Table ofContents

 

 

 

**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON, D.C. 20549**

 

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**FORM 10-Q**

 

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

 

**For TheQuarterly Period Ended September 30, 2010**

 

**OR**

 

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

** **

**FOR THE TRANSITION PERIOD FROM              TO              .**

 

**Commission File Number 001-33523**

 

**COMBIMATRIX CORPORATION**

(Exact Name of Registrant as Specified in Its Charter)

 

| **Delaware**                             | ** ** | **47-0899439**      |
|------------------------------------------|------------|---------------------|
| (State or Other Jurisdiction of          |       | (I.R.S. Employer    |
| Incorporation or Organization)           |       | Identification No.) |
| ** **                               | ** ** | ** **          |
| **310 Goddard, Suite 150,**         |       |                |
| **Irvine, CA**                           | ** ** | **92618**           |
| (Address of Principal Executive Offices) |       | (Zip Code)          |

 

Registrant’s telephone number, including area code: ** (949) 753-0624**

 

**N/A**

(Former name, former address and former fiscal year, if changed sincelast report.)

 

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

 

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

 

Indicate by check mark whether the registrant is alarge accelerated filer, an accelerated filer, a non-accelerated filer or asmaller reporting company.  See thedefinitions of “large accelerated filer,” “accelerated filer” and “smallerreporting company” in Rule 12b-2 of the Exchange Act. (Check one):

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

 

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

 

As of November 10,2010, 7,620,398 shares of CombiMatrix Corporation common stock, $0.001 parvalue, were issued and outstanding.

 

 

 

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Table ofContents

 

**COMBIMATRIX****CORPORATION**

**Table of Contents**

 
| **Part I. Financial  Information** | ** ** |
|-----------------------------------------|------------|
|                                    |       |   |   |
| Item 1.                                 |       | Financial  Statements (Unaudited) |   |
|                                    |       |   |   |
|                                    |       | Consolidated  Balance Sheets as of September 30, 2010 and December 31, 2009 | 3 |
|                                    |       |   |   |
|                                    |       | Consolidated  Statements of Operations for the Three and Nine Months Ended  September 30, 2010 and 2009 | 4 |
|                                    |       |   |   |
|                                    |       | Consolidated  Statements of Cash Flows for the Nine Months Ended September 30, 2010 and 2009 | 5 |
|                                    |       |   |   |
|                                    |       | Notes to Consolidated Financial Statements | 6 |
|                                    |       |   |   |
| Item 2.                                 |       | Management’s  Discussion and Analysis of Financial Condition and Results of Operations | 15 |
|                                    |       |   |   |
| Item  3.                                |       | Quantitative  and Qualitative Disclosures about Market Risk | 20 |
|                                    |       |   |   |
| Item  4.                                |       | Controls and  Procedures | 20 |
|                                    |       |   |   |
| **Part II.  Other Information**    | ** ** |
|                                    |       |   |   |
| Item 1.                                 |       | Legal Proceedings | 21 |
|                                    |       |   |   |
| Item 1A.                                |       | Risk Factors | 21 |
|                                    |       |   |   |
| Item  2.                                |       | Unregistered  Sales of Equity Securities and Use of Proceeds | 21 |
|                                    |       |   |   |
| Item  3.                                |       | Defaults  Upon Senior Securities | 21 |
|                                    |       |   |   |
| Item 4.                                 |       | (Removed and  Reserved) | 21 |
|                                    |       |   |   |
| Item 5.                                 |       | Other Information | 21 |
|                                    |       |   |   |
| Item 6.                                 |       | Exhibits | 21 |
|                                    |       |   |   |
| **Signatures**                          |       |   | 22 |
|                                    |       |   |   |
| **Exhibit Index**                  | 23         |

 

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**COMBIMATRIX CORPORATION**

**CONSOLIDATEDBALANCE SHEETS**

**(In thousands)**

* *
| ** **                                                                                                                        | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                                                                                                                        | ** ** | **2010**               | ** ** | **2009**              | ** ** |
| ** **                                                                                                                        | ** ** | **(unaudited)**        | ** ** | ** **            | ** ** |
| **ASSETS**                                                                                                                        |       |                   |       |                  |       |
|                                                                                                                              |       |                   |       |                  |       |
| Current assets:                                                                                                                   |       |                   |       |                  |       |
| Cash and cash equivalents                                                                                                         |       | $                      | 7,885      |                  | $          | 5,443 |   |
| Accounts receivable, net of allowance for doubtful  accounts of $90 and $190                                                      |       | 1,474                  |       | 1,045                 |       |
| Inventory                                                                                                                         |       | 535                    |       | 669                   |       |
| Prepaid expenses and other assets                                                                                                 |       | 304                    |       | 236                   |       |
| Total current assets                                                                                                              |       | 10,198                 |       | 7,393                 |       |
|                                                                                                                              |       |                   |       |                  |       |
| Property and equipment, net                                                                                                       |       | 603                    |       | 653                   |       |
| Investments in unconsolidated subsidiaries                                                                                        |       | 127                    |       | 296                   |       |
| Patents and licenses, net                                                                                                         |       | 214                    |       | 3,840                 |       |
| Goodwill                                                                                                                          |       | —                 |       | 16,918                |       |
| Total assets                                                                                                                      |       | $                      | 11,142     |                  | $          | 29,100 |   |
|                                                                                                                              |       |                   |       |                  |       |
| **LIABILITIES  AND SHAREHOLDERS’ EQUITY**                                                                                    | ** ** | ** **             | ** ** | ** **            | ** ** |
|                                                                                                                              |       |                   |       |                  |       |
| Current liabilities:                                                                                                              |       |                   |       |                  |       |
| Accounts payable, accrued expenses and other                                                                                      |       | $                      | 1,609      |                  | $          | 1,891 |   |
| Current portion, capital lease obligations                                                                                        |       | 70                     |       | 52                    |       |
| Deferred revenues                                                                                                                 |       | —                 |       | 255                   |       |
| Secured convertible debenture                                                                                                     |       | —                 |       | 7,608                 |       |
| Other liabilities                                                                                                                 |       | —                 |       | 605                   |       |
| Total current liabilities                                                                                                         |       | 1,679                  |       | 10,411                |       |
|                                                                                                                              |       |                   |       |                  |       |
| Capital lease obligations, net of current portion                                                                                 |       | 150                    |       | 170                   |       |
| Total liabilities                                                                                                                 |       | 1,829                  |       | 10,581                |       |
|                                                                                                                              |       |                   |       |                  |       |
| Commitments and contingencies                                                                                                     |       |                   |       |                  |       |
|                                                                                                                              |       |                   |       |                  |       |
| Shareholders’ equity:                                                                                                        |       |                   |       |                  |       |
| Preferred stock; $0.001 par value; 5,000,000  shares authorized; none issued and outstanding                                      |       | —                 |       | —                |       |
| Common stock; $0.001 par value; 25,000,000 shares  authorized 7,620,398 and 7,571,886 shares issued and outstanding, respectively |       | 8                      |       | 8                     |       |
| Additional paid-in capital                                                                                                        |       | 58,174                 |       | 55,758                |       |
| Accumulated net losses                                                                                                            |       | (48,869                | )          | (37,247               | )          |
| Total shareholders’ equity                                                                                                   |       | 9,313                  |       | 18,519                |       |
| Total liabilities and shareholders’ equity                                                                                   |       | $                      | 11,142     |                  | $          | 29,100 |   |

 

*The accompanying notes are an integral part of theseconsolidated financial statements.*

 

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**COMBIMATRIX CORPORATION**

**CONSOLIDATEDSTATEMENTS OF OPERATIONS**

**(In thousands, except share and per share information)**

**(Unaudited)**

* *
| ** **                                                         | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|--------------------------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                                                         | ** ** | **September 30,**           | ** ** | **September 30,**          | ** ** |
| ** **                                                         | ** ** | **2010**                         | ** ** | **2009**                        | ** ** | **2010** | ** ** | **2009** | ** ** |
|                                                               |       |                             |       |                            |       |   |   |   |   |
| Revenues:                                                          |       |                             |       |                            |       |   |   |   |   |
| Services                                                           |       | $                                | 924        |                            | $          | 507 |   | $ | 2,492 |   | $ | 1,760 |   |
| Products                                                           |       | 90                               |       | 96                              |       | 258 |   | 176 |   |
| Total revenues                                                     |       | 1,014                            |       | 603                             |       | 2,750 |   | 1,936 |   |
| Operating expenses:                                                |       |                             |       |                            |       |   |   |   |   |
| Cost of products and services                                      |       | 579                              |       | 329                             |       | 1,557 |   | 1,198 |   |
| Research and development expenses                                  |       | 575                              |       | 684                             |       | 1,810 |   | 2,046 |   |
| Marketing, general and administrative expenses                     |       | 1,736                            |       | 1,643                           |       | 5,877 |   | 5,160 |   |
| Patent amortization and royalties                                  |       | 16                               |       | 63                              |       | 157 |   | 194 |   |
| Equity in loss of investee                                         |       | —                           |       | 107                             |       | — |   | 618 |   |
| Goodwill impairment                                                |       | —                           |       | —                          |       | 16,918 |   | — |   |
| Total operating expenses                                           |       | 2,906                            |       | 2,826                           |       | 26,319 |   | 9,216 |   |
| Operating loss                                                     |       | (1,892                           | )          | (2,223                          | )          | (23,569 | ) | (7,280 | ) |
| Other income (expense):                                            |       |                             |       |                            |       |   |   |   |   |
| Litigation settlement gain                                         |       | —                           |       | —                          |       | 19,385 |   | — |   |
| Loss from early extinguishment of debt                             |       | —                           |       | —                          |       | (572 | ) | — |   |
| Interest income                                                    |       | 2                                |       | 2                               |       | 6 |   | 17 |   |
| Interest expense                                                   |       | (3                               | )          | (531                            | )          | (356 | ) | (1,553 | ) |
| Derivatives gains (charges)                                        |       | —                           |       | 977                             |       | 605 |   | (407 | ) |
| Total other income (expense)                                       |       | (1                               | )          | 448                             |       | 19,068 |   | (1,943 | ) |
| Net  loss from continuing operations                               |       | (1,893                           | )          | (1,775                          | )          | (4,501 | ) | (9,223 | ) |
| Loss from discontinued operations                                  |       | (265                             | )          | (1,526                          | )          | (7,121 | ) | (4,841 | ) |
| Net loss                                                           |       | $                                | (2,158     | )                               | $          | (3,301 | ) | $ | (11,622 | ) | $ | (14,064 | ) |
|                                                               |       |                             |       |                            |       |   |   |   |   |
| Basic and diluted net loss per share from continuing  operations   |       | $                                | (0.25      | )                               | $          | (0.24 | ) | $ | (0.59 | ) | $ | (1.32 | ) |
| Basic and diluted net loss per share from discontinued  operations |       | (0.03                            | )          | (0.20                           | )          | (0.94 | ) | (0.69 | ) |
|                                                               |       |                             |       |                            |       |   |   |   |   |
| Basic and diluted net loss per share                               |       | $                                | (0.28      | )                               | $          | (0.44 | ) | $ | (1.53 | ) | $ | (2.01 | ) |
|                                                               |       |                             |       |                            |       |   |   |   |   |
| Basic and diluted weighted average common shares  outstanding      |       | 7,620,079                        |       | 7,512,401                       |       | 7,609,808 |   | 6,983,157 |   |

