**UNITED STATES**

**SECURITIES AND EXCHANGECOMMISSION**

**WASHINGTON, D.C. 20549**

 

----

 

**FORM 10-Q**

 

| **x**                                                   | **QUARTERLY  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE  ACT OF 1934**                                                            |
|---------------------------------------------------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                                                    |                                                                                                                                                               |
| **FOR  THE QUARTERLY PERIOD ENDED MARCH 31, 2008** |
|                                                    |                                                                                                                                                               |
| **OR**                                                  |
|                                                    |                                                                                                                                                               |
| **o**                                                   | **TRANSITION REPORT  PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF  1934**                                                           |
| ** **                                              | **FOR THE TRANSITION PERIOD FROM             TO            .** |

 

**Commission File Number 001-33523**

 

**COMBIMATRIXCORPORATION**

(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 former fiscal year, if changed since last report.)

 

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

 

Indicate by check mark whether the registrant is a large acceleratedfiler, an accelerated filer, a non-accelerated filer, or a smaller reportingcompany. See definitions of “large accelerated filer,” “accelerated filer,” and“smaller reporting company” in Rule 12b-2 of the Exchange Act. (Checkone):

 

| 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 mark whether the registrant isa shell company (as defined in Rule 12b-2 of the Act).   Yes  o  No  x

 

As ofMay 2, 2008, 6,021,844 shares of CombiMatrix Corporation common stock wereissued and outstanding.

 

 

----

 

**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, 2008  (Unaudited) and December 31,  2007 | 3 |
|                                   |       |   |   |
|                                   |       | Consolidated  Statements of Operations for the Three Months Ended March 31,  2008 and 2007 (Unaudited) | 4 |
|                                   |       |   |   |
|                                   |       | Consolidated  Statements of Cash Flows for the Three Months Ended March 31, 2008 and  2007 (Unaudited) | 5 |
|                                   |       |   |   |
|                                   |       | Notes to Consolidated Financial Statements  (Unaudited) | 6 |
|                                   |       |   |   |
|                                   | Item 2.    | Management’s Discussion and Analysis of Financial  Condition and Results of  Operations | 16 |
|                                   |       |   |   |
|                                   | 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**                 | 27         |

 

2

----

 

**COMBIMATRIXCORPORATION**

**CONSOLIDATED BALANCE SHEETS**

**(Inthousands)**

**(Unaudited)**

** **
| ** **                                                                                                     | ** ** | **March 31,** | ** ** | **December 31,** | ** ** |
|----------------------------------------------------------------------------------------------------------------|------------|--------------------|------------|-----------------------|------------|
| ** **                                                                                                     | ** ** | **2008**           | ** ** | **2007**              | ** ** |
| ** **                                                                                                     |       | **(unaudited)**    |       |                  |       |
| **ASSETS**                                                                                                     |       |               |       |                  |       |
|                                                                                                           |       |               |       |                  |       |
| Current assets:                                                                                                |       |               |       |                  |       |
| Cash and cash equivalents                                                                                      |       | $                  | 3,686      |                  | $          | 2,314 |   |
| Available-for-sale investments                                                                                 |       | 958                |       | 5,920                 |       |
| Accounts receivable, net of allowance for  doubtful accounts of $48 and $0                                     |       | 1,190              |       | 692                   |       |
| Inventory                                                                                                      |       | 743                |       | 444                   |       |
| Prepaid expenses and other assets                                                                              |       | 265                |       | 323                   |       |
| Total current assets                                                                                           |       | 6,842              |       | 9,693                 |       |
|                                                                                                           |       |               |       |                  |       |
| Property and equipment, net                                                                                    |       | 1,093              |       | 1,178                 |       |
| Non-current available-for-sale investments                                                                     |       | 848                |       | —                |       |
| Investments in unconsolidated subsidiaries                                                                     |       | 1,678              |       | 1,923                 |       |
| Patents and licenses, net                                                                                      |       | 5,841              |       | 6,131                 |       |
| Goodwill                                                                                                       |       | 16,918             |       | 16,918                |       |
| Total assets                                                                                                   |       | $                  | 33,220     |                  | $          | 35,843 |   |
|                                                                                                           |       |               |       |                  |       |
| **LIABILITIES  AND SHAREHOLDERS’ EQUITY**                                                                 | ** ** | ** **         | ** ** | ** **            | ** ** |
| ** **                                                                                                     | ** ** | ** **         | ** ** | ** **            | ** ** |
| Current liabilities:                                                                                           |       |               |       |                  |       |
| Accounts payable, accrued expenses and  other                                                                  |       | $                  | 2,981      |                  | $          | 2,519 |   |
| Current portion of deferred revenues                                                                           |       | 296                |       | 301                   |       |
| Total current liabilities                                                                                      |       | 3,277              |       | 2,820                 |       |
|                                                                                                           |       |               |       |                  |       |
| Deferred revenues, net of current portion                                                                      |       | 312                |       | 375                   |       |
| Capital lease obligations, net of current  portion                                                             |       | 53                 |       | 6                     |       |
| Total liabilities                                                                                              |       | 3,642              |       | 3,201                 |       |
|                                                                                                           |       |               |       |                  |       |
| Commitments and contingencies (Note 6)                                                                         |       |               |       |                  |       |
|                                                                                                           |       |               |       |                  |       |
| Shareholders’ equity:                                                                                     |       |               |       |                  |       |
| Preferred stock; $0.001 par value;  30,000,000 shares authorized; none issued and outstanding                  |       | —             |       | —                |       |
| Common stock; $0.001 par value; 180,000,000  shares authorized; 6,018,601 and 5,990,515 issued and outstanding |       | 6                  |       | 6                     |       |
| Additional paid-in capital                                                                                     |       | 37,615             |       | 37,223                |       |
| Accumulated other comprehensive (loss)  income                                                                 |       | (69                | )          | 18                    |       |
| Accumulated net losses                                                                                         |       | (7,974             | )          | (4,605                | )          |
| Total shareholders’ equity                                                                                |       | 29,578             |       | 32,642                |       |
| Total liabilities and shareholders’ equity                                                                |       | $                  | 33,220     |                  | $          | 35,843 |   |

 

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

 

3

----

 

**COMBIMATRIXCORPORATION**

**CONSOLIDATED STATEMENTS OF OPERATIONS**

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

**(Unaudited)**

*** ***
| ** **                                                    | ** ** | **Three Months Ended** | ** ** |
|---------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                    | ** ** | **March 31,**               | ** ** |
| ** **                                                    | ** ** | **2008**                         | ** ** | **2007** | ** ** |
|                                                          |       |                             |       |   |   |
| Revenues:                                                     |       |                             |       |   |   |
| Government contracts                                          |       | $                                | 1,069      |   | $ | 549 |   |
| Products                                                      |       | 555                              |       | 440 |   |
| Services                                                      |       | 303                              |       | 85 |   |
| Collaboration agreements                                      |       | 62                               |       | 63 |   |
| Total revenues                                                |       | 1,989                            |       | 1,137 |   |
|                                                          |       |                             |       |   |   |
| Operating expenses:                                           |       |                             |       |   |   |
| Cost of government contracts                                  |       | 1,014                            |       | 534 |   |
| Cost of products                                              |       | 427                              |       | 303 |   |
| Research and development expenses                             |       | 1,323                            |       | 1,848 |   |
| Marketing, general and administrative  expenses               |       | 2,083                            |       | 2,485 |   |
| Patent amortization and royalties                             |       | 361                              |       | 318 |   |
| Equity in loss of investees                                   |       | 249                              |       | 272 |   |
| Total operating expenses                                      |       | 5,457                            |       | 5,760 |   |
| Operating loss                                                |       | (3,468                           | )          | (4,623 | ) |
|                                                          |       |                             |       |   |   |
| Other income (expense):                                       |       |                             |       |   |   |
| Interest income                                               |       | 100                              |       | 150 |   |
| Interest expense                                              |       | (1                               | )          | — |   |
| Warrant gains                                                 |       | —                           |       | 2,378 |   |
| Total other income                                            |       | 99                               |       | 2,528 |   |
|                                                          |       |                             |       |   |   |
| Net loss                                                      |       | $                                | (3,369     | ) | $ | (2,095 | ) |
|                                                          |       |                             |       |   |   |
| Basic and diluted net loss per share                          |       | $                                | (0.56      | ) |   |   |
|                                                          |       |                             |       |   |   |
| Basic and diluted weighted average common  shares outstanding |       | 5,997,087                        |       |   |   |

 

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

 

4

----

 

