Table of Contents

 

 

 

**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON, D.C. 20549**

 

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**FORM 10-Q**

 

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

** **

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

 

**OR**

 

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

** **

**FOR THE TRANSITIONPERIOD 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**

 

**6500 Harbour Heights Parkway, Suite 303**

**Mukilteo, WA 98275**

(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 August 10,2010, 7,620,398 shares of CombiMatrix Corporation common stock were issued andoutstanding.

 

 

 

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Table of Contents

 

**COMBIMATRIX****CORPORATION**

**Table of Contents**

 
| **Part I. Financial  Information** |       |
|-----------------------------------------|------------|
|                                    |       |   |
| Item 1.                                 |       | Financial  Statements (Unaudited) |   |
|                                    |       |   |   |
|                                    |       | Consolidated  Balance Sheets as of June 30, 2010 and December 31, 2009 | 3 |
|                                    |       |   |   |
|                                    |       | Consolidated  Statements of Operations for the Three and Six Months Ended June 30,  2010 and 2009 | 4 |
|                                    |       |   |   |
|                                    |       | Consolidated  Statements of Cash Flows for the Six Months Ended June 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 | 16 |
|                                    |       |   |   |
| Item 3.                                 |       | Quantitative and Qualitative  Disclosures about Market Risk | 21 |
|                                    |       |   |   |
| Item 4.                                 |       | Controls and Procedures | 22 |
|                                    |       |   |
| **Part II.  Other Information**    | ** ** |
|                                    |       |   |   |
| Item 1A.                                |       | Risk Factors | 22 |
|                                    |       |   |   |
| Item 5.                                 |       | Other Information | 23 |
|                                    |       |   |   |
| Item 6.                                 |       | Exhibits | 24 |
|                                    |       |   |   |
| **Signatures**                          |       | 25 |
|                                    |       |   |
| **Exhibit Index**                  |       | 26 |

 

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**COMBIMATRIX CORPORATION**

**CONSOLIDATEDBALANCE SHEETS**

**(In thousands)**

**(Unaudited)**

* *
| ** **                                                                                                           | ** ** | **June 30,** | ** ** | **December 31,** | ** ** |
|----------------------------------------------------------------------------------------------------------------------|------------|-------------------|------------|-----------------------|------------|
| ** **                                                                                                           | ** ** | **2010**          | ** ** | **2009**              | ** ** |
| ** **                                                                                                           | ** ** | **(unaudited)**   | ** ** | ** **            | ** ** |
| **ASSETS**                                                                                                           |       |              |       |                  |       |
|                                                                                                                 |       |              |       |                  |       |
| Current  assets:                                                                                                     |       |              |       |                  |       |
| Cash  and cash equivalents                                                                                           |       | $                 | 10,215     |                  | $          | 5,443 |   |
| Accounts  receivable, net of allowance for doubtful accounts of $73 and $190                                         |       | 1,316             |       | 1,045                 |       |
| Inventory                                                                                                            |       | 292               |       | 669                   |       |
| Prepaid  expenses and other assets                                                                                   |       | 145               |       | 236                   |       |
| Total  current assets                                                                                                |       | 11,968            |       | 7,393                 |       |
|                                                                                                                 |       |              |       |                  |       |
| Property  and equipment, net                                                                                         |       | 656               |       | 653                   |       |
| Investments  in unconsolidated subsidiaries                                                                          |       | 127               |       | 296                   |       |
| Patents  and licenses, net                                                                                           |       | 231               |       | 3,840                 |       |
| Goodwill                                                                                                             |       | —            |       | 16,918                |       |
| Total  assets                                                                                                        |       | $                 | 12,982     |                  | $          | 29,100 |   |
|                                                                                                                 |       |              |       |                  |       |
| **LIABILITIES AND SHAREHOLDERS’  EQUITY**                                                                       | ** ** | ** **        | ** ** |                  | ** ** |
| ** **                                                                                                           | ** ** | ** **        | ** ** | ** **            | ** ** |
| Current  liabilities:                                                                                                |       |              |       |                  |       |
| Accounts  payable, accrued expenses and other                                                                        |       | $                 | 1,886      |                  | $          | 1,891 |   |
| Current  portion, capital lease obligations                                                                          |       | 66                |       | 52                    |       |
| Deferred  revenues                                                                                                   |       | —            |       | 255                   |       |
| Secured  convertible debenture                                                                                       |       | —            |       | 7,608                 |       |
| Other  liabilities                                                                                                   |       | —            |       | 605                   |       |
| Total  current liabilities                                                                                           |       | 1,952             |       | 10,411                |       |
|                                                                                                                 |       |              |       |                  |       |
| Capital  lease obligations, net of current portion                                                                   |       | 169               |       | 170                   |       |
| Total  liabilities                                                                                                   |       | 2,121             |       | 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 7,605,708 and 7,571,886  shares issued and outstanding |       | 8                 |       | 8                     |       |
| Additional  paid-in capital                                                                                          |       | 57,564            |       | 55,758                |       |
| Accumulated  net losses                                                                                              |       | (46,711           | )          | (37,247               | )          |
| Total  shareholders’ equity                                                                                     |       | 10,861            |       | 18,519                |       |
| Total  liabilities and shareholders’ equity                                                                     |       | $                 | 12,982     |                  | $          | 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** | ** ** | **Six  Months Ended** | ** ** |
|--------------------------------------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                                                         | ** ** | **June 30,**      | ** ** | **June 30,**     | ** ** |
| ** **                                                         | ** ** | **2010**               | ** ** | **2009**              | ** ** | **2010** | ** ** | **2009** | ** ** |
|                                                               |       |                   |       |                  |       |   |   |   |   |
| Revenues:                                                          |       |                   |       |                  |       |   |   |   |   |
| Services                                                           |       | $                      | 796        |                  | $          | 565 |   | $ | 1,568 |   | $ | 1,253 |   |
| Products                                                           |       | 120                    |       | 41                    |       | 168 |   | 80 |   |
| Total  revenues                                                    |       | 916                    |       | 606                   |       | 1,736 |   | 1,333 |   |
| Operating  expenses:                                               |       |                   |       |                  |       |   |   |   |   |
| Cost  of products and services                                     |       | 393                    |       | 376                   |       | 715 |   | 869 |   |
| Research  and development expenses                                 |       | 725                    |       | 699                   |       | 1,498 |   | 1,362 |   |
| Marketing,  general and administrative expenses                    |       | 2,156                  |       | 1,658                 |       | 4,141 |   | 3,517 |   |
| Patent  amortization and royalties                                 |       | 79                     |       | 59                    |       | 141 |   | 131 |   |
| Equity  in loss of investee                                        |       | —                 |       | 261                   |       | — |   | 511 |   |
| Goodwill  impairment                                               |       | 16,918                 |       | —                |       | 16,918 |   | — |   |
| Total  operating expenses                                          |       | 20,271                 |       | 3,053                 |       | 23,413 |   | 6,390 |   |
| Operating  loss                                                    |       | (19,355                | )          | (2,447                | )          | (21,677 | ) | (5,057 | ) |
| Other  income (expense):                                           |       |                   |       |                  |       |   |   |   |   |
| Litigation  settlement gain                                        |       | —                 |       | —                |       | 19,385 |   | — |   |
| Loss  from early extinguishment of debt                            |       | —                 |       | —                |       | (572 | ) | — |   |
| Interest  income                                                   |       | 2                      |       | 5                     |       | 4 |   | 15 |   |
| Interest  expense                                                  |       | (5                     | )          | (509                  | )          | (353 | ) | (1,022 | ) |
| Derivatives  gains (charges)                                       |       | —                 |       | 137                   |       | 605 |   | (1,384 | ) |
| Total  other income (expense)                                      |       | (3                     | )          | (367                  | )          | 19,069 |   | (2,391 | ) |
| Net  loss from continuing operations                               |       | (19,358                | )          | (2,814                | )          | (2,608 | ) | (7,448 | ) |
| Loss  from discontinued operations                                 |       | (5,442                 | )          | (1,817                | )          | (6,856 | ) | (3,315 | ) |
| Net  loss                                                          |       | $                      | (24,800    | )                     | $          | (4,631 | ) | $ | (9,464 | ) | $ | (10,763 | ) |
|                                                               |       |                   |       |                  |       |   |   |   |   |
| Basic  and diluted net loss per share from continuing operations   |       | $                      | (2.55      | )                     | $          | (0.40 | ) | $ | (0.34 | ) | $ | (1.11 | ) |
| Basic  and diluted net loss per share from discontinued operations |       | (0.72                  | )          | (0.26                 | )          | (0.90 | ) | (0.49 | ) |
|                                                               |       |                   |       |                  |       |   |   |   |   |
| Basic  and diluted net loss per share                              |       | $                      | (3.27      | )                     | $          | (0.66 | ) | $ | (1.24 | ) | $ | (1.60 | ) |
|                                                               |       |                   |       |                  |       |   |   |   |   |
| Basic  and diluted weighted average common shares outstanding      |       | 7,605,708              |       | 7,103,330             |       | 7,604,587 |   | 6,714,149 |   |