 

*The accompanying notes are an integral part of theseconsolidated financial statements.*

 

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**COMBIMATRIX CORPORATION**

**CONSOLIDATEDSTATEMENTS OF CASH FLOWS**

**(In thousands)**

**(Unaudited)**

 
| ** **                                                                      | ** ** | **Nine Months Ended** | ** ** |
|---------------------------------------------------------------------------------|------------|---------------------------------|------------|
| ** **                                                                      | ** ** | **September 30,**          | ** ** |
| ** **                                                                      | ** ** | **2010**                        | ** ** | **2009** | ** ** |
|                                                                            |       |                            |       |   |   |
| Operating activities:                                                           |       |                            |       |   |   |
| Net loss                                                                        |       | $                               | (11,622    | ) | $ | (14,064 | ) |
| Adjustments to reconcile net loss to net cash  flows from operating activities: |       |                            |       |   |   |
| Depreciation and amortization                                                   |       | 491                             |       | 1,157 |   |
| Non-cash stock compensation                                                     |       | 2,187                           |       | 2,535 |   |
| Derivatives (gains) charges                                                     |       | (605                            | )          | 407 |   |
| Loss on early extinguishment of debt                                            |       | 572                             |       | — |   |
| Equity in loss of investee                                                      |       | —                          |       | 618 |   |
| Equity issued to consultants                                                    |       | —                          |       | 135 |   |
| Allowance for bad debt                                                          |       | 91                              |       | 278 |   |
| Amortization of debt discount and issuance costs                                |       | 211                             |       | 890 |   |
| Goodwill impairment                                                             |       | 16,918                          |       | — |   |
| Patent and other asset write-downs                                              |       | 3,664                           |       | — |   |
| Changes in assets and liabilities:                                              |       |                            |       |   |   |
| Accounts receivable                                                             |       | (520                            | )          | (43 | ) |
| Inventory, prepaid expenses and other assets                                    |       | 66                              |       | (175 | ) |
| Accounts payable, accrued expenses and other                                    |       | (206                            | )          | 322 |   |
| Deferred revenues                                                               |       | (255                            | )          | (212 | ) |
| Net cash flows from operating activities                                        |       | 10,992                          |       | (8,152 | ) |
| Investing activities:                                                           |       |                            |       |   |   |
| Purchase of property and equipment                                              |       | (99                             | )          | (59 | ) |
| Sale of available-for-sale investments                                          |       | —                          |       | 1,526 |   |
| Net cash flows from investing activities                                        |       | (99                             | )          | 1,467 |   |
| Financing activities:                                                           |       |                            |       |   |   |
| Repayment of secured convertible debenture                                      |       | (8,400                          | )          | — |   |
| Net proceeds from issuance of common stock, net                                 |       | —                          |       | 7,846 |   |
| Repayment of line of credit                                                     |       | —                          |       | (820 | ) |
| Repayment of capital lease obligations                                          |       | (51                             | )          | (15 | ) |
| Net cash flows from financing activities                                        |       | (8,451                          | )          | 7,011 |   |
|                                                                            |       |                            |       |   |   |
| Increase in cash and cash equivalents                                           |       | 2,442                           |       | 326 |   |
| Cash and cash equivalents, beginning                                            |       | 5,443                           |       | 7,579 |   |
| Cash and cash equivalents, ending                                               |       | $                               | 7,885      |   | $ | 7,905 |   |
|                                                                            |       |                            |       |   |   |
| Non-cash financing activities:                                                  |       |                            |       |   |   |
| Accrued interest paid in common stock                                           |       | $                               | 215        |   | $ | 634 |   |
|                                                                            |       |                            |       |   |   |
| Conversion of secured convertible debenture to  common stock                    |       | $                               | —     |   | $ | 100 |   |

 

*The accompanying notes are an integral part of theseconsolidated financial statements.*

 

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**COMBIMATRIXCORPORATION**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**(Unaudited)**

 

**1.    OVERVIEWAND BACKGROUND**

 

CombiMatrix Corporation (the “Company,” “we,” “us” and“our”) was originally incorporated in October 1995 as a California corporationand later reincorporated as a Delaware corporation in September 2000.  In December 2002, we merged with and became awholly owned subsidiary of Acacia Research Corporation (“Acacia”).  In December 2006, we filed a registrationstatement with the U.S. Securities and Exchange Commission (“SEC”) in order toregister our common stock as part of a plan to split-off from Acacia (the “Split-Off”).  On August 15, 2007 (the “Split-Off Date”),the Split-Off was effected and our common stock became publicly traded on theNasdaq Global Market (symbol: “CBMX”). As of the Split-Off Date, we ceased to be a subsidiary of, or affiliatedwith, Acacia.

 

*Description of the Company*

 

We are a moleculardiagnostics company that operates primarily in the field of genetic analysisand molecular diagnostics through our wholly owned subsidiary, CombiMatrixDiagnostics, Inc. (“CMDX”), located in Irvine, California.  CMDX operates as a diagnostics referencelaboratory that provides DNA-based clinical diagnostic testing services tophysicians, hospitals and clinics for pre-and postnatal development disordersand oncology.  Our mission is to empowerphysicians to positively impact patient care through the delivery of innovativeDNA-based clinical services.

 

On April 19, 2010, we announced a strategic andoperational restructuring plan (the “Restructuring Plan”) intended tosignificantly reduce operating costs, increase the focus on the Company’sdiagnostic services business and transition senior management.  As part of the Restructuring Plan, we haveclosed our Mukilteo, Washington facility, which had been focused primarily onresearch, development and commercialization of the Company’s oligonucleotidemicroarray technologies, also known as our “CustomArray” business.  We have also relocated our corporateheadquarters from Mukilteo to our Irvine, California location.  Since the restructuring, we are now focusedprimarily on our diagnostics services business, including increasing theutilization of our existing tests, expanding the test menu, increasing thenumber of customers and partners, and improving reimbursement for our testingservices.  As a component of this RestructuringPlan, we initiated a search for a new President and Chief Executive Officer,which was completed on August 11, 2010 with the hiring of R. Judd Jessup.  Concurrent with Mr. Jessup’s appointment,Mark McGowan, our Chairman of the Board of Directors, stepped down from hisrole as interim President and CEO.  Mr.McGowan had assumed this role as a result of Dr. Amit Kumar’s resignation fromthat role on June 30, 2010.

 

*Basis of Presentation*

 

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 8-03 of Regulation S-X.  Accordingly, certain information andfootnotes required by generally accepted accounting principles in annualfinancial statements have been omitted or condensed.  These interim consolidated financialstatements should be read in conjunction with the consolidated financialstatements and notes thereto for the year ended December 31, 2009, as reportedby us in our Annual Report on Form 10-K filed with the SEC on March 18,2010.  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 September 30, 2010, and results of operationsand cash flows for the interim periods presented.  The results of operations for the three andnine months ended September 30, 2010 are not necessarily indicative of theresults to be expected for the entire year.

 

Asa result of executing the Restructuring Plan, the financial results of ourCustomArray business have been classified as discontinued operations in theconsolidated statements of operations for all periods presented.  See Note 3 for additional information regardingdiscontinued operations.  Unlessotherwise noted, amounts and disclosures throughout the notes to ourconsolidated financial statements relate to our continuing operations.

 

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**COMBIMATRIXCORPORATION**

**NOTES TOCONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)**

**(Unaudited)**

 

*Liquidity and Risks*

 

We have a history of incurring net losses and netoperating cash flow deficits.  We arealso deploying new and unproven technologies and continue to develop commercialtests and products.

 

At September 30, 2010, we had cash and cashequivalents of $7.9 million.  As aresult, we anticipate that our cash and cash equivalent balances, anticipatedcash flows from operations, anticipated operating cash savings from ourRestructuring Plan and other anticipated sources of funding from the capitalmarkets will be sufficient to meet our cash requirements into the fourthquarter of 2011.  In order for us tocontinue as a going concern beyond this point and ultimately to achieveprofitability, we may be required to obtain capital from external sources,increase revenues and reduce operating costs. However, there can be no assurances that our operations will becomeprofitable or that external sources of financing, including the issuance ofdebt and/or equity securities, will be available at times and at termsacceptable to us, or at all.  Theissuance of additional equity or convertible debt securities will also causedilution to our shareholders.  Ifexternal financing sources are not available or are inadequate to fund ouroperations, we will be required to reduce operating costs, including researchprojects and personnel, which could jeopardize our future strategic initiativesand business plans.

 

Our business operations are also subject to certainrisks 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; and

 

·                  government regulation that may restrict ourbusiness.

