximum amount of$1.5 million.  The minimum quarterlypayments under the settlement agreement are $25,000 per quarter until thepatents expire in 2018.  Royalty expensesrecognized under the agreement for the three months ended March 31, 2009and 2008 were $25,000 and $43,000, respectively, and are included in patentamortization and royalties in the accompanying consolidated statements ofoperations.

 

In April 2005,Acacia and CombiMatrix filed a complaint against our insurance carrier,National Union, seeking reimbursement of litigation and settlement costs for alawsuit, pursuant to our directors’ and officers’ insurance policy withNational Union.  A trial was held andconcluded during the fourth quarter of 2007. In March 2008, the District Court issued its Judgment in favor ofAcacia and us, and awarded approximately $32.1 million in monetary damages tobe paid by National Union.  In accordancewith the distribution agreement entered into between Acacia and us prior to ourseparation, all proceeds from the lawsuit will be paid to us.  In May 2008, the District 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 theappeal.  In September 2008, theDistrict Court required National Union to post an appellate bond in the amountof $39.2 million to cover the Judgment as well as accrued interestcharges.  The appellate bond will remainin place until the appeal process is concluded.

 

We aresubject to other claims and legal actions that arise in the ordinary course ofbusiness.  We believe that the ultimateliability with respect to these claims and legal actions, if any, will not havea material effect on our financial position, results of operations or cashflows.  Based on a distribution agreementexecuted between us and Acacia, it is expected that such claims, legal actions,etc. attributable to CombiMatrix Corporation prior to the Redemption Date willremain with the Company subsequent to the Redemption Date.  As of the date of this report and for allperiods presented, we are not aware of the existence of any such claims or legalactions, however.

 

**9.  SUBSEQUENT EVENT**

** **

**On May 1, 2009, we closed aregistered direct offering (the “Offering”) of our common stock and warrantsfor gross proceeds of $8.25 million. Under the terms of the Offering, we sold 1.1 million units for $7.50 perunit to investors.**

** **

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** **

**COMBIMATRIX CORPORATION**

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS (CONTINUED)**

**(Unaudited)**

 

**Each unit consisted of one share of our common stock andone warrant, each warrant to purchase one share of our common stock at anexercise price of $9.00 per share.  Thewarrants may not be exercised until six months after the Offering and have a termof five years.  The warrants are alsocallable if our common stock trades at or above $22.50 per share during any 20trading days during a period of 30 consecutive trading days, with a minimumdaily trading volume of 50,000 shares each day during that 30 trading dayperiod.  Net proceeds from the Offering,net of placement agent fees and expenses, were approximately $7.6 million.  As a result of executing the Offering, thefixed conversion price of the Debenture has been reduced to $7.50 per share,effective May 1, 2009.**

 

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**Table ofContents**

** **

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

** **

**Cautionary Statement**

 

You shouldread the following discussion and analysis in conjunction with the consolidatedfinancial statements and related notes thereto contained in Part I, Item 1of this report.  The informationcontained in this Quarterly Report on Form 10-Q is not a completedescription of our businesses or the risks associated with an investment in ourcommon stock.  We urge you to carefullyreview and consider the various disclosures made by us in this report and inour other reports filed with the U.S. Securities and Exchange Commission, or “SEC,”including our Annual Report on Form 10-K, filed on March 27, 2009.

 