**COMBIMATRIXCORPORATION**

**CONSOLIDATED STATEMENTS OF CASH FLOWS**

**(Inthousands)**

**(Unaudited)**

*** ***
| ** **                                                                   | ** ** | **Three Months Ended** | ** ** |
|------------------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                                   | ** ** | **March 31,**               | ** ** |
| ** **                                                                   | ** ** | **2008**                         | ** ** | **2007** | ** ** |
|                                                                         |       |                             |       |   |   |
| Operating activities:                                                        |       |                             |       |   |   |
| Net loss                                                                     |       | $                                | (3,369     | ) | $ | (2,095 | ) |
| Adjustments to reconcile net loss to net  cash used in operating activities: |       |                             |       |   |   |
| Depreciation and amortization                                                |       | 460                              |       | 484 |   |
| Non-cash stock compensation                                                  |       | 361                              |       | 475 |   |
| Warrant gains                                                                |       | —                           |       | (2,378 | ) |
| Equity in loss of investees                                                  |       | 249                              |       | 272 |   |
| Allowance for bad debt                                                       |       | 16                               |       | — |   |
| Other                                                                        |       | —                           |       | 27 |   |
| Changes in assets and liabilities:                                           |       |                             |       |   |   |
| Accounts receivable                                                          |       | (514                             | )          | (176 | ) |
| Inventory, prepaid expenses and other  assets                                |       | (250                             | )          | (137 | ) |
| Accounts payable, accrued expenses and  other                                |       | 451                              |       | (552 | ) |
| Deferred revenues                                                            |       | (68                              | )          | (90 | ) |
| Net cash used in operating activities                                        |       | (2,664                           | )          | (4,170 | ) |
|                                                                         |       |                             |       |   |   |
| Investing activities:                                                        |       |                             |       |   |   |
| Purchase of property and equipment                                           |       | (18                              | )          | (53 | ) |
| Purchase of available-for-sale investments                                   |       | —                           |       | (968 | ) |
| Sale of available-for-sale investments                                       |       | 4,030                            |       | 1,089 |   |
| Net cash provided by investing activities                                    |       | 4,012                            |       | 68 |   |
|                                                                         |       |                             |       |   |   |
| Financing activities:                                                        |       |                             |       |   |   |
| Net proceeds from issuance of common stock                                   |       | 31                               |       | — |   |
| Repayment of capital lease obligations                                       |       | (7                               | )          | — |   |
| Net cash flows transferred from Acacia  Research Corporation                 |       | —                           |       | 390 |   |
| Net cash provided by financing activities                                    |       | 24                               |       | 390 |   |
|                                                                         |       |                             |       |   |   |
| Increase (decrease) in cash and cash  equivalents                            |       | 1,372                            |       | (3,712 | ) |
|                                                                         |       |                             |       |   |   |
| Cash and cash equivalents, beginning                                         |       | 2,314                            |       | 7,829 |   |
|                                                                         |       |                             |       |   |   |
| Cash and cash equivalents, ending                                            |       | $                                | 3,686      |   | $ | 4,117 |   |

 

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

 

5

----

 

**COMBIMATRIXCORPORATION**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**(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”), wemerged with and became a wholly owned subsidiary of Acacia Research Corporation(“Acacia”). Also on the Merger Date, Acacia entered into a recapitalizationtransaction whereby Acacia created two classes of registered common stockcalled Acacia Research-CombiMatrix common stock (“AR-CombiMatrix stock”) andAcacia Research-Acacia Technologies common stock (“AR-Acacia Technologies stock”)and divided its existing Acacia common stock into shares of the two new classesof common stock. The AR-CombiMatrix stock was intended to reflect separatelythe performance of CombiMatrix Corporation and its subsidiaries, referred to as“the CombiMatrix group,” whereas the AR-Acacia Technologies stock was intendedto reflect separately the performance of Acacia’s technology business, referredto as “the Acacia Technologies group.” Immediately following the Merger Date,the Company had 1,000 shares of common stock authorized and 100 shares issuedand outstanding, all of which were owned by Acacia.

 

In2006, Acacia announced its intent to split off the Company as an independentpublic company. On December 26, 2006, we filed a registration statementwith the U.S. Securities and Exchange Commission (“SEC”) in order to registerour common stock under the Securities Act of 1934 to be redeemed forAR-CombiMatrix stock.  On June 8,2007, the SEC declared our registration statement effective.  On August 15, 2007 (the “Redemption Date”),all currently issued and outstanding shares of AR-CombiMatrix were redeemed andexchanged for shares of CombiMatrix common stock at a redemption ratio of tenshares of AR-CombiMatrix common stock for one share of CombiMatrix common stock(the “Redemption Ratio”), which is publicly traded on the Nasdaq Capital Marketexchange.  As of the Redemption Date, weare no longer a subsidiary of, nor are we affiliated with, Acacia.

 

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

 

We area diversified biotechnology business, through the development of proprietarytechnologies, products and services in the areas of drug development, geneticanalysis, molecular diagnostics, nanotechnology research, defense and homelandsecurity markets, as well as other potential markets where our products andservices could be utilized. The technologies we have developed include aplatform technology to rapidly produce customizable, 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.  We havealso developed the capabilities of producing arrays that utilize bacterialartificial chromosomes on our arrays, also enabling genetic analysis.  Other technologies include proprietarymolecular synthesis and screening methods for the discovery of potential newdrugs.  We currently recognize revenuesfrom selling these products and services and providing research and developmentservices for organizations including the U.S. Department of Defense (“DoD”) andother strategic partners.

 

CombiMatrixMolecular Diagnostics, Inc. (“CMDX”), our wholly owned subsidiary locatedin Irvine, California, has developed capabilities of producing arrays thatutilize bacterial artificial chromosomes, which also enable genetic analysis.

 

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

 

Throughthe Redemption Date, the consolidated financial statements include allocationsof certain Acacia corporate expenses, including governance, legal, accounting,insurance services, management of treasury and other Acacia corporate andinfrastructure costs. The expense allocations were determined on bases thatAcacia and the Company considered to be a reasonable reflection of theutilization of services provided or the benefit received by us. However, thefinancial information included herein may not reflect the consolidatedfinancial position, operating results, changes in shareholders’ equity and cashflows of the Company in the future or what they would have been had we been aseparate, stand-alone entity during the periods presented.  For the three months ended March 31,2008 and 2007, corporate expenses totaling $0 and $56,000, respectively, wereallocated to us by Acacia.  Acacia ceasedallocating overhead charges to us following the Redemption Date.

 

Theaccompanying consolidated financial statements have been prepared in accordancewith generally accepted accounting principles for interim financial informationand with the instructions to Form 10-Q and Rule 10-01 of RegulationS-X.  Accordingly, certain informationand footnotes required by generally accepted accounting principles in annualfinancial statements have been omitted or condensed in accordance withquarterly reporting requirements of the SEC.

 

6

----

 

**COMBIMATRIX CORPORATION**

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

**(Unaudited)**

 

These interim consolidatedfinancial statements should be read in conjunction with the consolidatedfinancial statements and notes thereto for the year ended December 31,2007, as reported by us in our Annual Report on Form 10-K filed on March 19,2008.  The year-end consolidated balancesheet data was derived from audited financial statements but does not includeall disclosures required by accounting principles generally accepted in theUnited States of America.  Theconsolidated financial statements include all adjustments of a normal recurringnature which, in the opinion of management, are necessary for a fair statementof our financial position as of March 31, 2008, and results of operationsand cash flows for the interim periods presented.  The results of operations for the threemonths ended March 31, 2008, are not necessarily indicative of the resultsto be expected for the entire year.

 

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

 

Wehave a history of incurring net losses and net operating cash flow deficits. Weare also deploying new and unproven technologies and continue to developcommercial products. We have several ongoing long-term development projectsthat involve experimental technology and may require several years andsubstantial expenditures to complete. Based on our cash and investment balances as of December 31, 2007,we believed that our cash and cash equivalent balances, anticipated cash flowsfrom operations and other external sources of available credit would besufficient to meet our cash requirements through September 30, 2008, whichraised substantial doubt about our ability to continue as a going concernbeyond this point.  See Note 3 belowregarding additional liquidity risks due to certain of our available-for-saleinvestments held in auction rate securities (“ARS”) as of December 31,2007 and March 31, 2008.

 

Wewill continue to require capital from external sources, and there can be noassurances that additional sources of financing, including the issuance of debtand/or equity securities will be available at times and at terms acceptable tous. The issuance of equity securities will also 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 CustomArrayTMproducts and services. Also, reduction in operating costs at CMDX, should theyoccur, could jeopardize its ability to launch, market and sell additionalproducts and services necessary in order to grow and sustain its operations andeventually achieve profitability.

 

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

 

·                  market acceptance of products and services;

 

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

 

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

 

·                  the availability and cost of capital;

 

·                  general economic conditions; and

 

·                  governmental regulation that may restrict ourbusiness.

 

Historically,we have been substantially dependent on arrangements with strategic partnersand have relied upon payments by our partners for a significant component ofour working capital. We intend to enter into additional strategic partnershipsto develop and commercialize future products. However, there can be noassurance that we will be able to implement our future plans. Failure toachieve our plans would have a material adverse effect on our ability toachieve our intended business objectives. Our success also depends on ourability to protect our intellectual property, the loss thereof or our failureto secure the issuance of additional patents covering elements of our businessprocesses could materially harm our business and financial condition. The patentscovering our core technology begin to expire in 2018.