 

Our services are concentrated in a highlycompetitive market that is characterized by rapid technological advances,frequent changes in customer requirements and evolving regulatory requirementsand industry standards.  Failure toanticipate or respond adequately to technological advances, changes in customerrequirements, changes in regulatory requirements or industry standards, or anysignificant delays in the development or introduction of planned products orservices, could have a material adverse effect on our business and operatingresults.  The accompanying consolidatedfinancial statements have been prepared assuming that the Company continues asa going concern.  The financialstatements do not include any adjustments to reflect the possible futureeffects on the recoverability and classification of assets or the amounts andclassification of liabilities that may result from the matters discussedherein.

 

**2.    SUMMARY OFSIGNIFICANT ACCOUNTING POLICIES**

 

*References to AuthoritativeAccounting Literature. *In June 2009,the Financial Accounting Standards Board (“FASB”) issued the AccountingStandards Codification (“ASC”) as the single source of authoritative U.S.generally accepted accounting principles (“U.S. GAAP”) recognized by the FASBto be applied by non-governmental entities in preparation of financialstatements in conformity with U.S. GAAP, except for additional authoritativerules and interpretative releases issued by the SEC.  While the adoption of the ASC changes how wereference accounting standards, the adoption did not have an impact on ourconsolidated financial statements.

 

*DiscontinuedOperations.*  Wereclassify, from continuing operations to discontinued operations, for allperiods presented, the results of operations for any component either held forsale or disposed of.  We define acomponent as being distinguishable from the rest of our Company because it hasits own operations and cash flows.  Acomponent may be a reportable segment, an operating segment, a reporting unit,a subsidiary, or an asset group.  Suchreclassifications had no effect on our net loss or shareholders’ equity.

 

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**COMBIMATRIXCORPORATION**

**NOTES TOCONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)**

**(Unaudited)**

 

*Useof Estimates. *The preparation of financial statements in conformity with U.S.GAAP requires management to make estimates and assumptions that affect thereported amount of assets and liabilities and disclosure of contingent assetsand liabilities 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.

 

*Principles of Consolidation*.  The accompanying consolidated financialstatements include the accounts of the Company and our wholly owned andmajority-owned subsidiaries.  Investmentsfor which we possess the power to direct or cause the direction of themanagement and policies, either through majority ownership or other means, areaccounted for under the consolidation method. Material intercompanytransactions and balances have been eliminated in consolidation.  Investments in companies in which we maintainan ownership interest of 20% to 50% or exercise significant influence overoperating and financial policies are accounted for under the equitymethod.  The cost method is used where wemaintain ownership interests of less than 20% and do not exercise significantinfluence over the investee.  Inaddition, U.S. GAAP generally stipulates that an entity is a variable interestentity, or VIE, if it does not have sufficient equity investment at risk, or ifthe holders of the entity’s equity instruments lack the essentialcharacteristics of a controlling financial interest.  Further, these standards require that theholder subject to a majority of the risk of loss from a VIE’s activities mustconsolidate the VIE.  However, if noholder has a majority of the risk of loss, then a holder entitled to receive amajority of the entity’s residual returns would consolidate the entity.

 

*Revenue Recognition*. We recognizerevenue 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.

 

Service revenues from providing diagnostic tests arerecognized when the testing process is complete and test results are reportedto the ordering physician or clinic. These diagnostic services are billed to various payors, includingcommercial insurance companies, healthcare institutions, individuals and governmentpayors including Medicare and Medicaid. We report revenues from contracted payors based on a contractual rate,or in the case of Medicare and Medicaid, published fee schedules for our tests.  We report revenues from non-contracted payorsbased on the amount expected to be collected. The difference between the amount billed and the amount expected to becollected from non-contracted payors is recorded as a contractual allowance toarrive at net recognized revenues.  Theexpected revenues from non-contracted payors are based on the historicalcollection experience of each payor or payor group, as appropriate.  In each reporting period, we review ourhistorical collection experience for non-contracted payors and adjust ourexpected revenues for current and subsequent periods accordingly.  Because a substantial portion of our revenuesis from non-contracted third-party payors, it is likely that we will berequired to make positive or negative adjustments to accounting estimates withrespect to contractual allowances in the future, which may positively oradversely affect our results of operations.

 

Revenues from the sale of aCGH slides, includingshipping and handling fees but excluding statutory taxes collected fromcustomers, as applicable, are recognized when delivery occurrs.  There is no written or implied right toreturn or exchange the products.

 

Revenues from multiple element arrangements arebased on the relative selling price method, whereby we allocate considerationreceived to all deliverables of an arrangement at the inception of thearrangement based on the relative selling prices of each element. In order todetermine the selling price of a deliverable, we apply the following hierarchy:1) vendor-specific objective evidence (“VSOE”); 2) third-party evidence if VSOEis not available; and 3) our best estimate of selling price for the deliverableif neither VSOE nor third-party evidence is available.  Several factors are considered whendetermining the estimated selling price of a deliverable, including, but notlimited to, the cost to produce the deliverable, the expected margin on thatdeliverable, our ongoing pricing strategy and policies and the value-addedcomponents of differentiated deliverables, if determinable.  In order for a deliverable to be accountedfor as a separate unit of accounting, both of the following criteria must bemet: 1) the delivered item or items have value to the customer on a standalonebasis; and 2) when a general right of return exists, the delivery or performanceof an undelivered item is considered probable and under our control.  Our revenue arrangements do not have ageneral right of return.  When adeliverable does not meet the criteria to be considered a separate unit ofaccounting, we group that deliverable with other deliverables that, whencombined, meet the criteria, and the appropriate allocation of arrangementconsideration and revenue recognition is determined.

 

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**COMBIMATRIXCORPORATION**

**NOTES TOCONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)**

**(Unaudited)**

 

*Cash and Cash Equivalents*.  We consider all highly liquid, short-terminvestments with original maturities of three months or less when purchased tobe cash equivalents.

 

*Fair Value Measurements. *We measure fair value as anexit price, representing the amount that would be received to sell an asset orpaid to transfer a liability in an orderly transaction between marketparticipants.  As such, fair value is amarket-based measurement that is determined based on assumptions that marketparticipants would use in pricing an asset or liability.  We utilize a three-tier fair value hierarchy,which prioritizes the inputs used in measuring fair value as follows:

 
| · |   | 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.  |

 

*Accounts Receivable and Allowance for Doubtful Accounts.*  Accounts receivableare stated at principal amounts and are primarily comprised of amountscontractually due from customers for products and services.  An allowance for doubtful accounts isrecorded for estimated uncollectible amounts due from various payor groups suchas commercial insurance companies, healthcare institutions, government payorsand individuals.  The process forestimating the allowance for doubtful accounts involves significant assumptionsand judgments.  Specifically, theallowance for doubtful accounts is adjusted periodically and is principallybased upon specific identification of past due or disputed accounts.  We also review the age of receivables bypayor class to assess our allowance at each period end.  The payment realization cycle for certaingovernmental and commercial insurance payors can be lengthy, involving denial,appeal and adjudication processes, and is subject to periodic adjustments thatmay be significant.  Accounts receivableare periodically written off when identified as uncollectible and deducted fromthe allowance for doubtful accounts after appropriate collection efforts havebeen exhausted. Additions to the allowance for doubtful accounts are charged tobad debt expense as a component of marketing, general and administrativeexpenses in the consolidated statements of operations.  Collection of governmental, private healthinsurer, and client receivables are generally a function of providing completeand correct billing information to the insurers and clients within the filingdeadlines required by each payor. Collection of receivables due from patients and clients is generallysubject to increased credit risk due to credit worthiness or inability to pay.

 

*Impairment of Long-Lived Assetsand Goodwill*.  Long-livedassets and intangible assets are reviewed for potential impairment when eventsor changes in circumstances indicate the carrying amount of an asset may not berecoverable.  In the event the sum of theexpected undiscounted future cash flows resulting from the use of the asset isless than the carrying amount of the asset, an impairment loss equal to theexcess of the asset’s carrying value over its fair value is recorded.  If an asset is determined to be impaired, theloss is measured based on quoted market prices in active markets, ifavailable.  If quoted market prices arenot available, the estimate of fair value is based on various valuationtechniques, including a discounted value of estimated future cash flows.  Due to the Restructuring Plan, managementdetermined that our patent intangible assets were impaired — see Note 3 below.

 

Goodwill is evaluated annually for impairment at thereporting unit level, or earlier if an event occurs or circumstances changethat would more likely than not indicate that the fair value of a reportingunit is below its carrying amount.  Areporting unit can be an operating segment or a business if discrete financialinformation is prepared and reviewed by management.  Under the impairment test, if a reportingunit’s carrying amount exceeds its estimated fair value, goodwill impairment isrecognized to the extent that the reporting unit’s carrying amount of goodwillexceeds the implied fair value of the goodwill. We performed our annual impairment test during the fourth quarter of2009 and determined that goodwill was not impaired.  During the second quarter of 2010, theCompany’s fair value (as determined by the trading price of our common stock onthe Nasdaq Global Market) fell below our carrying value, triggering animpairment analysis — see Note 5 below.

 

*Derivatives Embedded in Certain Debt Securities. *Weevaluate financial instruments for freestanding or embedded derivatives.Derivative instruments that have been separated from the host contract and donot qualify for hedge accounting are recorded at fair value with changes invalue recognized as other non-operating income (expense) in the consolidatedstatements of operations in the period of change.