This reportcontains forward-looking statements within the meaning of the “safe harbor”provisions of the Private Securities Litigation Reform Act of 1995. Referenceis made in particular to the description of our plans and objectives for futureoperations, assumptions underlying such plans and objectives, and otherforward-looking statements included in this report. Such statements may beidentified by the use of forward-looking terminology such as “may,” “will,” “expect,”“believe,” “estimate,” “anticipate,” “intend,” “continue,” or similar terms,variations of such terms or the negative of such terms.  Such statements are based on management’scurrent expectations and are subject to a number of factors and uncertainties,which could cause actual results to differ materially from those described inthe forward-looking statements.  Suchstatements address future events and conditions concerning product development,capital expenditures, earnings, litigation, regulatory matters, markets forproducts and services, liquidity and capital resources and accountingmatters.  Actual results in each casecould differ materially from those anticipated in such statements by reason offactors such as future economic conditions, changes in consumer demand,legislative, regulatory and competitive developments in markets in which we andour subsidiaries operate, results of litigation and other circumstancesaffecting anticipated revenues and costs. We expressly disclaim any obligation or undertaking to release publiclyany updates or revisions to any forward-looking statements contained herein toreflect any change in our expectations with regard thereto or any change inevents, conditions or circumstances on which any such statement is based.  Additional factors that could cause suchresults to differ materially from those described in the forward-lookingstatements are set forth in connection with the forward-looking statements andin the “Risk Factors” described in our Annual Report on Form 10-K filed onMarch 27, 2009.

 

## **General**

## ** **

****Weare a diversified biotechnology business that develops proprietarytechnologies, including products and services in the areas of drug development,genetic analysis, molecular diagnostics, nanotechnology and defense andhomeland security markets, as well as in other potential markets where ourproducts and services could be utilized. The technologies we have developedinclude a platform technology to rapidly produce user-defined, in-situ synthesized,oligonucleotide arrays for use in identifying and determining the roles ofgenes, gene mutations and proteins. This technology has a wide range ofpotential applications in the areas of genomics, proteomics, biosensors, drugdiscovery, drug development, diagnostics, combinatorial chemistry, materialsciences and nanotechnology. Other technologies include proprietary molecularsynthesis and screening methods for the discovery of potential new drugs.****  We currently recognize revenues from sellingthese products and services and providing research and development services fororganizations including the U.S. Department of Defense, or “DoD” and otherstrategic partners.

 

CombiMatrixMolecular Diagnostics, Inc., or “**CMDX,**”our wholly owned subsidiary located in Irvine, California, has developedcapabilities of producing arrays that utilize bacterial artificial chromosomes,or “BACs,” which also enable genetic analysis. CMDX functions primarily as a diagnostics reference laboratory.

 

LeuchemixInc. (“Leuchemix”), a minority owned subsidiary, is developing a series ofcompounds to address a number of oncology-related diseases.

 

## **RelationshipWith Acacia 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.

 

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Inlate 2006, Acacia announced its intent to split off the Company as anindependent public company.  On August 15,2007 (the “Redemption Date”), all currently issued and outstanding shares ofAR-CombiMatrix stock were redeemed and exchanged for shares of CombiMatrixcommon stock at a redemption ratio of ten shares of AR-CombiMatrix stock forone share of CombiMatrix common stock (the “Redemption Ratio”), which ispublicly traded on the Nasdaq Global Market. Also, warrants to purchase AR-CombiMatrix stock became exercisable topurchase CombiMatrix common stock, adjusted for the Redemption Ratio.  As of the Redemption Date, we ceased to be asubsidiary of, or affiliated with, Acacia. Our common stock currently trades on the Nasdaq Global Market under thesymbol “CBMX.”

 

## **Liquidity**

## ** **

At December 31,2008 and March 31, 2009, we had cash, cash equivalents andavailable-for-sale investments of $9.1 million and $5.9 million, respectively,which we believed would be sufficient to meet our cash requirements to September 2009.  On May 1, 2009, we closed a registered directoffering of our common stock and warrants which, after placement agent fees andother costs, netted $7.6 million to us, and thereby extending our ability tocontinue operating as a going concern into 2010 (see Liquidity and CapitalResources below as well as Note 9 to the consolidated interim financialstatements included elsewhere herein for further discussion).