 

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

 

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**COMBIMATRIX CORPORATION**

**CONSOLIDATEDSTATEMENTS OF CASH FLOWS**

**(In thousands)**

**(Unaudited)**

 
| ** **                                                                      | ** ** | **Six Months Ended** | ** ** |
|---------------------------------------------------------------------------------|------------|----------------------|------------|
| ** **                                                                      | ** ** | **June 30,**    | ** ** |
| ** **                                                                      | ** ** | **2010**             | ** ** | **2009** | ** ** |
|                                                                            |       |                 |       |   |   |
| Operating  activities:                                                          |       |                 |       |   |   |
| Net loss                                                                        |       | $                    | (9,464     | ) | $ | (10,763 | ) |
| Adjustments  to reconcile net loss to net cash flows from operating activities: |       |                 |       |   |   |
| Depreciation  and amortization                                                  |       | 395                  |       | 775 |   |
| Non-cash  stock compensation                                                    |       | 1,615                |       | 1,646 |   |
| Derivatives  (gains) charges                                                    |       | (605                 | )          | 1,384 |   |
| Loss  on early extinguishment of debt                                           |       | 572                  |       | — |   |
| Equity  in loss of investee                                                     |       | —               |       | 511 |   |
| Warrants  issued to consultants                                                 |       | —               |       | 190 |   |
| Allowance  for bad debt                                                         |       | 74                   |       | 287 |   |
| Amortization  of debt discount and issuance costs                               |       | 211                  |       | 571 |   |
| Goodwill  impairment                                                            |       | 16,918               |       | — |   |
| Patent  and other asset write-downs                                             |       | 3,664                |       | — |   |
| Changes  in assets and liabilities:                                             |       |                 |       |   |   |
| Accounts  receivable                                                            |       | (345                 | )          | (206 | ) |
| Inventory,  prepaid expenses and other assets                                   |       | 441                  |       | (131 | ) |
| Accounts  payable, accrued expenses and other                                   |       | 60                   |       | 839 |   |
| Deferred  revenues                                                              |       | (255                 | )          | (137 | ) |
| Net  cash flows from operating activities                                       |       | 13,281               |       | (5,034 | ) |
| Investing  activities:                                                          |       |                 |       |   |   |
| Purchase  of property and equipment                                             |       | (73                  | )          | (15 | ) |
| Sale  of available-for-sale investments                                         |       | —               |       | 1,526 |   |
| Net  cash flows from investing activities                                       |       | (73                  | )          | 1,511 |   |
| Financing  activities:                                                          |       |                 |       |   |   |
| Repayment  of secured convertible debenture                                     |       | (8,400               | )          | — |   |
| Net  proceeds from issuance of common stock, net                                |       | —               |       | 7,761 |   |
| Repayment  of line of credit                                                    |       | —               |       | (820 | ) |
| Repayment  of capital lease obligations                                         |       | (36                  | )          | (12 | ) |
| Net  cash flows from financing activities                                       |       | (8,436               | )          | 6,929 |   |
|                                                                            |       |                 |       |   |   |
| Increase  in cash and cash equivalents                                          |       | 4,772                |       | 3,406 |   |
| Cash  and cash equivalents, beginning                                           |       | 5,443                |       | 7,579 |   |
| Cash  and cash equivalents, ending                                              |       | $                    | 10,215     |   | $ | 10,985 |   |
|                                                                            |       |                 |       |   |   |
| Non-cash  financing activities:                                                 |       |                 |       |   |   |
| Accrued  interest paid in common stock                                          |       | $                    | 215        |   | $ | 451 |   |
|                                                                            |       |                 |       |   |   |
| Conversion  of secured convertible debenture to common stock                    |       | $                    | —     |   | $ | 100 |   |
|                                                                            |       |                 |       |   |   |
| Accrued  financing costs                                                        |       | $                    | —     |   | $ | 205 |   |

 

*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 Californiacorporation and later reincorporated as a Delaware corporation in September 2000.  In December 2002, we merged with andbecame a wholly owned subsidiary of Acacia Research Corporation (“Acacia”).  In December 2006, we filed aregistration statement with the U.S. Securities and Exchange Commission (“SEC”)in order to register our common stock as part of a plan to split-off fromAcacia (the “Split-Off”).  On August 15,2007 (the “Split-Off Date”), the Split-Off was effected and our common stockbecame publicly traded on the Nasdaq Global Market (symbol: “CBMX”).  As of the Split-Off Date, we ceased to be asubsidiary of, or affiliated with, Acacia.

 

*Description of the Company*

 

We are a diversifiedbiotechnology business that primarily operates in the field of genetic analysisand molecular diagnostics through our wholly owned subsidiary, CombiMatrixMolecular Diagnostics, Inc. (“CMDX”). CMDX operates as a diagnosticsreference laboratory that provides genetic and other diagnostics services tophysicians, hospitals and clinics.

 

Leuchemix Inc. (“Leuchemix”),a minority-owned subsidiary, is developing a series of compounds to address anumber of oncology-related diseases. Leuchemix’s first compound has entered initial clinical trials in theUnited Kingdom.

 

On April 19, 2010, we announced a strategic andoperational restructuring plan (the “Restructuring Plan”) to significantlyreduce operating costs, increase the focus on the Company’s diagnostic servicesbusiness and transition senior management. As part of the Restructuring Plan, we have closed our Mukilteo,Washington facility, which had been focused primarily on research, developmentand commercialization of the Company’s oligonucleotide microarray technologies,also known as our “CustomArray” business. We have also relocated our corporate headquarters from Mukilteo to CMDX’sIrvine, California location.  After therestructuring, we will be focused primarily on our diagnostics services business,including increasing the utilization of our existing tests, expanding the testmenu, increasing the number of customers and partners, and improvingreimbursement for our testing services. As a component of this plan, we initiated a search for a new Presidentand Chief Executive Officer, which was completed on August 11, 2010 (see Note9).  On June 30, 2010, Dr. AmitKumar stepped down from his role as President and Chief Executive Officer and Mr. MarkMcGowan, our Chairman of our Board of Directors, assumed this role on aninterim basis.

 

*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 RegulationS-X.  Accordingly, certain informationand footnotes required by generally accepted accounting principles in annualfinancial statements have been omitted or condensed in accordance withquarterly reporting requirements of the SEC. These interim consolidated financial statements should be read inconjunction with the consolidated financial statements and notes thereto forthe year ended December 31, 2009, as reported by us in our Annual Reporton Form 10-K filed on March 18, 2010. The year-end consolidated balance sheet data was derived from auditedfinancial statements but does not include all disclosures required byaccounting principles generally accepted in the United States of America.  The consolidated financial statements includeall adjustments of a normal recurring nature which, in the opinion ofmanagement, are necessary for a fair statement of our financial position as of June 30,2010, and results of operations and cash flows for the interim periods presented.  The results of operations for the three andsix months ended June 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 informationregarding discontinued operations. Unless otherwise noted, amounts and disclosures throughout the notes toour consolidated 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 June 30, 2010, we had cash and cashequivalents of $10.2 million.  As aresult, we anticipate that our cash and cash equivalent balances, anticipatedcash flows from operations, operating cash savings from our Restructuring Planand other sources of funding from the capital markets will be sufficient tomeet our cash requirements beyond the next twelve months.  In order for us to continue as a goingconcern beyond this point, we may be required to obtain capital from externalsources. However, there can be no assurances that additional sources offinancing, including the issuance of debt and/or equity securities, will beavailable at times and at terms acceptable to us.

