Tableof Contents

 

 

 

**UNITED STATES**

**SECURITIES AND EXCHANGECOMMISSION**

**WASHINGTON, D.C. 20549**

 

----

 

**FORM 10-Q**

 

| **x** | **QUARTERLY REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
|-------|--------------------------------------------------------------------------------------------------------|

 

**For The Quarterly Period Ended March 31,2010**

 

**OR**

 

| **o** | **TRANSITION  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE  ACT OF 1934** |
|-------|----------------------------------------------------------------------------------------------------------|

** **

**FOR THE TRANSITIONPERIOD FROM            TO           .**

 

**CommissionFile Number 001-33523**

 

**COMBIMATRIXCORPORATION**

(Exact Name ofRegistrant as Specified in Its Charter)

 

| **Delaware**                                | ** ** | **47-0899439**       |
|---------------------------------------------|------------|----------------------|
| (State or Other  Jurisdiction of            |       | (I.R.S. Employer     |
| Incorporation or  Organization)             |       | Identification  No.) |
|                                        |       |                 |
| **6500  Harbour Heights Pkwy., Suite 303,** | ** ** | ** **           |
| **Mukilteo,  WA**                           | ** ** | **98275**            |
| (Address of  Principal Executive Offices)   |       | (Zip Code)           |

 

Registrant’stelephone number, including area code: ** (425) 493-2000**

 

 

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

 

Indicateby check mark whether the registrant (1) has filed all reports required tobe filed by Section 13 or 15(d) of the Securities Exchange Act of1934 during the preceding 12 months (or for such shorter period that theregistrant was required to file such reports), and (2) has been subject tofiling requirements for the past 90 days.   Yes x  No o

 

Indicateby check mark whether the registrant has submitted electronically and posted onits corporate Website, if any, every Interactive Data File required to besubmitted and posted pursuant to Rule 405 of Regulation S-T during thepreceding 12 months (or for such shorter period that the registrant wasrequired to submit and post such files).   Yes o  No o

 

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

 

| Large accelerated filer o                                              |   | Accelerated filer o         |
|-----------------------------------------------------------------------------|--------|----------------------------------|
|                                                                        |   |                             |
| Non-accelerated filer o

(Do not check if a smaller reporting company) |   | Smaller reporting company x |

 

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

 

As of May 10, 2010, 7,605,708 sharesof CombiMatrix Corporation common stock were issued and outstanding.

 

 

 

----

Tableof Contents

 

**COMBIMATRIX****CORPORATION**

**Table of Contents**

 
| **Part I.   Financial Information** | ** ** |
|---------------------------------------------------------|------------|
|                                                    |       |   |
| Item 1.                                                 |       | Financial Statements  (Unaudited) |   |
|                                                    |       |   |   |
|                                                    |       | Consolidated  Balance Sheets as of March 31, 2010 and December 31, 2009 | 3 |
|                                                    |       |   |   |
|                                                    |       | Consolidated  Statements of Operations for the Three Months Ended March 31, 2010 and  2009 | 4 |
|                                                    |       |   |   |
|                                                    |       | Consolidated  Statements of Cash Flows for the Three Months Ended March 31, 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 | 22 |
|                                                    |       |   |   |
| Item 4T.                                                |       | Controls and  Procedures | 22 |
|                                                    |       |   |   |
| **Part II.   Other Information**    | ** ** |
|                                                    |       |   |
| Item 1.                                                 |       | Legal Proceedings | 23 |
|                                                    |       |   |   |
| Item 1A.                                                |       | Risk Factors | 23 |
|                                                    |       |   |   |
| Item 2.                                                 |       | Unregistered  Sales of Equity Securities and Use of Proceeds | 24 |
|                                                    |       |   |   |
| Item 5.                                                 |       | Other Information | 24 |
|                                                    |       |   |   |
| Item 6.                                                 |       | Exhibits | 24 |
|                                                    |       |   |   |
| **Signatures**                                          |       | 25 |
|                                                    |       |   |
| **Exhibit Index**                                  |       | 26 |

 

2

----

Tableof Contents

 

**COMBIMATRIXCORPORATION**

**CONSOLIDATED BALANCE SHEETS**

**(Inthousands)**

**(Unaudited)**

 
| ** **                                                                                                           | ** ** | **March 31,** | ** ** | **December 31,** | ** ** |
|----------------------------------------------------------------------------------------------------------------------|------------|--------------------|------------|-----------------------|------------|
| ** **                                                                                                           | ** ** | **2010**           | ** ** | **2009**              | ** ** |
| **ASSETS**                                                                                                           |       |               |       |                  |       |
|                                                                                                                 |       |               |       |                  |       |
| Current assets:                                                                                                      |       |               |       |                  |       |
| Cash and cash  equivalents                                                                                           |       | $                  | 13,486     |                  | $          | 5,443 |   |
| Accounts receivable,  net of allowance for doubtful accounts of $190 and $190                                        |       | 1,159              |       | 1,045                 |       |
| Inventory                                                                                                            |       | 676                |       | 669                   |       |
| Prepaid expenses and  other assets                                                                                   |       | 246                |       | 236                   |       |
| Total current assets                                                                                                 |       | 15,567             |       | 7,393                 |       |
|                                                                                                                 |       |               |       |                  |       |
| Property and equipment,  net                                                                                         |       | 811                |       | 653                   |       |
| Investments in  unconsolidated subsidiaries                                                                          |       | 309                |       | 296                   |       |
| Patents and licenses,  net                                                                                           |       | 3,738              |       | 3,840                 |       |
| Goodwill                                                                                                             |       | 16,918             |       | 16,918                |       |
| Total assets                                                                                                         |       | $                  | 37,343     |                  | $          | 29,100 |   |
|                                                                                                                 |       |               |       |                  |       |
| **LIABILITIES AND SHAREHOLDERS’ EQUITY**                                                                        |       |               |       |                  |       |
| ** **                                                                                                           | ** ** | ** **         | ** ** | ** **            | ** ** |
| Current liabilities:                                                                                                 |       |               |       |                  |       |
| Accounts payable,  accrued expenses and other                                                                        |       | $                  | 1,994      |                  | $          | 1,891 |   |
| Current portion,  capital lease obligations                                                                          |       | 66                 |       | 52                    |       |
| Deferred revenues                                                                                                    |       | 192                |       | 255                   |       |
| Secured convertible  debenture                                                                                       |       | —             |       | 7,608                 |       |
| Other liabilities                                                                                                    |       | —             |       | 605                   |       |
| Total current  liabilities                                                                                           |       | 2,252              |       | 10,411                |       |
|                                                                                                                 |       |               |       |                  |       |
| Capital lease  obligations, net of current portion                                                                   |       | 192                |       | 170                   |       |
| Total liabilities                                                                                                    |       | 2,444              |       | 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                                                                                          |       | 56,802             |       | 55,758                |       |
| Accumulated net losses                                                                                               |       | (21,911            | )          | (37,247               | )          |
| Total shareholders’  equity                                                                                     |       | 34,899             |       | 18,519                |       |
| Total liabilities and  shareholders’ equity                                                                     |       | $                  | 37,343     |                  | $          | 29,100 |   |

 

*Theaccompanying notes are an integral part of these consolidated financialstatements.*

 

3

----

Tableof Contents

 

**COMBIMATRIXCORPORATION**

**CONSOLIDATED STATEMENTS OF OPERATIONS**

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

**(Unaudited)**

 
| ** **                                          | ** ** | **Three Months Ended** | ** ** |
|-----------------------------------------------------|------------|------------------------|------------|
| ** **                                          | ** ** | **March 31,**     | ** ** |
| ** **                                          | ** ** | **2010**               | ** ** | **2009** | ** ** |
|                                                |       |                   |       |   |   |
| Revenues:                                           |       |                   |       |   |   |
| Government contracts                                |       | $                      | 200        |   | $ | 525 |   |
| Products                                            |       | 204                    |       | 257 |   |
| Services                                            |       | 788                    |       | 696 |   |
| Collaboration  agreements                           |       | 63                     |       | 62 |   |
| Total revenues                                      |       | 1,255                  |       | 1,540 |   |
|                                                |       |                   |       |   |   |
| Operating expenses:                                 |       |                   |       |   |   |
| Cost of government  contract revenues               |       | 183                    |       | 495 |   |
| Cost of products and  services                      |       | 428                    |       | 657 |   |
| Research and  development expenses                  |       | 1,548                  |       | 1,131 |   |
| Marketing, general and  administrative expenses     |       | 2,685                  |       | 2,769 |   |
| Patent amortization and  royalties                  |       | 147                    |       | 346 |   |
| Equity in loss of  investee                         |       | —                 |       | 250 |   |
| Total operating  expenses                           |       | 4,991                  |       | 5,648 |   |
| Operating loss                                      |       | (3,736                 | )          | (4,108 | ) |
|                                                |       |                   |       |   |   |
| Other income (expense):                             |       |                   |       |   |   |
| Litigation settlement  gain                         |       | 19,385                 |       | — |   |
| Loss from early extinguishment  of debt             |       | (572                   | )          | — |   |
| Interest income                                     |       | 2                      |       | 10 |   |
| Interest expense                                    |       | (348                   | )          | (513 | ) |
| Derivatives gains  (charges)                        |       | 605                    |       | (1,521 | ) |
| Total other income  (expense)                       |       | 19,072                 |       | (2,024 | ) |
|                                                |       |                   |       |   |   |
| Net income (loss)                                   |       | $                      | 15,336     |   | $ | (6,132 | ) |
|                                                |       |                   |       |   |   |
| Basic net income (loss)  per share                  |       | $                      | 2.02       |   | $ | (0.97 | ) |
| Diluted net income  (loss) per share                |       | $                      | 1.96       |   | $ | (0.97 | ) |
|                                                |       |                   |       |   |   |
| Basic weighted average  common shares outstanding   |       | 7,603,453              |       | 6,320,644 |   |
| Diluted weighted  average common shares outstanding |       | 7,826,201              |       | 6,320,644 |   |