 

Inorder for our company to continue as a going concern beyond 2010 and ultimatelyto achieve profitability, we will be required to increase revenues, reduceoperating costs and possibly to obtain capital from external sources.  However, there can be no assurance that suchcapital will be available at times and at terms acceptable to us, or thathigher levels of product and service revenues will be achieved.  The issuance of additional equity securities,should that occur, will cause dilution to our shareholders.  If external financing sources are notavailable or are inadequate to fund our operations, we will be required toreduce operating costs including research projects and personnel, which couldjeopardize our future strategic initiatives and business plans.  See Note 1 to the consolidated financialstatements included elsewhere in this report for additional discussion of thesematters.

 

## **BasisOf Presentation Of Financial Statements**

## ** **

Theconsolidated financial statements included in this Form 10-Q areconsistent with our historical financial statements included in our Form 10-Kfor our fiscal year ended December 31, 2008.

 

## **OverviewOf Recent Business Activities**

## ** **

Forthe three months ended March 31, 2009, our operating activities includedthe recognition of $1.5 million in revenues, including $525,000 in governmentcontract revenues, $288,000 in CustomArray product and service revenues and $727,000in diagnostic lab revenues.  Research anddevelopment expenses, excluding government contract costs and non-cash stockbased compensation, decreased in the first quarter of 2009 due primarily to theincreased focus on commercialization of our existing suite of products anddiagnostic test offerings, rather than on the development of new products andservices.  Marketing, general andadministrative expenses increased due primarily to increased sales and marketingefforts at CMDX and also due to increased investor and public relations costs.

 

Significantbusiness developments that occurred during and subsequent to the first quarterended March 31, 2009 were:

 

·                  In January 2009, CMDX entered into a newpartnership with Lenetix, a New York-based diagnostics laboratory, to co-marketCMDX’s suite of CGH array-based tests. These include the industry leading BACHD ScanTM test,which is used for characterizing genomic causes of childhood developmentaldisorders.  The BAC HD Scan test canidentify over 290 genomic causes of developmental disorders and is routinelyused in postnatal genetic diagnostics.

 

·      In January 2009,Leuchemix, Inc., provided additional information regarding the initialclinical trial of its novel anticancer drug LC-1.  The initial trial is being performed atCardiff University in the United Kingdom under the supervision of ProfessorAlan Burnett.  Work from ProfessorBurnett’s laboratory has also demonstrated that LC-1 may be valuable forin-patients that respond poorly to conventional therapy.

 

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·                  In January 2009, former U.S. Food andDrug Administration Deputy Commissioner Scott Gottlieb, M.D., joined our boardof directors.

 

·                 InFebruary 2009, we announced preliminary data on our investigationalComprehensive Cancer Array test, showing that it can non-invasively screen forthe early detection of prostate, colon, ovarian, breast and lung cancerssimultaneously.  The results werepresented at Cambridge Healthtech Institute’s 16th International Molecular MedicineTri-Conference held in San Francisco.

 

·      In March 2009,we executed a four-year contract with NASA’s Ames Research Center to design andtest a microfluidic system that incorporates our semiconductor microarray aspart of an integrated genetic analysis platform that can be deployed insatellites.  Funding to us for the firstyear of this program will be $214,000 with three option years at similarfunding levels.

 

·      In March 2009,we announced that the Agency for Health Protection and Promotion in Ontario,Canada had independently verified the function of our Influenza-Detectionsystem during the 2007-2008 influenza season.

 

·      In April 2009, Dr. Karine Hovanesjoined our wholly owned subsidiary, Combimatrix Molecular Diagnostics, Inc.(CMDX), as its Laboratory Director.  Dr. Hovanesis a Diplomat of the American Board of Medical Genetics in Clinical MolecularGenetics and Clinical Cytogenetics and is also licensed in New York andCalifornia in both cytogenetics and molecular genetics. Dr. Hovanes joinsCMDX from the Laboratory Corporation of America, otherwise known as LabCorp.

 

## **CriticalAccounting 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 27, 2009, 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.