 

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

 

**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. generallyaccepted accounting principles (“GAAP”) recognized by the FASB to be applied bynon-governmental entities in preparation of financial statements in conformitywith U.S. GAAP, except for additional authoritative rules andinterpretative releases issued by the SEC. While the adoption of the ASC changes how we reference accountingstandards, the adoption did not have an impact on our consolidated financialstatements.

 

*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.  A componentmay be a reportable segment, an operating segment, a reporting unit, asubsidiary, or an asset group.  Suchreclassifications had no effect on our net loss or shareholders’ equity.

 

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

 

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**COMBIMATRIXCORPORATION**

**NOTES TOCONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)**

**(Unaudited)**

 

*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, including commercialinsurance companies, healthcare institutions, individuals and government payorsincluding Medicare and Medicaid.  Wereport revenues from contracted payors based on a contractual rate, or in thecase 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, have been recognized when delivery occurred.  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 orperformance of an undelivered item is considered probable and under ourcontrol.  Our revenue arrangements do nothave a general 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.

 

*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.

 

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**COMBIMATRIXCORPORATION**

**NOTES TOCONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)**

**(Unaudited)**

 

Weutilize a three-tier fair value hierarchy, which prioritizes the inputs used inmeasuring 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 Allowances 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 of our common stock onNasdaq) fell below our carrying value, triggering an impairment analysis — seeNote 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.

 

*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.  

 

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**COMBIMATRIXCORPORATION**

**NOTES TOCONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)**

**(Unaudited)**

 

Stock-based compensation expense for allperiods presented attributable to our functional expense categories were asfollows (in thousands; unaudited):

 
| ** **                             | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|----------------------------------------|------------|------------------------|------------|----------------------|------------|
| ** **                             | ** ** | **June 30,**      | ** ** | **June 30,**    | ** ** |
| ** **                             | ** ** | **2010**               | ** ** | **2009**             | ** ** | **2010** | ** ** | **2009** | ** ** |
| ** **                             | ** ** | ** **             | ** ** | ** **           | ** ** | ** ** | ** ** | ** ** | ** ** |
| Cost  of products and services         |       | $                      | 14         |                 | $          | 16 |   | $ | 27 |   | $ | 37 |   |
| Research  and development              |       | 46                     |       | 46                   |       | 94 |   | 82 |   |
| Marketing,  general and administrative |       | 522                    |       | 502                  |       | 1,031 |   | 974 |   |
| Discontinued  operations               |       | 190                    |       | 266                  |       | 463 |   | 553 |   |
| Total  non-cash stock compensation     |       | $                      | 772        |                 | $          | 830 |   | $ | 1,615 |   | $ | 1,646 |   |

 

*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** | ** ** | **Six Months Ended** | ** ** |
|--------------------------------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                                                         | ** ** | **June 30,**                | ** ** | **June 30,**              | ** ** |
| ** **                                                         | ** ** | **2010**                         | ** ** | **2009**                       | ** ** | **2010** | ** ** | **2009** | ** ** |
| Numerator:                                                         |       |                             |       |                           |       |   |   |   |   |
| Loss  from continuing operations applicable to common shareholders |       | $                                | (19,358    | )                              | $          | (2,814 | ) | $ | (2,608 | ) | $ | (7,448 | ) |
| Denominator:                                                       |       |                             |       |                           |       |   |   |   |   |
| Weighted-average  common shares outstanding                        |       | 7,605,708                        |       | 7,103,330                      |       | 7,604,587 |   | 6,714,149 |   |
| Basic  and diluted loss per share from continuing operations       |       | $                                | (2.55      | )                              | $          | (0.40 | ) | $ | (0.34 | ) | $ | (1.11 | ) |
|                                                               |       |                             |       |                           |       |   |   |   |   |
| Common  stock options                                              |       | 2,009,102                        |       | 2,059,502                      |       | 2,009,102 |   | 2,059,502 |   |
| Common  stock warrants                                             |       | 3,843,646                        |       | 3,813,646                      |       | 3,843,646 |   | 3,813,646 |   |
| Convertible  debenture                                             |       | —                           |       | 1,120,000                      |       | — |   | 1,120,000 |   |
| Excluded  potentially dilutive securities                          |       | 5,852,748                        |       | 6,993,148                      |       | 5,852,748 |   | 6,993,148 |   |

 

*Recent and Adopted AccountingPronouncements*.  In March 2010,the FASB issued new authoritative guidance regarding revenue recognition todefine a milestone and clarify that the milestone method of revenue recognitionis a valid application of the proportional performance model when applied toresearch or development arrangements. Accordingly, a company can make an accounting policy election torecognize a payment that is contingent upon the achievement of a substantivemilestone in its entirety in the period in which the milestone isachieved.  This guidance begins phasingin during the third quarter of 2010.  Wedo not expect the implementation of this guidance to have a material impact onour consolidated financial statements.

 

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 to significanttransfers between each fair value level as well as requiring additionalinformation about Level 3 activity.  Thisguidance begins phasing in during the first fiscal period after December 15,2009.  We do not expect theimplementation of this guidance to have a material impact on our consolidatedfinancial statements.

 

InOctober 2009, the FASB issued new authoritative guidance to requirecompanies to allocate revenue in multiple-element arrangements based on anelement’s estimated selling price if vendor-specific or other third-party evidenceof value is not available. The new guidance is effective for revenuetransactions entered into during fiscal years beginning on or after June 15,2010, with earlier application permitted. We do not believe the adoption of this guidance will have a materialimpact on our consolidated financial statements.

 

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**COMBIMATRIXCORPORATION**

**NOTES TOCONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)**

**(Unaudited)**

 

**3.     RESTRUCTURING**

 

On April 19, 2010, we announced a RestructuringPlan that will focus our Company on our diagnostic services business whileshutting down our CustomArray business. Related charges incurred as of June 30, 2010 are as follows (inthousands):

 
| ** **                                 | ** ** | **Restructuring** | ** ** |
|--------------------------------------------|------------|-------------------|------------|
| ** **                                 | ** ** | **Charges**       | ** ** |
|                                       |       |              |       |
| 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        |       | 38                |       |
| Subtotal                                   |       | 1,653             |       |
| Sale  of surplus property and equipment    |       | (401              | )          |
|                                       |       | $                 | 1,252      |   |

 

Of the $1.7 million in restructuring charges listedabove, $465,000 were non-cash write-downs, $826,000 were paid out in cash as ofJune 30, 2010, and $362,000 were accrued as short-term payables and areexpected to be paid out during the third quarter of 2010. Remaining costs thatare primarily associated with facilities clean-up and relocation are notexpected to be significant.  Net ofproceeds received from the sales of surplus property, equipment and inventory,we recognized a loss from restructuring of $1.4 million, which is included as acomponent of loss from discontinued operations in the three and six monthsended June 30, 2010 statements of operations.

 

As a result of the Restructuring Plan, managementperformed an impairment analysis of its intangible patent assets and determinedthat these assets were fully impaired. As a result, these assets were written down by $3.4 million during thesecond quarter of 2010.  The write-downis included as a component of loss from discontinued operations in theaccompanying consolidated statements of operations for the three and six monthsended June 30, 2010.