 

*Theaccompanying notes are an integral part of these consolidated financialstatements.*

 

4

----

Tableof Contents

 

**COMBIMATRIXCORPORATION**

**CONSOLIDATED STATEMENTS OF CASH FLOWS**

**(Inthousands)**

**(Unaudited)**

 
| ** **                                                                               | ** ** | **Three Months Ended** | ** ** |
|------------------------------------------------------------------------------------------|------------|------------------------|------------|
| ** **                                                                               | ** ** | **March 31,**     | ** ** |
| ** **                                                                               | ** ** | **2010**               | ** ** | **2009** | ** ** |
|                                                                                     |       |                   |       |   |   |
| Operating activities:                                                                    |       |                   |       |   |   |
| Net income (loss)                                                                        |       | $                      | 15,336     |   | $ | (6,132 | ) |
| Adjustments to  reconcile net income (loss) to net cash flows from operating activities: |       |                   |       |   |   |
| Depreciation and  amortization                                                           |       | 197                    |       | 386 |   |
| Non-cash stock  compensation                                                             |       | 843                    |       | 816 |   |
| Derivatives (gains)  charges                                                             |       | (605                   | )          | 1,521 |   |
| Loss from early  extinguishment of debt                                                  |       | 572                    |       | — |   |
| Equity in loss of  investee                                                              |       | —                 |       | 250 |   |
| Warrants issued to consultants                                                           |       | —                 |       | 61 |   |
| Allowance for bad debt                                                                   |       | —                 |       | 110 |   |
| Amortization of debt  discount and issuance costs                                        |       | 221                    |       | 275 |   |
| Changes in assets and  liabilities:                                                      |       |                   |       |   |   |
| Accounts receivable                                                                      |       | (114                   | )          | (402 | ) |
| Inventory, prepaid  expenses and other assets                                            |       | (45                    | )          | 107 |   |
| Accounts payable,  accrued expenses and other                                            |       | 168                    |       | 656 |   |
| Deferred revenues                                                                        |       | (63                    | )          | (45 | ) |
| Net cash flows from  operating activities                                                |       | 16,510                 |       | (2,397 | ) |
| Investing activities:                                                                    |       |                   |       |   |   |
| Purchase of property  and equipment                                                      |       | (54                    | )          | (13 | ) |
| Sale of  available-for-sale investments                                                  |       | —                 |       | 1,526 |   |
| Net cash flows from  investing activities                                                |       | (54                    | )          | 1,513 |   |
| Financing activities:                                                                    |       |                   |       |   |   |
| Repayment of secured  convertible debenture                                              |       | (8,400                 | )          | — |   |
| Net proceeds from  issuance of common stock                                              |       | —                 |       | 81 |   |
| Repayment of line of  credit                                                             |       | —                 |       | (820 | ) |
| Repayment of capital  lease obligations                                                  |       | (13                    | )          | (8 | ) |
| Net cash flows from  financing activities                                                |       | (8,413                 | )          | (747 | ) |
|                                                                                     |       |                   |       |   |   |
| Increase (decrease) in  cash and cash equivalents                                        |       | 8,043                  |       | (1,631 | ) |
| Cash and cash  equivalents, beginning                                                    |       | 5,443                  |       | 7,579 |   |
| Cash and cash equivalents,  ending                                                       |       | $                      | 13,486     |   | $ | 5,948 |   |
|                                                                                     |       |                   |       |   |   |
| Non-cash financing  activities:                                                          |       |                   |       |   |   |
| Accrued interest paid  in common stock                                                   |       | $                      | 215        |   | $ | 240 |   |

 

*Theaccompanying notes are an integral part of these consolidated financialstatements.*

 

5

----

 

Tableof Contents

 

**COMBIMATRIX CORPORATION**

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS**

**(Unaudited)**

 

**1.    OVERVIEW AND BACKGROUND**

 

CombiMatrix Corporation (the “Company” “we” “us” and“our”) was originally incorporated in October 1995 as a California corporationand later reincorporated as a Delaware corporation in September 2000.  In December 2002, we merged with and became awholly owned subsidiary of Acacia Research Corporation (“Acacia”).  In December 2006, we filed a registrationstatement with the U.S. Securities and Exchange Commission (“SEC”) in order toregister our common stock as part of a plan to split-off from Acacia (the“Split-Off”).  On August 15, 2007 (the“Split-Off Date”), the Split-Off was effected and our common stock becamepublicly 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 diversified biotechnology business thatprimarily operates in the field of genetic analysis and molecular diagnosticsthrough our wholly owned subsidiary, CombiMatrix MolecularDiagnostics, Inc. (“CMDX”). CMDX operates as a diagnostics referencelaboratory that provides genetic and other diagnostics services to physicians,hospitals and clinics.

 

Leuchemix Inc. (“Leuchemix”), a minority ownedsubsidiary, is developing a series of compounds to address a number ofoncology-related diseases.  Leuchemix’sfirst compound has entered initial clinical trials in the United 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 are in the process of closing downour Mukilteo, Washington facility, which has been focused primarily onresearch, development and commercialization of the Company’s oligonucleotidemicroarray technologies.  We will also berelocating our corporate headquarters from Mukilteo to CMDX’s Irvine,California location.  After therestructuring, CombiMatrix will be focused primarily on our diagnosticsservices business, including increasing the utilization of our existing tests,expanding the test menu, increasing the number of customers and partners, andimproving reimbursement for our testing services.  As a component of this plan, we haveinitiated a search for a new President and Chief Executive Officer, which weanticipate will be completed by the end of the second quarter of 2010, at whichtime our current President and CEO, Dr. Kumar, will step down.  The Restructuring Plan is expected to yieldannualized cost savings of approximately $4.0 million to $5.0 million per yearafter its completion (see Note 7).

 

*Basis of Presentation*

 

The accompanyingconsolidated financial statements have been prepared in accordance withgenerally accepted accounting principles for interim financial information andwith the instructions to Form 10-Q and Rule 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 ofMarch 31, 2010, and results of operations and cash flows for the interimperiods presented.  The results ofoperations for the three months ended March 31, 2010 are not necessarilyindicative of the results to be expected for the entire year.

 

6

----

Table ofContents

 

**COMBIMATRIX CORPORATION**

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

**(Unaudited)**

 

*Liquidity and Risks*

 

We have a history ofincurring net losses and net operating cash flow deficits.  We are also deploying new and unproventechnologies and continue to develop commercial tests and products.

 

At March 31, 2010,we had cash and cash equivalents of $13.5 million, which included the receiptof $19.4 million in proceeds from our settlement with National Union Fire Ins.Co. of Pittsburgh, PA (“National Union”), net of attorneys’ fees and costs, inFebruary 2010.  As a result, weanticipate that our cash and cash equivalent balances, anticipated cash flows fromoperations, 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, we maybe required to obtain capital from external sources. However, there can be noassurances that additional sources of financing, including the issuance of debtand/or equity securities will be available at times and at terms acceptable to us.

 

Our business operationsare also subject to certain risks and uncertainties, including:

 

·     market acceptance of products andservices;

 

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

 

·     increases in operating costs, includingcosts for supplies, personnel and equipment;

 

·     the availability and cost of capital; and

 

·     government regulation that may restrictour business.

 

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

 

**2.    SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES**

 

*References to AuthoritativeAccounting Literature.*  In June 2009, theFinancial Accounting Standards Board (“FASB”) issued the Accounting StandardsCodification (“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 financial statements.

 

*Use ofEstimates. *The preparation of financial statementsin conformity with generally accepted accounting principles in the UnitedStates of America requires management to make estimates and assumptions thataffect the reported amount of assets and liabilities and disclosure ofcontingent assets and liabilities at the date of the consolidated financialstatements and the reported amounts of revenues and expenses during thereporting period. Actual results could differ from these estimates.

 

*Principles of Consolidation*. The accompanying consolidated financial statements include the accountsof the Company and our wholly owned and majority-owned subsidiaries.  Investments for which we possess the power todirect or cause the direction of the management and policies, either throughmajority ownership or other means, are accounted for under the consolidationmethod.  Material intercompanytransactions and balances have been 

 

7

----

Table ofContents

 

**COMBIMATRIX CORPORATION**

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

**(Unaudited)**

 

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 essential characteristicsof a controlling financial interest. Further, these standards require that the holder subject to a majorityof the risk of loss from a VIE’s activities must consolidate the VIE.  However, if no holder has a majority of therisk of loss, then a holder entitled to receive a majority of the entity’sresidual returns would consolidate the entity.

