UNITED
STATES
 SECURITIES
AND EXCHANGE COMMISSION
 Washington,
D.C. 20549
 
 FORM
10-Q
 
 (Mark
One)
 T
              QUARTERLY
      REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT
      OF 1934
 
 For the
quarterly period ended March 31, 2009
 
 OR
 
 £
              TRANSITION
      REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT
      OF 1934
 
 For the
transition period
from                     to
 
 Commission
file number 001-33678
 
 NOVABAY
PHARMACEUTICALS, INC.
 (Exact
name of registrant as specified in its charter)
 
 California
              
              68-0454536(State
      or other jurisdiction of incorporation or organization)
              
              (I.R.S.
      Employer Identification No.)
 
 5980
Horton Street, Suite 550, Emeryville CA 94608
 (Address
of principal executive offices) (Zip Code)
 
 Registrant’s
Telephone Number, Including Area Code: (510) 899-8800
 
  
 Title
      of each class
              
              Name
      of each exchange on which registeredCommon
      Stock, $0.01 par value per share
              
              NYSE
      Amex
 
 Indicate
by check mark whether the registrant (1) has filed all reports required to be
filed by Section 13 or 15(d) of the
 Securities
Exchange Act of 1934 during the preceding 12 months (or for such shorter period
that the registrant was required to
 file such
reports), and (2) has been subject to such filing requirements for the past 90
days. Yes T  No £
 
 Indicate
by check mark whether the registrant has submitted electronically and posted on
its corporate Web site, if any, every
 Interactive
Data File required to be submitted and posted pursuant to Rule 405 of Regulation
S-T (§232.405 of this chapter) during the
 preceding
12 months (or for such shorter period that the registrant was required to submit
and post such files).Yes T  No
£
 
 Indicate
by check mark whether the registrant is a large accelerated filer, an
accelerated filer, a non-accelerated filer, or a smaller reporting company. See
the definitions of “large accelerated filer,” “accelerated filer” and “smaller
reporting company” in Rule 12b-2 of the ExchangeAct. (Check one):
 
 Large
      accelerated filer
              £
              Accelerated
      filer
              £Non-accelerated
      filer
              £
              Smaller
      reporting company
              T
 (Do not
check if a smaller reporting company)
 
 Indicate
by check mark whether the registrant is a shell company (as defined in Exchange
Act Rule 12b-2). Yes  ̈ No T
 
 
 As of May
8, 2009, there were 21,910,543 shares of the registrant’s common stock
outstanding.
 
  
 
 
 
 NOVABAY
PHARMACEUTICALS, INC.
 
 TABLE
OF CONTENTS
 
 
 Part
              PageI. Financial InformationItem 1. Financial Statements
              2Item 2. Management’s Discussion and Analysis of Financial
      Condition and Results of Operation
              21Item 3. Quantitative and Qualitative Disclosures About
      Market Risk
              28Item 4. Controls and
    Procedures
              29II.Other InformationItem 1. Legal Proceedings
              29Item 1A. Risk Factors
              29Item 2. Unregistered Sales of Equity Securities and Use of
      Proceeds
              47Item 3. Defaults Upon Senior
    Securities
              47Item 4. Submission of Matters to a Vote of Security
      Holders
              47Item 5. Other Information
              47Item 6. Exhibits
              49
 SIGNATURES
 
  Unless
the context requires otherwise, all references in this report to “we,” “our,”
“us,” the “Company” and “NovaBay” refer to NovaBay Pharmaceuticals, Inc. and its
subsidiaries.
 
 NovaBay
Pharma ®, Aganocide®, NovaBayTM AgaDermTM, AgaNaseTM, and NeutroPhaseTM are
trademarks of NovaBay Pharmaceuticals, Inc. All other trademarks and trade names
are the property of their respective owners.
 
  Table of Contents
 -1-
  
 
 PART
I
 
 ITEM1.
              FINANCIAL
      STATEMENTS
 NOVABAY
PHARMACEUTICALS, INC.
 (a
development stage company)
 CONSOLIDATED
BALANCE SHEETS
 (in
thousands, except per share data)
 
 December
      31,
              
              
              March
      31,2008
              
              
              2009(unaudited)ASSETSCurrent
      assets:Cash
      and cash equivalents
              
              $
              12,099
              
              
              $
              10,243Short-term
      investments (Note 3)
              
              
              -
              
              
              
              2,631Prepaid
      expenses and other current assets
              
              
              414
              
              
              
              684Total
      current assets
              
              
              12,513
              
              
              
              13,558Property
      and equipment, net (Note 4)
              
              
              1,456
              
              
              
              1,400TOTAL
      ASSETS
              
              $
              13,969
              
              
              $
              14,958LIABILITIES
      AND STOCKHOLDERS' EQUITYLiabilities:Current
      liabilities:Accounts
      payable
              
              $
              406
              
              
              $
              367Accrued
      liabilities (Note 5)
              
              
              1,166
              
              
              
              1,075Capital
      lease obligation (Note 6)
              
              
              42
              
              
              
              39Equipment
      loan (Note 7)
              
              
              366
              
              
              
              376Deferred
      revenue
              
              
              2,500
              
              
              
              3,836Total
      current liabilities
              
              
              4,480
              
              
              
              5,693Capital
      lease obligation - non-current (Note 6)
              
              
              7
              
              
              
              -Equipment
      loan - non-current (Note 7)
              
              
              470
              
              
              
              372Deferred
      revenue - non-current
              
              
              1,667
              
              
              
              1,392Total
      liabilities
              
              
              6,624
              
              
              
              7,457Commitments
      and ContingenciesStockholders'
      Equity:Common
      stock, $0.01 par value; 65,000  and 65,000 shares authorized at
      December 31, 2008 and March 31, 2009, respectively; 21,471 and 21,662
      shares issued and outstanding at December 31, 2008 and March 31, 2009,
      respectively
              
              
              215
              
              
              
              217Additional
      paid-in capital
              
              
              33,718
              
              
              
              34,199Accumulated
      other comprehensive income (loss)
              
              
              -
              
              
              
              (8
              )Accumulated
      deficit during development stage
              
              
              (26,588
              )
              
              
              (26,907
              )Total
      stockholders' equity
              
              
              7,345
              
              
              
              7,501TOTAL
      LIABILITIES AND STOCKHOLDERS' EQUITY
              
              $
              13,969
              
              
              $
              14,958
 
 The
accompanying notes are an integral part of these consolidated financial
statements.
 