 

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

 
| ** **                                       | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|--------------------------------------------------|------------|------------------------|------------|----------------------|------------|
| ** **                                       | ** ** | **June 30,**      | ** ** | **June 30,**    | ** ** |
| ** **                                       | ** ** | **2010**               | ** ** | **2009**             | ** ** | **2010** | ** ** | **2009** | ** ** |
| Revenues                                         |       | $                      | 320        |                 | $          | 630 |   | $ | 754 |   | $ | 1,444 |   |
| Operating  expenses                              |       | 1,076                  |       | 2,447                |       | 2,924 |   | 4,759 |   |
| Impairment  of patents                           |       | 3,434                  |       | —               |       | 3,434 |   | — |   |
| Restructuring  and other charges, net of surplus |       | 1,252                  |       | —               |       | 1,252 |   | — |   |
| Loss  from discontinued operations               |       | $                      | (5,442     | )                    | $          | (1,817 | ) | $ | (6,856 | ) | $ | (3,315 | ) |

 

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**COMBIMATRIXCORPORATION**

**NOTES TO CONSOLIDATEDFINANCIAL 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 June 30, 2010 and theclassification by level of input within the fair value hierarchy defined above(in thousands; unaudited):

 
| ** **        | ** ** | **June 30,** | ** ** | **Fair Value Measurements at** | ** ** |
|-------------------|------------|-------------------|------------|--------------------------------|------------|
| ** **        | ** ** | **2010**          | ** ** | **Level 1**                    | ** ** | **Level 2** | ** ** | **Level 3** | ** ** |
| Assets:           |       |              |       |                           |       |   |   |   |   |
| Cash  equivalents |       | $                 | 9,755      |                           | $          | 9,755 |   | $ | — |   | $ | — |   |
|                   |            |                   |            |                                |            |  |  |  |  |  |  |  |  |

 

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

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

 

----

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

 

**5.     GOODWILL IMPAIRMENT**

 

The decline in our marketcapitalization during the second quarter of 2010 (as indicated by the tradingof our common stock on Nasdaq) was considered by management to be a potentialgoodwill impairment triggering event.  Asa result, we performed a business valuation using a market based approach anddetermined that all of our $16.9 million in goodwill was impaired.  The related charge was recognized as “goodwillimpairment” in our 2010 consolidated statements of operations.  The change in the carrying amount of goodwilland impairment losses for the period ended June 30, 2010 is as follows (inthousands):

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

 

**6.     SECURED CONVERTIBLE DEBENTURE**

 

*Description*

 

OnJuly 10, 2008 (the “Closing Date”), we issued to YA Global Investments,L.P. (“YA”): (i) a secured convertible debenture (the “Debenture”) with anaggregate principal amount of $10 million, which was convertible into shares ofour common stock at a fixed conversion price of $11.87 per share (and wasreduced during 2009 to $7.50 per share); and (ii) warrants (the “YAWarrants”) to purchase up to 336,984 shares of our common stock.  The Debenture was originally due on theearlier of July 10, 2010 (the “Term”) or within four months after receiptof payment of judgment or settlement proceeds from National Union FireInsurance Company of Pittsburg, PA (“National Union”) in accordance with the$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 $25million in settlement proceeds from National Union, $8.6 million of which wasused to fully retire the remaining principal balance of the Debenture, plusaccrued interest, on March 2, 2010 (the “Retirement Date”).

 

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 fixedconversion price of the Debenture was reduced from $11.87 per share to $7.50per share pursuant to anti-dilution provisions of the Debenture.  The YA Warrants, which remain outstanding,and have a five-year term and allow YA to purchase: (i) 168,492 shares ofcommon stock at an exercise price of $11.87; and (ii) 168,492 shares ofcommon stock at an exercise price of $13.65.

 

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**COMBIMATRIXCORPORATION**

**NOTES TOCONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)**

**(Unaudited)**

 

Asa result 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 six monthsended June 30, 2010 and 2009, interest and amortization charges were $0,$348,000, $506,000 and $1.0 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 six-month ended June 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 RetirementDate and $1.8 million as of June 30, 2009, resulting in net non-operatingderivative gains (charges) of $0, $605,000, $137,000 and $(1.4 million) for thethree and six months ended June 30, 2010 and 2009, respectively.

 

**7.     SHAREHOLDERS’ EQUITY**

 

*Equity Financings*

 

On May 1, 2009, weclosed a registered direct offering (the “Offering”) of our common stock andwarrants for gross proceeds of $8.25 million. Under the terms of the Offering, we sold 1.1 million units for $7.50 perunit to certain investors.  Each unitconsisted of one share of our common stock and one warrant, each warrant topurchase one share of our common stock at an exercise price of $9.00 per share.  The warrants were not exercisable until sixmonths after the Offering and have a term of five years.  The warrants are also callable if our commonstock trades at or above $22.50 per share during any 20 trading days during aperiod of 30 consecutive trading days, with a minimum daily trading volume of50,000 shares each day during that 30 trading day period.  Subsequent to the date of the Offering, welisted the warrants on the Nasdaq Global Market under the symbol “CBMXW”.  Net proceeds from the Offering, net ofplacement agent fees and expenses, were approximately $7.6 million.  As a result of the Offering, the fixedconversion price of the Debenture was reduced to $7.50 per share, effective May 1,2009.

 

*Warrants*

 

Outstandingwarrants to purchase CombiMatrix stock are as follows:

 
| ** **          | ** ** | **Shares of Common Stock** | ** ** | ** **            | ** ** | ** **       | ** ** |
|---------------------|------------|----------------------------|------------|-----------------------|------------|------------------|------------|
| ** **          | ** ** | **Issuable from Warrants** | ** ** | ** **            | ** ** | ** **       | ** ** |
| ** **          | ** ** | **Outstanding as of**      | ** ** | ** **            | ** ** | ** **       | ** ** |
| ** **          | ** ** | **June 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                    |       | 159,648               |       | $24.00           |       | September 2010 |   |
| Total               |       | 3,843,646                  |       | 3,943,646             |       |             |       |   |   |

 

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**COMBIMATRIXCORPORATION**

**NOTES TOCONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)**

**(Unaudited)**

 

**8.    COMMITMENTS ANDCONTINGENCIES**

 

*Human Resources*

 

We provide certain severance benefits such that ifan executive of CombiMatrix who is a vice president or higher is terminated forother than cause, death or disability, the executive will receive paymentsequal to three months’ base salary plus medical and dental benefits.

 

In addition, we have implemented an Executive Changeof Control Severance Plan (the “Severance Plan”) that affects certain of oursenior management-level employees of CombiMatrix Corporation.  Pursuant tothe Severance Plan, if a participating employee isinvoluntarily terminated (other than for death, disability or for cause)or resigns for “good reason” (as defined in the Severance Plan) during thetwo-year period following a “change of control” (as defined in the SeverancePlan) of the Company, then, subject to execution of a release of claims againstthe Company, the employee will be entitled to receive: (i) a cashseverance payment equal to one times annual base salary, in the case of ourChief Executive Officer; or one-half times annual base salary, in the case ofother participating employees; (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.Internal Revenue Code.  The Severance Plan is administered by a planadministrator, which initially is the Compensation Committee of the Board ofDirectors.  In order to participate in the Severance Plan, an eligibleemployee must waive any prior retention or severance agreements. The SeverancePlan was modified on August 10, 2010 (see Note 9 below).

 

*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, $50,000, $25,000, and $50,000, for the three and sixmonths ended June 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.  In March 2008,the District Court issued its Judgment in favor of Acacia and us, and awardedapproximately $32.1 million in monetary damages to be paid by NationalUnion.  In May 2008, the DistrictCourt awarded us an additional $3.6 million in attorneys’ fees and litigationcosts, 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 enteredinto a settlement agreement whereby National Union agreed to pay $25 million tous in order to settle the dispute.  Theseproceeds, net of attorneys’ fees and costs of $5.6 million, were paid to us on February 3,2010 and a dismissal of the action was entered by the District Court on February 11,2010.