 

7

----

 

**COMBIMATRIX CORPORATION**

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

**(Unaudited)**

 

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 adequately to technological advances, changesin customer requirements, changes in regulatory requirements or industrystandards, or any significant delays in the development or introduction ofplanned products or services, could have a material adverse effect on ourbusiness and operating results. The accompanying consolidated financialstatements have been prepared assuming that the Company continues as a goingconcern.  The financial statements do notinclude any adjustments to reflect the possible future effects on therecoverability and classification of assets or the amounts and classificationof liabilities that may result from the matters discussed herein.

 

Inaddition to seeking additional capital from outside sources, our plans inregard to these matters include reductions in personnel and in our overheadcosts that are not considered strategically vital to our business.  Also, we are focusing our sales and productdevelopment efforts on our core diagnostic array platform as well as our fundedresearch and development projects for the DoD.

 

****2.    SUMMARY OF SIGNIFICANTACCOUNTING POLICIES****

 

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

 

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

 

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

 

Revenuesfrom government grants and contracts are recognized in accordance withAccounting Research Bulletin No. 43, “Government Contracts,” and relatedpronouncements, such as Statement of Position 81-1, “Accounting for Performanceof Construction-Type and Certain Production-Type Contracts.”  Accordingly, revenues are recognized underthe percentage-of-completion method of accounting, using the cost-to-costapproach to measure completeness at each reporting period.  Under the percentage-of-completion method ofaccounting, contract revenues and expenses are recognized in the period thatwork is performed based on the percentage of actual incurred costs to totalcontract costs.  Actual contract costsinclude direct charges for labor and materials and indirect charges for labor,overhead and certain general and administrative charges.  Contract change orders and claims areincluded when they can be reliably estimated and are considered probable.  For contracts that extend over a one-yearperiod, revisions in contract cost estimates, if they occur, have the effect ofadjusting current period earnings applicable to performance in priorperiods.  Should current contractestimates indicate an overall future loss to be incurred, a provision is madefor the total anticipated loss in the current period.  Historically, contract revenue recognizedapproximates the amounts invoiced, resulting in no estimated costs and earningsin excess of billings or billings in excess of estimated costs and earnings.

 

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.

 

8

----

 

**COMBIMATRIX CORPORATION**

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

**(Unaudited)**

 

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

 

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

 

Effective January 1,2006, we adopted the provisions of Statement of Financial Accounting Standards(“SFAS”) No. 123 (revised 2004), “Share-Based Payment” (“SFAS 123R”),which sets forth the accounting requirements for “share-based” compensationpayments to employees and non-employee directors and requires that compensationcost relating to share-based payment transactions be recognized in thestatement of operations. The compensation cost for all stock-based awards ismeasured at the grant date, based on the fair value of the award, and isrecognized as an expense, on a straight-line basis, over the employee’srequisite service period (generally the vesting period of the equity award)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 123R requires stock-based compensation expense to be recorded onlyfor those awards expected 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 expensefor all periods presented attributable to our functional expense categorieswere as follows (in thousands; unaudited):

 
| ** **                            | ** ** | **Three Months Ended** | ** ** |
|---------------------------------------|------------|----------------------------------|------------|
| ** **                            | ** ** | **March 31,**               | ** ** |
| ** **                            | ** ** | **2008**                         | ** ** | **2007** | ** ** |
| ** **                            | ** ** | ** **                       | ** ** | ** ** | ** ** |
| Cost of product sales                 |       | $                                | 28         |   | $ | — |   |
| Research and development              |       | 46                               |       | 258 |   |
| Marketing, general and administrative |       | 287                              |       | 217 |   |
| Total non-cash stock compensation     |       | $                                | 361        |   | $ | 475 |   |

 

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

 

**NetLoss Per Share**. As discussed in Note 1, we were a wholly owned subsidiary of Acacia andhad 100 shares of common stock outstanding for all periods presented prior tothe Redemption Date. Therefore, historical net loss per share for the periodspresented prior to the Redemption Date have not been presented in theconsolidated financial statements, as this information is not consideredmeaningful.  Net loss per share has beenpresented for the current financial period only in order to reflect our capitalstructure subsequent to the Redemption Date.

 

Basicand diluted net loss per share has been computed by dividing the net loss bythe weighted average number of common shares issued and outstanding during theperiod.  Options and warrants to purchaseCombiMatrix stock are anti-dilutive and therefore are not included in thedetermination of the diluted net loss per share.  The following table presents a reconciliationof basic and diluted loss per share for the three-months ended March 31,2008 (in thousands, except share and per-share data; unaudited):

 

9

----

 

**COMBIMATRIX CORPORATION**

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

**(Unaudited)**

 
| ** **                                 | ** ** | **March 31,** | ** ** |
|--------------------------------------------|------------|--------------------|------------|
| ** **                                 | ** ** | **2008**           | ** ** |
| Numerator:                                 |       |               |       |
| Loss applicable to common shareholders     |       | $                  | (3,369     | ) |
| Denominator:                               |       |               |       |
| Weighted-average common shares outstanding |       | 5,997,087          |       |
| Basic and diluted loss per share           |       | $                  | (0.56      | ) |
|                                       |       |               |       |
| Common stock options                       |       | 1,014,963          |       |
| Common stock warrants                      |       | 2,337,479          |       |
| Excluded potentially dilutive securities   |       | 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 are classified as available-for-sale, which are reportedat fair value with related unrealized gains and losses in the value of suchsecurities recorded as a component of accumulated other comprehensive incomeuntil realized.  The fair value of our available-for-saleinvestments was determined by quoted market prices at December 31, 2007and in accordance with SFAS No. 157 (see “Fair Value Measurements” belowand in Note 3) subsequent to year-end. We account for investments with fair values less than historical cost inaccordance with FASB Staff Position 115-1, “The Meaning of Other-Than-TemporaryImpairment and Its Application to Certain Investments” (“FSP 115-1”).  Under FSP 115-1, an impairment is deemedother than temporary based on a variety of factors including:  (a) the duration and severity of theimpairment; (b) the ability and intent to hold an investment for a periodof time sufficient for recovery of its carrying amount; and (c) thefinancial condition of the issuer.  Allavailable evidence, both positive and negative, is considered to determinewhether the carrying amount of the investment is recoverable within areasonable period of time.  In general,management does not consider an investment impairment to beother-than-temporary if the duration and amount of the impairment is less thantwelve months and five percent of the historical cost of the investment,respectively.

 

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

 

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

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

 

We adopted SFAS No. 159, “The Fair Value Optionfor Financial Assets and Financial Liabilities,” which provides entities theoption to measure many financial instruments and certain other items at 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.

 

10

----

 

**COMBIMATRIX CORPORATION**

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

**(Unaudited)**

 

*****Recent Accounting Pronouncements.********* ****In December 2007, the FASB issuedSFAS No. 141 (revised 2007), “Business Combinations”**(“SFAS 141R”).  Under SFAS 141R, a company is requiredto recognize the assets acquired, liabilities assumed, contractualcontingencies and contingent consideration at their fair value at theacquisition date.  It further requiresthat acquisition-related costs are to be recognized separately from theacquisition and expensed as incurred. Among other changes, SFAS 141R also requires that “negativegoodwill” be recognized in earnings as a gain attributable to the acquisition,and any deferred tax benefits resulting from a business combination be recognizedin income from continuing operations in the period of the combination.  SFAS 141R is effective for businesscombinations for which the acquisition date is on or after the beginning of thefirst annual reporting period beginning on or after December 15,2008.  We are evaluating what impactSFAS 141R will have on our consolidated financial position, results ofoperations and cash flows.

 

In December 2007, the FASB issued Statement No. 160,“Noncontrolling Interests in Consolidated Financial Statements — anamendment of ARB No. 51” (“SFAS 160”).  SFAS 160 requires a company to clearlyidentify and present ownership interests in subsidiaries held by parties otherthan the company in the consolidated financial statements within the equitysection but separate from the company’s equity. It also requires the amounts of consolidated net income attributable tothe parent and to the noncontrolling interest to be clearly identified andpresented on the face of the consolidated statement of operations; changes inownership interest to be accounted for as equity transactions; and when asubsidiary is deconsolidated, any retained noncontrolling equity investment inthe former subsidiary and the gain or loss on the deconsolidation of thesubsidiary must be measured at fair value. SFAS 160 is effective for fiscal years, and interim periods withinthose fiscal years, beginning on or after December 15, 2008.  We are evaluating what impact SFAS 160will have on our consolidated financial position, results of operations andcash flows.