 
 
 
 
 Table of Contents
 -2-
 
 
 
 NOVABAY
PHARMACEUTICALS, INC.
 (a
development stage company)
 CONSOLIDATED STATEMENTS OF OPERATIONS
 (in
thousands, except per share data)
  Cumulative
      Period from
                  July
      1, 2002 (date of developmentThree
      Months Ended
                
                
                stage
      inception)March
      31,
                
                
                to
      March 31,2008
                
                
                2009
                
                
                2009(unaudited)
                
                
                (unaudited)
                
                
                (unaudited)REVENUELicense
      and collaboration revenue
                
                $
                1,492
                
                
                $
                2,611
                
                
                $
                16,779Total
      revenue
                
                
                1,492
                
                
                
                2,611
                
                
                
                16,779EXPENSESOperating
      Expenses:Research
      and development
                
                
                2,647
                
                
                
                1,361
                
                
                
                26,368General
      and administrative
                
                
                1,684
                
                
                
                1,579
                
                
                
                18,544Total
      operating expenses
                
                
                4,331
                
                
                
                2,940
                
                
                
                44,912Other
      income, net
                
                
                163
                
                
                
                11
                
                
                
                1,240Net
      loss before income taxes
                
                
                (2,676
                )
                
                
                (318
                )
                
                
                (26,893
                )Provision
      for income taxes
                
                
                (2
                )
                
                
                -
                
                
                
                (14
                )Net
      loss
                
                $
                (2,678
                )
                
                $
                (318
                )
                
                $
                (26,907
                )Net
      loss per share:Basic
      and diluted
                
                $
                (0.13
                )
                
                $
                (0.01
                )Shares
      used in per share calculations:Basic
      and diluted
                
                
                21,288
                
                
                
                21,620
 The
accompanying notes are an integral part of these consolidated financial
statements.
 
  Table of Contents
 -3-
 NOVABAY
PHARMACEUTICALS, INC.
 (a
development stage company)
 CONSOLIDATED
STATEMENTS OF CASH FLOWS
 (in
thousands)
 
 CumulativePeriod
      fromJuly
      1, 2002(date
      ofdevelopmentstage
      inception)to
      March 31,2008
              
              
              2009
              
              
              2009(unaudited)
              
              
              (unaudited)
              
              
              (unaudited)Cash
      flows from operating activities:Net
      loss
              
              $
              (2,678
              )
              
              $
              (318
              )
              
              $
              (26,907
              )Adjustments
      to reconcile net loss to net cashused
      in operating activities:Depreciation
      and amortization
              
              
              67
              
              
              
              84
              
              
              
              788Accretion
      of discount on short-term investments
              
              
              (25
              )
              
              
              -
              
              
              
              (301
              )Net
      realized gain on sales of short-term investments
              
              
              -
              
              
              
              -
              
              
              
              (3
              )Loss
      on disposal of property and equipment
              
              
              -
              
              
              
              -
              
              
              
              121Stock-based
      compensation expense for optionsissued
      to employees and directors
              
              
              282
              
              
              
              167
              
              
              
              1,629Compensation
      expense for warrants and stockissued
      for services
              
              
              -
              
              
              
              212
              
              
              
              313Stock-based
      compensation expense for optionsand
      stock issued to non-employees
              
              
              (11
              )
              
              
              56
              
              
              
              581Changes
      in operating assets and liabilities:Increase
      in prepaid expenses and other assets
              
              
              (193
              )
              
              
              (269
              )
              
              
              (678
              )Increase
      (decrease) in accounts payable and accrued liabilities
              
              
              619
              
              
              
              (131
              )
              
              
              1,466Increase
      (decrease) in deferred revenue
              
              
              (4
              )
              
              
              1,061
              
              
              
              5,227Net
      cash provided by (used in) operating activities
              
              
              (1,943
              )
              
              
              862
              
              
              
              (17,764
              )Cash
      flows from investing activities:Purchases
      of property and equipment
              
              
              (372
              )
              
              
              (27
              )
              
              
              (2,187
              )Proceeds
      from disposal of property and equipment
              
              
              -
              
              
              
              -
              
              
              
              44Purchases
      of short-term investments
              
              
              (12,100
              )
              
              
              (3,015
              )
              
              
              (97,559
              )Proceeds
      from maturities and sales of short-term investments
              
              
              14,655
              
              
              
              375
              
              
              
              95,222Cash
      acquired in purchase of LLC
              
              
              -
              
              
              
              -
              
              
              
              516Net
      cash provided by (used in) investing activities
              
              
              2,183
              
              
              
              (2,667
              )
              
              
              (3,964
              )Cash
      flows from financing activities:Proceeds
      from preferred stock issuances, net
              
              
              -
              
              
              
              -
              
              
              
              11,160Proceeds
      from common stock issuances
              
              
              -
              
              
              
              47
              
              
              
              64Proceeds
      from exercise of options and warrants
              
              
              -
              
              
              
              -
              
              
              
              1,761Initial
      public offering costs
              
              
              -
              
              
              
              -
              
              
              
              17,077Proceeds
      from stock subscription receivable
              
              
              -
              
              
              
              -
              
              
              
              873Proceeds
      from issuance of notes
              
              
              -
              
              
              
              -
              
              
              
              405Principal
      payments on capital lease
              
              
              (9
              )
              
              
              (10
              )
              
              
              (117
              )Proceeds
      from borrowings  under equipment loan
              
              
              202
              
              
              
              -
              
              
              
              1,216Principal
      payments on equipment loan
              
              
              (65
              )
              
              
              (88
              )
              
              
              (468
              )Net
      cash provided by (used in) financing activities
              
              
              128
              
              
              
              (51
              )
              
              
              31,971Net
      increase (decrease) in cash and cash equivalents
              
              
              368
              
              
              
              (1,856
              )
              
              
              10,243Cash
      and cash equivalents, beginning of period
              
              
              10,941
              
              
              
              12,099
              
              
              
              -Cash
      and cash equivalents, end of period
              
              $
              11,309
              
              
              $
              10,243
              
              
              $
              10,243
 The
accompanying notes are an integral part of these consolidated financial
statements.
  Table of Contents
 -4-
 
 NOVABAY
PHARMACEUTICALS, INC.
 (a
development stage company)
 