 

**Comparison of the Results of Operations for the Threemonths Ended March 31, 2009 and 2008**

 

Revenues and Cost ofRevenues (In thousands)

 
| ** **                           | ** ** | **Three Months Ended  March 31,** | ** ** | **Change** | ** ** |
|--------------------------------------|------------|----------------------------------------|------------|------------|------------|
| ** **                           | ** ** | **2009**                               | ** ** | **2008**   | ** ** | **$** | ** ** | **%** | ** ** |
|                                 |       |                                   |       |       |       |   |   |   |   |
| Government contracts                 |       | $                                      | 525        |       | $          | 1,069 |   | $ | (544 | ) | (51 | )% |
| Cost of government contract revenues |       | (495                                   | )          | (1,014     | )          | 519 |   | (51 | )% |
| Products                             |       | 257                                    |       | 575        |       | (318 | ) | (55 | )% |
| Services                             |       | 696                                    |       | 283        |       | 413 |   | 146 | % |
| Cost of products and services        |       | (657                                   | )          | (405       | )          | (252 | ) | 62 | % |
| Collaboration agreements             |       | 62                                     |       | 62         |       | — |   | — |   |
|                                      |            |                                        |            |            |            |  |  |  |  |  |  |  |

 

**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.  Under theterms of our contract with NASA, we are reimbursed on a periodic basis based onscheduled, contractual fixed amounts. Revenues are recognized under the percentage-of-completion method ofaccounting, using the cost-to-cost approach to measure completeness at the endof the each reporting period.  Cost ofgovernment contracts reflect research and development expenses incurred inconnection with our commitments under our current contracts with the DoD.

 

Thedecrease in government contract revenues for the three months ended March 31,2009 versus the comparable period in 2008 was due primarily to fewer activecontracts during 2009 versus 2008.  Therecent completion of our multipathogen and electrochemical detection contractsresulted in a decrease in government contract activity and thus lowergovernment contract revenues recognized during the three months ended March 31,2009 versus the comparable period in 2008.

 

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SeeNote 8 to our consolidated interim financial statements included elsewhere inthis report for a detailed description of the amounts, completion rates andestimated costs to complete of our government contracts that are ongoing aswell as prior contracts that were completed during the periods presented.  As these contracts near completion, futurecontract revenues could be volatile in the short-term and decrease in thelonger term if new government contracts are not awarded or executed.

 

**Productsand Cost of Products**. Product revenues and costs of products relate to domestic andinternational sales of our array products, which include DNA synthesizerinstruments, CustomArray 12K, 4X2K, 2X40K and 90K DNA expression arrays,ElectraSense® microarray readers and related hardware.  Product revenues decreased in the threemonths ended March 31, 2009 versus the comparable period in 2008 dueprimarily to lower instrument sales in 2009 than 2008.  As we expand our business focus fromexclusively selling array-based research and development products to providingarray-based diagnostic services, we have reduced internal sales staff,marketing and production efforts regarding sales of CustomArray products and insteadhave executed product distribution and manufacturing agreements with variousthird-party distributors for the sales of our suite of CustomArray productsinto the research and development markets. Also, declining global economic conditions have negatively impacted thesales of our instruments.  As a result,CustomArray product revenues will likely be volatile and could decrease infuture periods, depending largely on the sales efforts of our distributors.

 

*Services.* Services revenues are comprised primarily of diagnostic servicesprovided by CMDX as well as the amortization of one-year equipment maintenanceand service contracts executed with certain customers of our DNAsynthesizers.  Diagnostic servicesrevenue from CMDX was $688,000 for the three months ended March 31, 2009,versus $253,000 in the comparable period in 2008.  These revenues have increased due to anincreased number of diagnostic test offerings as well as increased customerdemand for our suite of diagnostic lab services provided by CMDX, which is dueprimarily to increased sales and marketing efforts.  Including BAC array product sales, totaldiagnostic lab revenues at CMDX were $727,000 for the three months ended March 31,2009 versus $273,000 in the comparable period in 2008.