 

*Revenue Recognition*. We recognize revenue when(i) persuasive evidence of an arrangement exists, (ii) delivery hasoccurred or services have been performed, (iii) amounts are fixed ordeterminable and (iv) collectibility of amounts is reasonably assured.

 

Service revenues fromproviding diagnostic tests are recognized when the testing process is completeand test results are reported to the ordering physician or clinic.  These diagnostic services are billed tovarious payors, including commercial insurance companies, healthcareinstitutions, individuals and government payors including Medicare andMedicaid.  We report revenues fromcontracted payors based on a contractual rate, or in the case of Medicare andMedicaid, 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 governmentcontracts have been recognized using the partial performance method ofaccounting, whereby performance to date was established based on costs incurredto the total amount of estimated costs at each reporting period.  Under the partial performance method ofaccounting, contract revenues and costs were recognized in the period that workwas performed based on the percentage of actual incurred costs to totalcontract costs.  The partial performance methodwas used to recognize revenue because management considered actual costsincurred to be the best available measure of progress towards the completion ofgovernment contracts, the total profit was reasonably computed, and collectionwas reasonably assured.  Actual contractcosts included direct charges for labor and materials and indirect charges forlabor, overhead and certain general and administrative charges.  Historically, contract revenue recognizedapproximated the amounts invoiced.  We donot anticipate continuing performance under our government contracts followingcompletion of the Restructuring Plan.

 

Revenues from the sale ofproducts, including shipping and handling fees but excluding statutory taxescollected from customers, as applicable, have been recognized when delivery occurred.  Historically, we have sold our productsdirectly to customers and also through distributors, and our right tocollection has not been dependent upon installation or a subsequent sale of ourproducts to end-users.  Our standardagreements have not provided for credits, returns or exchanges with ourcustomers or distributors.  Ourdistribution agreements included fixed pricing arrangements for our productsand after customer acceptance, there is no written or implied right to returnor exchange the products.  We do notanticipate to continue manufacturing, marketing or selling our microarray-basedproducts following completion of the Restructuring Plan.

 

Revenues from multipleelement arrangements are based on the relative selling price method, whereby weallocate consideration received to all deliverables of an arrangement at theinception of the arrangement based on the relative selling prices of eachelement.  In order to determine theselling price of a deliverable, we apply the following hierarchy: 1)vendor-specific objective evidence (“VSOE”); 2) third-party evidence if VSOE isnot available; and 3) our best estimate of selling price for the deliverable ifneither VSOE nor third-party evidence is available.  Several factors are considered when determiningthe estimated selling price of a deliverable, including, but not limited to,the cost to produce the deliverable, the expected margin on that deliverable,our ongoing pricing strategy and policies and the value-added components ofdifferentiated deliverables, if determinable. In order for a 

 

8

----

Table ofContents

 

**COMBIMATRIX CORPORATION**

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

**(Unaudited)**

 

deliverable to be accounted for as a separate unit ofaccounting, both of the following criteria must be met: 1) the delivered itemor items have value to the customer on a standalone basis; and 2) when ageneral right of return exists, the delivery or performance of an undelivereditem is considered probable and under our control.  Our revenue arrangements do not have ageneral right of return.  When adeliverable does not meet the criteria to be considered a separate unit of accounting,we group that deliverable with other deliverables that, when combined, meet thecriteria, and the appropriate allocation of arrangement consideration andrevenue recognition is determined.

 

Deferred revenues arisefrom payments received in advance of the culmination of the earningsprocess.  Deferred revenues expected tobe recognized within the next twelve months are classified within currentliabilities.  Deferred revenues will berecognized as revenue in future periods when the applicable revenue recognitioncriteria as described above are met.

 

*Cashand Cash Equivalents*.  We consider all highly liquid,short-term investments with original maturities of three months or less whenpurchased to be cash equivalents.

 

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

 

·      Level 1:      Observable market inputs such as quotedprices in active markets;

 

·      Level 2:      Observable market inputs, other than thequoted prices in active markets, that are observable either directly orindirectly; and

 

·      Level 3:      Unobservable inputs where there is littleor no market data, which require the reporting entity to develop its ownassumptions.

 

*AccountsReceivable and Allowances for Doubtful Accounts.*  Accountsreceivable are stated at principal amounts and are primarily comprised ofamounts contractually due from customers for products and services as well asamounts due from government contracts. For billings to customers of our products, we provide an allowance fordoubtful accounts based on an evaluation of specific customer account balancespast due approximately 30 days from the date of invoicing.  In determining whether to record an allowancefor a specific customer, we consider a number of factors, including priorpayment history and financial information for the customer.

 

For billings to customersof our diagnostic services, an allowance for doubtful accounts is recorded forestimated uncollectible amounts due from various payor groups such ascommercial insurance companies, healthcare institutions, government payors andindividuals.  The process for estimatingthe allowance for doubtful accounts associated with our diagnostic servicesinvolves significant assumptions and judgments. Specifically, the allowance for doubtful accounts is adjusted periodicallyand is principally based upon specific identification of past due or disputedaccounts.  We also review the age ofreceivables by payor 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.

 

*DerivativesEmbedded in Certain Debt Securities. *We evaluate financial instruments forfreestanding or embedded derivatives. Derivative instruments that have been separated from the host contractand do not qualify for hedge accounting are recorded at fair value with changesin value recognized as other non-operating income (expense) in the consolidatedstatements of operations in the period of change.

 

9

----

Table ofContents

 

**COMBIMATRIX CORPORATION**

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

**(Unaudited)**

 

*Stock-BasedCompensation*.  The compensation cost for allstock-based awards is measured at the grant date, based on the fair value ofthe award, and is recognized as an expense, on a straight-line basis, over theemployee’s requisite service period (generally the vesting period of the equityaward) which is generally three years. The fair value of each option award is estimated on the date of grantusing a Black-Scholes option valuation model. Stock-based compensation expense is recognized only for those awardsthat are expected to vest using an estimated forfeiture rate.  We estimate pre-vesting option forfeitures atthe time of grant and reflect the impact of estimated pre-vesting optionforfeitures in compensation expense recognized. Stock-based compensation expense for all periods presented attributableto our functional expense categories were as follows (in thousands; unaudited):

 
| ** **                             | ** ** | **Three  Months Ended** | ** ** |
|----------------------------------------|------------|-------------------------|------------|
| ** **                             | ** ** | **March 31,**      | ** ** |
| ** **                             | ** ** | **2010**                | ** ** | **2009** | ** ** |
|                                   |       |                    |       |   |   |
| Cost of products and  services         |       | $                       | 17         |   | $ | 25 |   |
| Research and development               |       | 166                     |       | 137 |   |
| Marketing, general and  administrative |       | 660                     |       | 654 |   |
| Total non-cash stock  compensation     |       | $                       | 843        |   | $ | 816 |   |

 

*Income(Loss) Per Share*.  Basic net income (loss) pershare is computed by dividing net income (loss) by the weighted-average numberof common shares outstanding during the reporting period.  Diluted net income per share is computed bydividing net income by the weighted average number of common shares outstandingduring the reporting period increased to include dilutive potential common sharesusing the treasury stock method. Dilutive potential common shares consist of stock options with combinedexercise prices and unrecognized compensation expense that are less than theaverage market price of the Company’s common stock and warrants with exerciseprices that are less than the average market price of the Company’s commonstock.  Under the treasury stock method,the amount that must be paid to exercise stock options and warrants, the amountof compensation expense for future services that the Company has not yetrecognized for stock options and the amount of tax benefits that will berecorded in additional paid-in capital when the awards become deductible areassumed to be used to repurchase shares of common stock.  In loss periods, basic net loss per share anddiluted net loss per share are identical since the effect of dilutive potentialcommon shares is anti-dilutive and therefore excluded.

 

The following tablepresents a reconciliation of basic and diluted net income (loss) per share aswell as excluded potential common securities for all periods presented (inthousands, except share and per-share data; unaudited):

 
| ** **                                           | ** ** | **Three  Months Ended** | ** ** |
|------------------------------------------------------|------------|-------------------------|------------|
| ** **                                           | ** ** | **March 31,**      | ** ** |
| ** **                                           | ** ** | **2010**                | ** ** | **2009** | ** ** |
| Numerator:                                           |       |                    |       |   |   |
| Income (loss)  applicable to common shareholders     |       | $                       | 15,336     |   | $ | (6,132 | ) |
| Denominator:                                         |       |                    |       |   |   |
| Basic weighted-average  common shares outstanding    |       | 7,603,453               |       | 6,320,644 |   |
| Plus: effect of  dilutive common stock option awards |       | 119,956                 |       | — |   |
| Plus: effect of  dilutive common stock warrants      |       | 102,792                 |       | — |   |
| Diluted weighted-average  common shares outstanding  |       | 7,826,201               |       | 6,320,644 |   |
|                                                 |       |                    |       |   |   |
| Basic income (loss) per  share                       |       | $                       | 2.02       |   | $ | (0.97 | ) |
| Diluted income (loss)  per share                     |       | $                       | 1.96       |   | $ | (0.97 | ) |
|                                                 |       |                    |       |   |   |
| Common stock options                                 |       | 2,012,582               |       | 1,664,067 |   |
| Common stock warrants                                |       | 3,840,854               |       | 2,583,958 |   |
| Convertible debenture                                |       | —                  |       | 716,091 |   |
| Excluded potentially  dilutive securities            |       | 5,853,436               |       | 4,964,116 |   |

 

10

----

Table ofContents

 

**COMBIMATRIX CORPORATION**

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

**(Unaudited)**

 

*Recentand Adopted Accounting Pronouncements*. In March 2010, The FASB issued new authoritative guidance regardingrevenue recognition to define a milestone and clarify that the milestone methodof revenue recognition is a valid application of the proportional performancemodel when applied to research or development arrangements.  Accordingly, a company can make an accountingpolicy election to recognize a payment that is contingent upon the achievementof a substantive milestone in its entirety in the period in which the milestoneis achieved.  This guidance beginsphasing in during the third quarter of 2010. We do not expect the implementation of this guidance to have a materialimpact on our consolidated financial statements.