 

In March 2008, the FASB issued SFAS No. 161,“Disclosures about Derivative Instruments and Hedging Activities, an amendmentof FASB Statement No. 133” (“SFAS 161”).  SFAS 161 requires enhanced disclosuresabout an entity’s derivative instruments and hedging activities including: (1) howand why an entity uses derivative instruments; (2) how derivativeinstruments and related hedged items are accounted for under SFAS 133 andits related interpretations; and (3) how derivative instruments andrelated hedged items affect an entity’s financial position, financialperformance, and cash flows. SFAS 161 is effective for financial statements issued for fiscalyears and interim periods beginning after November 15, 2008, with earlierapplication encouraged.  We areevaluating what impact SFAS 161 will have on our consolidated financialposition, results of operations and cash flows.

 

# **3.**     FAIR VALUE

# ** **

The following table summarizes, for each majorcategory of assets or liabilities, the respective fair value at March 31,2008 and the classification by level of input within the fair value hierarchydefined in SFAS 157 (in thousands, unaudited):

 
| ** **                     | ** ** | **March 31,** | ** ** | **Fair Value Measurements at  March 31, 2008 Using:** | ** ** |
|--------------------------------|------------|--------------------|------------|-------------------------------------------------------------------------------------|------------|
| ** **                     | ** ** | **2008**           | ** ** | **Level 1**                                                                    | ** ** | **Level 2** | ** ** | **Level 3** | ** ** |
| Assets:                        |       |               |       |                                                                                |       |   |   |   |   |
| Cash equivalents               |       | $                  | 2,128      |                                                                                | $          | 2,128 |   | $ | — |   | $ | — |   |
| Available-for-sale investments |       | 1,806              |       | —                                                                              |       | — |   | 1,806 |   |
| Total                          |       | $                  | 3,934      |                                                                                | $          | 2,128 |   | $ | — |   | $ | 1,806 |   |

 

The following table is a reconciliation of financialassets measured at fair value using significant unobservable inputs (Level 3)during the quarter ended March 31, 2008 (in thousands, unaudited):

 

11

----

 

**COMBIMATRIX CORPORATION**

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

**(Unaudited)**

 
| ** **                    | ** ** | **March 31,** | ** ** |
|-------------------------------|------------|--------------------|------------|
| ** **                    | ** ** | **2008**           | ** ** |
|                          |       |               |       |
| Balance, January 1, 2008 |       | $                  | —     |   |
| Transfers of ARS to Level 3   |       | 3,375              |       |
| Purchases and sales of ARS    |       | (1,500             | )          |
| Unrealized losses             |       | (69                | )          |
| Balance, March 31, 2008  |       | $                  | 1,806      |   |

 

At March 31, 2008 and December 31,2007, our available-for-sale investments included $1.9 million and $3.4million, respectively, of ARS at par value.  Historically, the carrying value of our ARSapproximated fair value due to active, liquid markets for these securities aswell as the frequent resetting of the interest rates at auction, whichtypically occurred every 7 to 30 days. However, in mid-February of 2008, the market for ARS collapsed andas a result, our ARS have experienced multiple failed auctions since this timeand are currently illiquid.  Of the $1.9million in par-value ARS held at March 31, 2008, $900,000 are issued by astate student-loan lending organization, carry an A2/A rating and are insuredby the Federal Family Education Loan Program. The remaining $975,000 of ARS are AAA-rated auction market preferredstock issued by publicly traded mutual funds that are required to maintain atleast 200% of asset coverage for issued ARS. All of our ARS continue to pay interest at the maximum contractual rate,which currently exceeds market interest rates for short-term securities.

 

At March 31, 2008, the fair values of ourARS were estimated using discounted cash flow models.  These models consider, among other things,the timing of expected future successful auctions, estimated future cash flows,collateralization and credit worthiness of underlying security investments anddiscount rates applied to the estimated future cash flows.  Since these inputs were not observable, theyare classified as Level 3 inputs under SFAS 157.  As a result of the lack of liquidity in theARS market and not as a result of the quality of the underlying collateral, forthe three months ended March 31, 2008, we recorded an unrealized losson our ARS of $69,000, which is reflected in accumulated other comprehensive(loss) income in our consolidated balance sheet.  Our valuation models assume an averagematurity of one year for our ARS issued in preferred stock and greater than oneyear for our ARS that are backed by student-loans.  As a result, we have classified thestudent-loan ARS with a fair value of $848,000 as a non-current investment inour March 31, 2008 consolidated balance sheet.

 

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

 

# **4. COMPREHENSIVE LOSS**

 

Priorto the Redemption Date, comprehensive loss was included as a component of netallocations from Acacia and was not separately reported in our consolidatedfinancial statements.  The followingtable shows our comprehensive net loss in accordance with SFAS No. 130,“Reporting Comprehensive Income,” subsequent to the Redemption Date (inthousands; unaudited):

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

 

# **5.  COMMON STOCK WARRANTS**

# ** **

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

 

12

----

 

**COMBIMATRIX CORPORATION**

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

**(Unaudited)**

 

Outstandingwarrants to purchase CombiMatrix stock (adjusted for the Redemption Ratio) areas follows:

 
| ** **                  | ** ** | **Number of Warrants Outstanding** | ** ** | ** **            | ** ** | ** **     | ** ** |
|-----------------------------|------------|---------------------------------------------------|------------|-----------------------|------------|----------------|------------|
| ** **                  | ** ** | **March 31,**                                | ** ** | **December 31,** | ** ** | **Exercise**   | ** ** | ** ** | ** ** |
| **Date of Issue** | ** ** | **2008**                                          | ** ** | **2007**              | ** ** | **Price**      | ** ** | **Expiration** | ** ** |
| ** **                  | ** ** | **(unaudited)**                                   | ** ** | ** **            | ** ** | ** **     | ** ** | ** ** | ** ** |
| ** **                  | ** ** | ** **                                        | ** ** | ** **            | ** ** | ** **     | ** ** | ** ** | ** ** |
| May 2007               |       | 970,754                                           |       | 1,017,140             |       | $5.50          |       | May 2012 |   |
| December 2006          |       | 1,178,736                                         |       | 1,178,736             |       | $8.70 - $10.88 |       | December 2011 |   |
| September 2005         |       | 159,648                                           |       | 159,648               |       | $24.00         |       | September 2010 |   |
| May 2003               |       | 28,341                                            |       | 28,341                |       | $27.50         |       | May 2008 |   |
| Total                       |       | 2,337,479                                         |       | 2,383,865             |       |           |       |   |   |

 

Acacia’s classes of common stock were subject to certain redemptionprovisions in the event that Acacia were to sell, transfer, assign or otherwisedispose of, in one transaction or a series of related transactions, all orsubstantially all of the properties and assets attributed to the CombiMatrixgroup, in which case the shareholders of AR-CombiMatrix common stock would havethe right to receive a dividend or a redemption of the stock equal to the netproceeds generated from the sale of assets. Pursuant to guidance set forth in FSP No. 150-5, EITF 00-19 andrelated guidance, we recorded a liability representing the fair value of commonstock warrants issued to investors and adjusted the warrant liability to itsmarket value at each balance sheet date. Our current capital structure does not include the redemption provisionsthat required liability classification of the warrants and as such, since theRedemption Date, we have classified all outstanding warrants to purchaseCombiMatrix common stock as a component of permanent equity.  For the three months ended March 31,2007, adjusting the warrant liabilities to their fair values resulted in netwarrant gains to our consolidated statements of operations of $2,378,000. We have not incurred warrant gains or charges since the Redemption Datefrom our existing warrants as a result of achieving permanent equityclassification as of the Redemption Date.

 

The fair value of AR-CombiMatrix stock purchase warrants at March 31,2007 was determined using the Black-Scholes option-pricing model, usingweighted-average assumptions as follows (unaudited):

 
| ** **              | ** ** | **March 31,** | ** ** |
|-------------------------|------------|--------------------|------------|
| ** **              | ** ** | **2007**           | ** ** |
| ** **              | ** ** | ** **         | ** ** |
| Risk free interest rate |       | 4.60               | %          |
| Volatility              |       | 79                 | %          |
| Expected term           |       | 4.5 years          |       |
| Expected dividends      |       | 0                  | %          |

 

**6.    COMMITMENTS AND CONTINGENCIES**

** **

**Collaboration andResearch Agreements**

 

On July 26, 2007, we executed aone-year, $2.2 million contract with the DoD to further development of ourmicroarray technologies.  The primaryobjectives of the contract are to continue development of a multipathogen andchemical detection system.  Under theterms of this contract, we will perform research and development activities, as described under thecontract, and will be reimbursed on a periodic basis for actual costs incurredto perform these obligations, plus a fixed fee, of up to $2.2 million.  As of March 31, 2008, we had incurred$1.0 million in actual contract costs for the chemical detection contract,which was 63% complete.

 

On March 13,2007, we executed a one-year, $869,000 contract with the DoD, focusing on thedevelopment of a field-deployable influenza genotyping system based on ourelectrochemical detection technology to be used for military and homelandsecurity applications.  Under the termsof this contract, we will perform research and development activities, asdescribed under the contract, and will be reimbursed on a periodic basis foractual costs incurred to perform our obligations, plus a fixed fee, of up to$869,000.  As of March 31, 2008, wehad incurred $603,000 in actual contract costs for the genotyping contract,which was 94% complete.