 

Operating Expenses (In thousands)

 
| ** **                                      | ** ** | **Three Months Ended  March 31,** | ** ** | **Change** | ** ** |
|-------------------------------------------------|------------|----------------------------------------|------------|------------|------------|
| ** **                                      | ** ** | **2009**                               | ** ** | **2008**   | ** ** | **$** | ** ** | **%** | ** ** |
|                                            |       |                                   |       |       |       |   |   |   |   |
| Research and development expenses               |       | $                                      | 1,131      |       | $          | 1,345 |   | $ | (214 | ) | (16 | )% |
| Marketing, general and administrative  expenses |       | 2,769                                  |       | 2,083      |       | 686 |   | 33 | % |
|                                                 |            |                                        |            |            |            |  |  |  |  |  |  |  |

 

*Research and Development Expenses*.  The decrease in internal research anddevelopment expenses for the 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 as well as reduceddevelopment efforts for new diagnostic tests. In addition, for the three months ended March 31, 2009 and 2008,research and development expenses included $137,000 and $46,000, respectively,of non-cash stock compensation expense recognized under SFAS No. 123R.  This increase was due primarily to increasesin the number of stock option awards granted to our employees during the pasttwelve months.  See Note 2 to ourconsolidated interim financial statements included elsewhere in this report fora detailed description of the amounts recognized for the periods presented.

 

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

 

**Marketing,General and Administrative Expenses.**  The increase in marketing, general andadministrative expenses for the three months ended March 31, 2009 versusthe comparable period in 2008 was due primarily to increases in sales andmarketing expenses at CMDX, as well as increased investor and public relationsexpenses.  In addition, for the threemonths ended March 31, 2009 and 2008, marketing, general andadministrative expenses included $654,000 and $287,000, respectively, ofnon-cash stock compensation expense recognized under SFAS No. 123R.  This increase was due primarily to increasesin the number of stock option awards granted to our employees during the pasttwelve months.

 

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SeeNote 2 to our consolidated interim financial statements included elsewhere inthis report for a detailed description of the amounts recognized for theperiods presented.

 

****OtherNon-Operating Items****

 
| ** **         | ** ** | **Three Months Ended  March 31,** | ** ** | **Change** | ** ** |
|--------------------|------------|----------------------------------------|------------|------------|------------|
| ** **         | ** ** | **2009**                               | ** ** | **2008**   | ** ** | **$** | ** ** | **%** | ** ** |
|               |       |                                   |       |       |       |   |   |   |   |
| Interest expense   |       | $                                      | (513       | )          | $          | (1 | ) | $ | (512 | ) | — |   |
| Derivative charges |       | (1,521                                 | )          | —     |       | (1,521 | ) | — |   |
|                    |            |                                        |            |            |            |  |  |  |  |  |  |  |

### * *

**InterestExpense.****  Since July 2008,interest expense is recognized from the issuance of a secured convertibledebenture (the “Debenture”), which accrues interest at an annual rate of 10%and with a current principal amount of $8.5 million.  Interest expense also includes amortizationof the $2.9 million of debt discount recognized from issuance of the Debentureand warrants using the effective interest method.**

 

**DerivativeCharges.****  These chargesrepresent the net expense recognized during the period from mark-to-modeladjustments to the embedded derivatives associated with the Debenture that wereoutstanding as of March 31, 2009. There were no such debenture or embedded derivatives outstanding duringthe period ended March 31, 2008. **In accordance with SFAS 133, DerivativeImplementation Group Statement 133 Implementation Issue No. B16, “EmbeddedDerivatives: Calls and Puts in Debt Instruments” and related guidance as well as the early adoption of EITF 07-5, theconversion feature, cash redemption option, potential acceleration of maturityof the Debenture and potential adjustments to the fixed conversion price allrepresent embedded derivatives of the Debenture that are recorded separately atfair value as other liabilities, with the corresponding fair value adjustmentsreflected as non-operating charges or credits, depending upon the results ofmark-to-model valuation adjustments.  Thefair value of the embedded derivatives was determined using the convertiblebond model, discounted cash flows and binomial lattice models.