 

In January 2010, theFASB issued new authoritative guidance regarding the disclosure of fair valuemeasurements, which clarifies certain existing disclosure requirements as wellas requiring new disclosures related to significant transfers between each fairvalue level as well as requiring additional information about Level 3activity.  This guidance begins phasingin during the first fiscal period after December 15, 2009.  We do not expect the implementation of thisguidance to have a material impact on our consolidated financial statements.

 

In October 2009, theFASB issued new authoritative guidance to require companies to allocate revenuein multiple-element arrangements based on an element’s estimated selling priceif vendor-specific or other third-party evidence of value is notavailable.  The new guidance is effectivefor revenue transactions entered into during fiscal years beginning on or afterJune 15, 2010, with earlier application permitted.  We do not believe the adoption of thisguidance will have a material impact on our consolidated financial statements.

 

**3.****    ****FAIR VALUE MEASUREMENTS**

 

The following tablesummarizes, for each major category of financial assets measured on a recurringbasis, the respective fair value at March 31, 2010 and the classificationby level of input within the fair value hierarchy defined above (in thousands;unaudited):

 
| ** **       | ** ** | **March 31,** | ** ** | **Fair  Value Measurements at** | ** ** |
|------------------|------------|--------------------|------------|---------------------------------|------------|
| ** **       | ** ** | **2010**           | ** ** | **Level 1**                     | ** ** | **Level 2** | ** ** | **Level 3** | ** ** |
| Assets:          |       |               |       |                            |       |   |   |   |   |
| Cash equivalents |       | $                  | 12,832     |                            | $          | 12,832 |   | $ | — |   | $ | — |   |
|                  |            |                    |            |                                 |            |  |  |  |  |  |  |  |  |

 

The following table is areconciliation of financial liabilities measured at fair value on a recurringbasis using significant unobservable inputs (Level 3) during the three monthsended March 31, 2010 (in thousands; unaudited):

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

 

----

(1)   Included in “other liabilities” in the accompanyingDecember 31, 2009 consolidated balance sheet.

 

**4.****    ****SECURED CONVERTIBLE DEBENTURE**

 

*Description*

 

On July 10, 2008(the “Closing Date”), we issued to YA Global Investments, L.P. (“YA”):(i) a secured convertible debenture (the “Debenture”) with an aggregateprincipal amount of $10 million, which was convertible into shares of ourcommon stock at a fixed conversion price of $11.87 per share (and was reducedduring 2009 to $7.50 per share); and (ii) warrants (the “YA Warrants”) topurchase 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

 

11

----

Table of Contents

 

**COMBIMATRIX CORPORATION**

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

**(Unaudited)**

 

(“National Union”) in accordance with the $35.7million judgment (the “Judgment”) issued by the U.S. District Court for theCentral District of California (the “District Court”).  As discussed more fully in Note 6 below, wereceived $25 million in settlement proceeds from National Union inFebruary 2010, $8.6 million of which were used to fully retire theremaining principal balance of the Debenture, plus accrued interest, onMarch 2, 2010 (the “Retirement Date”).

 

The Debenture boreinterest at an annual rate of 10%, with interest payments due quarterly ineither cash or our common stock.  As aresult of a registered direct offering of our common stock that occurred inMay 2009, the fixed conversion price of the Debenture was reduced from$11.87 per share to $7.50 per share pursuant to anti-dilution provisions of theDebenture.  The YA Warrants, which remainoutstanding, and have a five-year term and allow YA to purchase:(i) 168,492 shares of common stock at an exercise price of $11.87; and(ii) 168,492 shares of common stock at an exercise price of $13.65.  As a result of separating the YA Warrants andembedded derivative features of the Debenture, an aggregate contra-liabilitytotaling $2.9 million was recognized as of the Closing Date and was nettedagainst the Debenture as a debt discount, which was being accreted to the faceamount due YA over the Term using the effective interest method, with thecorresponding charges recorded as interest expense.  For the three months ended March 31,2010 and 2009, interest and amortization charges were $348,000 and $513,000,respectively.  As of the Retirement Date,the remaining unamortized debt discount of $572,000 was written off as anon-operating loss from early extinguishment of debt in the March 31, 2010consolidated statement of operations.

 

Since the Closing Date,YA had converted $1.6 million of the Debenture into common stock, leaving anoutstanding principal balance plus accrued interest due of $8.6 million priorto being retired as of the Retirement Date. The embedded derivative liabilities were marked to fair value of zero asof the Retirement Date and $2.0 million as of March 31, 2009, resulting innet non-operating derivative gains (charges) of $605,000 and $(1.5 million) forthe three months ended March 31, 2010 and 2009, respectively.

 

During the periodsended March 31, 2010 and 2009, accrued interest at December 31, 2009and 2008 to YA in the amount of $213,000 and $215,000 was paid by issuing33,822 and 31,053 shares of our common stock, respectively.

 

**5.****    ****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 pershare.  The warrants were not exercisableuntil six months 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 executing the Offering, thefixed conversion price of the Debenture was reduced to $7.50 per share,effective May 1, 2009.

 

12

----

Table of Contents

 

**COMBIMATRIX CORPORATION**

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

**(Unaudited)**

 

*Warrants*

 

Outstanding warrants to purchase CombiMatrix stock areas follows:

 
| ** **        | ** ** | **Shares  of Common Stock** | ** ** | ** **            | ** ** | ** **      | ** ** |
|-------------------|------------|-----------------------------|------------|-----------------------|------------|-----------------|------------|
| ** **        | ** ** | **Issuable  from Warrants** | ** ** | ** **            | ** ** | ** **      | ** ** |
| ** **        | ** ** | **Outstanding  as of**      | ** ** | ** **            | ** ** | ** **      | ** ** |
| ** **        | ** ** | **March 31,**          | ** ** | **December 31,** | ** ** | **Exercise**    | ** ** | ** ** | ** ** |
| **Date of Issue** | ** ** | **2010**                    | ** ** | **2009**              | ** ** | **Price**       | ** ** | **Expiration** | ** ** |
|              | ** ** | ** **                  |       |                  |       |            |       |   |   |
| October 2009      |       | 130,000                     |       | 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             |       | 3,943,646                   |       | 3,943,646             |       |            |       |   |   |

 

On May 19, 2009, weissued three warrants (the “May Consultant Warrants”) to a consultant topurchase a total of 125,000 shares of our common stock with an exercise priceof $9.00 per share and a term of five years. The first warrant was for 25,000 shares, which became fully vested onNovember 19, 2009.  The second andthird warrants (the “May Contingent Warrants”) were for 50,000 shares eachof common stock, and become fully vested only if our underlying stock priceachieves or exceeds $12.00 and $14.00 per share, respectively, for fiveconsecutive trading days as quoted on Nasdaq, over a period of twenty-fourmonths from May 19, 2009.  If theseterms are not achieved during this twenty-four month period, theMay Contingent Warrants will expire on May 19, 2011.  Otherwise, if the vesting conditions areachieved within twenty-four months from May 19, 2009, theMay Contingent Warrants will become fully exercisable for the remainder ofthe five-year term.

 

On October 2, 2009,we issued three warrants (the “October Consultant Warrants”) to aconsultant to purchase a total of 130,000 shares of our common stock with anexercise price of $7.78 per share.  Thefirst warrant was for 30,000 shares, which became fully vested on April 2,2010, with a term of five years.  Thesecond and third warrants (the “October Contingent Warrants”) were for50,000 shares each of common stock, and become fully vested only if ourunderlying stock price achieves or exceeds $12.00 and $14.00 per share,respectively, for five consecutive trading days as quoted on Nasdaq, over aperiod of six months from October 2, 2009. These contingencies were not achieved and as a result, theOctober Contingent Warrants expired on April 2, 2010.

 

Based on the criteria setforth by U.S. GAAP for distinguishing liabilities from equity, issuingderivative contracts in an entity’s own equity and related guidance, thewarrants listed above have been classified as a component of additional paid-incapital for all periods presented.  Giventhe variable vesting terms of the May and October ConsultantWarrants, mark-to-model adjustments were recognized in order to reflect changesin fair value, with said adjustments reflected as a component of marketing,general and administrative expenses in our consolidated statements ofoperations.  We recognized mark-to-modelcredits of $13,000 for the three months ended March 31, 2010, using theBlack-Scholes model, assuming a remaining terms of approximately 4.4 years,volatilities of 65%, no dividends, and risk-free interest rates ofapproximately 2.6%.  We will continue torecognize mark-to-model adjustments to the Consultant Warrants during theirrespective vesting periods.