 

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**COMBIMATRIXCORPORATION**

**NOTES TOCONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)**

**(Unaudited)**

 

*Stock-Based Compensation*.  Thecompensation cost for all stock-based awards is measured at the grant date,based on the fair value of the award, and is recognized as an expense, on astraight-line basis, over the employee’s requisite service period (generallythe vesting period of the equity award) which is generally three years.  The fair value of each option award isestimated on the date of grant using a Black-Scholes option valuationmodel.  Stock-based compensation expenseis recognized only for those awards that are expected to vest using anestimated forfeiture rate.  We estimatepre-vesting option forfeitures at the time of grant and reflect the impact ofestimated pre-vesting option forfeitures in compensation expenserecognized.  Stock-based compensationexpense for all periods presented attributable to our functional expensecategories were as follows (in thousands; unaudited):

 
| ** **                            | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|---------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                            | ** ** | **September 30,**           | ** ** | **September 30,**          | ** ** |
| ** **                            | ** ** | **2010**                         | ** ** | **2009**                        | ** ** | **2010** | ** ** | **2009** | ** ** |
| ** **                            | ** ** | ** **                       | ** ** | ** **                      | ** ** | ** ** | ** ** | ** ** | ** ** |
| Cost of products and services         |       | $                                | 16         |                            | $          | 10 |   | $ | 43 |   | $ | 47 |   |
| Research and development              |       | 42                               |       | 49                              |       | 136 |   | 131 |   |
| Marketing, general and administrative |       | 506                              |       | 527                             |       | 1,537 |   | 1,501 |   |
| Discontinued operations               |       | 8                                |       | 303                             |       | 471 |   | 856 |   |
| Total non-cash stock compensation     |       | $                                | 572        |                            | $          | 889 |   | $ | 2,187 |   | $ | 2,535 |   |

 

*Net Loss Per Share*.  Basic and diluted net loss per share has beencomputed by dividing the net loss by the weighted average number of commonshares issued and outstanding during the periods presented.  Options and warrants to purchase CombiMatrixstock are anti-dilutive and therefore are not included in the determination ofthe diluted net loss per share.  Thefollowing table presents a reconciliation of basic and diluted loss per sharefrom continuing operations for all periods presented (in thousands, exceptshare and per share data; unaudited):

 
| ** **                                                         | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|--------------------------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                                                         | ** ** | **September 30,**           | ** ** | **September 30,**          | ** ** |
| ** **                                                         | ** ** | **2010**                         | ** ** | **2009**                        | ** ** | **2010** | ** ** | **2009** | ** ** |
| Numerator:                                                         |       |                             |       |                            |       |   |   |   |   |
| Loss from continuing operations applicable to  common shareholders |       | $                                | (1,893     | )                               | $          | (1,775 | ) | $ | (4,501 | ) | $ | (9,223 | ) |
| Denominator:                                                       |       |                             |       |                            |       |   |   |   |   |
| Weighted-average common shares outstanding                         |       | 7,620,079                        |       | 7,512,401                       |       | 7,609,808 |   | 6,983,157 |   |
| Basic and diluted loss per share from continuing  operations       |       | $                                | (0.25      | )                               | $          | (0.24 | ) | $ | (0.59 | ) | $ | (1.32 | ) |
|                                                               |       |                             |       |                            |       |   |   |   |   |
| Common stock options                                               |       | 1,801,127                        |       | 1,980,577                       |       | 1,801,127 |   | 1,980,577 |   |
| Common stock warrants                                              |       | 3,683,998                        |       | 3,813,646                       |       | 3,683,998 |   | 3,813,646 |   |
| Convertible debenture                                              |       | —                           |       | 1,120,000                       |       | — |   | 1,120,000 |   |
| Excluded potentially dilutive securities                           |       | 5,485,125                        |       | 6,914,223                       |       | 5,485,125 |   | 6,914,223 |   |

 

*Recent and Adopted AccountingPronouncements*.  In March2010, the FASB issued new authoritative guidance regarding revenue recognitionto define a milestone and clarify that the milestone method of revenuerecognition is a valid application of the proportional performance model whenapplied to research or development arrangements.  Accordingly, a company can make an accountingpolicy election to recognize a payment that is contingent upon the achievementof a substantive milestone in its entirety in the period in which the milestoneis achieved.  This guidance began phasingin during the third quarter of 2010.  Theimplementation of this guidance did not have a material impact on ourconsolidated financial position, results of operations or cash flows.

 

InJanuary 2010, the FASB issued new authoritative guidance regarding thedisclosure of fair value measurements, which clarifies certain existingdisclosure requirements as well as requiring new disclosures related tosignificant transfers between each fair value level as well as requiringadditional information about Level 3 activity. This guidance began phasing in during the first fiscal period afterDecember 15, 2009.  The implementation ofthis guidance did not have a material impact on our consolidated financialposition, results of operations or cash flows.

 

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**COMBIMATRIXCORPORATION**

**NOTES TOCONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)**

**(Unaudited)**

 

InOctober 2009, the FASB issued new authoritative guidance to require companiesto allocate revenue in multiple-element arrangements based on an element’sestimated selling price if vendor-specific or other third-party evidence ofvalue is not available. The new guidance is effective for revenue transactionsentered into during fiscal years beginning on or after June 15, 2010, withearlier application permitted.  The earlyadoption of this guidance did not have a material impact on our consolidatedfinancial position, results of operations or cash flows.

 

**3.     RESTRUCTURING**

 

On April 19, 2010, we announced a Restructuring Planintended to focus our Company on our diagnostic services business whileshutting down our CustomArray business. Related charges for the periods presented are as follows (in thousands;unaudited):

 
| ** **                                | ** ** | **Nine Months**          | ** ** |
|-------------------------------------------|------------|-------------------------------|------------|
| ** **                                | ** ** | **Ended Sept. 30,** | ** ** |
| ** **                                | ** ** | **2010**                      | ** ** |
|                                      |       |                          |       |
| Severance payments and benefits           |       | $                             | 1,069      |   |
| Inventory write-downs                     |       | 386                           |       |
| Accrued lease costs                       |       | 81                            |       |
| Property, plant and equipment write-downs |       | 79                            |       |
| Facilities clean-up and relocation        |       | 104                           |       |
| Subtotal                                  |       | 1,719                         |       |
| Sale of surplus property and equipment    |       | (468                          | )          |
|                                      |       | $                             | 1,251      |   |

 

Of the $1.7 million in restructuring charges listedabove (before sale of surplus property and equipment), $465,000 were non-cashwrite-downs, $1.2 million were paid out in cash as of September 30, 2010, and$48,000 were accrued as short-term payables and are expected to be paid out insubsequent periods.  Net of proceedsreceived from the sales of surplus property, equipment and inventory, werecognized a loss from restructuring for the nine months ended September 30,2010 of $1.3 million, which is included as a component of loss fromdiscontinued operations in the accompanying consolidated statements ofoperations.

 

 As a resultof the Restructuring Plan, management performed an impairment analysis of itsintangible patent assets and determined that these assets were fullyimpaired.  As a result, these assets werewritten down by $3.4 million during the second quarter of 2010.  The write-down is included as a component ofloss from discontinued operations in the accompanying consolidated statementsof operations for the nine months ended September 30, 2010.

 

The following table summarizes results of ourCustomArray business classified as discontinued operations in the accompanyingconsolidated statements of operations for the three and nine months endedSeptember 30, 2010 and 2009 (in thousands; unaudited):

 
| ** **                                      | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|-------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                                      | ** ** | **September 30,**           | ** ** | **September 30,**          | ** ** |
| ** **                                      | ** ** | **2010**                         | ** ** | **2009**                        | ** ** | **2010** | ** ** | **2009** | ** ** |
| Revenues                                        |       | $                                | 263        |                            | $          | 366 |   | $ | 1,018 |   | $ | 1,810 |   |
| Operating expenses                              |       | 528                              |       | 1,892                           |       | 3,454 |   | 6,651 |   |
| Impairment of patents                           |       | —                           |       | —                          |       | 3,434 |   | — |   |
| Restructuring and other charges, net of surplus |       | —                           |       | —                          |       | 1,251 |   | — |   |
| Loss from discontinued operations               |       | $                                | (265       | )                               | $          | (1,526 | ) | $ | (7,121 | ) | $ | (4,841 | ) |

 

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**COMBIMATRIXCORPORATION**

**NOTES TOCONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)**

**(Unaudited)**

 

**4.****             ****FAIR VALUE MEASUREMENTS**

 

The followingtable summarizes, for each major category of financial assets measured on arecurring basis, the respective fair value at September 30, 2010 and theclassification by level of input within the fair value hierarchy defined above(in thousands; unaudited):

 
| ** **       | ** ** | **September 30,** | ** ** | **Fair Value Measurements at** | ** ** |
|------------------|------------|------------------------|------------|-----------------------------------------------|------------|
| ** **       | ** ** | **2010**               | ** ** | **Level 1**                              | ** ** | **Level 2** | ** ** | **Level 3** | ** ** |
| Assets:          |       |                   |       |                                          |       |   |   |   |   |
| Cash equivalents |       | $                      | 7,506      |                                          | $          | 7,506 |   | $ | —   |   | $ | — |   |
|                  |            |                        |            |                                               |            |  |  |  |  |  |  |  |  |

 

The followingtable is a reconciliation of financial liabilities measured at fair value on arecurring basis using significant unobservable inputs (Level 3) during the ninemonths ended September 30, 2010 (in thousands; unaudited):

 
| ** **                  | ** ** | **Embedded**       | ** ** |
|-----------------------------|------------|--------------------|------------|
| ** **                  | ** ** | **Derivatives(1)** | ** ** |
|                        |       |               |       |
| Balance, December 31, 2009  |       | $                  | (605       | ) |
| Realized gains              |       | 605                |       |
| Balance, September 30, 2010 |       | $                  | —     |   |

 

----

(1)          Included in “otherliabilities” in the accompanying December 31, 2009 consolidated balance sheet.