 

**Inflation**

 

Inflationhas not had a significant impact on our Company.

 

**Liquidity and CapitalResources**

** **

At March 31,2009, cash, cash equivalents and available-for-sale investments totaled $5.9million versus to $9.1 million at December 31, 2008.  Working capital at March 31, 2009 was$5.0 million, compared to $7.6 million at December 31, 2008.  The change in working capital was dueprimarily to the impact of net cash flow activities as discussed below.  The net change in cash and cash equivalentsfor the periods presented was comprised of the following (in thousands):

 
| ** **                                        | ** ** | **Three Months Ended  March 31,** | ** ** |
|---------------------------------------------------|------------|----------------------------------------|------------|
| ** **                                        | ** ** | **2009**                               | ** ** | **2008** | ** ** |
| Net cash provided by (used in) operations:        |       |                                   |       |   |   |
| Operating activities                              |       | $                                      | (2,397     | ) | $ | (2,664 | ) |
| Investing activities                              |       | 1,513                                  |       | 4,012 |   |
| Financing activities                              |       | (747                                   | )          | 24 |   |
| (Decrease) increase in cash and cash  equivalents |       | $                                      | (1,631     | ) | $ | 1,372 |   |

 

*Operating Activities.*  The overall net decrease in cash used inoperating activities for the three months ended March 31, 2009 versus thecomparable period in 2008 was due primarily to a decrease in operating cashoutflows, which totaled $3.6 million for the three months ended March 31,2009 versus $4.1 million in the comparable period in 2008.  This decrease was due primarily from thevariances in timing of vendor payments. The improvement in net cash used in operating activities from thisactivity was partially offset by a decrease in cash inflows from customers,which were $1.2 million for the three months ended March 31, 2009 versus$1.5 million in the comparable period in 2008. Cash inflows from customers decreased for the periods presentedprimarily due to a decrease in billable DoD activity and reduced product salesas discussed above.

 

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*Investing Activities.*  The change in net cash flows from investingactivities was due primarily to net sales of available-for-sale investments inconnection with ongoing cash management activities during the periodspresented.  Also, for the three monthsended March 31, 2009 and 2008, we incurred $13,000 and $18,000,respectively, of capital expenditures.

 

*Financing Activities.*  The decrease in net cash flows from financingactivities was due primarily to the repayment of credit line borrowingstotaling $820,000 during the period ended March 31, 2009 versus no suchactivity in the comparable period in 2008. Also, proceeds from the exercise of common stock options and warrantswere $81,000 during the period ended March 31, 2009 versus $31,000 in thecomparable period in 2008.

 

*Future Liquidity.*  On May 1, 2009, we closed a registereddirect offering (the “Offering”) of our common stock and warrants for grossproceeds of $8.3 million.  Under theterms of the Offering, we sold 1.1 million units for $7.50 per unit toinvestors.  Each unit consisted of oneshare of our common stock and one warrant, each warrant to purchase one shareof our common stock at an exercise price of $9.00 per share.  The warrants may not be exercised until sixmonths after the Offering and have a term of five years.  The warrants are also callable if our commonstock trades at or above $22.50 per share during any 20 trading days during aperiod of 30 consecutive trading days, with a minimum daily trading volume of50,000 shares each day during that 30 trading day period.  Net proceeds from the Offering, net ofplacement agent fees and expenses, were approximately $7.6 million.  We believe that the addition of this capitalwill allow us to meet our operating cash requirements into the later half of2010.  In order for us to continue tomeet our cash requirements beyond 2010, we will be required to increaserevenues, reduce operating costs and possibly to obtain capital from externalsources.  However, there can be noassurances that we will be able to secure additional sources of financing attimes and at terms acceptable to management. The issuance of additional equity securities, should that occur, willcause dilution to our shareholders.  Ifexternal financing sources are not available or are inadequate to fund ouroperations, management will be required to reduce our operating costs includingresearch projects and personnel, which could jeopardize our future strategicinitiatives and business plans.  Forexample, reductions in research and development activities and/or personnel atour Mukilteo, Washington facility could result in the inability to invest theresources necessary to continue to develop next-generation products and improveexisting product lines in order to remain competitive in the marketplace,resulting in reduced revenues and cash flows from the sales of our CustomArrayproducts and services.  Also, reductionsin operating costs at CMDX, should they occur, could jeopardize our ability tolaunch, market and sell additional products and services necessary to grow andsustain our operations and eventually achieve profitability.