 

We are subject to other claims and legal actionsthat arise in the ordinary course of business. We believe that the ultimate liability with respect to these claims andlegal actions, if any, will not have a material effect on our financialposition, results of operations or cash flows. Based on a distribution agreement executed between us and Acacia, it isexpected that such claims, legal actions, etc. attributable to CombiMatrixCorporation prior to the Split-Off Date will remain with us subsequent to theSplit-Off Date.  As of the date of thisreport and prior to such date, we are not aware of the existence of any suchclaims or legal actions.

 

**9.     SUBSEQUENT EVENTS**

 

On August 10, 2010,our Board of Directors approved a restatement of the Severance Plan, thataffects certain of our senior management-level employees of CombiMatrixCorporation.  As restated, anycash severance payment payable under the Severance Plan will be equal toone-half times annual base salary for all senior management-level employees ofthe Company, including our Chief Executive Officer.

 

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**COMBIMATRIXCORPORATION**

**NOTES TOCONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)**

**(Unaudited)**

 

On August 11, 2010, R. Judd Jessup accepted ouroffer to become the Company’s new President and Chief Executive Officer, andhis employment with us will commence on August 23, 2010.  Mr. Jessup was also elected to serve asa member of our Board of Directors, effective August 23, 2010.  Mr. Jessup replaces Mark McGowan who hadserved as our interim President and Chief Executive Officer.  Mr. McGowan will continue to serve asChairman of the Board.  Mr. Jessupwill be paid a base salary of $420,000 per year and, subject to Board approval,an annual performance bonus.  We alsogranted Mr. Jessup a stock option to purchase 400,000 shares of our commonstock at an exercise price of $2.74 per share. The stock option vests over four years. Mr. Jessup is entitled to standard company benefits and may beentitled to certain severance benefits under the Company’s Severance Plan. Pursuantto the Severance Plan, if Mr. Jessup is involuntarily terminated(other than for death, disability or for cause) or resigns for “good reason”(as defined in the Severance Plan) during the two-year period following a “changeof control” (as defined in the Severance Plan) of the Company, then, subject toexecution of a release of claims against the Company, the Mr. Jessup willbe entitled to receive: (i) a cash severance payment equal to one-half timeshis annual base salary; (ii) immediate vesting of outstanding compensatoryequity awards; and (iii) payment of COBRA premiums for Mr. Jessup andeligible dependants for a pre-determined period of time.

 

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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, Item1 of this report.  The informationcontained in this Quarterly Report on Form 10-Q is not a completedescription of our businesses or the risks associated with an investment in ourcommon stock.  We urge you to carefullyreview and consider the various disclosures made by us in this report and inour other reports filed with the U.S. Securities and Exchange Commission, or “SEC,”including our Annual Report on Form 10-K, filed on March 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,” “expect,”“believe,” “estimate,” “anticipate,” “intend,” “continue,” or similar terms,variations of such terms or the negative of such terms.  Such statements are based on management’scurrent expectations and are subject to a number of factors and uncertainties,which could cause actual results to differ materially from those described inthe forward-looking statements.  Suchstatements address future events and conditions concerning product development,capital expenditures, earnings, litigation, regulatory matters, markets forproducts and services, liquidity and capital resources and accountingmatters.  Actual results in each casecould differ materially from those anticipated in such statements by reason offactors such as future economic conditions, changes in consumer demand,legislative, regulatory and competitive developments in markets in which we andour subsidiaries operate, results of litigation and other circumstancesaffecting anticipated revenues and costs. We expressly disclaim any obligation or undertaking to release publiclyany updates or revisions to any forward-looking statements contained herein toreflect any change in our expectations with regard thereto or any change inevents, conditions or circumstances on which any such statement is based.  Additional factors that could cause suchresults to differ materially from those described in the forward-lookingstatements are set forth in connection with the forward-looking statements andin the “Risk Factors” described in our Annual Report on Form 10-K filed onMarch 18, 2010.

 

**General**

 

We are a diversifiedbiotechnology business that primarily operates in the field of genetic analysisand molecular diagnostics through our wholly owned subsidiary, CombiMatrixMolecular Diagnostics, Inc. (“CMDX”). CMDX operates as a diagnosticsreference laboratory that provides genetic and other diagnostics services tophysicians, hospitals and clinics.

 

Leuchemix Inc. (“Leuchemix”),a minority-owned subsidiary, is developing a series of compounds to address anumber of oncology-related diseases. Leuchemix’s first compound has entered initial clinical trials in theUnited Kingdom.

 

On April 19, 2010, we announced a strategic andoperational restructuring plan (the “Restructuring Plan”) to significantlyreduce operating costs, increase the focus on the Company’s diagnostic servicesbusiness and transition senior management. As part of the Restructuring Plan, we closed our Mukilteo, Washingtonfacility, which had been focused primarily on research, development andcommercialization of the Company’s oligonucleotide microarray technologies,previously referred to as our “CustomArray” business. We also relocated ourcorporate headquarters to CMDX’s Irvine, California location.  After the restructuring, CombiMatrix will befocused primarily on our diagnostics services business, including increasingthe utilization 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 plan,we initiated a search for a new President and Chief Executive Officer, which wascompleted on August 11, 2010 with the hiring of R. Judd Jessup as our permanentPresident and CEO.  On June 30,2010, Dr. Amit Kumar stepped down from his role as President and ChiefExecutive Officer and Mr. Mark McGowan, our Chairman of our Board ofDirectors, assumed this role on an interim basis.  See Notes 1, 3 and 9 to the consolidatedfinancial statements included elsewhere in this report for additionaldiscussion of these matters.

 

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**Prior Relationship with Acacia Research Corporation**

 

We were originally incorporated in October 1995as a California corporation and later reincorporated as a Delaware corporationin September 2000.  In December 2002,we merged with and became a wholly owned subsidiary of Acacia ResearchCorporation (“Acacia”).  In December 2006,we filed a registration statement with the U.S. Securities and ExchangeCommission (“SEC”) in order to register our common stock under the SecuritiesAct of 1933 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).  Asof the Split-Off Date, we ceased to be a subsidiary of, or affiliated with,Acacia.

 

**Liquidity**

 

At June 30, 2010, we had cash and cashequivalents of $10.2 million.  As aresult, we anticipate that our cash and cash equivalent balances, cash flowsfrom operations, operating cash savings from our Restructuring Plan and othersources of funding from the capital markets will be sufficient to meet our cashrequirements beyond 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 capital will beavailable at times and at terms acceptable to us.  The issuance of additional equity securitiesmay also cause dilution to our shareholders. If external financing sources are not available or are inadequate tofund our operations, we will be required to reduce operating costs, includingresearch projects and personnel, of which reduction could jeopardize the futurestrategic initiatives and business plans of our company.  See the Liquidity and Capital Resourcessection below as well as Note 1 to the consolidated financial statementsincluded elsewhere in this report for additional discussion of these matters.

 

**Basis Of Presentation Of Financial Statements**

 

The consolidated financial statements included inthis Form 10-Q are consistent with our historical financial statementsincluded in our Form 10-K for our fiscal year ended December 31,2009.

 

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 the notes to ourconsolidated financial statements relate to our continuing operations.

 

**Overview of Recent Business Activities**

 

For the three months ended June 30, 2010, ouroperating activities included the recognition of $916,000 in revenues,including $796,000 in diagnostic lab revenues and $120,000 from the sale of CGHarrays to foreign distributors.  Marketing,general and administrative expenses increased due to increased sales andmarketing activities and increased headcount in general and administrativedepartments.  Due primarily to a declinein our market capitalization during the second quarter, an impairment analysisof our goodwill resulted in an impairment charge of $16.9 million.

 

Significant business developments that occurredduring the second quarter ended June 30, 2010 were:

 

·                  In April 2010, weannounced the Restructuring Plan described above.  Also, see Notes 1 and 3 to the consolidatedfinancial statements included elsewhere in this report for additionaldiscussion of this matter.