 

**5.****             ****GOODWILL IMPAIRMENT**

 

The decline in our marketcapitalization during the second quarter of 2010 (as indicated by the tradingprice of our common stock on the Nasdaq Global Market) was considered bymanagement to be a potential goodwill impairment triggering event.  As a result, we performed a businessvaluation using a market-based approach and determined that all of our$16.9 million in goodwill was impaired. The related charge was recognizedas “goodwill impairment” in our consolidated statements of operations for thenine months ended September 30, 2010. The change in the carrying amount of goodwill and impairment losses forthe period ended September 30, 2010 is as follows (in thousands; unaudited):

 
| ** **                  | ** ** | ** **   | ** ** | **Impairment** | ** ** | ** ** | ** ** |
|-----------------------------|------------|--------------|------------|----------------|------------|------------|------------|
| ** **                  | ** ** | **Goodwill** | ** ** | **Losses**     | ** ** | **Net**    | ** ** |
|                        |       |         |       |           |       |       |       |
| Balance, December 31, 2009  |       | $            | 16,918     |           | $          | —     |       | $ | 16,918 |   |
| Impairment loss             |       | —       |       | (16,918        | )          | (16,918    | )          |
| Balance, September 30, 2010 |       | $            | 16,918     |           | $          | (16,918    | )          | $ | — |   |

 

**6.****             ****SECURED CONVERTIBLE DEBENTURE**

 

On July 10, 2008 (the “Closing Date”), we issued toYA Global Investments, L.P. (“YA”): (i) a secured convertible debenture (the “Debenture”)with an aggregate principal amount of $10 million, which was convertible intoshares of our common stock at a fixed conversion price of $11.87 per share (andwas reduced during 2009 to $7.50 per share); and (ii) warrants (the “YAWarrants”) to purchase up to an aggregate of 336,984 shares of our commonstock.  The Debenture was originally dueon the earlier of July 10, 2010 (the “Term”) or within four months afterreceipt of payment of judgment or settlement proceeds from National Union FireInsurance Company of Pittsburg, PA (“National Union”) in accordance with a$35.7 million judgment (the “Judgment”) issued by the U.S. District Court forthe Central District of California (the “District Court”).  In February 2010, we received $25 million insettlement proceeds from National Union, $8.6 million of which was used tofully retire the remaining principal balance of the Debenture, plus accruedinterest, on March 2, 2010 (the “Retirement Date”).

 

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**COMBIMATRIXCORPORATION**

**NOTES TOCONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)**

**(Unaudited)**

 

TheDebenture bore interest at an annual rate of 10%, with interest payments duequarterly in either cash or our common stock. As a result of a registereddirect offering of our common stock that occurred in May 2009, the conversionprice of the Debenture was reduced from $11.87 per share to $7.50 per sharepursuant to anti-dilution provisions of the Debenture.  The YA Warrants, which remain outstanding,have a five-year term and allow YA to purchase: (i) 168,492 shares of commonstock at an exercise price of $11.87; and (ii) 168,492 shares of common stockat an exercise price of $13.65.  As aresult of separating the YA Warrants and embedded derivative features of theDebenture, an aggregate contra-liability totaling $2.9 million was recognizedas of the Closing Date and was netted against the Debenture as a debt discount,which was being accreted to the face amount due YA over the Term using theeffective interest method, with the corresponding charges recorded as interestexpense.  For the three and nine monthsended September 30, 2010 and 2009, interest and amortization charges were $0,$343,000, $531,000 and $1.5 million, respectively.  As of the Retirement Date, the remainingunamortized debt discount of $572,000 was written off as a non-operating lossfrom early extinguishment of debt in the nine-months ended September 30, 2010consolidated statement of operations.

 

Since the Closing Date, YA had converted $1.6million of the Debenture into common stock, leaving an outstanding principalbalance plus accrued interest due of $8.6 million prior to being retired as ofthe Retirement Date.  The embeddedderivative liabilities were marked to fair value of zero as of the Retirement Dateand $1.8 million as of September 30, 2009, resulting in net non-operatingderivative gains (charges) of $0, $605,000, $977,000 and $(407,000) for thethree and nine months ended September 30, 2010 and 2009, respectively.

 

**7.****             ****SHAREHOLDERS’ EQUITY**

 

Outstandingwarrants to purchase CombiMatrix stock are as follows:

 
| ** **                  | ** ** | **Shares of Common Stock** | ** ** | ** **            | ** ** | ** **      | ** ** |
|-----------------------------|------------|-------------------------------------------|------------|-----------------------|------------|-----------------|------------|
| ** **                  | ** ** | **Issuable from Warrants**      | ** ** | ** **            | ** ** | ** **      | ** ** |
| ** **                  | ** ** | **Outstanding as of**           | ** ** | ** **            | ** ** | ** **      | ** ** |
| ** **                  | ** ** | **September 30,**                    | ** ** | **December 31,** | ** ** | **Exercise**    | ** ** | ** ** | ** ** |
| **Date of Issue** | ** ** | **2010**                                  | ** ** | **2009**              | ** ** | **Price**       | ** ** | **Expiration** | ** ** |
| ** **                  | ** ** | ** **                                | ** ** | ** **            | ** ** | ** **      | ** ** | ** ** | ** ** |
| October 2009                |       | 30,000                                    |       | 130,000               |       | $7.78           |       | April 2010 - October 2014 |   |
| May 2009                    |       | 129,688                                   |       | 129,688               |       | $7.50 - $9.00   |       | May 2014 - June 2014 |   |
| May 2009                    |       | 1,100,000                                 |       | 1,100,000             |       | $9.00           |       | May 2014 |   |
| July 2008                   |       | 336,984                                   |       | 336,984               |       | $11.87 - $13.65 |       | July 2013 |   |
| May 2007                    |       | 959,390                                   |       | 959,390               |       | $5.50           |       | May 2012 |   |
| December 2006               |       | 1,127,936                                 |       | 1,127,936             |       | $8.70 - $10.88  |       | December 2011 |   |
| September 2005              |       | —                                    |       | 159,648               |       | $24.00          |       | September 2010 |   |
| Total                       |       | 3,683,998                                 |       | 3,943,646             |       |            |       |   |   |

 

**8.    COMMITMENTS ANDCONTINGENCIES**

 

*Human Resources*

 

We provide certain severance benefits such that ifan executive of CombiMatrix Corporation who is a vice president or higher isterminated for other than cause, death or disability, the executive willreceive payments equal to three months’ base salary plus medical and dentalbenefits.

 

In addition, we have implemented an Executive Changeof Control Severance Plan, as amended (the “Severance Plan”) that affectscertain of our senior management-level employees of CombiMatrixCorporation.  Pursuant to the Severance Plan, if a participating employeeis involuntarily terminated (other than for death, disability or forcause) or resigns for “good reason” (as defined in the Severance Plan) duringthe two-year period following a “change of control” (as defined in theSeverance Plan) of the Company, then, subject to execution of a release ofclaims against the Company, the employee will be entitled to receive: (i)one-half times annual base salary; (ii) immediate vesting of outstandingcompensatory equity awards; and (iii) payment of COBRA premiums for theparticipating employee and eligible dependants for a pre-determined period oftime.  Payment of benefits under the Severance Plan willbe limited by provisions contained in Section 409A of the U.S. InternalRevenue Code.  The Severance Plan is administered by a plan administrator,which initially is the Compensation Committee of the Board of Directors. In order to participate in the Severance Plan, an eligible employee must waiveany prior retention or severance agreements.

 

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**COMBIMATRIXCORPORATION**

**NOTES TOCONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)**

**(Unaudited)**

 

*Litigation*

 

On September 30, 2002, we entered into a settlementagreement with Nanogen, Inc. (“Nanogen”) to settle all pending litigationbetween the parties.  Pursuant to theterms of the settlement agreement, we agreed to make quarterly payments toNanogen equal to 12.5% of total sales of products developed by us and ouraffiliates based on the patents that had been in dispute in the litigation, upto an annual maximum amount of $1.5 million. The minimum quarterly payments under the settlement agreement are$25,000 per quarter until the patents expire in 2018.  Royalty expenses recognized under theagreement were $25,000, $75,000, $25,000, and $75,000, for the three and ninemonths ended September 30, 2010 and 2009, respectively, and are included inpatent amortization and royalties in the accompanying consolidated statementsof operations.

 

In April 2005, Acacia and CombiMatrix filed acomplaint against our insurance carrier, National Union (collectively, the “Parties”),seeking reimbursement of litigation and settlement costs for a prior lawsuitpursuant to our directors and officers insurance policy with NationalUnion.  A trial was held and concludedduring the fourth quarter of 2007.  InMarch 2008, the District Court issued its Judgment in favor of Acacia and us,and awarded approximately $32.1 million in monetary damages to be paid byNational Union.  In May 2008, theDistrict Court awarded us an additional $3.6 million in attorneys’ fees andlitigation costs, thereby increasing the overall award to $35.7 million.  National Union appealed the Judgment tothe U.S. Ninth Circuit Court of Appeals, which we vigorously opposed.  On January 27, 2010, the Parties entered intoa settlement agreement whereby National Union agreed to pay $25 million to usin order to settle the dispute.  Theseproceeds, net of attorneys’ fees and costs of $5.6 million, were paid to us onFebruary 3, 2010 and a dismissal of the action was entered by the DistrictCourt on February 11, 2010.

 

From time to time, we are subject to other claimsand legal actions that arise in the ordinary course of business.  We believe that the ultimate liability withrespect to these claims and legal actions, if any, will not have a materialeffect on our financial position, results of operations or cash flows.  Based on a distribution agreement executedbetween us and Acacia, it is expected that such claims and legal actionsattributable to CombiMatrix Corporation prior to the Split-Off Date will remainwith us subsequent to the Split-Off Date. As of the date of this report and prior to such date, we are not awareof the existence of any such claims or legal actions.

 

**9.****             ****SUBSEQUENTEVENT**

 

On November 3, 2010, we were notified by the U.S.Internal Revenue Service that we were awarded two grants totaling $488,958 under Section 48D of the QualifyingTherapeutic Discovery Program (the Program). The funds from the grants are expected to be received during the fourthquarter of 2010.  In July 2010, we submittedgrant proposals for two projects: (i) the Array Comparative Genomic Hybridization,or “aCGH” project; and (ii) the Comprehensive Cancer Array, or “CCA”project.  Both grant proposals wereaccepted, and we were awarded $244,479 for each program.  There are no matching funding requirements orother requirements necessary in order to receive the funding.

 

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**Item2.****          ****MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIALCONDITION AND RESULTS OF OPERATIONS**

 

**CautionaryStatement**

 

You should readthe following discussion and analysis in conjunction with the consolidatedfinancial statements and related notes thereto contained in Part I, Item 1 ofthis report.  The information containedin this Quarterly Report on Form 10-Q is not a complete description of ourbusinesses or the risks associated with an investment in our common stock.  We urge you to carefully review and considerthe various disclosures made by us in this report and in our other reports filedwith the U.S. Securities and Exchange Commission, or “SEC,” including ourAnnual Report on Form 10-K for the year ended December 31, 2009, filed with theSEC on March 18, 2010.