 

**6.    COMMITMENTS AND CONTINGENCIES**

 

*Collaborative and ResearchAgreements*

 

On March 8, 2010, weexecuted a contract modification to our existing NASA contract to proceed withthe second year (“Phase II”) of the development agreement that was originallyexecuted in March 2009.  Under theterms of this modification, we were to continue performing research anddevelopment activities during Phase II of

 

13

----

Table ofContents

 

**COMBIMATRIX CORPORATION**

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

**(Unaudited)**

 

the agreement, for a fixed price of $214,000.  As a result of the Restructuring Plan,efforts on this contract were halted in April 2010, and we do not expectto incur additional revenues or costs associated with this contract in thefuture.

 

On September 11,2009, we executed a fifteen-month, $1.5 million contract with the U.S. AirForce Research Laboratory for the development of automated instrumentation thatuses our semiconductor microarray technologies for detecting chemical,biological and environmental hazards, each of which can impact the health ofdeployed military personnel.  As a resultof the Restructuring Plan, efforts on this contract were halted inApril 2010, and we do not expect to incur additional revenues or costsassociated with this contract in the future.

 

On July 31, 2008, weexecuted a six-month, $250,000 contract with the DoD for the development oflabel-free detection techniques using our microarray technology.  These detection techniques involve thesynthesis of molecules known as “aptamers,” which are molecules with uniquebiological properties.  We substantiallycompleted this contract during the first quarter of 2009 and do not expect toincur additional costs or revenues from this contract beyond 2009.

 

On July 11, 2008, weexecuted a fifteen-month, $923,000 contract with the DoD to further developmentof our microarray technologies for a multipathogen detection system.  The primary objectives of the contract wereto continue development of an automated biothreat agent detection system basedupon our complementary metal oxide semiconductor microarray and electrochemicaldetection techniques, to continue the integration of serological and genomicassays for orthogonal testing and to explore new methods of detection thatexpand target identification, reduce reagent burden, and improve assaytime.  Under the terms of this contract,we performed research and development activities, as described under the contract,and were reimbursed on a periodic basis for actual costs incurred to performthese obligations, plus a fixed fee, of up to $923,000.  We substantially completed this contractduring the second quarter of 2009 and do not expect to incur additional costsor revenues from this contract beyond 2009.

 

*Human Resources*

 

We provide certainseverance benefits such that if an executive of CombiMatrix who is a vicepresident or higher is terminated for other than cause, death or disability,the executive will receive payments equal to three months’ base salary plusmedical and dental benefits.  Also, ifour chief executive officer is terminated for other than cause, or for death ordisability, he will receive payments equal to one year’s base salary plus medicaland dental benefits.

 

In addition, we haveimplemented an Executive Change of Control Severance Plan (the “SeverancePlan”) that affects certain of our senior management-level employees. Pursuant to the 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.

 

*Litigation*

 

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

 

14

----

Table of Contents

 

**COMBIMATRIX CORPORATION**

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

**(Unaudited)**

 

March 31, 2010 and 2009, respectively, and areincluded in patent amortization and royalties in the accompanying consolidatedstatements of operations.

 

In April 2005,Acacia and CombiMatrix filed a complaint against our insurance carrier,National Union (collectively, the “Parties”), seeking reimbursement oflitigation and settlement costs for a prior lawsuit pursuant to our directorsand officers insurance policy with National Union.  A trial was held and concluded during thefourth quarter of 2007.  InMarch 2008, the District Court issued its Judgment in favor of Acacia andus, and awarded approximately $32.1 million in monetary damages to be paid byNational Union.  In May 2008, theDistrict Court awarded us an additional $3.6 million in attorneys’ fees andlitigation costs, thereby increasing the overall award to $35.7 million.  National Union appealed the Judgment tothe U.S. Ninth Circuit Court of Appeals, which we vigorously opposed.  On January 27, 2010, the Parties enteredinto a settlement agreement (the “Settlement Agreement”) whereby National Unionagreed to pay $25 million to us in order to settle the dispute.  These proceeds, net of attorneys’ fees andcosts of $5.6 million, were paid to us on February 3, 2010 and a dismissalof the action was entered by the District Court on February 11, 2010.

 

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

 

**7.****    ****SUBSEQUENT EVENT**

 

On April 19, 2010,we announced a Restructuring Plan that will focus our Company on our diagnosticservices business and to transition senior management.  Based on the analysis done to date, we expectto incur cash outlays, excluding executive severance costs, of approximately$1.1 million in connection with this action, of which approximately $650,000are expected to result from non-executive employee benefit and severancearrangements and approximately $430,000 in remaining lease payments, plantclosure and facilities clean-up and relocation expenses.  In addition, we expect to incur approximately$460,000 in non-cash write-downs of inventory, property and equipment andrelated assets. On May 12, 2010, our Board of Directors finalized theterminations of certain of our executives as a result of the RestructuringPlan, and reaffirmed the termination benefits they will receive in accordancewith our existing executive severance benefits described above in Note 6.  The executive severance cash benefitstotaling $565,000 will be paid out by June 30, 2010.

 

We are performing an impairmentassessment on goodwill and other long-lived assets impacted by theRestructuring Plan, in addition to inventory, property and equipment assetsdescribed above.  At this time, we areunable to make a determination of the estimated range related to the impairmentcharges.  The impairment chargesultimately recorded are not expected to result in future cash expenditures.

 

We anticipate that themajority of these costs will be recorded in our operating results for thefiscal quarter ending June 30, 2010. We do not expect that the charges will result in significant cashexpenditures after completion of the Restructuring Plan.  Once completed, the Restructuring Plan isexpected to yield annualized cost savings of approximately $4.0 million to $5.0million per year.

 

15

----

 

Tableof Contents

 

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

 

**Cautionary Statement**

 

You should read thefollowing discussion and analysis in conjunction with the consolidatedfinancial statements and related notes thereto contained in Part I, Item 1of this report.  The informationcontained in this Quarterly Report on Form 10-Q is not a completedescription of our businesses or the risks associated with an investment in ourcommon stock.  We urge you to carefullyreview and consider the various disclosures made by us in this report and inour other reports filed with the U.S. Securities and Exchange Commission, or“SEC,” including our Annual Report on Form 10-K, filed on March 18,2010.

 

This report containsforward-looking statements within the meaning of the “safe harbor” provisionsof the Private Securities Litigation Reform Act of 1995. Reference is made inparticular to the description of our plans and objectives for futureoperations, assumptions underlying such plans and objectives, and otherforward-looking statements included in this report. Such statements may beidentified by the use of forward-looking terminology such as “may,” “will,”“expect,” “believe,” “estimate,” “anticipate,” “intend,” “continue,” or similarterms, variations of such terms or the negative of such terms.  Such statements are based on management’scurrent expectations and are subject to a number of factors and uncertainties,which could cause actual results to differ materially from those described inthe forward-looking statements.  Suchstatements address future events and conditions concerning 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 compoundsto address a number of oncology-related diseases.  Leuchemix’s first compound has enteredinitial clinical trials in the United Kingdom.

 

On April 19, 2010,we announced a strategic and operational restructuring plan (the “RestructuringPlan”) to significantly reduce operating costs, increase the focus on theCompany’s diagnostic services business and transition senior management.  As part of the Restructuring Plan, we are inthe process of closing down our Mukilteo, Washington facility, which has beenfocused primarily on research, development and commercialization of theCompany’s oligonucleotide microarray technologies.  We will also be relocating our corporateheadquarters 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 have initiated a search for a new President and Chief Executive Officer,which we anticipate to be completed by the end of the second quarter of 2010,at which time our current President and CEO, Dr. Kumar, will stepdown.  The Restructuring Plan is expectedto yield annualized cost savings of approximately $4.0 million to $5.0 millionper year after its completion.  See Notes1 and 7 to the consolidated financial statements included elsewhere in thisreport for additional discussion of these matters.

 

16

----

Tableof Contents

 

**Prior Relationship with AcaciaResearch Corporation**

 

We were originallyincorporated in October 1995 as a California corporation and laterreincorporated 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 fileda registration statement with the U.S. Securities and Exchange Commission(“SEC”) in order to register our common stock under the Securities Act of 1933as 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 March 31, 2010,we had cash and cash equivalents of $13.5 million, which included the receiptof $19.4 million in proceeds from our settlement with National Union Fire Ins.Co. of Pittsburgh, PA (“National Union”), net of attorneys’ fees and costs, in February 2010.  As a result, we anticipate that our cash andcash equivalent balances, anticipated cash flows from operations, operatingcash savings from our Restructuring Plan and other sources of funding from thecapital markets will be sufficient to meet our cash requirements beyond thenext twelve months.  In order for us tocontinue as a going concern beyond this point and ultimately to achieveprofitability, we may be required to obtain capital from external sources,increase revenues and reduce operating costs. However, there can be no assurance that our operations will becomeprofitable or that external sources of capital will be available at times andat terms acceptable to us.  The issuanceof additional equity securities may also cause dilution to ourshareholders.  If external financingsources are not available or are inadequate to fund our operations, we will berequired to reduce operating costs, including research projects and personnel,of which reduction could jeopardize the future strategic initiatives andbusiness plans of our company.  See theLiquidity and Capital Resources section below as well as Note 1 to theconsolidated financial statements included elsewhere in this report foradditional discussion of these matters.