 

·                  In June 2010, weannounced that we ceased our M&A activities to focus primarily on theRestructuring Plan, growing our diagnostics business and recruitment of a newPresident and Chief Executive Officer. Later in June, we announced that Mr. Tom Akin and Dr. BrookeAnderson would be stepping down from our Board of Directors, and that Mr. MarkMcGowan was named Chairman of the Board. Mr. Rigdon Currie was named Chairman of the Audit Committee.  Finally, on June 30, 2010, Dr. AmitKumar stepped down as President and CEO of the Company and Mr. MarkMcGowan assumed these roles on an interim basis effective July 1, 2010.

 

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·                  On June 15, 2010, weannounced that CMDX had received final licensure documentation and approvals inorder to begin billing for its suite of array-based diagnostic tests toMedicare.

 

**Critical Accounting Estimates**

 

Our unauditedinterim financial statements have been prepared in accordance with accountingprinciples generally accepted in the United States of America.  Preparation of these statements requiresmanagement to make judgments and estimates. Some accounting policies have a significant impact on amounts reportedin these financial statements.  A summaryof significant accounting policies and a description of accounting policiesthat are considered critical may be found in our Annual Report on Form 10-K,filed on March 18, 2010, in the Notes to the Consolidated FinancialStatements and the Critical Accounting Estimates section.  In addition, refer to Note 2 to theconsolidated interim financial statements included in Part I, Item 1of this report.

 

**Comparison of the Results of Operations for the Three and SixMonths Ended June 30, 2010 and 2009**

 

Revenues and Cost of Revenues:

 
| ** **                     | ** ** | **Three Months Ended** | ** ** | ** ** | ** ** | **Six Months Ended** | ** ** | ** ** | ** ** |
|--------------------------------|------------|------------------------|------------|------------|------------|----------------------|------------|------------|------------|
| ** **                     | ** ** | **June 30,**      | ** ** | **Change** | ** ** | **June 30,**    | ** ** | **Change** | ** ** |
| ** **                     | ** ** | **2010**               | ** ** | **2009**   | ** ** | **$**                | ** ** | **%**      | ** ** | **2010** | ** ** | **2009** | ** ** | **$** | ** ** | **%** | ** ** |
|                           |       |                   |       |       |       |                 |       |       |       |   |   |   |   |   |   |   |   |
| Services                       |       | $                      | 796        |       | $          | 565                  |       | $          | 231        |   | 41% |   | $ | 1,568 |   | $ | 1,253 |   | $ | 315 |   | 25% |   |
| Products                       |       | 120                    |       | 41         |       | 79                   |       | 193%       |       | 168 |   | 80 |   | 88 |   | 110% |   |
| Cost  of products and services |       | (393                   | )          | (376       | )          | (17                  | )          | (5)%       |       | (715 | ) | (869 | ) | 154 |   | 18% |   |
|                                |            |                        |            |            |            |                      |            |            |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

*Services.*  Revenuesincreased primarily due to test volume increases as well as increases inaverage revenue recognized per test. Billable test volumes were 773 and 1,400for the three and six months ended June 30, 2010, respectively, comparedto 637 and 1,560 for the comparable periods in 2009.  The decrease in volumes for the six monthperiods presented was due to the loss of test samples from the State of NewYork (which we are in the process of applying for licensing in thatstate).  Moreover, the period ending in June 30,2009 contained certain one-time clinical trial services that were performed forthe University of Texas, Health Science Center at San Antonio.  Average revenue per test was approximately$1,120 in 2010 versus $803 in 2009.  Thisincrease is due primarily to improved reimbursement from non-contractedthird-party payors, resulting in higher average recognized revenues per testduring 2010 compared with 2009.

 

*Products. *Product revenues fromselling bacterial artificial chromosome, or “BAC,” comparative genomichybridization, or “CGH,” arrays to a customer in Taiwan increased due to highervolumes, which were 660 and 900 arrays sold for the three and six months ended June 30,2010, versus 120 and 220 in the comparable 2009 periods.  Increased volumes were due mainly toincreased demand for array CGH services in Asia from our Taiwanese customer.

 

*Cost of Products andServices. *Cost of services for our diagnostic tests include direct materials and directlaboratory labor costs (wages and benefits).   Costs for the threeand six month periods ending June 30, 2009 represent higher material costsper unit that have been reduced in 2010 due to better pricing from oursuppliers, based on our increased test volume.

 

Operating Expenses:

 
| ** **                              | ** ** | **Three Months Ended** | ** ** | ** ** | ** ** | **Six Months Ended** | ** ** | ** ** | ** ** |
|-----------------------------------------|------------|------------------------|------------|------------|------------|----------------------|------------|------------|------------|
| ** **                              | ** ** | **June 30,**      | ** ** | **Change** | ** ** | **June 30,**    | ** ** | **Change** | ** ** |
| ** **                              | ** ** | **2010**               | ** ** | **2009**   | ** ** | **$**                | ** ** | **%**      | ** ** | **2010** | ** ** | **2009** | ** ** | **$** | ** ** | **%** | ** ** |
|                                    |       |                   |       |       |       |                 |       |       |       |   |   |   |   |   |   |   |   |
| Research  and development expenses      |       | $                      | 725        |       | $          | 699                  |       | $          | 26         |   | 4% |   | $ | 1,498 |   | $ | 1,362 |   | $ | 136 |   | 10% |   |
| Marketing,  general and admin. expenses |       | 2,156                  |       | 1,658      |       | 498                  |       | 30%        |       | 4,141 |   | 3,517 |   | 624 |   | 18% |   |
| Patent  amortization and royalties      |       | 79                     |       | 59         |       | 20                   |       | 34%        |       | 141 |   | 131 |   | 10 |   | 8% |   |
| Equity  in loss of investee             |       | —                 |       | 261        |       | (261                 | )          | (100)%     |       | — |   | 511 |   | (511 | ) | (100)% |   |
| Goodwill  impairment                    |       | 16,918                 |       | —     |       | 16,918               |       | —     |       | 16,918 |   | — |   | 16,918 |   | — |   |
|                                         |            |                        |            |            |            |                      |            |            |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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*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 increase for the six months ended June 30,2010 was due primarily to additional labor and supply costs incurred frommaintaining and improving our diagnostic test suite as compared to the priorperiod.  In addition, for the three andsix months ended June 30, 2010 and 2009, research and development expensesincluded $46,000, $94,000, $46,000 and $82,000, respectively, of non-cash stockcompensation expense.  This increase wasdue primarily to increases in the number of stock option awards granted to ouremployees during the past twelve months. See Note 2 to our consolidated interim financial statements includedelsewhere in this report for a detailed description of the amounts recognizedfor the periods presented.

 

*Marketing, General andAdministrative Expenses.*  Theincrease in marketing, general and administrative expenses for the three andsix months ended June 30, 2010 versus the comparable period in 2009 wasdue primarily to increased sales and marketing activities as well as higherheadcount compared to the prior periods. In addition, the three and six months ended June 30, 2010 generaland administrative expenses 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 theinvestment.  In addition, for the threeand six months ended June 30, 2010 and 2009, research and developmentexpenses included $522,000, $1.0 million, $502,000 and $974,000, respectively,of non-cash stock compensation expense. This increase was due primarily to increases in the number of stockoption awards granted to our employees during the past twelve months.  See Note 2 to our consolidated interimfinancial statements included elsewhere in this report for a detaileddescription of the amounts recognized for the periods presented.

 

*Goodwill Impairment. *The decline inour market capitalization during the second quarter of 2010 (as indicated bythe trading of our common stock on Nasdaq) was considered by management to be apotential goodwill impairment triggering event. As a result, we performed a business valuation using a market-basedapproach and determined that all of our $16.9 million in goodwill wasimpaired.

 

*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, in which we own a one-thirdminority interest.  During the third quarterof 2009, our equity investment in Leuchemix reached $0 and as a result, we havenot been recognizing any additional expense from their underlying operations.