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 NOTE
1. ORGANIZATION
 
 NovaBay
Pharmaceuticals, Inc. (the “Company”) is a development stage biopharmaceutical
company focused on developing innovative product candidates for the treatment or
prevention of a wide range of infections in hospital and non-hospital
environments. Many of these infections have become increasingly difficult to
treat because of the rapid rise in drug resistance. The Company has discovered
and is developing a class of non-antibiotic anti-infective compounds, which it
had named Aganocide compounds. These compounds are based upon small molecules
that are naturally generated by white blood cells when defending the body
against invading pathogens. The Company believes that its Aganocide compounds
could form a platform on which to create a variety of products to address
differing needs in the treatment and prevention of bacterial and viral
infections. In laboratory testing, the Company’s Aganocide compounds have
demonstrated the ability to destroy all bacteria against which they have been
tested. Furthermore, because of their mechanism of action, the Company believes
that bacteria are unlikely to develop resistance to its Aganocide
compounds.
  The
Company was incorporated under the laws of the State of California on
January 19, 2000 as NovaCal Pharmaceuticals, Inc. The Company had no
operations until July 1, 2002, on which date it acquired all of the
operating assets of NovaCal Pharmaceuticals, LLC, a California limited liability
company. In February 2007, the Company changed its name from NovaCal
Pharmaceuticals, Inc. to NovaBay Pharmaceuticals, Inc. In August 2007, the
Company formed two subsidiaries––NovaBay Pharmaceuticals Canada, Inc., a
wholly-owned subsidiary incorporated under the laws of British Columbia
(Canada), which may conduct research and development in Canada, and DermaBay,
Inc., a wholly-owned U.S. subsidiary, which may explore and pursue
dermatological opportunities. The Company currently operate in one business
segment.
  In
October 2007, the Company completed an initial public offering of its common
stock (“IPO”) in which it sold and issued 5,000,000 shares of our common stock
at a price to the public of $4.00 per share. The Company raised a total of $20.0
million from the IPO, or approximately $17.1 million in net cash proceeds after
deducting underwriting discounts and commissions of $1.4 million and other
offering costs of $1.5 million. Upon the closing of the IPO, all shares of
convertible preferred stock outstanding automatically converted into 9,613,554
shares of common stock. In connection with the IPO, the Company also issued
warrants to the underwriters to purchase an aggregate of 350,000 shares of
common stock at an exercise price of $4.00 per share. The warrants are
exercisable on or after October 31, 2008 and expire on October 31,
2010.
 
 NOTE
2.  SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
 
 Basis
of Presentation
 
 The
accompanying unaudited Consolidated Financial Statements have been prepared in
accordance with U.S. generally accepted accounting principles (U.S. GAAP) for
interim financial information, and are expressed in U.S. dollars. The financial
statements include all adjustments (consisting only of normal recurring
adjustments) that the management of Novabay Pharmaceuticals, Inc. (Novabay, the
Company, we or our) believes are necessary for a fair presentation of the
periods presented. These interim financial results are not necessarily
indicative of results expected for the full fiscal year or for any subsequent
interim period.
 
 The
unaudited consolidated financial statements include the Company’s accounts and
the accounts of its wholly owned subsidiaries. Intercompany transactions and
balances have been eliminated. The financial statements have been prepared under
the guidelines of Statement of Financial Accounting Standard (“SFAS”)
No. 7, “Accounting and Reporting by Development Stage Enterprises”. A
development stage enterprise is one in which planned principal operations have
not commenced, or if its operations have commenced, there have been no
significant revenues therefrom. As of March 31, 2009, the Company had not
commenced its planned principal operations.
 
 Certain amounts for prior periods have been reclassified to conform to current
period presentation.
 Principles
of Consolidation
 
 The
accompanying consolidated financial statements include the accounts of the
Company and its wholly owned subsidiaries, NovaBay Pharmaceuticals Canada, Inc.
and DermaBay, Inc. All inter-company accounts and transactions have been
eliminated in consolidation.
 
 Reverse
Stock Split
 
 On
August 10, 2007, the Company filed an amendment to its articles of
incorporation to effect a 1-for-2 reverse stock split of its common stock.
All share and per share amounts relating to the common stock, stock options and
warrants and the conversion ratios of preferred stock included in the financial
statements and footnotes have been restated to reflect the reverse stock
split.
 
 Use
of Estimates
 
 The
preparation of financial statements in accordance with U.S. GAAP requires
management to make estimates and assumptions that affect the reported amounts of
assets and liabilities, the disclosure of contingent assets and liabilities at
the date of the financial statements, and the reported amounts of revenue and
expenses during the reporting period. Actual results could differ from those
estimates.
 
 Table of Contents
 -5-
 NOVABAY
PHARMACEUTICALS, INC.
 (a
development stage company)
 
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
 
 Cash
and Cash Equivalents and Short-Term Investments
 
 The
Company considers all highly liquid instruments with a stated maturity of three
months or less to be cash and cash equivalents. Cash and cash equivalents are
stated at cost, which approximate their fair value. As of March 31, 2009, the
Company's cash and cash equivalents were held in financial institutions in the
United States and include deposits in money market funds, which were
unrestricted as to withdrawal or use.
 
 The
Company classifies all highly liquid investments with a stated maturity of
greater than three months as short-term investments. Short-term investments
generally consist of United States government, municipal and corporate debt
securities. The Company has classified its short-term investments as
available-for-sale. The Company does not intend to hold securities with stated
maturities greater than twelve months until maturity. In response to changes in
the availability of and the yield on alternative investments as well as
liquidity requirements, the Company occasionally sell these securities
prior to their stated maturities. These securities are carried at fair value,
with the unrealized gains and losses reported as a component of other
comprehensive income (loss) until realized. Realized gains and losses from the
sale of available-for-sale securities, if any, are determined on a specific
identification basis. A decline in the market value below cost of any
available-for-sale security that is determined to be other than temporary
results in a revaluation of its carrying amount to fair value and an impairment
charge to earnings, resulting in a new cost basis for the security. No such
impairment charges were recorded for the periods presented. Premiums and
discounts are amortized or accreted over the life of the related security as an
adjustment to yield using the straight-line method. The amortization and
accretion, interest income and realized gains and losses are included in other
income, net within the consolidated statements of operations. Interest income is
recognized when earned.
 
 Comprehensive
Loss
 
 Comprehensive loss consists of net loss
plus the change in unrealized gains and losses on investments. At each balance
sheet date presented, the Company’s other comprehensive loss consists solely of
unrealized gains and losses on investments. Comprehensive loss for the three
months ended March 31, 2008 and 2009 are as follows (in thousands):
 
 
 Three
      Months EndedMarch
      31,2008
              
              
              2009Net
      loss
              
              $
              (2,678
              )
              
              $
              (318
              )Change
      in unrealized gains (losses) on investments
              
              
              16
              
              
              
              (8
              )Comprehensive
      loss
              
              $
              (2,662
              )
              
              $
              (326
              )
 
 
 
 Concentrations
of Credit Risk
 
 Financial
instruments which potentially subject the Company to significant concentrations
of credit risk consist primarily of cash and cash equivalents and short-term
investments. The Company maintains deposits of cash, cash equivalents and
short-term investments with three highly-rated, major financial institutions in
the United States.
 
 Deposits
in these banks may exceed the amount of federal insurance provided on such
deposits. The Company does not believe it is exposed to significant credit risk
due to the financial position of the financial institutions in which these
deposits are held. Additionally, the Company  has established
guidelines regarding diversification and investment maturities, which are
designed to maintain safety and liquidity.
 
 Fair
Value of Financial Assets and Liabilities
 
 Financial
instruments, including cash and cash equivalents and short term investments,
accounts payable and accrued liabilities are carried at cost, which management
believes approximates fair value due to the short-term nature of these
instruments. The fair value of capital lease obligations and equipment loans
approximates its carrying amounts as a market rate of interest is attached to
their repayment.
 