 

**Basis Of Presentation Of FinancialStatements**

 

The consolidatedfinancial statements included in this Form 10-Q are consistent with ourhistorical financial statements included in our Form 10-K for our fiscalyear ended December 31, 2009.

 

**Overview of Recent BusinessActivities**

 

For the three months endedMarch 31, 2010, our operating activities included the recognition of $1.3million in revenues, including $200,000 in government contract revenues,$235,000 in CustomArray product and service revenues and $820,000 in diagnosticlab revenues.  Research and developmentexpenses, excluding government contract costs and non-cash stock basedcompensation, increased in the first quarter of 2010 due primarily to thereduced utilization of our R&D resources from lower DoD contract activityas well as ongoing costs from our comprehensive cancer array testdevelopment.  Marketing, general andadministrative expenses were relatively unchanged, as increased sales andmarketing efforts and G&A costs at CMDX were largely offset by reductionsin legal and investor relations costs.

 

Significant businessdevelopments that occurred during and subsequent to the first quarter ended March 31,2010 were:

 

·                  On January 27, 2010, we reached a settlement inour ongoing litigation with National Union and received settlement proceeds,net of attorneys’ costs and fees, of $19.4 million on February 3,2010.   On March 2, 2010, we retiredthe Debenture, which had a remaining principal balance of $8.4 million as ofthat date.  As a result of retiring theDebenture, the potentially dilutive reserve of approximately 1.1 million sharesof common stock that could have been issued from conversion of the Debenturewas also retired.

 

·                  In January 2010, we announced that Mark McGowanhad joined the Board of Directors of CombiMatrix.  Mr. McGowan is the managing member ofSAF Capital Management LLC, a value-oriented investment firm which he foundedin November, 2006.  Prior to forming SAFCapital Management LLC, Mr. McGowan was Co-founder and Managing Partner ofMPG Capital Management LLC, an equity market research firm which derived andlicensed statistically validated algorithmic trading models and investmentstrategies for wealthy individuals and institutional investors.  Mr. McGowan previously worked within theConsumer and Market

 

17

----

Tableof Contents

 

Knowledge function ofProcter & Gamble, where he was instrumental in shaping marketingstrategies for multiple brands, as well as leading Market Mix Modeling and thedevelopment of macroeconomic forecasting capabilities within Procter &Gamble’s Homecare division. Mr. McGowan performed two cooperativeassignments with Johnson & Johnson; working within global operationsfor Johnson & Johnson subsidiary Ethicon Endo Surgery and in domesticoperations for Johnson & Johnson’s Consumer Products headquarters. Mr. McGowanreceived his Bachelor of Science in Microbiology, with a focus in Genomics andMolecular Genetics, from Michigan State University.

 

·               On April 19, 2010, we announced theRestructuring Plan described above. Also, see Note 7 to the consolidatedfinancial statements included elsewhere in this report for additionaldiscussion of this matter.

 

**Critical Accounting Estimates**

 

Our unaudited interimfinancial 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 1 ofthis report.

 

**Comparison of the Results ofOperations for the Three Months Ended March 31, 2010 and 2009**

 

Revenues and Cost of Revenues:

** **
| ** **                     | ** ** | **Three Months Ended**      | ** ** | ** ** | ** ** |
|--------------------------------|------------|-----------------------------|------------|------------|------------|
| ** **                     | ** ** | **March 31,**          | ** ** | **Change** | ** ** |
| ** **                     | ** ** | **2010**                    | ** ** | **2009**   | ** ** | **$** | ** ** | **%** | ** ** |
| ** **                     | ** ** | **(dollars  in thousands)** | ** ** |
|                           |       |                        |       |       |       |   |   |   |   |
| Government contracts           |       | $                           | 200        |       | $          | 525 |   | $ | (325 | ) | (62)% |   |
| Cost of government  contracts  |       | (183                        | )          | (495       | )          | 312 |   | 63% |   |
| Products                       |       | 204                         |       | 257        |       | (53 | ) | (21)% |   |
| Services                       |       | 788                         |       | 696        |       | 92 |   | 13% |   |
| Cost of products and  services |       | (428                        | )          | (657       | )          | 229 |   | 35% |   |
| Collaboration  agreements      |       | 63                          |       | 62         |       | 1 |   | — |   |
|                                |            |                             |            |            |            |  |  |  |  |  |  |  |

 

*Government Contracts and Cost ofGovernment Contracts.*  Under the terms of ourcontracts with the DoD, we are reimbursed on a periodic basis for actual costsincurred to perform our obligations, plus a fixed fee.  Under the terms of our contract with NASA, weare reimbursed on a periodic basis based on scheduled, contractual fixedamounts.  Revenues are recognized underthe partial performance method of accounting, using the cost-to-cost approachto measure completeness at the end of the each reporting period.  Cost of government contracts reflect researchand development expenses incurred in connection with our commitments under ourcurrent contracts with the DoD and NASA.

 

The decrease ingovernment contract revenues for the three months ended March 31, 2010versus the comparable period in 2009 was due primarily to fewer activecontracts during 2010 versus 2009.  SeeNote 6 to our consolidated interim financial statements included elsewhere inthis report for a detailed description of the amounts, completion rates andestimated costs to complete of our government contracts that are ongoing aswell as prior contracts that were completed during the periods presented.  As a result of our Restructuring Planannounced in April 2010, we expect our contract activities to be phasedout during the second quarter of 2010.

 

*Products and Cost of Products*. Product revenues and costs of products relate to domestic andinternational sales of our array products, which include CustomArray 12K, 4X2K,2X40K and 90K DNA expression arrays, ElectraSense® microarray readers and related hardware.  Product revenues decreased in the threemonths ended March 31, 2010 versus the comparable period in 2009 dueprimarily to lower CustomArray sales.  Aswe expand our business focus from exclusively selling array-based research anddevelopment products to providing array-based diagnostic services, we havereduced internal sales staff, marketing and production efforts regarding salesof

 

18

----

Tableof Contents

 

CustomArray products and instead have executed productdistribution and manufacturing agreements with various third-party distributorsfor the sales of our suite of CustomArray products into the research anddevelopment markets.  As a result of ourRestructuring Plan announced in April 2010, we expect our CustomArrayproducts sales to be phased out during the second quarter of 2010.

 

*Services.* Services revenues are comprised primarily of diagnostic servicesprovided by CMDX as well as the amortization of one-year equipment maintenanceand service contracts executed with certain customers of our DNAsynthesizers.  Diagnostic servicesrevenue from CMDX was $772,000 for the three months ended March 31, 2010,versus $688,000 in the comparable period in 2009.  These revenues have increased due toincreased sales and marketing efforts as well as improved third-partyreimbursement for our tests.  IncludingBAC array product sales, total diagnostic lab revenues at CMDX were $820,000for the three months ended March 31, 2010 versus $727,000 in thecomparable period in 2009.

 

Operating Expenses:

 
| ** **                                      | ** ** | **Three Months Ended**      | ** ** | ** ** | ** ** |
|-------------------------------------------------|------------|-----------------------------|------------|------------|------------|
| ** **                                      | ** ** | **March 31,**          | ** ** | **Change** | ** ** |
| ** **                                      | ** ** | **2010**                    | ** ** | **2009**   | ** ** | **$** | ** ** | **%** | ** ** |
| ** **                                      | ** ** | **(dollars  in thousands)** | ** ** |
|                                            |       |                        |       |       |       |   |   |   |   |
| Research and  development expenses              |       | $                           | 1,548      |       | $          | 1,131 |   | $ | 417 |   | 37% |   |
| Marketing, general and  administrative expenses |       | 2,685                       |       | 2,769      |       | (84 | ) | (3)% |   |
| Patent amortization and  royalties              |       | 147                         |       | 346        |       | (199 | ) | (58)% |   |
| Equity in loss of  investee                     |       | —                      |       | 250        |       | (250 | ) | (100)% |   |
|                                                 |            |                             |            |            |            |  |  |  |  |  |  |  |

 

*Researchand Development Expenses*.  The increase in internalresearch and development expenses for the periods presented was due primarilyto lower utilization of our R&D resources from lower DoD contract activityas well as ongoing development of our comprehensive cancer array.  In addition, for the three months ended March 31,2010 and 2009, research and development expenses included $166,000 and $137,000,respectively, of non-cash stock compensation expense.  This increase was due primarily to increasesin the number of stock option awards granted to our employees during the pasttwelve months.  See Note 2 to ourconsolidated interim financial statements included elsewhere in this report fora detailed description of the amounts recognized for the periods presented.

 

As a result of theRestructuring Plan announced in April 2010, future research anddevelopment expenses will decrease in the short-term as a result of shuttingdown our research facilities in Mukilteo, Washington.  Research and development surrounding ourdiagnostic laboratory tests will continue and could increase as additionalinternal research and development agreements are undertaken and/or as newresearch and development collaborations are executed with strategic partnersfor the development of new diagnostic tests.

 

*Marketing, General andAdministrative Expenses.*  The decrease in marketing,general and administrative expenses for the three months ended March 31,2010 versus the comparable period in 2009 was due primarily to lower legal andinvestor relations expenses, partially offset by increases in sales andmarketing expenses at CMDX.  In addition,for the three months ended March 31, 2010 and 2009, marketing, general andadministrative expenses included $660,000 and $654,000, respectively, ofnon-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.