 

13

----

 

**COMBIMATRIX CORPORATION**

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

**(Unaudited)**

 

On August 9,2006, we executed a two-year, $1.9 million contract with the DoD, focusing onthe integration of our electrochemical detection technology currently underdevelopment with our microfluidics “lab-on-a-chip” technology to be used formilitary and homeland security applications. Under the terms of this contract,we will perform research and development activities, as described under thecontract, and will be reimbursed on a periodic basis for actual costs incurredto perform our obligations, plus a fixed fee, of up to $1.9 million. As of March 31,2008, we had incurred $1.1 million in actual costs for the microfluidicscontract, which was approximately 79% complete.

 

On February 8,2006, we executed a one-year, $2.1 million contract with the DoD to further thedevelopment of our array technology for the electrochemical detection ofbiological and chemical threat agents. Under the terms of this contract, wewill perform research and development activities as described under thecontract and will be reimbursed on a periodic basis for actual costs incurredto perform our obligations, plus a fixed fee, of up to $2.1 million. Wesubstantially completed this contract during the first quarter of 2007 and donot expect to incur significant costs or revenues from this contract beyond thefirst quarter of 2007.

 

**Human Resources**

 

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

 

**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 ofthe settlement agreement, we agreed to make quarterly payments to Nanogen equalto 12.5% of total sales of products developed by us and our affiliates based onthe patents that had been in dispute in the litigation, up to an annual maximumof $1.5 million. The minimum quarterly payments under the settlement agreementare $25,000 per quarter until the patents expire in 2018. Royalty expensesrecognized under the agreement for the three months ended March 31, 2008and 2007 were $43,000 and $25,000, respectively, and are included in patentamortization and royalties in the accompanying consolidated statements ofoperations.

 

In July of2007, Mr. Jeffrey Oster, a former employee of the Company, filed acomplaint against CombiMatrix and others alleging that Mr. Oster’semployment with us was terminated in violation of federal law and was a breachof his employment contract.  Mr. Osteris requesting damages for back pay, front pay in lieu of reinstatement underhis employment agreement, damages for adverse tax consequences, and attorney’sfees and costs.  We believe Mr. Oster’sclaims are without merit and continue to vigorously defend against them.  We have alleged counterclaims against Mr. Osterfor breach of employment contract, breach of common law duties of loyalty andconfidentiality, and misappropriation of trade secrets, with a demand forunspecified damages.  A trial date hasbeen scheduled for early 2009.

 

In September of2005, Ms. Jennifer Dent and Mr. Michael Strathmann (a marriedcouple), who are both former employees of the Company, filed a complaintagainst the Company asserting claims arising out of the resignation of theiremployment with CombiMatrix and were seeking alleged unpaid bonuses and salescommissions. They also raised other claims regarding certain intellectualproperty rights.  We believe these claimsare without merit and have vigorously defended against them.  We have asserted intellectual propertycounterclaims against Mr. Strathmann and have asked for certain injunctiverelief and damages based on those counterclaims.  This case went to trial on January 14,2008 and closing arguments were made on March 17, 2008.  A decision is expected later in 2008.

 

In April of2005, we and Acacia filed a complaint in the U.S. District Court for theCentral District of California (the “Court”) against our insurance carrier,National Union Fire Ins. Co. of Pittsburgh, PA (“National Union”), seekingreimbursement of litigation and settlement costs for a lawsuit, pursuant to ourdirectors’ and officers’ insurance policy with National Union.  In March of 2008, the Court issued ajudgment (the “Judgment”) in favor of Acacia and us, and awarded approximately$32.1 million in monetary damages to be paid by National Union.  In accordance with the distribution agreemententered into between us and Acacia prior to the Redemption Date, all proceedsfrom the lawsuit will be paid to us.  Itis possible that National Union will appeal the Judgement, in which case weinted to vigerously defend the appeal.

 

14

----

 

**COMBIMATRIX CORPORATION**

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

**(Unaudited)**

 

**7.****  ****SUBSEQUENT EVENTS**

 

On April 23, 2008, the Court awardedCombiMatrix an additional $3.6 million in attorneys’ fees and litigation costsrelating to its previous $32.1 million Judgment against National Union, therebyincreasing the overall award payable to CombiMatrix to $35.7 million.  This award will be entered as a FinalJudgment at a later date, and will continue to earn interest until paid.

 

On May 9, 2008, pursuant to a loan managementaccount agreement (“LMA”) with a financial institution, we borrowed $807,500,secured by our current holdings in ARS. The LMA is similar to a revolving line of credit borrowing facility.  The LMA provides that we are to pay monthlyinterest-only payments 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, up to a maximum amount of $2.8 million.  However, based upon the amount and type ofsecurities currently held by us with the financial institution, the maximumborrowing ceiling is limited to $807,500.

 

15

----

 

**Item 2.****   ****MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITIONAND 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 information contained in this Quarterly Report on Form 10-Qis not a complete description of our businesses or the risks associated with aninvestment in our common stock. We urge you to carefully review and considerthe various disclosures made by us in this report and in our other reportsfiled with the U.S. Securities and Exchange Commission, or SEC, including ourAnnual Report on Form 10-K, filed on March 19, 2008.

 

This reportcontains forward-looking statements within the meaning of the “safe harbor” provisionsof the Private Securities Litigation Reform Act of 1995. Reference is made inparticular 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 arebased on management’s current expectations and are subject to a number offactors and uncertainties, which could cause actual results to differmaterially from those described in the 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 accounting matters.Actual results in each case could differ materially from those anticipated insuch statements by reason of factors such as future economic conditions,changes in consumer demand, legislative, regulatory and competitivedevelopments in markets in which we and our subsidiaries operate, results oflitigation and other circumstances affecting anticipated revenues and costs. Weexpressly disclaim any obligation or undertaking to release publicly anyupdates 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 such results to differ materially fromthose described in the forward-looking statements are set forth in connectionwith the forward-looking statements and in the “Risk Factors” described in ourAnnual Report on Form 10-K filed on March 19, 2008.

 

## **General**

## ** **

We area diversified biotechnology business, through the development of proprietarytechnologies, products and services in the areas of drug development, geneticanalysis, molecular diagnostics, nanotechnology research, defense and homelandsecurity markets, as well as other potential markets where our products andservices could be utilized. The technologies we have developed include aplatform technology to rapidly produce customizable, 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.  We havealso developed the capabilities of producing arrays that utilize bacterialartificial chromosomes on our arrays, also enabling genetic analysis.  Other technologies include proprietarymolecular synthesis and screening methods for the discovery of potential newdrugs.  We currently recognize revenuesfrom selling these products and services and providing research and developmentservices for organizations including the U.S. Department of Defense and otherstrategic partners.

 

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

 

## **Relationship With 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**.”

 

16

----

 

On thesame date, Acacia entered into a recapitalization transaction whereby Acaciacreated two classes of registered common stock called AcaciaResearch-CombiMatrix common stock (“**AR-CombiMatrix stock**”) andAcacia Research-Acacia Technologies common stock (“**AR-Acacia Technologies stock**”)and divided its existing Acacia common stock into shares of the two new classesof common stock. The AR-CombiMatrix stock was intended to reflect separatelythe performance of the CombiMatrix Corporation and its subsidiaries, referredto as the******“CombiMatrix group****,**” whereas theAR-Acacia Technologies stock was intended to reflect separately the performanceof Acacia’s technology business, referred to as “**Acacia Technologies group**.”

 

In December 2006,we filed a registration statement on Form S-1 with the Securities andExchange Commission (“SEC”) to register our common stock in order to affect asplit off of our Company from Acacia by redeeming shares of existingAR-CombiMatrix common stock with our common stock.  The Form S-1 was declared effective bythe SEC on June 8, 2007 and on August 15, 2007 (the “Redemption Date”),each one (1) share of our common stock was issued in exchange for everyten (10) shares AR-CombiMatrix common issued and outstanding on August 15,2007.  Since the Redemption Date, we areno longer a subsidiary or an affiliate of Acacia, and the holders ofAR-CombiMatrix became the stockholders of our company.  Our common stock currently trades on theNasdaq Global Market under the symbol “CBMX.”

 

## **Liquidity**

## ** **

At March 31,2008 and December 31, 2007, we had cash, cash equivalents and short- andlong-term available-for-sale investments of $5.5 million and $8.2 million.  As a result, we anticipated that our cash,cash equivalents and anticipated cash flows from operations would be sufficientto meet our cash requirements through September of 2008.  In order for our company to continue as agoing concern beyond this point and ultimately to achieve profitability, wewill be required to obtain capital from external sources, increase revenues andreduce operating costs.  However, therecan be no assurance that such capital will be available at times and at termsacceptable to us, or that higher levels of product and service revenues will beachieved.  The issuance of additionalequity securities will also cause dilution to our shareholders.  If external financing sources of financingare not available or are inadequate to fund our operations, we will be requiredto reduce operating costs including research projects and personnel, whichcould jeopardize the future strategic initiatives and business plans of ourcompany.