 The
Company measures the fair value of financial assets and liabilities based on the
guidance of Statement of Financial Accounting Standards No. 157, Fair Value
Measurements (“Statement No. 157”) which defines fair value, establishes a
framework for measuring fair value, and expands disclosures about fair
value measurements. Effective January 1, 2008, the Company adopted
the
 
 Table of Contents
 -6-
 NOVABAY
PHARMACEUTICALS, INC.
 (a
development stage company)
 
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
 
 provisions
of Statement No. 157 for financial assets and liabilities, as well as for any
other assets and liabilities that are carried at fair value on a recurring
basis. The adoption of the provisions of Statement No. 157 did not materially
impact the Company’s consolidated financial position and results of
operations.
 
 Statement
No. 157 defines fair value as the exchange price that would be received for an
asset or paid to transfer a liability (an exit price) in the principal or most
advantageous market for the asset or liability in an orderly transaction between
market participants on the measurement date. Statement No. 157 also
establishes a fair value hierarchy, which requires an entity to maximize the use
of observable inputs and minimize the use of unobservable inputs when
measuring fair value. Statement No. 157 describes three levels of inputs that
may be used to measure fair value:
 
 Level 1 –
quoted prices in active markets for identical assets or liabilities
 Level 2 –
quoted prices for similar assets and liabilities in active markets or inputs
that are observable
 Level 3 –
inputs that are unobservable (for example cash flow modeling inputs based on
assumptions)
 
 Property
and Equipment
 
 Property
and equipment are stated at cost, less accumulated depreciation and
amortization. Depreciation is calculated using the straight-line method over the
estimated useful lives of the related assets of five to seven years for office
and laboratory equipment,
 three
years for software and seven years for furniture and fixtures. Leasehold
improvements are depreciated on the shorter of seven years or the life of the
lease term. Depreciation of assets recorded under capital leases is included in
depreciation expense.
 
 The costs
of normal maintenance, repairs, and minor replacements are charged to operations
when incurred.
 
 Impairment
of Long-Lived Assets
 
 The
Company accounts for long-lived assets in accordance with SFAS No. 144,
“Accounting for the Impairment or Disposal of Long-Lived Assets and for
Long-Lived Assets to be Disposed of”, which requires that companies consider
whether events or changes in facts and circumstances, both internally and
externally, may indicate that an impairment of long-lived assets held for use
are present. Management periodically evaluates the carrying value of long-lived
assets and has determined that there was no impairment as of all periods
presented. Should there be impairment in the future, the Company would recognize
the amount of the impairment based on the expected future cash flows from the
impaired assets. The cash flow estimates would be based on management’s best
estimates, using appropriate and customary assumptions and projections at the
time.
 
 Accumulated
Other Comprehensive Income
 
 Accumulated
other comprehensive income consists of unrealized gains and losses on short-term
investments classified as available-for-sale.
 
 Revenue
Recognition
 
 License
and collaboration revenue is primarily generated through agreements with
strategic partners for the development and commercialization of the
Company's product candidates. The terms of the agreements typically include
non-refundable upfront fees, funding of research and development activities,
payments based upon achievement of certain milestones and royalties on net
product sales. In accordance with Emerging Issues Task Force (“EITF”) Issue No.
00-21, “Revenue Arrangements with Multiple Deliverables”, the Company
analyzes its multiple element arrangements to determine whether the
elements can be separated. The Company perform its analysis at the
inception of the arrangement and as each product or service is delivered. If a
product or service is not separable, the combined deliverables are accounted for
as a single unit of accounting and recognized over the
performance obligation period. The Company recognizes revenue in
accordance with SEC Staff Accounting Bulletin (“SAB”) No. 101, “Revenue
Recognition in Financial Statements”, as amended by SAB No. 104 (together,
“SAB 104”). In accordance with SAB 104, revenue is recognized when the following
criteria have been met: persuasive evidence of an arrangement exists; delivery
has occurred and risk of loss has passed; the seller’s price to the buyer is
fixed or determinable; and collectibility is reasonably assured.
 
 Assuming
the elements meet the EITF No. 00-21 criteria for separation and the SAB 104
requirements for recognition, the revenue recognition methodology prescribed for
each unit of accounting is summarized below:
 
 Upfront Fees—The Company
defers recognition of non-refundable upfront fees if it has have
continuing performance obligations without which the technology licensed has no
utility to the licensee. If the Company has continuing involvement
through research and development services that are required because its
know-how and expertise related to the technology is proprietary to it, or can
only be performed by it, then such up-front fees are deferred and recognized
over the period of continuing involvement.
 
 Funded Research and
Development—Revenue from research and development services is recognized
during the period in
  Table of Contents
 -7-
 NOVABAY
PHARMACEUTICALS, INC.
 (a
development stage company)
 
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
 
 which the
services are performed and is based upon the number of full-time-equivalent
personnel working on the specific project at the agreed-upon rate.
Reimbursements from collaborative partners for agreed upon direct costs
including direct materials and outsourced, or subcontracted, pre-clinical
studies are classified as revenue in accordance with EITF Issue No. 99-19,
“Reporting Revenue Gross as a Principal versus Net as an Agent,” and recognized
in the period the reimbursable expenses are incurred. Payments received
in advance are recorded as deferred revenue until the research and development
services are performed or costs are incurred.
 
 Milestones—Substantive
milestone payments are considered to be performance bonuses that are recognized
upon achievement of the milestone only if all of the following conditions are
met: the milestone payments are non-refundable; achievement of the milestone
involves a degree of risk and was not reasonably assured at the inception of the
arrangement; substantive effort is involved in achieving the milestone; the
amount of the milestone is reasonable in relation to the effort expended or the
risk associated with achievement of the milestone; and a reasonable amount of
time passes between the up-front license payment and the first milestone payment
as well as between each subsequent milestone payment. If any of these conditions
are not met, the milestone payments are deferred and recognized as revenue over
the term of the arrangement as the Company completes its performance
obligations.
 
 Royalties—The Company
recognizes royalty revenues from licensed products upon the sale of the related
products.
 
 Advertising
Costs
 
 There
were no advertising costs incurred for any of the periods
presented.
 
 Research
and Development Costs
 
 The
Company charges research and development costs to expense as incurred. These
costs include salaries and benefits for research and development personnel,
costs associated with clinical trials managed by contract research
organizations, and other costs associated with research, development and
regulatory activities. The Company uses external service providers to conduct
clinical trials, to manufacture supplies of product candidates and to provide
various other research and development-related products and
services.
 
 Patent
Costs
 
 The
Company expenses patent costs, including legal expenses, in the period in which
they are incurred. Patent expenses are included as general and administrative
expenses in the Company's statements of operations.
 