 

This reportcontains forward-looking statements within the meaning of the “safe harbor”provisions of the Private Securities Litigation Reform Act of 1995. Referenceis made in particular to the description of our plans and objectives for futureoperations, assumptions underlying such plans and objectives, and otherforward-looking statements included in this report. Such statements may beidentified by the use of forward-looking terminology such as “may,” “will,” “should,”“would,” “could,” “expect,” “believe,” “estimate,” “anticipate,” “intend,” “plan,”“predict,” “seek,” “potential,” “continue,” “focus,” “ongoing,” or similarterms, variations of such terms or the negative of such terms.  Such statements are based on management’scurrent expectations and are subject to a number of factors and uncertainties,which could cause actual results to differ materially from those described inthe forward-looking statements.  Suchstatements address future events and conditions concerning our testingservices, product development and expansion, our Restructuring Plan, capitalexpenditures, earnings, litigation, regulatory matters, markets for productsand services, increasing our number of customers and partners, liquidity andcapital resources and accounting matters. Actual results in each case could differ materially from those anticipatedin such 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 andcosts.  Additional factors that couldcause such results to differ materially from those described in theforward-looking statements are set forth in connection with the forward-lookingstatements and in the “Risk Factors” described in our Annual Report on Form10-K for the year ended December 31, 2009 filed with the SEC on March 18,2010.  We expressly disclaim anyobligation or undertaking to release publicly any updates or revisions to anyforward-looking statements contained herein to reflect any change in ourexpectations with regard thereto or any change in events, conditions orcircumstances on which any such statement is based, except as required by law.

 

**General**

 

We are a moleculardiagnostics company that operates primarily in the field of genetic analysisand molecular diagnostics through our wholly owned subsidiary, CombiMatrixDiagnostics, Inc. (“CMDX”), located in Irvine, California.  CMDX operates as a diagnostics referencelaboratory that provides DNA-based clinical diagnostic testing services tophysicians, hospitals and clinics for pre-and postnatal development disordersand oncology.  Our mission is to empowerphysicians to positively impact patient care through the delivery of innovativeDNA-based clinical services.

 

On April 19, 2010, we announced a strategic andoperational restructuring plan (the “Restructuring Plan”) intended tosignificantly reduce operating costs, increase the focus on the Company’sdiagnostic services business and transition senior management.  As part of the Restructuring Plan, we haveclosed our Mukilteo, Washington facility, which had been focused primarily onresearch, development and commercialization of the Company’s oligonucleotidemicroarray technologies, also known as our “CustomArray” business.  We have also relocated our corporateheadquarters from Mukilteo to our Irvine, California location.  Since the restructuring, we are now focusedprimarily on our diagnostics services business, including increasing theutilization of our existing tests, expanding the test menu, increasing thenumber of customers and partners, and improving reimbursement for our testingservices.  As a component of thisRestructuring Plan, we initiated a search for a new President and Chief ExecutiveOfficer, which was completed on August 11, 2010 with the hiring of R. JuddJessup.  Concurrent with Mr. Jessup’sappointment, Mark McGowan, our Chairman of the Board of Directors, stepped downfrom his role as interim President and CEO. Mr. McGowan had assumed this role as a result of Dr. Amit Kumar’sresignation from that role on June 30, 2010.

 

As a result of executing the Restructuring Plan, thefinancial results of our CustomArray business have been classified asdiscontinued operations in the consolidated statements of operations for allperiods presented.  See Note 3 to theconsolidated financial statements for additional information regardingdiscontinued operations.  Unlessotherwise noted, amounts and disclosures throughout this report relate to ourcontinuing operations.

 

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**Overview**

 

For the three months ended September 30, 2010, ouroperating activities included the recognition of $1.0 million in revenues,including $924,000 in diagnostic lab revenues and $90,000 from the sale ofcomparative genomic hybridization, or “CGH,” arrays to a foreigndistributor.  Marketing, general andadministrative expenses increased due to increased sales and marketingactivities and increased headcount in general and administrativedepartments.  Net loss decreased dueprimarily to reduced losses from discontinued operations as we near the end ofour Restructuring Plan.

 

**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 forthe year ended December 31, 2009, filed with the SEC on March 18, 2010, in theNotes to the Consolidated Financial Statements and the Critical AccountingEstimates sections.  In addition, referto Note 2 to the consolidated interim financial statements included in Part I, Item1 of this report.

 

**Comparison of the Results of Operations for the Three andNine months Ended September 30, 2010 and 2009**

 

Revenues and Cost of Revenues:

 
| ** **                    | ** ** | **Three Months Ended** | ** ** | ** ** | ** ** | **Nine Months Ended** | ** ** | ** ** | ** ** |
|-------------------------------|------------|----------------------------------|------------|------------|------------|---------------------------------|------------|------------|------------|
| ** **                    | ** ** | **September 30,**           | ** ** | **Change** | ** ** | **September 30,**          | ** ** | **Change** | ** ** |
| ** **                    | ** ** | **2010**                         | ** ** | **2009**   | ** ** | **$**                           | ** ** | **%**      | ** ** | **2010** | ** ** | **2009** | ** ** | **$** | ** ** | **%** | ** ** |
|                          |       |                             |       |       |       |                            |       |       |       |   |   |   |   |   |   |   |   |
| Services                      |       | $                                | 924        |       | $          | 507                             |       | $          | 417        |   | 82% |   | $ | 2,492 |   | $ | 1,760 |   | $ | 732 |   | 42% |   |
| Products                      |       | 90                               |       | 96         |       | (6                              | )          | (6)%       |       | 258 |   | 176 |   | 82 |   | 47% |   |
| Cost of products and services |       | (579                             | )          | (329       | )          | (250                            | )          | (76)%      |       | (1,557 | ) | (1,198 | ) | (359 | ) | (30)% |   |
|                               |            |                                  |            |            |            |                                 |            |            |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

*Services.*  Services revenues aregenerated from providing DNA-based genomic testing services in the areas ofprenatal and postnatal development disorders in children as well asoncology.  Service revenues increasedprimarily due to volume increases of our genomic tests as well as increases inaverage revenue recognized per test. Billable test volumes were 967 and 2,367 for the three and nine monthsended September 30, 2010, respectively, compared to 551 and 2,011 for thecomparable periods in 2009.  Theseincreases were driven primarily by increased sales and market penetration overprevious periods.  For the nine-monthperiods ending, average revenue per test was approximately $1,052 in 2010compared to $875 in 2009.  This increaseis due primarily to improved reimbursement from non-contracted third-partypayors, resulting in higher average recognized revenues per test during 2010compared with 2009.

 

*Products. *Product revenues aregenerated exclusively from selling bacterial artificial chromosome, or “BAC,”CGH arrays and related reagents to a single distributor located in Taiwan.  These revenues decreased slightly for thethree months ended September 30, 2010 compared to the comparable 2009 perioddue primarily to lower reagent sales during the period.  For the nine months ended September 30, 2010compared to the comparable 2009 period, product revenues increased dueprimarily to increased volumes of our BAC CGH arrays delivered to the Taiwanesedistributor.  We have recently been notified from ourdistributor that its customers are considering other BAC CGH array providersand as a result, it is likely that our revenues from product sales may decreasein future periods.

 

*Cost of Products andServices. *Cost of products and services include direct materials such as arrayand laboratory costs, direct laboratory labor (wages and benefits),allocation of overhead and stock-compensation expenses.  Cost ofproducts and services for the three and nine month periods ended September 30,2009 included higher material costs per unit that have been reduced in 2010 dueto better pricing from our suppliers, based on our increased volumes.  For the three and nine months ended September30, 2010 and 2009, cost of products and services included $16,000, $10,000,$43,000 and $47,000, respectively, of non-cash stock compensation expense.  See Note 2 to our consolidated interimfinancial statements included elsewhere in this report for a detaileddescription of the amounts of non-cash stock compensation expense recognizedfor the periods presented.

 

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Operating Expenses:

 
| ** **                             | ** ** | **Three Months Ended** | ** ** | ** ** | ** ** | **Nine Months Ended** | ** ** | ** ** | ** ** |
|----------------------------------------|------------|----------------------------------|------------|------------|------------|---------------------------------|------------|------------|------------|
| ** **                             | ** ** | **September 30,**           | ** ** | **Change** | ** ** | **September 30,**          | ** ** | **Change** | ** ** |
| ** **                             | ** ** | **2010**                         | ** ** | **2009**   | ** ** | **$**                           | ** ** | **%**      | ** ** | **2010** | ** ** | **2009** | ** ** | **$** | ** ** | **%** | ** ** |
|                                   |       |                             |       |       |       |                            |       |       |       |   |   |   |   |   |   |   |   |
| Research and development expenses      |       | $                                | 575        |       | $          | 684                             |       | $          | (109       | ) | (16)% |   | $ | 1,810 |   | $ | 2,046 |   | $ | (236 | ) | (12)% |   |
| Marketing, general and admin. expenses |       | 1,736                            |       | 1,643      |       | 93                              |       | 6%         |       | 5,877 |   | 5,160 |   | 717 |   | 14% |   |
| Patent amortization and royalties      |       | 16                               |       | 63         |       | (47                             | )          | (75)%      |       | 157 |   | 194 |   | (37 | ) | (19)% |   |
| Equity in loss of investee             |       | —                           |       | 107        |       | (107                            | )          | (100)%     |       | — |   | 618 |   | (618 | ) | (100)% |   |
| Goodwill impairment                    |       | —                           |       | —     |       | —                          |       | —     |       | 16,918 |   | — |   | 16,918 |   | — |   |
|                                        |            |                                  |            |            |            |                                 |            |            |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

*Research and Development Expenses*.  These expenses include labor and laboratorysupply costs associated with investigating new tests, but primarily consist ofdevelopment costs to maintain and improve our existing suite of diagnostictests offered.  Prior to launching a new test or modifying an existingtest, appropriate clinical trials and extensive laboratory validations,consistent with the various regulatory bodies that govern our industry, must beperformed.  These costs are classified as research and development for allperiods presented.  The decrease for all 2010 periods presented was dueprimarily to greater allocation of laboratory resources on production andcommercial efforts compared to the prior comparable periods, where there was agreater emphasis on developing new tests. In addition, for the three and nine months ended September 30, 2010 and2009, research and development expenses included $42,000, $49,000, $136,000 and$131,000, respectively, of non-cash stock compensation expense.  See Note 2 to our consolidated interimfinancial statements included elsewhere in this report for a detaileddescription of the amounts of non-cash stock compensation expense recognizedfor the periods presented.