 

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

 

·                  the 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.

 

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.

 

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If anyof these transactions were to occur, the split off could be deemed to be ataxable distribution to Acacia.  Inparticular, we have agreed to indemnify Acacia for any tax resulting from anacquisition by one or more persons of a 50% or greater interest in our company.

 

#### **Off-Balance Sheet Arrangements**

 

 

Wehave not entered into off-balance sheet financing arrangements, other thanoperating leases for our office and laboratory premises.  We have no significant commitments forcapital expenditures in 2009 or beyond. We have executed two capital leases totaling $109,000 for certainlaboratory equipment.  The followingtable lists our material known future cash commitments as of March 31,2009:

 
| ** **                         | ** ** | **Payments Due by Period (in thousands)** | ** ** |
|------------------------------------|------------|-------------------------------------------|------------|
| ** **                         | ** ** | ** **                                | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | **2013 and** | ** ** |
| ** **                         | ** ** | **2009**                                  | ** ** | **2010** | ** ** | **2011** | ** ** | **2012** | ** ** | **Thereafter** | ** ** |
| ** **                         | ** ** | ** **                                | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Operating leases                   |       | $                                         | 409        |   | $ | 367 |   | $ | — |   | $ | — |   | $ | — |   |
| Capital leases                     |       | 10                                        |       | 13 |   | 14 |   | 15 |   | 1 |   |
| Minimum royalty payments           |       | 75                                        |       | 100 |   | 100 |   | 100 |   | 575 |   |
| Securred convertible debenture (1) |       | —                                    |       | 8,500 |   | — |   | — |   | — |   |
| Total contractual obligations      |       | $                                         | 494        |   | $ | 8,980 |   | $ | 114 |   | $ | 115 |   | $ | 576 |   |

 

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(1)   The principalamount of the Debenture as of March 31, 2009, which is due the earlier of July 10,2010 or four months after receiving the settlement payment from National Union,is reflected as being due in July, 2010 (the maturity date of the Debenture), assumingno additional conversions or early prepayments occur.

 

**Recent AccountingPronouncements**

 

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

 

**Item 3.        QUANTITATIVE AND QUALITATIVE DISCLOSURESABOUT MARKET RISK**

 

Not required for smallerreporting companies.

 

**Item 4T.     CONTROLSAND PROCEDURES**

 

*Evaluation of DisclosureControls and Procedures*

 

We maintain disclosure controls andprocedures that are designed to ensure that information required to be disclosedin our reports filed or submitted under the Securities Exchange Act of 1934, asamended (the “Exchange Act”) is recorded, processed, summarized and reportedwithin 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 March 31,2009.  Based on this evaluation, ourChief Executive Officer and Chief Financial Officer concluded that as of March 31,2009, the design and operation of our disclosure controls and procedures wereeffective.

 

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*Changes in InternalControls*

 

There wereno changes in our internal control over financial reporting that occurredduring our last fiscal quarter (the quarter ended March 31, 2009) thathave materially affected, or are reasonably likely to materially affect, ourinternal control over financial reporting.