 
 Stock-Based
Compensation
 
 On
January 1, 2006, the Company adopted the fair value recognition provisions
of SFAS No. 123R, “Share-Based Payment”. SFAS No. 123R replaced SFAS
No. 123 and superseded Accounting Principles Board (“APB”) Opinion
No. 25, “Accounting for Stock Issued to Employees” and related
interpretations. Under the fair value recognition provisions of SFAS
No. 123R, stock-based compensation expense is measured at the grant date
for all stock-based awards to employees and directors and is recognized as
expense over the requisite service period, which is generally the vesting
period. The Company was required to utilize the prospective application method
prescribed by SFAS No. 123R, under which prior periods are not revised for
comparative purposes. Under the prospective application transition method,
non-public entities that previously used the minimum value method of SFAS
No. 123 should continue to account for non-vested equity awards outstanding
at the date of adoption of SFAS No. 123R in the same manner as they had
been accounted for prior to adoption. SFAS No. 123R specifically prohibits
pro forma disclosures for those awards valued using the minimum value method.
The valuation and recognition provisions of SFAS No. 123R apply to new
awards and to awards outstanding as of the adoption date that are subsequently
modified. The adoption of SFAS No.123R had a material effect on the Company's
financial position and results of operations. See Note 10 for further
information regarding stock-based compensation expense and the assumptions used
in estimating that expense.
 
 Prior to
the adoption of SFAS No. 123R, the Company valued its stock-based
awards using the minimum value method and provided pro-forma information
regarding stock-based compensation and net income required by SFAS
No. 123. The Company  did not recognize stock-based
compensation expense in its statements of operations for option grants
to its employees or directors for the periods prior to its adoption of SFAS
No. 123R because the exercise price of options granted was generally equal
to the fair market value of the underlying common stock on the date of
grant.
 
 The
Company accounts for stock compensation arrangements with non-employees in
accordance with SFAS No. 123R and EITF Issue No. 96-18, “Accounting
for Equity Instruments That Are Issued to Other Than Employees for Acquiring, or
in Conjunction with Selling, Goods or Services”, which require that such equity
instruments are recorded at their fair value on the
  Table of Contents
 -8-
  NOVABAY
PHARMACEUTICALS, INC.
 (a
development stage company)
 
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
 
 measurement
date. The measurement of stock-based compensation is subject to periodic
adjustment as the underlying equity instruments vest. Non-employee stock-based
compensation charges are amortized over the vesting period on a straight-line
basis. For stock options granted to non-employees, the fair value of the stock
options is estimated using a Black-Scholes-Merton valuation model.
 
 Income
Taxes
 
 The
Company accounts for income taxes under the asset and liability method. Deferred
tax assets and liabilities are recognized for the future tax consequences
attributable to differences between the financial statement carrying amounts of
existing assets and liabilities and their respective tax bases and operating
loss and tax credit carryforwards. Deferred tax assets and liabilities are
measured using enacted tax rates expected to apply to taxable income in the
years in which those temporary differences are expected to be recovered or
settled. The effect on deferred tax assets and liabilities of a change in tax
rates is recognized in income in the period that includes the enactment date. A
valuation allowance is recognized if it is more likely than not that some
portion or all of the deferred tax asset will not be recognized.
 
 Net
Income (Loss) per Share
 
 The
Company computes net income (loss) per share in accordance with SFAS
No. 128, “Earnings per Share” which requires presentation of both basic and
diluted earnings (loss) per share (“EPS”).
 
 Basic EPS
is computed by dividing net income (loss) available to common shareholders
(numerator) by the weighted average number of common shares outstanding
(denominator) during the period. Diluted EPS gives effect to all dilutive
potential common shares outstanding during the period including stock options
and stock warrants, using the treasury stock method, and convertible preferred
stock, using the if-converted method. In computing diluted EPS, the average
stock price for the period is used in
 determining
the number of shares assumed to be purchased from the exercise of stock options
or warrants. Potentially dilutive common share equivalents are excluded from the
diluted EPS computation in net loss periods as their effect would be
anti-dilutive. There is no difference between basic and diluted net loss per
share for all periods presented due to the Company’s net losses.
 
 The
following outstanding preferred stock, stock options and stock warrants were
excluded from the diluted EPS computation as their effect would have been
anti-dilutive:
 
 Quarter
      Ended March 31,(In
      thousands)
              
              2008
              
              
              2009Convertible
      preferred stock
              
              
              -
              
              
              
              -Stock
      options
              
              
              3,105
              
              
              
              3,651Stock
      warrants
              
              
              350
              
              
              
              650
 
 
 Recent
Accounting Pronouncements
 
 
 A variety
of proposed or otherwise potential accounting standards are currently under
study by standard setting organizations and various regulatory agencies.
Due to the tentative and preliminary nature of those proposed standards,
management has not determined whether implementation of such proposed
standards would be material to the Company's consolidated financial
statements.
 
 
 Table of Contents
 -9-
 
 
 
 NOVABAY
PHARMACEUTICALS, INC.
 (a
development stage company)
 
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
 
 
 NOTE
3. INVESTMENTS AND FAIR VALUE MEASUREMENTS
 
 There
were no short-term investments at year end December 31, 2008. Short-term
investments at March 31, 2009 consisted of the following:
 
 
 
 
 March
      31, 2009Cost
              
              
              Gross
              
              
              Gross
              
              
              Other-ThanUnrealized
              
              
              Unrealized
              
              
              Temporary
              
              
              Fair(in
      thousands)
              
              
              
              
              Gains
              
              
              Losses
              
              
              Impairment
              
              
              ValueCorporate
      bonds
              
              $
              764
              
              
              $
              -
              
              
              $
              (8
              )
              
              $
              -
              
              
              $
              756U.S.
      Agencies
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -Municipal
      bonds
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -Certificates
      of Deposit
              
              
              1,875
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              1,875Other
      Fixed Income
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -Total
              
              $
              2,639
              
              
              
              -
              
              
              
              (8
              )
              
              
              -
              
              
              $
              2,631
 
 
 
 Contractual
maturities of short-term investments as of March 31, 2009 were as
follows:
 
 
 March
      31, 2009(in
      thousands)
              Cost
              
              Fair ValueDue
      in one year or less
              
              $
              2,639
              
              
              $
              2,631Due
      after ten years
              
              
              -
              
              
              
              -Total
              
              $
              2,639
              
              
              $
              2,631
 
 
 
 Table of Contents
 -10-
 
 
 NOVABAY
PHARMACEUTICALS, INC.
 (a
development stage company)
 
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
 
 
 For the
year ended December 31, 2008 and the three months ended March 31, 2009 the
Company recognized a net realized gain/ (loss) on short-term investments of
$35,000 and $0 respectively. For the cumulative period from July 1, 2002
(date of development stage inception) to March 31, 2009, the
Company  recognized a net realized gain of $3,000.
 