 

OtherNon-Operating Items:

 
| ** **                              | ** ** | **Three Months Ended** | ** ** | ** ** | ** ** | **Six Months Ended** | ** ** | ** ** | ** ** |
|-----------------------------------------|------------|------------------------|------------|------------|------------|----------------------|------------|------------|------------|
| ** **                              | ** ** | **June 30,**      | ** ** | **Change** | ** ** | **June 30,**    | ** ** | **Change** | ** ** |
| ** **                              | ** ** | **2010**               | ** ** | **2009**   | ** ** | **$**                | ** ** | **%**      | ** ** | **2010** | ** ** | **2009** | ** ** | **$** | ** ** | **%** | ** ** |
|                                    |       |                   |       |       |       |                 |       |       |       |   |   |   |   |   |   |   |   |
| Litigation  settlement gain             |       | $                      | —     |       | $          | —               |       | $          | —     |   | — |   | $ | 19,385 |   | $ | — |   | $ | 19,385 |   | — |   |
| Loss  from early extinguishment of debt |       | —                 |       | —     |       | —               |       | —     |       | (572 | ) | — |   | (572 | ) | — |   |
| Interest  income                        |       | 2                      |       | 5          |       | (3                   | )          | (60)%      |       | 4 |   | 15 |   | (11 | ) | (73)% |   |
| Interest  expense                       |       | (5                     | )          | (509       | )          | 504                  |       | 99%        |       | (353 | ) | (1,022 | ) | 669 |   | 65% |   |
| Derivatives  gains (charges)            |       | —                 |       | 137        |       | (137                 | )          | —     |       | 605 |   | (1,384 | ) | 1,989 |   | 144% |   |
|                                         |            |                        |            |            |            |                      |            |            |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

*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 six months ended June 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 aresult, the remaining, unamortized debt discount of $572,000 was written off asa non-operating loss from early extinguishment of debt in our six months ended June 30,2010 consolidated statement of operations. 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 warrants using the effective interestmethod.  

 

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Interestexpense decreased as a result of retiring the Debenture inMarch 2010.  Remaining interestcharges are from certain capital 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 fixed conversion price all represented embedded derivativesof the Debenture that were recorded separately at fair value as otherliabilities, with the corresponding fair value adjustments reflected asnon-operating charges or gains, depending upon the results of mark-to-modelvaluation adjustments.  The fair value ofthe embedded derivatives was determined using the convertible bond model,discounted cash flows and binomial lattice models.  In March 2010, the Debenture wasretired.  As a result, the remainingderivatives liability of $605,000 was written off as a non-operating gain inour six months ended June 30, 2010 consolidated statement of operations.

 

**Inflation**

 

Inflation has not had a significant impacton our Company.

 

**Liquidity and CapitalResources**

 

At June 30, 2010, cash and cash equivalentstotaled $10.2 million, versus $5.4 million at December 31, 2009.  Working capital at June 30, 2010 was$10.0 million, compared to a working capital deficit of $(3.0 million) at December 31,2009.  The change in working capital wasdue primarily to the impact of net cash flow activities as discussedbelow.  The net change in cash and cashequivalents for the periods presented was comprised of the following (inthousands):

 
| ** **                                        | ** ** | **Six Months Ended** | ** ** | ** ** | ** ** |
|---------------------------------------------------|------------|----------------------|------------|------------|------------|
| ** **                                        | ** ** | **June 30,**    | ** ** | ** ** | ** ** |
| ** **                                        | ** ** | **2010**             | ** ** | **2009**   | ** ** | **Change** | ** ** |
| Net  cash provided by (used in) operations:       |       |                 |       |       |       |   |   |
| Operating  activities                             |       | $                    | 13,281     |       | $          | (5,034 | ) | $ | 18,315 |   |
| Investing  activities                             |       | (73                  | )          | 1,511      |       | (1,584 | ) |
| Financing  activities                             |       | (8,436               | )          | 6,929      |       | (15,365 | ) |
| Increase  (decrease) in cash and cash equivalents |       | $                    | 4,772      |       | $          | 3,406 |   | $ | 1,366 |   |

 

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

 

*Investing Activities.*  The change in net cash flows from investingactivities was due primarily to net sales of available-for-sale investments inconnection with ongoing cash management activities during the periodspresented.  Also, for the six monthsended June 30, 2010 and 2009, we incurred $73,000 and $15,000,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 period ended June 30, 2010 versus repayment of a lineof credit totaling $820,000 in the comparable period in 2009.  Also, net proceeds from the sale of common stockand warrants as well as the exercise of common stock options were zero duringthe period ended June 30, 2010 versus $7.7 million in the comparableperiod in 2009.

 

*Restructuring Plan. *On April 19, 2010, weannounced a Restructuring Plan that will focus our Company on our diagnosticservices business while shutting down our CustomArray business.  Total restructuring charges incurred through June 30,2010 were $1.7 million, of which $465,000 were non-cash write-downs, $826,000were paid out in cash as of June 30, 2010 and $362,000 were accrued asshort-term payables and are expected to be paid out during the third quarter of2010.  Remaining costs associated withfacilities clean-up, relocation and other restructuring costs are not expectedto be significant.  Net of proceedsreceived from the sales of surplus property, equipment and inventory, werecognized a loss from restructuring of $1.4 million, which is included as acomponent of loss from discontinued operations in our 2010 statements ofoperations. 

 

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*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 and otherexternal sources of available credit will be sufficient to meet our cash requirementsbeyond the next twelve months, as the Restructuring Plan will significantlyreduce our operating cash burn.  In orderfor us to continue as a going concern and to eventually reach profitability, wemay be required to obtain capital from external sources.  However, there can be no assurances thatadditional sources of financing, including the issuance of debt and/or equitysecurities, will be available at times and at terms acceptable to us.  The issuance of equity securities will alsocause dilution to our shareholders.  Ifexternal financing sources of financing are not available or are inadequate tofund our operations, we will be required to reduce operating costs includingresearch projects and personnel, which could jeopardize the future strategicinitiatives and business plans of the Company.

 

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

 

·                  the costs of commercializationactivities, including sales and marketing costs and capital equipment;

 

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

 

·                  our ability to licensetechnology, if necessary;

 

·                  competing technologicaldevelopments;

 

·                  the creation and formationof strategic partnerships;

 

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

 

·                  other factors that may notbe within our control.

 

**Off-Balance Sheet Arrangements**

 

We have not entered into off-balance sheet financingarrangements, other than operating leases for our premises.  We have no significant commitments forcapital expenditures in 2010 or beyond. We have executed three capital leases totaling $293,000 for certainlaboratory equipment.  The followingtable lists our material known future cash commitments as of June 30, 2010:

 
| ** **                     | ** ** | **Payments Due by Period (in thousands)** | ** ** |
|--------------------------------|------------|-------------------------------------------|------------|
| ** **                     | ** ** | ** **                                | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | **2014 and** | ** ** |
| ** **                     | ** ** | **2010**                                  | ** ** | **2011** | ** ** | **2012** | ** ** | **2013** | ** ** | **Thereafter** | ** ** |
| ** **                     | ** ** | ** **                                | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Operating  leases              |       | $                                         | 266        |   | $ | 189 |   | $ | 196 |   | $ | 16 |   | $ | — |   |
| Capital  leases                |       | 42                                        |       | 85 |   | 85 |   | 58 |   | — |   |
| Minimum  royalty payments      |       | 50                                        |       | 100 |   | 100 |   | 100 |   | 475 |   |
| Total  contractual obligations |       | $                                         | 358        |   | $ | 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 QUALITATIVEDISCLOSURES ABOUT MARKET RISK**

 

Not required for smallerreporting companies.