 

As of March 31,2008, our short- and long-term available-for-sale investments (net ofunrealized losses) of $1.8 million were held in auction rate securities (“ARS”),which are currently illiquid due to the collapse in the auction rate securitiesmarket since February of 2008.  Theinability to liquidate the remainder of these securities at par value in thenear future could materially jeopardize our ability to execute our businessstrategies.  See the Liquidity andCapital Resources section below as well as Notes 1, 3 and 7 to the consolidatedfinancial statements included elsewhere in this report for additionaldiscussion of these matters.

 

## **Basis Of Presentation Of Financial Statements**

## ** **

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

 

## **Overview Of Recent Business Activities**

## ** **

Forthe three months ended March 31, 2008, our operating activities includedthe recognition of $2.0 million in revenues, including $1.1 million ingovernment contract revenues and $920,000 in CustomArray product anddiagnostics service revenues.  Researchand development expenses, excluding government contract costs and non-cashstock based compensation, decreased due primarily to the impact of our costreduction efforts, which began during the fourth quarter of 2006 and continuedduring the first and second quarter of 2007. Such efforts also contributed to the overall decrease in general andadministrative expenses, which were impacted primarily by the execution of anamendment to our facilities lease in Mukilteo that reduced the amount of spaceas well as the lease rate paid by us.

 

17

----

 

Significantbusiness developments that occurred during the quarter ended March 31,2008 were as follows:

 

| · | In  December of 2007, we announced that CMDX had launched the first of its  ATScanTM suite of comparative genomic hybridization (“CGH”) array  tests to detect known copy-number variations associated with Autism Spectrum  Disorder (“ASD”). During January of 2008, we announced that a number of  peer-reviewed scientific publications, including an article in the New  England Journal of Medicine and the American Journal of Human Genetics,  confirmed the validity and importance of CMDX’s ATScan test for ASD.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               |
|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| · | On January 31,  2008, CombiMatrix and  Clarient, Inc. (Nasdaq: CLRT) jointly announced the establishment of a  strategic partnership to market and sell a genomics-based cancer test called  HemeScanTM, which is a comprehensive test related to  the treatment and care of chronic lymphocytic leukemia, among other cancers.  The HemeScan test was developed by CMDX and validated in collaboration with a  team of academic centers, including the M.D. Anderson Cancer Center in  Houston, the University of Texas Health Science Center in San Antonio, and  Netherlands Cancer Institute in Amsterdam.                                                                                                                                                                                                                                                                                                                                                                                                                                 |
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| · | On  February 15, 2008, we announced that Dr. Kavita Reddy had joined CMDX as its  Laboratory Director. Dr. Reddy is a Diplomat of the American Board of  Medical Genetics in Clinical Molecular Genetics and Clinical Cytogenetics and  is also licensed in New York and California in both cytogenetics and  molecular genetics.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             |
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| · | On February 26, 2008, we announced that CMDX  had completed clinical validation and had commercially launched the HerScanTM test, the first CGH array-based diagnostics test for breast cancer.  The HerScan test is designed to detect amplification of the HER2 gene in  early breast cancer while simultaneously giving clinicians a complete profile  of a patient’s tumor genome.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| · | On  March 7, 2008, we announced that the U. S. District Court for the Central District of California (the  “Court”) issued a Judgment in favor of Acacia and CombiMatrix by awarding us  $32.1 million in monetary damages, to be paid by our insurance carrier,  National Union Fire Ins. Co. of Pittsburgh, PA (“National Union”), which had  refused to defend and indemnify us under our directors’ and officers’  insurance policy with National Union. On April 23, 2008, the  Court awarded CombiMatrix an additional $3.6 million in attorneys’ fees and  litigation costs relating to its previous Judgment against National Union,  thereby increasing the overall award payable to CombiMatrix to $35.7 million.  This award will be entered as a Final Judgment at a later date, and will  continue to earn interest until paid. In accordance with the distribution  agreement entered into between us and Acacia prior to the Redemption Date,  all proceeds from the lawsuit will be paid to us. |
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| · | On  April 8, 2008, we  announced that CMDX had completed clinical validation and had launched the  BAC HD ScanTM test, which is CMDX’s highest-density CGH  test launched to-date. This test utilizes CMDX’s bacterial artificial  chromosome array technology and is comprised of 2,437 unique validated loci  obtained through the CMDX’s partnership with The Center of Applied Genomics  (TCAG), in Toronto, Canada.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             |

 

**Critical Accounting Estimates**

 

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

 

18

----

 

**Comparison of the Resultsof Operations for the Three Months Ended March 31, 2008 and 2007**

** **

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

** **
| ** **                   | ** ** | **Three Months Ended** | ** ** |
|------------------------------|------------|----------------------------------|------------|
| ** **                   | ** ** | **March 31,**               | ** ** |
| ** **                   | ** ** | **2008**                         | ** ** | **2007** | ** ** |
|                         |       |                             |       |   |   |
| Government contracts         |       | $                                | 1,069      |   | $ | 549 |   |
| Cost of government contracts |       | (1,014                           | )          | (534 | ) |
| Products                     |       | 555                              |       | 440 |   |
| Cost of products             |       | (427                             | )          | (303 | ) |
| Services                     |       | 303                              |       | 85 |   |
| Collaboration agreements     |       | 62                               |       | 63 |   |
|                              |            |                                  |            |  |  |  |  |

 

**GovernmentContracts and Cost of Government Contracts. **Under the terms of our contracts with the U.S.Department of Defense (“DoD”), we are reimbursed on a periodic basis for actualcosts incurred to perform our obligations, plus a fixed fee.  Revenues are recognized under thepercentage-of-completion method of accounting, using the cost-to-cost approachto measure completeness at the end of the each reporting period.  Cost of government contracts reflect researchand development expenses incurred in connection with our commitments under ourcurrent contracts with the DoD.

 

Governmentcontract revenues for the three-month periods ended March 31, 2008 vs.2007 reflect ongoing performance of our electrochemical detection,microfluidics and influenza genotyping contracts.  Changes in the number of contracts underwaycoupled with increases in the underlying contract activity contributed to theoverall increase for the comparable periods. These changes in contract activity also contribute to the change ingovernment contract costs during the three-month periods ended March 31,2008 vs. 2007.  See Note 6 to ourconsolidated financial statements included elsewhere in this report for adetailed description of the amounts, completion rates and estimated costs tocomplete of our government contracts that are ongoing as well as priorcontracts that were completed during the years 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. Product revenues include the sale of DNA synthesizer instruments,CustomArray 12K, 4X2K and 90K DNA expression arrays, ElectraSense®microarray readers and related hardware during the three-month period ended March 31,2008, compared to 12K and 4X2K DNA expression arrays, ElectraSense readers andrelated hardware during the comparable 2007 period.  The increase in product revenues was dueprimarily to the increase of DNA synthesizer instrument sales for thethree-month period ended March 31, 2008 vs. the comparable 2007period.  As we expand our business focusfrom exclusively selling array-based research and development products toproviding array-based diagnostic services, we have reduced internal sales staff,marketing and production efforts regarding sales of CustomArray products andinstead have executed product distribution and manufacturing agreements withvarious third party distributors for the sales of our suite of CustomArrayproducts into the research and development markets.  As a result, CustomArray product revenueswill likely be volatile in future periods depending on the sales efforts of ourdistributors.

 

*Services.* Services revenue includes amortization of one-year equipment maintenanceand service contracts executed with certain customers of our DNA synthesizersas well as diagnostic services provided by CMDX.  Diagnostic services revenue from CMDX was$273,000 and $28,000 for the three-month periods ended March 31, 2008 and2007, respectively, and have increased due to an increased number of diagnostictest offerings due primarily to increased sales and marketing efforts at CMDXduring the periods presented.

 

**Operating Expenses (InThousands)**

 
| ** **                        | ** ** | **Three Months Ended** | ** ** |
|-----------------------------------|------------|----------------------------------|------------|
| ** **                        | ** ** | **March 31,**               | ** ** |
| ** **                        | ** ** | **2008**                         | ** ** | **2007** | ** ** |
|                              |       |                             |       |   |   |
| Research and development expenses |       | $                                | 1,323      |   | $ | 1,848 |   |
|                                   |            |                                  |            |  |  |  |  |

 

*Research and Development Expenses*.  The decrease in internal research anddevelopment expenses was due primarily to the impact of cost reduction effortsin the area of full-time staff and ongoing research and development projectsfor the CustomArray platform, while continuing to develop microarray-baseddiagnostics services.