 The
Company’s cash equivalents and investments are classified within Level 1 or
Level 2 of the fair value hierarchy because they are valued using quoted
market prices in active markets, broker or dealer quotations, or alternative
pricing sources with reasonable levels of price transparency. The types of
investments that are generally classified within Level 1 of the fair value
hierarchy include money market securities. The types of investments that are
generally classified within Level 2 of the fair value hierarchy include
corporate securities, certificates of deposits and U.S. government
securities.
 
 The
following table presents the Company’s investments measured at fair value on a
recurring basis as of March 31, 2009 classified by the SFAS No. 157 valuation
hierarchy:
 
 Fair
      Value Measurements Using(in
      thousands)
              
              Total
              
              
              Level
      1
              
              
              Level
      2
              
              
              Level
      3Cash
      equivalents
              
              $
              2,112
              
              
              $
              2,112
              
              
              $
              -
              
              
              $
              -Short-term
      investments:Corporate
      bonds
              
              $
              756
              
              
              $
              -
              
              
              $
              756
              
              
              $
              -U.S.
      Agencies
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -Municipal
      bonds
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -Certificates
      of Deposit
              
              
              1,875
              
              
              
              -
              
              
              
              1,875
              
              
              
              -Other
      Fixed Income
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -Total
      short-term investments
              
              $
              2,631
              
              
              $
              -
              
              
              $
              2,631
              
              
              $
              -Total
              
              $
              4,743
              
              
              $
              2,112
              
              
              $
              2,631
              
              
              $
              -
 
 
 
 
 NOTE
4. PROPERTY AND EQUIPMENT
 
 Property
and equipment consisted of the following:
 
 December 31,
              
              
              March
      31,(in
      thousands)
              
              2008
              
              
              2009Office
      and laboratory equipment
              
              $
              1,728
              
              
              $
              1,756Furniture
      and fixtures
              
              
              113
              
              
              
              113Software
              
              
              110
              
              
              
              110Leasehold
      improvements
              
              
              143
              
              
              
              143Total
      property and equipment, cost
              
              
              2,094
              
              
              
              2,122Less:
      accumulated depreciation
              
              
              (638
              )
              
              
              (722
              )Total
      property and equipment, net
              
              $
              1,456
              
              
              $
              1,400
 
 
 Depreciation
expense was $304,000 and $ $84,000 for the year ended December 31, 2008 and the
three months ended March 31, 2009, respectively and $788,000 for the cumulative
period from July 1, 2002 (date of development stage inception) to March 31,
2009.
 
 
 
 Table of Contents
 -11-
 
 
 
 NOVABAY
PHARMACEUTICALS, INC.
 (a
development stage company)
 
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
 
 NOTE
5. ACCRUED LIABILITIES
 
 Accrued
liabilities consisted of the following:
 
 (in
      thousands)
                
                December
      31,
                  2008
                
                
                March
      31,
                  2009Research
      and development
                
                $
                509
                
                
                $
                202Employee
      payroll and benefits
                
                
                423
                
                
                
                454Professional
      fees
                
                
                182
                
                
                
                242Other
                
                
                52
                
                
                
                177Total
      accrued liabilities
                
                $
                1,166
                
                
                $
                1,075
 NOTE
6. CAPITAL LEASE OBLIGATION
 
 During
the first quarter of 2007, the Company commenced a lease for a portion of its
laboratory equipment. This arrangement is accounted for as a capital lease.
Assets under capital leases that are included in property and equipment are as
follows:
 
 (in
      thousands)
              
              December 31,
              
              
              March
      31,2008
              
              
              2009Office
      and laboratory equipment
              
              $
              229
              
              
              $
              229Less:
      accumulated depreciation
              
              
              (47
              )
              
              
              (56
              )Capital
      lease assets, net
              
              $
              182
              
              
              $
              173
 
 
 
 Future
minimum lease payments under capital leases were as follows at March 31,
2009:
 
 (in
      thousands)
              
              LeaseCommitmentYear
      ending December 31:2009
              
              $
              342010
              
              
              72011
              
              
              -2012
              
              
              -2013
              
              
              -Total
      minimum lease payments
              
              
              41Less:
      amount representing interest
              
              
              (2
              )Present
      value of minimum lease payments
              
              $
              39
 
 
 
 
 Table of Contents
 -12-
 
 
 
 NOVABAY
PHARMACEUTICALS, INC.
 (a
development stage company)
 
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
 
 
 NOTE
7. EQUIPMENT LOAN
 
 During
April 2007, the Company entered into a master security agreement to establish a
$1.0 million equipment loan facility with a financial institution. The purpose
of this loan is to finance equipment purchases, principally in the build-out
of the Company's laboratory facilities. Borrowings under the loan are
secured by eligible equipment purchased from January 2006 through April 2008 and
will be repaid over 40 months at an interest rate equal to the greater of 5.94%
over the three year Treasury rate in effect at the time of funding or 10.45%.
There are no loan covenants specified in the agreement.
 
 As of
March 31, 2009, the Company had an outstanding equipment loan balance of
$836,291carrying a weighted-average interest rate of 10.95%. At March 31, 2009,
there was $216,253 available for borrowing under this equipment loan
facility.
 
 Future
minimum loan payments under equipment loans were as follows at March 31,
2009:
 
 
 (in
      thousands)
              
              LoanCommitmentYear
      ending December 31:2009
              
              $
              3302010
              
              
              3962011
              
              
              1092012
              
              
              -2013
              
              
              -Total
      minimum loan payments
              
              $
              835Less:
      amount representing interest
              
              
              (87
              )Present
      value of minimum loan payments
              
              $
              748
 
 
 NOTE
8. COMMITMENTS AND CONTINGENCIES
 
 Operating
Leases
 
 The
Company leases laboratory facilities and office space under operating leases
which expire at various dates through 2015. Rent expense was $169,000 and
$226,218 for the three months ended March 31, 2008 and 2009, respectively,
and $2,167,750 for the cumulative period from July 1, 2002 (date of
development stage inception) to March 31, 2009.
 
 
 
 Table of Contents
 -13-
 
  NOVABAY
PHARMACEUTICALS, INC.
 (a
development stage company)
 
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
 
 
 
 The
future minimum lease payments under non-cancellable operating leases were as
follows as of March 31, 2009:
 
 Lease(in
      thousands)
              
              CommitmentYear
      ending December 31:2009*
              
              $
              6462010
              
              
              8932011
              
              
              9292012
              
              
              9652013
              
              
              1,0042014
              
              
              1,0442015
              
              
              899Total
      lease commitment
              
              $
              6,380
 
 
 
 Legal
Matters
 
 From time
to time, the Company may be involved in various legal proceedings arising in the
ordinary course of business. There are no matters at March 31, 2009 that, in the
opinion of management, would have a material adverse effect on the
Company's financial position, results of operations or cash
flows.
 