 

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**PART II—OTHER INFORMATION**

** **

**Item 1.  LEGAL PROCEEDINGS**

 

In April of 2005, Acacia and we filed a complaintin U.S. District Court for the Central District of California (the “District Court”) against ourinsurance carrier, National Union Fire Ins. Co. of Pittsburgh, PA (“NationalUnion”), seeking reimbursement of litigation and settlement costs for alawsuit, pursuant to our directors’ and officers’ insurance policy withNational Union.  A trial was held andconcluded during the fourth quarter of 2007. In March 2008, the District Court issued the Judgment in favor ofAcacia and us, and awarded approximately $32.1 million in monetary damages tobe paid by National Union.  In accordancewith the distribution agreement entered into between Acacia and us prior to ourseparation, all proceeds from the lawsuit will be paid to us.  In May 2008, the District Court awardedus an additional $3.6 million in attorneys’ fees and litigation costs, therebyincreasing the overall award to $35.7 million. This award was entered as a final Judgment in May 2008 and willcontinue to earn interest until paid.  National Union has appealed theJudgment to the U.S. Ninth Circuit Court of Appeals, and we intend tovigorously defend against the appeal. The District Court has required, and National Union has posted, anappellate bond in the amount of $39.2 million to cover the Judgment as well asaccrued interest charges.  The appellatebond will remain in place until the appeal process is concluded.

 

**Item 2.  UNREGISTERED SALES OF EQUITY SECURITIES AND USEOF PROCEEDS**

 

During thefirst quarter of 2009, we issued 31,053 shares of our common stock to YA inconsideration of our quarterly interest charges accrued during the fourthquarter of 2008 under the terms of the Debenture.  The issuance of common stock to YA was made pursuantto an exemption under Rule 506 of Regulation D.

 

**Item 6. EXHIBITS**

 
| **Exhibit  Number** | ** ** | **Description**                                                                                      |
|---------------------|------------|------------------------------------------------------------------------------------------------------|
|                |       |                                                                                                 |
| 3.1                 |       | Amended and  Restated Certificate of Incorporation (1)                                               |
| 3.1a                |       | Certificate  of Amendment to Amended and Restated Certificate of Incorporation (2)                   |
| 3.2                 |       | Amended and  Restated Bylaws (1)                                                                     |
| 10.1                |       | Amendment  No. 2 to Lease dated as of March 11, 2009 (2)                                   |
| 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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(1)   Incorporated byreference to CombiMatrix Corporation’s Registration Statement on Form S-1(SEC File No. 333-139679), which became effective June 8, 2007.

(2)   Incorporatedby reference to Exhibit 10.28 to CombiMatrix Corporation’s Annual Reporton Form 10-K filed March 27, 2009.

 

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** **

**SIGNATURES**

** **

Pursuant tothe 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, PH.D. |
|     |                    | Amit Kumar, Ph.D. |
|     |                    | Chief Executive Officer |
| * * |                    | *(Authorized Signatory)* |
|     |                    |
|     |                    |
|     | By:                     | /s/ SCOTT R. BURELL |
|     |                    | Scott R. Burell |
|     |                    | Chief Financial Officer |
| * * |                    | *(Principal Financial and Accounting Officer)* |

 

Date:  May 13, 2009

 

 

**EXHIBITINDEX**

 
| **Exhibit  Number** | ** ** | **Description**                                                                                      |
|---------------------|------------|------------------------------------------------------------------------------------------------------|
|                |       |                                                                                                 |
| 3.1                 |       | Amended and  Restated Certificate of Incorporation (1)                                               |
| 3.1a                |       | Certificate  of Amendment to Amended and Restated Certificate of Incorporation (2)                   |
| 3.2                 |       | Amended and  Restated Bylaws (1)                                                                     |
| 10.1                |       | Amendment  No. 2 to Lease dated as of March 11, 2009 (2)                                   |
| 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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(1)   Incorporated byreference to CombiMatrix Corporation’s Registration Statement on Form S-1(SEC File No. 333-139679), which became effective June 8, 2007.

(2)   Incorporatedby reference to Exhibit 10.28 to CombiMatrix Corporation’s Annual Reporton Form 10-K filed March 27, 2009.

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