 

*Marketing, General and AdministrativeExpenses.*  Theseexpenses include costs associated with marketing our tests to healthcareproviders, compensation and benefit costs of our sales force and general andadministrative staff, information technology, executive management, financialaccounting and human resources, as well as facilities-related costs, insurance,legal, audit and other professional services. The increase in marketing, general and administrative expenses for thethree and nine months ended September 30, 2010 compared to the comparableperiod in 2009 was due primarily to increased sales and marketing activities aswell as higher headcount.  In addition,marketing, general and administrative expenses for the three and nine monthsended September 30, 2010 includes a one time, $180,000 write-down of acost-basis investment that in management’s view had incurred another-than-temporary decline in the underlying market value of the investment,as well as one-time CEO recruiting costs. In addition, for the three and nine months ended September 30, 2010 and2009, marketing, general and administrative expenses included $506,000, $1.5million, $527,000 and $1.5 million, respectively, of non-cash stockcompensation expense.  See Note 2 to ourconsolidated interim financial statements included elsewhere in this report fora detailed description of the amounts of non-cash stock compensation expenserecognized for the periods presented.

 

*Goodwill Impairment. *The decline inour market capitalization during the second quarter of 2010 (as indicated bythe trading price of our common stock on the Nasdaq Global Market) wasconsidered by management to be a potential goodwill impairment triggeringevent.  As a result, we performed abusiness valuation using a market-based approach and determined that all of our$16.9 million in goodwill was impaired.

 

*Equity in Loss of Investee*.  For the periods presented in 2009, thisexpense represents our recognition under the equity method of accounting of ourminority interests in the operations of Leuchemix Inc., a privately owned drugdevelopment company in which we own a one-third minority interest.  During the third quarter of 2009, our equityinvestment in Leuchemix reached $0 and, as a result, we have not beenrecognizing any additional expense from its underlying operations.

 

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OtherNon-Operating Items:

 
| ** **                             | ** ** | **Three Months Ended** | ** ** | ** ** | ** ** | **Nine Months Ended** | ** ** | ** ** | ** ** |
|----------------------------------------|------------|----------------------------------|------------|------------|------------|---------------------------------|------------|------------|------------|
| ** **                             | ** ** | **September 30,**           | ** ** | **Change** | ** ** | **September 30,**          | ** ** | **Change** | ** ** |
| ** **                             | ** ** | **2010**                         | ** ** | **2009**   | ** ** | **$**                           | ** ** | **%**      | ** ** | **2010** | ** ** | **2009** | ** ** | **$** | ** ** | **%** | ** ** |
|                                   |       |                             |       |       |       |                            |       |       |       |   |   |   |   |   |   |   |   |
| Litigation settlement gain             |       | $                                | —     |       | $          | —                          |       | $          | —     |   | — |   | $ | 19,385 |   | $ | — |   | $ | 19,385 |   | — |   |
| Loss from early extinguishment of debt |       | —                           |       | —     |       | —                          |       | —     |       | (572 | ) | — |   | (572 | ) | — |   |
| Interest income                        |       | 2                                |       | 2          |       | —                          |       | 0%         |       | 6 |   | 17 |   | (11 | ) | (65)% |   |
| Interest expense                       |       | (3                               | )          | (531       | )          | 528                             |       | 99%        |       | (356 | ) | (1,553 | ) | 1,197 |   | 77% |   |
| Derivatives gains (charges)            |       | —                           |       | 977        |       | (977                            | )          | —     |       | 605 |   | (407 | ) | 1,012 |   | 249% |   |
|                                        |            |                                  |            |            |            |                                 |            |            |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

*Litigation Settlement Gain. *InFebruary 2010, we received gross proceeds of $25 million from enteringinto a settlement agreement with National Union.  Contingent attorneys’ costs and expensesrelating to the settlement were $5.6 million. Thus, the net amount of the settlement gain recognized was $19.4 millionduring the nine months ended September 30, 2010.  There were no such events in 2009.

 

*Loss from Early Extinguishment ofDebt.*  In March 2010,we fully retired our secured convertible debenture (the “Debenture”).  As a result, the remaining, unamortized debtdiscount of $572,000 was written off as a non-operating loss from earlyextinguishment of debt in the nine months ended September 30, 2010.  There were no such events in 2009.

 

*Interest Expense.*  Since July 2008, interest expense wasprimarily comprised of interest charges associated with the Debenture, whichaccrued interest at an annual rate of 10% on the outstanding principalbalance.  Interest expense also includedamortization of the $2.9 million of debt discount originally recognized fromissuance of the Debenture and related warrants using the effective interestmethod.  Interest expense decreased as aresult of retiring the Debenture in March 2010.  Remaining interest charges are from certaincapital leases for laboratory equipment.

 

*Derivative Gains (Charges).* These gains(charges) represent the net gain or expense recognized from mark-to-modeladjustments to the embedded derivatives associated with the Debenture that wereoutstanding during the periods presented. In accordance with U.S. GAAP, the conversion feature, cash redemptionoption, potential acceleration of maturity of the Debenture and potentialadjustments to the conversion price all represented embedded derivatives of theDebenture that were recorded separately at fair value as other liabilities,with the corresponding fair value adjustments reflected as non-operatingcharges or gains, depending upon the results of mark-to-model valuationadjustments.  The fair value of theembedded derivatives was determined using the convertible bond model,discounted cash flows and binomial lattice models.  In March 2010, the Debenture was retired.  As a result, the remaining derivativesliability of $605,000 was written off as a non-operating gain in the ninemonths ended September 30, 2010.

 

**Inflation**

 

Inflation has not had a significant impacton our business, results of operations or financial condition.

 

**Liquidity and CapitalResources**

 

At September 30, 2010, cash and cashequivalents totaled $7.9 million, compared to $5.4 million at December 31,2009.  Cash is held primarily in generalchecking accounts as well as in money market mutual funds backed by U.S.government securities.  Working capitalat September 30, 2010 was $8.5 million, compared to a working capitaldeficit of $(3.0 million) at December 31, 2009.  The change in working capital was dueprimarily to the impact of net cash flow activities as discussed below.  The net change in cash and cash equivalentsfor the periods presented was comprised of the following (in thousands):

 
| ** **                                 | ** ** | **Nine Months Ended** | ** ** | ** ** | ** ** |
|--------------------------------------------|------------|---------------------------------|------------|------------|------------|
| ** **                                 | ** ** | **September 30,**          | ** ** | ** ** | ** ** |
| ** **                                 | ** ** | **2010**                        | ** ** | **2009**   | ** ** | **Change** | ** ** |
| Net cash provided by (used in) operations: |       |                            |       |       |       |   |   |
| Operating activities                       |       | $                               | 10,992     |       | $          | (8,152 | ) | $ | 19,144 |   |
| Investing activities                       |       | (99                             | )          | 1,467      |       | (1,566 | ) |
| Financing activities                       |       | (8,451                          | )          | 7,011      |       | (15,462 | ) |
| Increase in cash and cash equivalents      |       | $                               | 2,442      |       | $          | 326 |   | $ | 2,116 |   |

 

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*Operating Activities.*  The overall net increase in cash provided byoperating activities for the nine months ended September 30, 2010 comparedto the cash used in operating activities in the comparable 2009 period was dueprimarily to the net litigation settlement proceeds from National Union of$19.4 million received in February 2010.

 

*Investing Activities.*  The decrease in net cash flows from investingactivities was due primarily to net sales of available-for-sale investments inconnection with ongoing cash management activities during the nine months endedSeptember 30, 2010.  Also, for thenine months ended September 30, 2010 and 2009, we incurred $99,000 and$59,000, respectively, of capital expenditures.

 

*Financing Activities.*  The decrease in net cash flows from financingactivities was due primarily to the repayment of the Debenture totaling $8.4million during the nine months ended September 30, 2010 compared torepayment of a line of credit totaling $820,000 in the comparable period in2009.  Also, net proceeds from the saleof common stock and warrants as well as the exercise of common stock options werezero during the period ended September 30, 2010 compared to $7.7 millionin the comparable period in 2009.

 

*Restructuring Plan. *On April 19, 2010, weannounced a Restructuring Plan intended to focus our Company on our diagnosticservices business while shutting down our CustomArray business.  Total restructuring charges incurred through September 30,2010 were $1.7 million (before sale of surplus property and equipment), ofwhich $465,000 were non-cash write-downs, $1.2 million were paid out in cash asof September 30, 2010 and $48,000 were accrued as short-term payables andare expected to be paid out in subsequent periods.  Net of proceeds received from the sales ofsurplus property, equipment and inventory, we recognized a loss from restructuringfor the nine months ended September 20, 2010 of $1.3 million, which isincluded as a component of loss from discontinued operations in our 2010consolidated statement of operations.

 

*Future Liquidity.*  We have a history of incurring net losses andnet operating cash flow deficits.  We arealso deploying new technologies and continue to develop commercial products andservices.  We believe that our cash andcash equivalent balances, anticipated cash flows from operations, anticipatedoperating cash savings from our Restructuring Plan and other anticipatedsources of funding from the capital markets will be sufficient to meet our cashrequirements for the next twelve months. In order for us to continue as a going concern beyond this point andultimately to achieve profitability, we may be required to obtain capital fromexternal sources, increase revenues and reduce operating costs.  However, there can be no assurance that ouroperations will become profitable or that external sources of financing, includingthe issuance of debt and/or equity securities, will be available at times andat terms acceptable to us, or at all. The issuance of additional equity or convertible debt securities willalso cause dilution to our shareholders. If external financing sources are notavailable or are inadequate to fund our operations, we will be required toreduce operating costs, including research projects and personnel, which couldjeopardize our future strategic initiatives and business plans.  See Note 1 to the consolidated financialstatements included elsewhere in this report for additional discussion of thesematters.