 NOTE
9. STOCKHOLDERS’ EQUITY
 
 Preferred
Stock
 
 In 2002
and 2003, the Company issued 3.2 million shares of Series A Convertible
Preferred Stock for net proceeds of $647,000. In 2003 and 2004, the Company
issued 6.9 million shares of Series B Convertible Preferred Stock for net
proceeds of $3.0 million. In 2004 and 2005, the Company issued 6.7 million
shares of Series C Convertible Preferred Stock for net proceeds of $5.4 million.
In 2005 and 2006, the Company issued 2.5 million shares of Series D Convertible
Preferred Stock for net proceeds of $3.6 million. All outstanding shares of
convertible preferred stock automatically converted into 9.6 million shares of
common stock upon the closing of the Company's IPO in October 2007. In
connection with the IPO, the Company amended its articles of
incorporation to provide for the issuance of up to 5,000,000 shares of preferred
stock in such series and with such rights and preferences as may be approved by
the board of directors. As of December 31, 2008, and March 31, 2009 there were
no shares of preferred stock outstanding.
 
 Common
Stock
 
 Under the
Company's amended articles of incorporation, the Company is authorized to issue
65,000,000 shares of $0.01 par value common stock. Each holder of common stock
has the right to one vote but does not have cumulative voting rights. Shares of
common stock are not subject to any redemption or sinking fund provisions, nor
do they have any preemptive, subscription or conversion rights. Holders of
common stock are entitled to receive dividends whenever funds are legally
available and when declared by the board of directors, subject to the prior
rights of holders of all classes of stock outstanding having priority rights as
to dividends. No dividends have been declared or paid as of December 31, 2008,
and March 31, 2009. In August 2007, the Company filed an amendment to its
articles of incorporation to effect a 1-for-2 reverse stock split of its
common stock. All share and per share amounts relating to the common stock,
stock options and warrants and the conversion ratios of preferred stock included
in the financial statements and footnotes have been restated to reflect the
reverse stock split. In October 2007, the Company completed an initial public
offering of its common stock in which the Company sold and issued
5,000,000 shares of its common stock at a price to the public of $4.00 per
share. The Company raised a total of $20.0 million from the IPO, or
approximately $17.1 million in net cash proceeds after deducting underwriting
discounts and commissions of $1.4 million and other offering costs of $1.5
million.
 
 Stock
Warrants
 
 At March
31, 2009, there were outstanding warrants to purchase 650,000 shares of common
stock at a weighted-average exercise price of $4.00 per share.
 
 
 Table of Contents
 -14-
 
 
 NOVABAY
PHARMACEUTICALS, INC.
 (a
development stage company)
 
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
 NOTE
10. EQUITY-BASED COMPENSATION
 
 Equity
Compensation Plans
 
 Prior to
the IPO, the Company had two equity plans in place: the 2002 Stock Option Plan
and the 2005 Stock Option Plan. Upon the closing of the IPO in October
2007, the Company's adopted the 2007 Omnibus Incentive Plan (the “2007
Plan”) to provide for the granting of stock awards, such as stock options,
unrestricted and restricted common stock, stock units, dividend equivalent
rights, and stock appreciation rights to employees, directors and outside
consultants as determined by the board of directors. In conjunction with the
adoption of the 2007 Plan, no further option awards may be granted from the 2002
or 2005 Stock Option Plans and any option cancellations or expirations from the
2002 or 2005 Stock Option Plans may not be reissued. At the inception of the
2007 Plan, 2,000,000 shares were reserved for issuance under the Plan. As
of March 31, 2009, there were 410,863 shares available for future grants
under the 2007 Plan.
 
  Under the
terms of the 2007 Plan, the exercise price of incentive stock options may not be
less than 100% of the fair market value of the common stock on the date of grant
and, if granted to an owner of more than 10% of the Company's stock, then
not less than 110%. Stock options granted under the 2007 Plan expire no later
than ten years from the date of grant. Stock options granted to employees
generally vest over four years while options granted to directors and
consultants typically vest over a shorter period, subject to continued service.
All of the options granted prior to October 2007 include early exercise
provisions that allow for full exercise of the option prior to the option
vesting, subject to certain repurchase provisions. The Company issues new shares
to satisfy option exercises under the plans.
  
 Stock
Option Summary
 
  The
following table summarizes information about the Company's stock options
outstanding at March 31, 2009 and activity during the three month period
then ended.
 WeightedWeighted
                
                
                AverageAverage
                
                
                Remaining
                
                
                AggregateExercise
                
                
                Contractual
                
                
                Intrinsic(in
      thousands, except per share data)
                
                Options
                
                
                Price
                
                
                Life
      (years)
                
                
                ValueOutstanding
      at December 31, 2008
                
                
                3,371
                
                
                $
                1.71Options
      granted
                
                
                328
                
                
                $
                1.48Options
      exercised
                
                
                (39
                )
                
                $
                1.20Options
      forfeited/cancelled
                
                
                (9
                )
                
                $
                3.38Outstanding
      at March 31, 2009
                
                
                3,651
                
                
                $
                1.69
                
                
                
                7.1
                
                
                
                5,101Vested
      and expected to vest at March 31, 2009
                
                
                3,476
                
                
                $
                1.65
                
                
                
                7.0
                
                
                
                4,977Vested
      at March 31, 2009
                
                
                2,169
                
                
                $
                1.24
                
                
                
                5.7
                
                
                
                3,887Exercisable
      at March 31, 2009
                
                
                2,450
                
                
                $
                1.43
                
                
                
                6.0
                
                
                
                4,029
 The
aggregate intrinsic value is calculated as the difference between the exercise
price of the underlying stock option awards and the closing market price of the
Company's common stock as quoted on the NYSE Amex as of March 31, 2009. The
Company's  received cash payments for the exercise of stock options in the
amount of $47,000 during the three months ended March 31, 2009 and the aggregate
intrinsic value of stock option awards exercised was $9,000, as determined at
the date of option exercise. There were no options exercised in the three months
ended March 31, 2008.
 