 

19

----

 

Inaddition, for the three-month periods ended March 31, 2008 and 2007,research and development expenses included $46,000 and $258,000, respectively,of non-cash stock compensation expense incurred under SFAS No. 123R.  See Note 2 to our consolidated financialstatements included elsewhere in this report for a detailed description of theamounts recognized and assumptions used by management in determining thestock-based compensation charges incurred 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 development.   We expect our research and developmentexpenses to continue to fluctuate and such expenses could increase in futureperiods as additional internal research and development agreements areundertaken and/or as new research and development collaborations are executedwith strategic partners.

 
| ** **                                      | ** ** | **Three Months Ended** | ** ** |
|-------------------------------------------------|------------|----------------------------------|------------|
| ** **                                      | ** ** | **March 31,**               | ** ** |
| ** **                                      | ** ** | **2008**                         | ** ** | **2007** | ** ** |
|                                            |       |                             |       |   |   |
| Marketing, general and administrative  expenses |       | $                                | 2,083      |   | $ | 2,485 |   |
| Patent amortization and royalties               |       | 361                              |       | 318 |   |
| Equity in loss of of investees                  |       | 249                              |       | 272 |   |
|                                                 |            |                                  |            |  |  |  |  |

 

**Marketing,General and Administrative Expenses.**  The decrease in marketing, general andadministrative expenses was due primarily to a decrease in facilities-relatedcosts from executing the February 1, 2007 lease amendment thatsignificantly reduced our office space and lease rates, reduction in sales andmarketing staff and expenses at our Mukilteo operations and decreases in one-timeaccounting and legal costs incurred during 2007 as part of our split off fromAcacia.  In addition, for the three-monthperiods ended March 31, 2008 and 2007, marketing, general andadministrative expenses included $287,000 and $217,000, respectively, ofnon-cash stock compensation expense incurred under SFAS No. 123R.  See Note 2 to our consolidated financialstatements included elsewhere in this report for a detailed description of theamounts recognized and assumptions used by management in determining thestock-based compensation charges incurred for the periods presented.

 

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

### * *

**WarrantGains. ****Prior to the RedemptionDate and**in accordance with SFAS No. 150, “Accountingfor Certain Instruments with Characteristics of Both Liabilities and Equity,”and related interpretations, the outstanding AR-CombiMatrix stock purchasewarrants were classified as long-term liabilities due to certain redemptionprovisions associated with the underlying AR-CombiMatrix stock.  Changes in the fair value of the stockpurchase warrant liabilities were reflected in the consolidated statement ofoperations, which resulted in a net, non-cash benefit of $2.4 million for thethree-month period ended March 31, 2007. On the Redemption Date, all outstanding warrants to purchaseAR-CombiMatrix common stock became exercisable in CombiMatrix common stock,which is not subject to the redemption provisions that required liabilityclassification of the warrants prior to the Redemption Date.

 

**Inflation**

 

Inflationhas not had a significant impact on our Company.

 

**Liquidity and CapitalResources**

 

At March 31,2008, cash, cash equivalents and short- and long-term available-for-saleinvestments totaled $5.5 million compared to $8.2 million at December 31,2007.  Working capital at March 31,2008 was $3.6 million, compared $6.9 million at December 31, 2007.  The change in working capital was dueprimarily to the impact of net cash flow activities as discussed below as wellas the reclassification of certain of our ARS to long-term.  The net change in cash and cash equivalentsfor the periods presented was comprised of the following (in thousands):

 

20

----

 
| ** **                                             | ** ** | **Three Months Ended** | ** ** |
|--------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                             | ** ** | **March 31,**               | ** ** |
| ** **                                             | ** ** | **2008**                         | ** ** | **2007** | ** ** |
| Net cash provided by (used in) continuing  operations: |       |                             |       |   |   |
| Operating activities                                   |       | $                                | (2,664     | ) | $ | (4,170 | ) |
| Investing activities                                   |       | 4,012                            |       | 68 |   |
| Financing activities                                   |       | 24                               |       | 390 |   |
| Increase (decrease) in cash and cash  equivalents      |       | $                                | 1,372      |   | $ | (3,712 | ) |

 

*Operating Activities.*  The overall decrease in cash used inoperating activities for the three-month period ended March 31, 2008 vs.the comparable period in 2007 was due primarily to a decrease in operating cashoutflows, which totaled $4.1 million in 2008 compared to $5.0 million in2007.  This decrease was due primarily todecreased research and development and general and administrative costsincurred as a result of the cost reduction efforts discussed above, as well asthe net impact of the timing of the payments to certain vendors.  Contributing to the overall decrease in cashused in operating activities was an increase in cash receipts from customers,which totaled $1.5 million in 2008 compared to $0.9 million in 2007.  Included in cash receipts from customers wasgovernment contract billings of $0.8 million in 2008 vs. $0.4 million in thecomparable period in 2007, as well as receipts from array product and servicecustomers, which totaled $0.7 million in 2008 compared to $0.5 million in 2007.  The overall increase in cash receipts fromcustomers was due to higher revenues and increased billings during thethree-month period ended March 31, 2008 vs. the comparable period in 2007.

 

*Investing Activities.*  The change in net cash flows provided byinvesting activities was due primarily to net sales of available-for-saleinvestments in connection with ongoing cash management activities during theperiods presented.  For the three-monthperiods ended March 31, 2008 and 2007, we incurred $18,000 and $53,000,respectively, of capital expenditures.

 

*Financing Activities.*  The amounts and changes in net cash flowsfrom financing activities were not significant for the periods presented.

 

Basedon our ending cash balances as of December 31, 2007, we believed that ourcash and cash equivalent balances, anticipated cash flows from operations andexternal sources of funding from the capital markets will be sufficient to meetour cash requirements through September 2008.  In order for us to continue to meet our cashrequirements beyond this point, we will be required to obtain capital fromexternal sources.  However, there can beno assurances that we will be able to secure additional sources of financing attimes and at terms acceptable to management. The issuance of additional equity securities will also cause dilution toour shareholders.  If external financingsources of financing are not available or are inadequate to fund ouroperations, management will be required to reduce our operating costs includingresearch projects and personnel, which could jeopardize our future strategicinitiatives and business plans.  Forexample, reductions in research and development activities and/or personnel atour Mukilteo, Washington facility could result in the inability to invest theresources necessary to continue to develop next-generation products and improveexisting product lines in order to remain competitive in the marketplace,resulting in reduced revenues and cash flows from the sales of our CustomArrayproducts and services.  Also, reductionsin operating costs at CMDX, should they occur, could jeopardize our ability tolaunch, market and sell additional products and services necessary to grow andsustain our operations and eventually achieve profitability.  As discussed in Note 1 to the consolidatedfinancial statements included herein, the anticipation that we would berequired to obtain additional financing in the foreseeable future raisedsubstantial doubt about our ability to continue as a going concern beyond September of2008.  In addition to seeking capitalfrom outside sources, our plans in regard to these matters included reductionsin personnel and in fixed overhead costs (e.g., our lease commitment reductiondiscussed elsewhere herein) made in 2007. Also, we are focusing our sales and product development efforts on ourcore diagnostic array platform as well as our funded research and developmentprojects for the DoD.

 

*AuctionRate Securities.*  At March 31, 2008 and December 31,2007, our available-for-sale investments included $1.9 million and $3.4million, respectively, of ARS at par value.  Historically, the carrying value of our ARSapproximated fair value due to active, liquid markets for these securities aswell as the frequent resetting of the interest rates at auction, which typicallyoccurred every 7 to 30 days.  However, inmid-February of 2008, the market for ARS collapsed and as a result, ourARS have experienced multiple failed auctions since this time and are currentlyilliquid.  Of the $1.9 million inpar-value ARS held at March 31, 2008, $900,000 are issued by a statestudent-loan lending organization, carry an A2/A rating and are insured by theFederal Family Education Loan Program.

 

21

----

 

The remaining$975,000 of ARS are AAA-rated auction market preferred stock issued by publiclytraded mutual funds that are required to maintain at least 200% of assetcoverage for issued ARS.  All of our ARScontinue to pay interest at the maximum contractual rate, which currentlyexceeds market interest rates for short-term securities.

 

At March 31, 2008, the fair values of ourARS were estimated using discounted cash flow models.  These models consider, among other things,the timing of expected future successful auctions, estimated future cash flows,collateralization and credit worthiness of underlying security investments anddiscount rates applied to the estimated future cash flows.  Since these inputs were not observable, theyare classified as Level 3 inputs under Statement of Financial AccountingStandards No 157, “Fair Value Measurements.” As a result of the lack of liquidity in the ARS market and not as aresult of the quality of the underlying collateral, for the three months ended March 31, 2008,we recorded an unrealized loss on our ARS of $69,000, which is reflected inaccumulated other comprehensive (loss) income in our March 31, 2008consolidated balance sheet.  Ourvaluation models assume an average maturity of one year for our ARS issued inpreferred stock and greater than one year for our ARS that are backed bystudent-loans.  As a result, we haveclassified the student-loan ARS with a fair value of $848,000 as a non-currentinvestment in our March 31, 2008 consolidated balance sheet.