 

*PatentAmortization and Royalties. *During 2009, one of our two long-livedpatent assets became fully amortized, resulting in a decrease in patentamortization for the three months ended March 31, 2010 versus thecomparable period in 2009.

 

*Equity in Loss of Investee*. For the periods presented, this expense represents our recognition underthe equity method of accounting of our minority interests in the operations ofLeuchemix, in which we own a one-third minority interest.  During 2009, our equity investment inLeuchemix reached $0 and as a result, we ceased recognizing additional expensefrom their underlying operations.  Thishas caused a decrease in this expense for the three months ended March 31,2010 versus the comparable period in 2009.

 

19

----

Tableof Contents

 

Other Non-Operating Items:

** **
| ** **                              | ** ** | **Three Months Ended**      | ** ** | ** ** | ** ** |
|-----------------------------------------|------------|-----------------------------|------------|------------|------------|
| ** **                              | ** ** | **March 31,**          | ** ** | **Change** | ** ** |
| ** **                              | ** ** | **2010**                    | ** ** | **2009**   | ** ** | **$** | ** ** | **%** | ** ** |
| ** **                              | ** ** | **(dollars  in thousands)** | ** ** |
|                                    |       |                        |       |       |       |   |   |   |   |
| Litigation settlement  gain             |       | $                           | 19,385     |       | $          | — |   | $ | 19,385 |   | — |   |
| Loss from early  extinguishment of debt |       | (572                        | )          | —     |       | (572 | ) | — |   |
| Interest income                         |       | 2                           |       | 10         |       | (8 | ) | (80)% |   |
| Interest expense                        |       | (348                        | )          | (513       | )          | 165 |   | 32% |   |
| Derivatives gains  (charges)            |       | 605                         |       | (1,521     | )          | 2,126 |   | 140% |   |
|                                         |            |                             |            |            |            |  |  |  |  |  |  |  |

 

*Litigation Settlement Gain.* In February 2010, we received gross proceeds of $25 million fromentering into 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 $19.4million.

 

*Loss from Early Extinguishment ofDebt.*  In March 2010, we fully retired oursecured convertible debenture (the “Debenture”).  As a result, the remaining, unamortized debtdiscount of $572,000 was written off as a non-operating loss from earlyextinguishment of debt in our March 31, 2010 consolidated statement ofoperations.

 

*Interest Expense.* Since July 2008, interest expense was recognized from the issuanceof the Debenture, which accrued interest at an annual rate of 10% on theoutstanding principal balance.  Interestexpense also included amortization of the $2.9 million of debt discountoriginally recognized from issuance of the Debenture and warrants using theeffective interest method.  Interestexpense decreased as a result of retiring the Debenture in March 2010.

 

*Derivative Gains (Charges).* These gains (charges) represent the netgain or expense recognized from mark-to-model adjustments to the embeddedderivatives associated with the Debenture that were outstanding during theperiods presented.  In accordance U.S.GAAP, the conversion feature, cash redemption option, potential acceleration ofmaturity of the Debenture and potential adjustments to the fixed conversionprice all represented embedded derivatives of the Debenture that were recordedseparately at fair value as other liabilities, with the corresponding fairvalue adjustments reflected as non-operating charges or gains, depending uponthe results of mark-to-model valuation adjustments.  The fair value of the embedded derivativeswas determined using the convertible bond model, discounted cash flows andbinomial lattice models.  In March 2010,the Debenture was retired.  As a resultthe remaining derivatives liability of $605,000 was written off as anon-operating gain in our March 31, 2010 consolidated statement ofoperations.

 

**Inflation**

 

Inflation has not had asignificant impact on our Company.

 

**Liquidity and Capital Resources**

 

At March 31, 2010,cash and cash equivalents totaled $13.5 million, versus $5.4 million at December 31,2009.  Working capital at March 31,2010 was $13.3 million, compared to a working capital deficit of $(3.0 million)at December 31, 2009.  The change inworking capital was due primarily to the impact of net cash flow activities asdiscussed below.  The net change in cashand cash equivalents for the periods presented was comprised of the following:

** **
| ** **                                        | ** ** | **Three Months Ended** | ** ** | ** ** | ** ** |
|---------------------------------------------------|------------|------------------------|------------|------------|------------|
| ** **                                        | ** ** | **March 31,**     | ** ** | ** ** | ** ** |
| ** **                                        | ** ** | **2010**               | ** ** | **2009**   | ** ** | **Change** | ** ** |
| ** **                                        | ** ** | **(in  thousands)**    | ** ** | ** ** | ** ** |
| Net cash provided by  (used in):                  |       |                   |       |       |       |   |   |
| Operating activities                              |       | $                      | 16,510     |       | $          | (2,397 | ) | $ | 18,907 |   |
| Investing activities                              |       | (54                    | )          | 1,513      |       | (1,567 | ) |
| Financing activities                              |       | (8,413                 | )          | (747       | )          | (7,666 | ) |
| Increase (decrease) in  cash and cash equivalents |       | $                      | 8,043      |       | $          | (1,631 | ) | $ | 9,674 |   |

 

20

----

Tableof Contents

 

*OperatingActivities.*  The overall net increase in cash provided byoperating activities for the three months ended March 31, 2010 versus thecash used in operating activities in the comparable 2009 period was dueprimarily to the net litigation settlement proceeds from National Union of$19.4 million received in February 2010.

 

*InvestingActivities.*  The change in net cash flows from investingactivities was due primarily to net sales of available-for-sale investments inconnection with ongoing cash management activities during the periodspresented.  Also, for the three monthsended March 31, 2010 and 2009, we incurred $54,000 and $13,000,respectively, of capital expenditures.

 

*FinancingActivities.*  The decrease in net cash flows from financingactivities was due primarily to the repayment of the Debenture totaling $8.4million during the period ended March 31, 2010 versus repayment of a lineof credit totaling $820,000 in the comparable period in 2009.  Also, proceeds from the exercise of commonstock options and warrants were zero during the period ended March 31,2010 versus $81,000 in the comparable period in 2009.

 

*RestructuringPlan. *On April 19, 2010, we announced a RestructuringPlan that will focus our Company on our diagnostic services business and totransition senior management.  Based onthe analysis done to date, we expect to incur cash outlays, excluding executiveseverance costs, of approximately $1.1 million in connection with this action,of which approximately $650,000 are expected to result from non-executiveemployee benefit and severance arrangements and approximately $430,000 inremaining lease payments, plant closure and facilities clean-up and relocationexpenses.  In addition, we expect toincur approximately $460,000 in non-cash write-downs of inventory, property andequipment and related assets. On May 12, 2010, our Board of Directorsfinalized the terminations of certain of our executives as a result of theRestructuring Plan, and reaffirmed the termination benefits they will receivein accordance with our existing executive severance benefits described in Note6 to the consolidated financial statements included elsewhere in this report.  The executive severance cash benefitstotaling $565,000 will be paid out by June 30, 2010.

 

We are performing animpairment assessment on goodwill and other long-lived assets impacted by theRestructuring Plan, in addition to inventory and property and equipment assetsdescribed above.  At this time, we areunable to make a determination of the estimated range related to the impairmentcharges.  The impairment charges ultimatelyrecorded are not expected to result in future cash expenditures.

 

We anticipate that themajority of these costs will be recorded in our operating results for thefiscal quarter ending June 30, 2010. We do not expect that the charges will result in significant cashexpenditures after completion of the Restructuring Plan.  Once completed, the Restructuring Plan isexpected to yield annualized cost savings of approximately $4.0 million to $5.0million per year.

 

*FutureLiquidity.*  We have a history of incurring net losses andnet operating cash flow deficits.  We arealso deploying new and unproven technologies and continue to develop commercialproducts.  We believe that our cash andcash equivalent balances, proceeds from our settlement with National Union,anticipated cash flows from operations and other external sources of availablecredit will be sufficient to meet our cash requirements beyond the next twelvemonths, as the Restructuring Plan will significantly reduce our operating cashburn.

 

In order for us tocontinue as a going concern and to eventually reach profitability, we may berequired 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.

 

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

 

·                  the costs of commercialization activities, includingsales and marketing costs and capital equipment;

 

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

 

21

----

Tableof Contents

 

·                  our ability to license technology, if necessary;

 

·                  competing technological developments;

 

·                  the creation and formation of strategic partnerships;

 

·                  the costs associated with leasing and improving ourIrvine, California facility; and

 

·                  other factors that may not be within our control.

 

**Off-Balance Sheet Arrangements**

 

We have not entered intooff-balance sheet financing arrangements, other than operating leases for ourpremises.  We have no significantcommitments for capital expenditures in 2010 or beyond.  We have executed three capital leasestotaling $293,000 for certain laboratory equipment.  The following table lists our material knownfuture cash commitments as of March 31, 2010:

** **
| ** **                     | ** ** | **Payments Due by Period (in thousands)** | ** ** |
|--------------------------------|------------|--------------------------------------------------------------------|------------|
| ** **                     | ** ** | ** **                                                         | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | **2014 and** | ** ** |
| ** **                     | ** ** | **2010**                                                           | ** ** | **2011** | ** ** | **2012** | ** ** | **2013** | ** ** | **Thereafter** | ** ** |
| ** **                     | ** ** | ** **                                                         | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Operating leases               |       | $                                                                  | 398        |   | $ | 189 |   | $ | 196 |   | $ | 16 |   | $ | — |   |
| Capital leases                 |       | 63                                                                 |       | 85 |   | 85 |   | 57 |   | — |   |
| Minimum royalty  payments      |       | 75                                                                 |       | 100 |   | 100 |   | 100 |   | 475 |   |
| Total contractual  obligations |       | $                                                                  | 536        |   | $ | 374 |   | $ | 381 |   | $ | 173 |   | $ | 475 |   |

 

**Recent Accounting Pronouncements**

 

Refer to Note 2 to ourconsolidated interim financial statements included in Part I, Item 1 ofthis report.