 

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**Item 4.        CONTROLS AND PROCEDURES**

 

*Evaluation of DisclosureControls and Procedures*

 

Wemaintain disclosure controls and procedures that are designed to ensure thatinformation required to be disclosed in our reports filed or submitted underthe Securities Exchange Act of 1934, as amended (the “Exchange Act”) isrecorded, processed, summarized and reported within the time periods specifiedin SEC rules and forms.  Our disclosurecontrols and procedures include, without limitation, controls and proceduresdesigned to ensure that information required to be disclosed in our reportsfiled under the Exchange Act is accumulated and communicated to management asappropriate to allow timely decisions regarding required disclosures.  There are inherent limitations to theeffectiveness of any system of disclosure controls and procedures, includingthe possibility of human error and the circumvention or overriding of thecontrols and procedures. Accordingly, even effective disclosure controls andprocedures can only provide reasonable assurance of achieving their controlobjectives, and management necessarily is required to use its judgment inevaluating the cost-benefit relationship of possible controls andprocedures.  Our management, with theparticipation of our Chief Executive Officer and Chief Financial Officer,conducted an evaluation required by Rules 13a-15 and 15d-15 under the ExchangeAct of the effectiveness of our disclosure controls and procedures as definedin Rules 13a-15 and 15d-15 under the Exchange Act as of June 30, 2010.  Based on this evaluation, our Chief ExecutiveOfficer and Chief Financial Officer concluded that as of June 30, 2010, thedesign and operation of our disclosure controls and procedures were effective.

 

*Changes inInternal Controls*

 

There were nochanges in our internal control over financial reporting that occurred duringour last fiscal quarter (the quarter ended June 30, 2010) that have materiallyaffected, or are reasonably likely to materially affect, our internal controlover financial reporting.

 

**PART II—OTHER INFORMATION**

 

**Item1A.  RISK FACTORS**

 

Thefollowing risk factors should be read in conjunction with the risk factorscontained in our Annual Report on Form 10-K for the fiscal year ended December31, 2009, filed on March 18, 2010.

 

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

 

On April 19, 2010, weannounced a strategic and operation restructuring plan to significantly reduceoperating costs, increase the focus on the Company’s diagnostics servicesbusiness and transition senior management. We anticipate that the Restructuring Plan will result in a reduction ofour workforce by approximately 50% as a result of closing our Mukilteo,Washington facilities and relocating our corporate headquarters to oursubsidiary’s facilities in Irvine, California.

 

At present, we expect that the Restructuring Planwill yield significant cost savings. However, if we experience excessiveunanticipated inefficiencies or incremental costs in connection withrestructuring activities, such as unanticipated inefficiencies caused byreducing headcount or relocating operations, we may be unable to meaningfullyrealize 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 adversely impact our results of operations andfinancial 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 reduce our futureroyalties.

 

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**Item5.  OTHER INFORMATION**

 

*Severance Arrangements*

 

In connection with our Restructuring Plan, our Boardof Directors, on March 12, 2010, terminated the employment of Amit Kumar, Ph.D.(our President and Chief Executive Officer), Brooke Anderson, Ph.D. (our ChiefOperating Officer), and H. Sho Fuji (our Vice President of Engineering andProduction), each to be effective June 30, 2010.  Dr. Anderson has also resigned from our Boardof Directors.  In connection with eachtermination, the Board affirmed the executive severance plans already in placethat are described elsewhere in this Quarterly Report, except that in additionto the standard severance benefits described, Dr. Anderson received theequivalent of three months of salary in the form of the Company’s common stock,on July 1, 2010.

 

On August 8, 2010, Dr. Kumarand the Company entered into a separation agreement and release of claims (the “SeparationAgreement”).  The Separation Agreement is effective June 30, 2010 andprovides Dr. Kumar separation benefits in connection with his termination ofemployment with the Company in exchange for Dr. Kumar’s agreement to waive andrelease any and all claims that he has against the Company or itsaffiliates.  Under the Separation Agreement, Dr. Kumar is entitled to thefollowing severance benefits: (i) one year of regular base salary, less$80,000, (ii) continued enrollment in the Company’s group medical, dental, andlife insurance plans through June 30, 2011, and (iii) after Company-paidcoverage ends, continued group health plan coverage at Dr. Kumar’selection and expense and pursuant to the terms andconditions specified in the Consolidated Omnibus Budget Reconciliation Act(COBRA).  Dr. Kumar has no claims or disagreements with the Company.  Also, Dr. Kumar has agreed to remain on theBoard of Directors of CombiMatrix.

 

On August 10, 2010, our Board of Directorsapproved a restatement of the Executive Change of Control Severance Plan,originally effective as of November 10, 2009 (the “Severance Plan”), thataffects certain of our senior management-level employees.  Prior to therestatement, in addition to other benefits the Severance Plan providedfor a cash severance payment equal to one times annual base salary, in thecase of our Chief Executive Officer, and one-half times annual base salary, inthe case of our other senior management-level employees upon the employee’sinvoluntary termination or resignation for “good reason” (as defined in theSeverance Plan) during the two-year period following a “change of control” (asdefined in the Severance Plan) of the Company. As restated, the Severance Plan provides that any cash severance paymentpayable under the Severance Plan will be equal to one-half times annual basesalary for all senior management-level employees, including our Chief ExecutiveOfficer.

 

*NewPresident and Chief Executive Officer*

 

On August 11, 2010, R. Judd Jessup accepted ouroffer to become the Company’s new President and Chief Executive Officer, andhis employment with us will commence on August 23, 2010.  Mr. Jessup was also elected to serve as amember of our Board of Directors, effective August 23, 2010.  Mr. Jessup replaces Mark McGowan who hadserved as our interim President and Chief Executive Officer.  Mr. McGowan will continue to serve asChairman of the Board.

 

Mr. Jessup will be paid abase salary of $420,000 per year and, subject to Board approval, an annualperformance bonus.  We also granted Mr.Jessup a stock option to purchase 400,000 shares of our common stock at anexercise price of $2.74 per share.  Thestock option vests over four years.  Mr.Jessup is entitled to standard company benefits and may be entitled to certainseverance benefits under the Company’s Severance Plan.  Pursuant to the Severance Plan, if Mr. Jessupis involuntarily terminated (other than for death, disability or for cause)or resigns for “good reason” (as defined in the Severance Plan) during thetwo-year period following a “change of control” (as defined in the SeverancePlan) of the Company, then, subject to execution of a release of claims againstthe Company, the Mr. Jessup will be entitled to receive: (i) a cashseverance payment equal to one-half times his annual base salary;(ii) immediate vesting of outstanding compensatory equity awards; and(iii) payment of COBRA premiums for Mr. Jessup and eligible dependants fora pre-determined period of time.

 

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Mr. Jessup has over 35 yearsof experience in the healthcare and managed care industries.  Most recently, he served as Chief ExecutiveOfficer of US LABS, a national laboratory which provides cancer diagnostic andgenetic testing services, from 2002 to 2005. He served as President of the Health Plans Division of FHP InternationalCorporation, a diversified health care services company (“FHP”), from 1994 to1996.  From 1987 to 1994, Mr. Jessupwas President of TakeCare, Inc., a publicly held HMO operating in California,Colorado, Illinois and Ohio, until it was acquired by FHP.  Mr. Jessup currently serves on the Board ofDirectors of two public companies: NovaMed, Inc. since November 1998, andCorvel Corporation since August 1997.

 

**Item6.  EXHIBITS**

 

An index ofexhibits is found on page 26 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/ MARK MCGOWAN |
|     |                    | Mark McGowan |
|     |                    | Chief Executive Officer |
| * * | * *                | *(Authorized Signatory)* |
|     |                    |   |
|     |                    |   |
|     | By:                     | /s/ SCOTT R. BURELL |
|     |                    | Scott R. Burell |
|     |                    | Chief Financial Officer |
| * * | * *                | *(Principal Financial  and Accounting Officer)* |

 

Date:  August 16, 2010

 

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**EXHIBIT INDEX**

 
| **Exhibit  Number** | ** ** | **Description**                                                                                        |
|---------------------|------------|--------------------------------------------------------------------------------------------------------|
|                |       |                                                                                                   |
| 10.1                |       | Separation Agreement and General Release of Claims with Amit Kumar,  Ph.D., dated as of August 8, 2010 |
| 10.2                |       | Restated Executive Change in Control Severance Plan                                                    |
| 10.3                |       | Offer and Employment Agreement with R. Judd Jessup, dated as of  August 11, 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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