 

*Capital Requirements.*  We may also encounter unforeseen difficultiesthat may deplete our capital resources more rapidly than anticipated.  As a result, we may be required to seek additionalfunding through equity, debt or other external financing, and there can be noassurance that additional funding will be available on favorable terms, in atimely fashion or at all.  Our long-termcapital requirements will be substantial and the adequacy of available fundswill depend upon many factors, including:

 

·                  the costs ofcommercialization activities, including sales and marketing costs and capitalequipment;

 

·                  the costs involved infiling, prosecuting, enforcing and defending any patents claims, should theyarise;

 

·                  competing technologicaldevelopments;

 

·                  the creation and formationof strategic partnerships;

 

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·                  the costs associated withleasing and improving our Irvine, California facility; and

 

·                  other factors that may notbe within our control.

 

**Off-Balance Sheet Arrangements**

 

As of September 30, 2010, we did not have anysignificant off-balance sheet arrangements, as defined in Item 303(a)(4)(ii) ofRegulation S-K promulgated by the SEC. However, we have entered into an operating lease for our laboratoryspace and corporate offices, totaling approximately 13,000 square feet.  We have no significant commitments forcapital expenditures in 2010 or beyond. We have executed three capital leasestotaling $293,000 for certain laboratory equipment.  The following table lists our material knownfuture cash commitments as of September 30, 2010:

 
| ** **                    | ** ** | **Payments Due by Period (in thousands)** | ** ** |
|-------------------------------|------------|--------------------------------------------------------------------|------------|
| ** **                    | ** ** | ** **                                                         | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | **2014 and** | ** ** |
| ** **                    | ** ** | **2010**                                                           | ** ** | **2011** | ** ** | **2012** | ** ** | **2013** | ** ** | **Thereafter** | ** ** |
| ** **                    | ** ** | ** **                                                         | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Operating leases              |       | $                                                                  | 74         |   | $ | 189 |   | $ | 196 |   | $ | 16 |   | $ | — |   |
| Capital leases                |       | 22                                                                 |       | 85 |   | 85 |   | 58 |   | — |   |
| Minimum royalty payments      |       | 25                                                                 |       | 100 |   | 100 |   | 100 |   | 475 |   |
| Total contractual obligations |       | $                                                                  | 121        |   | $ | 374 |   | $ | 381 |   | $ | 174 |   | $ | 475 |   |

 

**Recent AccountingPronouncements**

 

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

 

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

 

Not required for smallerreporting companies.

 

**Item 4.        CONTROLSAND PROCEDURES**

 

*Evaluation of DisclosureControls and Procedures*

 

Ourmanagement, with the participation of our Chief Executive Officer and ChiefFinancial Officer, conducted an evaluation required by Rules 13a-15 and15d-15 under the Exchange Act of the effectiveness of our disclosure controlsand procedures as defined in Rules 13a-15(e) and 15d-15(e) underthe Exchange Act as of September 30, 2010. Based on this evaluation, our Chief Executive Officer and ChiefFinancial Officer concluded that as of September 30, 2010, our disclosurecontrols and procedures were effective in ensuring that information required tobe disclosed by us in the reports that we file or submit under the Exchange Actis (i) recorded, processed, summarized and reported, within the timeperiods specified in the rules and forms of the SEC and (ii) accumulatedand communicated to our management, including our principal executive andprincipal financial officers, or persons performing similar functions, asappropriate to allow timely decisions regarding required disclosure.

 

*Changes inInternal Control over Financial Reporting*

 

There were nochanges in our internal control over financial reporting (as defined in Rules 13a-15(f) and15d-15(f) under the Exchange Act) that occurred during our last fiscalquarter (the quarter ended September 30, 2010) that have materiallyaffected, or are reasonably likely to materially affect, our internal controlover financial reporting.

 

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**PART II—OTHER INFORMATION**

 

**Item 1.  LEGAL PROCEEDINGS**

 

From time totime, we are subject to claims and legal actions that arise in the ordinarycourse of business.  We believe that theultimate liability with respect to these claims and legal actions, if any, willnot have a material effect on our financial position, results of operations orcash flows.  Based on a distributionagreement executed between us and Acacia, it is expected that such claims andlegal actions attributable to CombiMatrix Corporation prior to the Split-OffDate will remain with us subsequent to the Split-Off Date.  As of the date of this report and prior tosuch date, we are not aware of the existence of any such claims or legalactions.

 

**Item1A.  RISK FACTORS**

 

Thefollowing risk factors include any and all material changes to, and should beread in conjunction with, the risk factors contained in Part 1, Item1A of our Annual Report on Form 10-K for the fiscal year ended December 31,2009, filed with the SEC on March 18,2010.

 

***We may not realize the expected benefits ofour initiatives to control costs.***

 

On April 19, 2010, we announced our strategicand operational Restructuring Plan intended to significantly reduce operatingcosts, increase the focus on the Company’s diagnostics services business andtransition senior management.  If weexperience excessive unanticipated inefficiencies or incremental costs inconnection with restructuring activities, such as unanticipated inefficienciescaused by reducing headcount or relocating operations, we may be unable tomeaningfully realize cost savings and we may incur expenses in excess of what weanticipate.  Further, in connection withthe Restructuring Plan, we may incur payments to third parties for fees, claimsor penalties associated with termination or default under existing agreementswith those parties. Any of these outcomes could prevent us from meeting ourstrategic objectives and could materially adversely impact our results ofoperations and financial condition.

 

***Healthcare reform and restrictions onreimbursements may limit our returns on molecular diagnostic products that wemay develop with our collaborators.***

 

We are currently collaborating with our partners todevelop diagnostic products.  The abilityof our collaborators to commercialize such products may depend, in part, on theextent to which reimbursement for the cost of these products will be availableunder U.S. regulations that govern reimbursement for clinical testing servicesby government authorities, private health insurers and otherorganizations.  In the United States,third-party payer price resistance, the trend towards managed health care andthe implementation of the Patient Protection and Affordable Care Act of 2010could reduce prices for health care products and services, adversely affectingthe profits of our customers and collaborative partners and reducing our futureroyalties.

 

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

 

None.

 

**Item3.  DEFAULTS UPON SENIOR SECURITIES**

 

None.

 

**Item4.  (REMOVED AND RESERVED)**

 

**Item5.  OTHER INFORMATION**

 

None.

 

**Item6.  EXHIBITS**

 

An index ofexhibits is found on page 23 of this report.

 

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**SIGNATURES**

 

Pursuant to therequirements of the Securities Exchange Act of 1934, the Registrant has dulycaused this report to be signed on its behalf by the undersigned, thereuntoduly authorized.

 

 
|   | COMBIMATRIX CORPORATION |
|--------|-------------------------|
|   |                    |   |
|   |                    |   |
|   | By:                     | /s/ R. JUDD JESSUP |
|   |                    | R. Judd Jessup |
|   |                    | Chief Executive Officer |
|   |                    | *(Principal Executive  Officer)* |
|   |                    |   |
|   |                    |   |
|   | By:                     | /s/ SCOTT R. BURELL |
|   |                    | Scott R. Burell |
|   |                    | Chief Financial Officer |
|   |                    | *(Principal Financial  and Accounting Officer)* |

 

Date:  November 15, 2010

 

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**EXHIBIT INDEX**

 
| **Exhibit  Number** | ** ** | **Description**                                                                                                                                                                                                                                                                              |
|---------------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                |       |                                                                                                                                                                                                                                                                                         |
| 3.1                 |       | Amended and Restated Certificate of Incorporation. Incorporated by  reference to Exhibit 3.1 to the Company’s Registration Statement on  Form S-1 (SEC File No. 333-139679) filed with the SEC on  December 26, 2006.                                               |
| 3.2                 |       | Certificate of Amendment to Amended and Restated Certificate of  Incorporation. Incorporated by reference to Exhibit 3.1A to the  Company’s Quarterly Report on Form 10-Q (File No. 001-33523) filed  with the SEC on August 14, 2008.                              |
| 3.3                 |       | Second Amended and Restated Bylaws. Incorporated by reference to  Exhibit 3.2 to the Company’s Annual Report on Form 10-K (File  No. 001-33523) filed with the SEC on March 18, 2010.                                                                               |
| 10.1                |       | Separation Agreement and General Release of Claims with Amit Kumar,  Ph.D., dated as of August 8, 2010. Incorporated by reference to  Exhibit 10.1 to the Company’s Quarterly Report on Form 10-Q (File  No. 001-33523) filed with the SEC on August 16, 2010. |
| 10.2                |       | Restated Executive Change in Control Severance Plan. Incorporated by  reference to Exhibit 10.2 to the Company’s Quarterly Report on  Form 10-Q (File No. 001-33523) filed with the SEC on  August 16, 2010.                                                        |
| 10.3                |       | Offer and Employment Agreement with R. Judd Jessup, dated as of  August 11, 2010. Incorporated by reference to Exhibit 10.3 to the  Company’s Quarterly Report on Form 10-Q (File No. 001-33523) filed  with the SEC on August 16, 2010.                       |
| 31.1                |       | Certification of Chief  Executive Officer pursuant to section 302 of the Sarbanes-Oxley Act of 2002  (*)                                                                                                                                                                                     |
| 31.2                |       | Certification of Chief  Financial Officer pursuant to section 302 of the Sarbanes-Oxley Act of 2002  (*)                                                                                                                                                                                     |
| 32.1                |       | Certification of Chief  Executive Officer pursuant to section 906 of the Sarbanes-Oxley Act of 2002  (*)                                                                                                                                                                                     |
| 32.2                |       | Certification of Chief Financial Officer pursuant to section 906 of  the Sarbanes-Oxley Act of 2002 (*)                                                                                                                                                                                      |

 

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(*)  Included herewith.

 

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