 

**Item 3.****                      ****QUANTITATIVE ANDQUALITATIVE DISCLOSURES ABOUT MARKET RISK**

 

Not required for smallerreporting companies.

 

**Item4T.     CONTROLS AND PROCEDURES**

 

*Evaluation of Disclosure Controlsand Procedures*

 

We maintain disclosurecontrols and procedures that are designed to ensure that information requiredto be disclosed in our reports filed or submitted under the Securities ExchangeAct of 1934, as amended (the “Exchange Act”) is recorded, processed, summarizedand reported within the time periods specified in SEC rules andforms.  Our disclosure controls andprocedures include, without limitation, controls and procedures designed toensure that information required to be disclosed in our reports filed under theExchange Act is accumulated and communicated to management as appropriate toallow timely decisions regarding required disclosures.  There are inherent limitations to theeffectiveness of any system of disclosure controls and procedures, includingthe possibility of human error and the circumvention or overriding of thecontrols and procedures. Accordingly, even effective disclosure controls andprocedures can only provide reasonable assurance of achieving their controlobjectives, and management necessarily is required to use its judgment inevaluating the cost-benefit relationship of possible controls andprocedures.  Our management, with theparticipation of our Chief Executive Officer and Chief Financial Officer,conducted an evaluation required by Rules 13a-15 and 15d-15 under theExchange Act of the effectiveness of our disclosure controls and procedures asdefined in Rules 13a-15 and 15d-15 under the Exchange Act as of March 31,2010.  Based on this evaluation, ourChief Executive Officer and Chief Financial Officer concluded that as of March 31,2010, the design and operation of our disclosure controls and procedures wereeffective.

 

*Changes in Internal Controls*

 

There were no changes inour internal control over financial reporting that occurred during our lastfiscal quarter (the quarter ended March 31, 2010) that have materiallyaffected, or are reasonably likely to materially affect, our internal controlover financial reporting.

 

22

----

 

Tableof Contents

 

**PART II—OTHERINFORMATION**

 

**Item1.  LEGAL PROCEEDINGS**

 

In April 2005,Acacia and CombiMatrix filed a complaint against our insurance carrier,National Union Fire Ins. Co. of Pittsburgh, PA (“National Union”)(collectively, the “Parties”), seeking reimbursement of litigation andsettlement costs for a prior lawsuit, pursuant to our directors and officersinsurance policy with National Union.  Atrial was held and concluded during the fourth quarter of 2007.  In March 2008, the U.S. District Courtfor the Central District of California (the “District Court”) issued itsjudgment in favor of Acacia and us, and awarded approximately $32.1 million inmonetary damages to be paid by National Union (the “Judgment”).  In accordance with the distribution agreemententered into between Acacia and us prior to the Split-Off, all proceeds fromthe lawsuit were to be paid to us.  In May 2008,the District Court awarded us an additional $3.6 million in attorneys’ fees andlitigation costs, thereby increasing the overall award to $35.7 million.  National Union appealed the Judgment to theU.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 were paid on February 3, 2010 and a dismissal of the action wasentered by the District Court on February 11, 2010.

 

**Item1A.  RISK FACTORS**

 

The following riskfactors should be read in conjunction with the risk factors contained in ourAnnual Report on Form 10-K for the fiscal year ended December 31,2009, filed on March 18, 2010.

 

***We may not realizethe expected benefits of our initiatives to control costs.***

 

On April 19, 2010,we announced a strategic and operation restructuring plan to significantlyreduce operating costs, increase the focus on the Company’s diagnosticsservices business and transition senior management.  We anticipate that the Restructuring Planwill result in a reduction of our workforce by approximately 50% as a result ofclosing our Mukilteo, Washington facilities and relocating our corporateheadquarters to our subsidiary’s facilities in Irvine, California.

 

At present, we expectthat the Restructuring Plan will yield annualized cost savings of approximately$4.0 million to $5.0 million upon completion. However, if we experience excessive unanticipated inefficiencies orincremental costs in connection with restructuring activities, such asunanticipated inefficiencies caused by reducing headcount or relocatingoperations, we may be unable to meaningfully realize cost savings and we mayincur expenses in excess of what we anticipate. Further, in connection with the Restructuring Plan, we may incurpayments to third parties for fees, claims or penalties associated withtermination or default under existing agreements with those parties. Any ofthese outcomes could prevent us from meeting our strategic objectives and couldadversely impact our results of operations and financial condition.

 

***An inability totimely identify and retain a qualified President and Chief Executive Officercould be disruptive to and harm our business.***

 

As a component of our RestructuringPlan, we have initiated a search for a new President and Chief ExecutiveOfficer, which we anticipate will be completed by the end of the second quarterof 2010, at which time our current President and Chief Executive Officer, Dr. AmitKumar, is expected to step down.  If wefail to identify, hire and retain a qualified person to fill that positionwithin that time frame, we may not be able to satisfactorily manage ourbusiness or address the complexities of being a public company.  Although we plan to interview candidates forthe President and Chief Executive Officer position, we cannot assure you thatwe will find someone suitable to fill this position.  There also are no assurances that ourPresident and Chief Executive Officer, once retained, will work well with ourcurrent or future management team or that his or her transition into the rolewill be efficient.  Our inability to findand employ a qualified President and Chief Executive Officer or to facilitatehis or her smooth transition into the role could have a material adverse effecton our business, results of operations and financial condition.

 

23

----

Tableof Contents

 

***Healthcare reformand restrictions on reimbursements may limit our returns on moleculardiagnostic products that we may develop with our collaborators.***

 

We are currentlycollaborating with our partners to develop diagnostic products.  The ability of our collaborators tocommercialize such products may depend, in part, on the extent to whichreimbursement for the cost of these products will be available under U.S.regulations that govern reimbursement for clinical testing services bygovernment authorities, private health insurers and other organizations.  In the United States, third-party payer priceresistance, the trend towards managed health care and the implementation of thePatient Protection and Affordable Care Act of 2010 could reduce prices forhealth care products and services, adversely affecting the profits of ourcustomers and collaborative partners and reduce our future royalties.

 

**Item2.  UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS**

 

For the three monthsended March 31, 2010, we issued 33,822 shares of our common stock to YAGlobal Investments, L.P. (“YA”), in consideration of quarterly interest chargesaccrued during the fourth quarter of 2009 under the terms of a securedconvertible debenture that we issued to YA in July 2008.  Theissuance of common stock to YA was made pursuant to an exemption under Rule 506of Regulation D and/or Section 4(2) of the Securities Act of 1933.

 

**Item5.  OTHER INFORMATION**

 

In connection withour Restructuring Plan, our Board of Directors, on March 12, 2010,terminated the employment of Amit Kumar, Ph.D. (our President and ChiefExecutive Officer), Brooke Anderson, Ph.D. (our Chief Operating Officer), andH. Sho Fuji (our Vice President of Engineering and Production), each to beeffective June 30, 2010.  On orbefore that time, Dr. Anderson will also resign from our Board ofDirectors.  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 will receive theequivalent of three months of salary in the form of the Company’s common stock.

 

**Item6.  EXHIBITS**

 

An index of exhibits isfound on page 26 of this report.

 

24

----

Tableof Contents

 

**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/ AMIT KUMAR, PH.D. |
|                           |                    | Amit Kumar, Ph.D. |
|                           |                    | Chief Executive Officer |
|                           |                    | *(Authorized Signatory)* |
|                           |                    |   |
|                           |                    |   |
|                           | By:                     | /s/ SCOTT R. BURELL |
|                           |                    | Scott R. Burell |
|                           |                    | Chief Financial Officer |
|                           |                    | *(Principal Financial and  Accounting Officer)* |
|                           |                    |   |
| Date:  May 17,  2010 |                    |   |

 

25

----

Tableof Contents

 

**EXHIBITINDEX**

 
| **Exhibit  Number** | ** ** | **Description**                                                                                                   |
|---------------------|------------|-------------------------------------------------------------------------------------------------------------------|
|                |       |                                                                                                              |
| 3.2                 |       | Second Amended and Restated Bylaws (1)                                                                            |
| 10.1                |       | Amendment No. 3 to Lease dated as of  January 11, 2010 (2)                                              |
| 10.2                |       | Settlement Agreement with National Union Fire  Insurance Co. of Pittsburgh, PA, dated as of January 27, 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               |

 

----

| (1) | Incorporated by reference to Exhibit 3.2 to  CombiMatrix Corporation’s Annual Report on Form 10-K, filed  March 18, 2010.    |
|-----|--------------------------------------------------------------------------------------------------------------------------------------------------|
| (2) | Incorporated by reference to Exhibit 10.1 to  CombiMatrix Corporation’s Current Report on Form 8-K, filed  January 15, 2010. |

 

26

----