 

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

 

On May9, 2008, pursuant to a loan management account agreement (“LMA”) with afinancial institution, we borrowed $807,500, secured by our current holdings inARS.  The LMA is similar to a revolvingline of credit borrowing facility.  TheLMA provides that we are to pay monthly interest-only payments at an annual,variable rate of 1% plus the 30-day LIBOR rate. The total amount available under the LMA ranges from 50% to 92% ofinvestments pledged as collateral, based upon the amount and security type, upto a maximum amount of $2.8 million. However, based upon the amount and type of securities currently held byus with the financial institution, the maximum borrowing ceiling is limited to$807,500.

 

*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.

 

Ourlong-term capital requirements will be substantial and the adequacy ofavailable funds will depend upon many factors, 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;

 

·                  our ability to license technology;

 

·                  competing technological developments;

 

·                  the creation and formation of strategicpartnerships; and

 

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

 

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

 

22

----

 

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

#### ** **

Wehave not entered into off-balance sheet financing arrangements, other thanoperating leases for our premises.  Wehave no significant commitments for capital expenditures in 2007 or beyond.  Other than as set forth below, we have nocommitted lines of credit or other committed funding or long-term debt.  The following table lists our material knownfuture cash commitments as of March 31, 2008:

 
| ** **                         | ** ** | **Payments Due by Period (in thousands)** | ** ** |
|------------------------------------|------------|--------------------------------------------------------------------|------------|
| ** **                         | ** ** | **2008**                                                           | ** ** | **2009** | ** ** | **2010** | ** ** | **2011** | ** ** | **2012 and  Thereafter** | ** ** |
|                               |       |                                                               |       |   |   |   |   |   |   |   |   |
| Operating leases                   |       | $                                                                  | 431        |   | $ | 517 |   | $ | 353 |   | $ | — |   | $ | — |   |
| Minimum royalty payments           |       | 75                                                                 |       | 100 |   | 100 |   | 100 |   | 675 |   |
| Total contractual cash obligations |       | $                                                                  | 506        |   | $ | 617 |   | $ | 453 |   | $ | 100 |   | $ | 675 |   |

 

**Recent AccountingPronouncements**

 

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

 

**Item 3.****                      ****QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK**

 

Our exposure to market risk is limited to interest income sensitivity,which is affected by changes in the general level of U. S. interest rates,particularly because the majority of our investments are in short-term debtsecurities issued by the U.S. treasury and by U.S. corporations as well asARS.  The primary objective of ourinvestment activities is to preserve principal while at the same timemaximizing the income we receive without significantly increasing risk.  To minimize risk, we maintain our portfolioof cash, cash equivalents and available-for-sale investments in a variety ofinvestment-grade securities and with a variety of issuers, including corporatenotes, commercial paper, government securities, ARS and money market funds.

 

We are exposed to liquidity and credit riskassociated with our ARS.  In the event ofa failed auction, we would not have access to these funds until a futureauction is successful.  If the issuersare unable to successfully close future auctions and their credit ratingsdeteriorate, we may be required to adjust the carrying value of theseinvestments through an impairment charge. Included within our investment portfolio at March 31, 2008, are ARSwith a par-value of $1.9 million and a fair value computed by management of$1.8 million.

 

**Item 4T.     CONTROLSAND PROCEDURES**

 

*Evaluation of DisclosureControls and Procedures*

 

We maintain disclosure controls and procedures that are designed toensure that information required to be disclosed in our reports filed orsubmitted under the Security Exchange Act of 1934, as amended (the “ExchangeAct”) is recorded, processed, summarized and reported within the time periodsspecified in Security and Exchange Commission (“SEC”) rules andforms.  Our disclosure controls andprocedures include, without limitation, controls and procedures designed toensure that information required to be disclosed in our reports filed under theExchange Act is accumulated and communicated to management as appropriate toallow timely 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 31,2008.  Based on this evaluation, ourChief Executive Officer and Chief Financial Officer concluded that as of March 31,2008, the design and operation of our disclosure controls and procedures wereeffective.

 

23

----

 

*Changes in InternalControls*

 

There wereno changes in our internal control over financial reporting that occurredduring our last fiscal quarter (the quarter ended March 31, 2008) thathave materially affected, or are reasonably likely to materially affect, ourinternal control over financial reporting.

 

24

----

 

**PART II—OTHER INFORMATION**

** **

**Item 1.  LEGAL PROCEEDINGS**

 

In July of2007, Mr. Jeffrey Oster, a former employee of the Company, filed acomplaint against CombiMatrix and others alleging that Mr. Oster’semployment with us was terminated in violation of federal law and was a breachof his employment contract.  Mr. Osteris requesting damages for back pay, front pay in lieu of reinstatement underhis employment agreement, damages for adverse tax consequences, and attorney’sfees and costs.  We believe Mr. Oster’sclaims are without merit and continue to vigorously defend against them.  We have alleged counterclaims against Mr. Osterfor breach of employment contract, breach of common law duties of loyalty andconfidentiality, and misappropriation of trade secrets, with a demand forunspecified damages.  A trial date hasbeen scheduled for early 2009.

 

In September of2005, Ms. Jennifer Dent and Mr. Michael Strathmann (a marriedcouple), who are both former employees of the Company, filed a complaintagainst the Company asserting claims arising out of the resignation of theiremployment with CombiMatrix and were seeking alleged unpaid bonuses and salescommissions. They also raised other claims regarding certain intellectualproperty rights.  We believe these claimsare without merit and have vigorously defended against them.  We have asserted intellectual propertycounterclaims against Mr. Strathmann and have asked for certain injunctiverelief and damages based on those counterclaims.  This case went to trial on January 14,2008 and closing arguments were made on March 17, 2008.  A decision is expected later in 2008.

 

In April of 2005, we and Acacia filed a complaintin the U.S. District Court for the Central District of California (the “Court”)against our insurance 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.  In March of 2008,the Court issued a judgment (the “Judgment”) in favor of Acacia and us, andawarded approximately $32.1 million in monetary damages to be paid by NationalUnion.  In accordance with thedistribution agreement entered into between us and Acacia prior to ourseparation, all proceeds from the lawsuit will be paid to us.  It is possible that National Union willappeal the Judgement, in which case we inted to vigerously defend the appeal.  On April 23, 2008, the Court awardedCombiMatrix an additional $3.6 million in attorneys’ fees and litigation costs,thereby increasing the overall award to $35.7 million.  This award will be entered as a FinalJudgment at a later date, and will continue to earn interest until paid.

 

**Item2.  UNREGISTERED SALES OF EQUITYSECURITIES AND USE OF PROCEEDS**

 

In March 2008, weissued 20,948 shares of our common stock upon the exercise of threewarrants.  The warrants, issued in May2007, entitled the holders to purchase an aggregate of up to 46,386 shares ofour common stock at $5.50 per share, but contained provisions permittingexercise on a cashless basis.  Becausethe holders elected to exercise their warrants on a cashless basis, only 20,948shares of common stock were issued, and we received no proceeds from thewarrant exercises.  We believe that theissuances of common stock were exempt from registration pursuant to Section3(a)(9) of the Securities Act of 1933.

 

**Item 6. EXHIBITS**

** **
| **Exhibit  Number** | ** ** | **Description**                                                                                      |
|---------------------|------------|------------------------------------------------------------------------------------------------------|
|                |       |                                                                                                 |
| 3.1                 |       | Amended and  Restated Articles of Incorporation (1)                                                  |
| 3.2                 |       | Amended and  Restated Bylaws (1)                                                                     |
| 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 |

 

----

(1)       Incorporatedby reference to CombiMatrix Corporation’s Registration Statement on Form S-1(SEC File No. 333-139679), which became effective on June 8, 2007.

 

25

----

 

**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 |
|                                |                    | Amit Kumar |
|                                |                    | Chief Executive Officer |
| * *                            |                    | *(Authorized Signatory)* |
|                                |                    |   |
|                                |                    |   |
|                                | By:                     | /s/ Scott Burell |
|                                |                    | Scott Burell |
|                                |                    | Chief Financial Officer |
| * *                            |                    | *(Principal Financial and Accounting Officer)* |
| * *                            |                    | * * |
| Date:   May 15, 2008 |                    | * * |

 

26

----

 

**EXHIBIT INDEX**

** **
| **Exhibit  Number** | ** ** | **Description**                                                                                      |
|---------------------|------------|------------------------------------------------------------------------------------------------------|
|                |       |                                                                                                 |
| 3.1                 |       | Amended  and Restated Articles of Incorporation (1)                                                  |
| 3.2                 |       | Amended  and Restated Bylaws (1)                                                                     |
| 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 |

 

----

(1)       Incorporatedby reference to CombiMatrix Corporation’s Registration Statement on Form S-1(SEC File No. 333-139679), which became effective on June 8, 2007.

 

27

----