 
 
 Table of Contents
 -15-
 
 NOVABAY
PHARMACEUTICALS, INC.
 (a
development stage company)
 
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
 
  The
options outstanding and vested by exercise price at March 31, 2009 were as
follows (number of options in thousands):
 
 Options
      Outstanding
                
                
                Options
      VestedWeightedAverage
                
                
                Weighted
                
                
                
                
                
                WeightedRemaining
                
                
                Average
                
                
                
                
                
                AverageRange
      of
                
                
                Number
                
                
                Contractual
                
                
                Exercise
                
                
                Number
                
                
                ExerciseExercise
      Prices
                
                
                Outstanding
                
                
                Life
      (years)
                
                
                Price
                
                
                Vested
                
                
                Price$
                0.20
                
                
                
                544
                
                
                
                2.9
                
                
                $
                0.20
                
                
                
                544
                
                
                $
                0.20$
                0.30
                
                
                
                318
                
                
                
                4.8
                
                
                $
                0.30
                
                
                
                318
                
                
                $
                0.30$
                0.56
                
                
                
                192
                
                
                
                5.2
                
                
                $
                0.56
                
                
                
                184
                
                
                $
                0.56$
                0.94 -
      $1.56
                
                
                
                542
                
                
                
                8.8
                
                
                $
                1.35
                
                
                
                196
                
                
                $
                1.13$
                1.70 -
      $1.97
                
                
                
                1,157
                
                
                
                8.1
                
                
                $
                1.82
                
                
                
                560
                
                
                $
                1.70$
                2.00 -
      $2.28
                
                
                
                214
                
                
                
                8.0
                
                
                $
                2.21
                
                
                
                101
                
                
                $
                2.22$
                3.56 -
      $4.00
                
                
                
                684
                
                
                
                8.6
                
                
                $
                3.71
                
                
                
                266
                
                
                $
                3.733,651
                
                
                
                7.1
                
                
                $
                1.69
                
                
                
                2,169
                
                
                $
                1.24
 Stock
Option Awards to Employees and Directors
  The
Company grants options to purchase common stock to some of its employees
and directors at prices equal to or greater than the market value of the stock
on the dates the options are granted. The Company has estimated the value of
certain stock option awards as of the date of the grant by applying the
Black-Scholes-Merton option pricing valuation model using the single-option
valuation approach. The application of this valuation model involves assumptions
that are judgmental and subjective in nature. See Note 2 for a description of
the accounting policies that the Company applied to value its
stock-based awards.
  The
weighted average assumptions used in determining the value of options granted
and a summary of the methodology applied to develop each assumption are as
follows:
  
 Three
      Months Ended
                March
      31,Assumption
              
              2008
              
              
              2009Expected
      price volatility
              
              
              70
              %
              
              
              83
              %Expected
      term (in years)
              
              
              6.1
              
              
              
              6.1Risk-free
      interest rate
              
              
              3.2
              %
              
              
              1.8
              %Dividend
      yield
              
              
              0.0
              %
              
              
              0.0
              %Weighted-average
      fair value of options granted during the period
              
              $
              2.42
              
              
              $
              1.07
  
 Expected Price
Volatility—This is a measure of the amount by which the stock price has
fluctuated or is expected to fluctuate. Prior to the adoption of SFAS
No. 123R, the Company assumed 0% price volatility in accordance with the
minimum value method requirements of SFAS No. 123. Under SFAS
No. 123R, which the Company adopted on January 1, 2006, the
computation of expected volatility was based on the historical volatility of
comparable companies from a representative peer group selected based on industry
and market capitalization data. An increase in the expected price volatility
will increase the value of the option granted and the related compensation
expense.
  Expected Term—This is the
period of time over which the options granted are expected to remain
outstanding. Because there is insufficient historical information available to
estimate the expected term of the stock-based awards, the Company adopted the
simplified method for estimating the expected term pursuant to SAB No. 107.
On this basis, the Company estimated the expected term of options granted by
taking the average of the vesting term and the contractual term of the option.
An increase in the expected life will increase the value of the option granted
and the related compensation expense.
 
 
 Table of Contents
 -16-
 NOVABAY
PHARMACEUTICALS, INC.
 (a
development stage company)
 
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
   Risk-Free Interest Rate—This
is the U.S. Treasury rate for the week of the grant having a term approximating
the expected life of the option. An increase in the risk-free interest rate will
increase the value of the option granted and the related compensation
expense.
 
  Dividend Yield—The Company
has not made any dividend payments nor does it  have plans to pay dividends
in the foreseeable future. An increase in the dividend yield will decrease the
value of the option granted and the related compensation expense.
  Forfeiture
Rate—Under SFAS No. 123R, forfeitures are estimated at the
time of grant and reduce compensation expense ratably over the vesting period.
This estimate is adjusted periodically based on the extent to which actual
forfeitures differ, or are expected to differ, from the previous estimate. For
the three months ended March 31, 2009 and 2008, the Company applied an estimated
forfeiture rate of 5% to employee grants and 0% to director grants.
  For the
three months ended March 31, 2009 and 2008, the Company recognized stock-based
compensation expense of $167,000 and $177,000, respectively, for option awards
to employees and directors. As of March 31, 2009, total unrecognized
compensation cost related to unvested stock options granted or modified on or
after January 1, 2006 was $1.8 million. This amount is expected to be
recognized as stock-based compensation expense in the Company's statements
of operations over the remaining weighted average vesting period of 2.9
years.
  
 Common
Stock Awards to Directors
 
 In
connection with the close of the IPO in October 2007, the Company adopted a new
plan to compensate the independent members of the Board of Directors for their
services. Under the terms of the Director Compensation Plan, each
independent member is entitled to a combination of cash and unrestricted common
stock for each board and committee meeting attended, up to specified annual
maximums.
 
 In
accordance with these provisions, the Company issued 93,384 shares of common
stock to independent directors during the three months ended March 31, 2009.
These shares were issued out of the 2007 Plan. The fair market value of the
stock issued to directors was recorded as an operating expense in the period in
which the meeting occurred, resulting in total compensation expense of $137,683
for common stock awards to directors during the three months ended
March 31, 2009.
 
 
 Summary
of Stock-Based Compensation Expense Under SFAS No. 123R
 
 Upon the
adoption of SFAS No. 123R on January 1, 2006, the Company began
recognizing stock-based compensation expense in the statements of operations for
all employee and director equity awards granted or modified on or after the
adoption date. Stock-based compensation expense is classified in the statements
of operations in the same expense line items as cash compensation.
Since the Company continues to operate at a net loss, itdoes not expect to
realize any current tax benefits related to stock options.
 
 A summary
of the stock-based compensation expense included in results of operations for
the option and stock awards to employees and directors discussed above is as
follows:
 March
      31,(in
      thousands)
              
              2008
              
              
              2009Research
      and Development
              
              $
              108
              
              
              $
              91General
      and Administrative
              
              
              123
              
              
              
              214Total
      stock-based compensation expense
              
              $
              231
              
              
              $
              305
 
  Stock-Based
Awards to Non-Employees
  During
the three months ended March 31, 2009 the Company granted options to purchase an
aggregate of 60,000 shares of common stock, to non-employees in exchange for
advisory and consulting services. There were no grants to non-employees in the
three months ended March 31, 2008. The stock options are recorded at their fair
value on the measurement date and recognized over the respective service or
vesting period. The fair value of the stock options granted was calculated using
the Black-Scholes-Merton option pricing model based upon the following
assumptions:
  
 Table of Contents
 -17-
  
 NOVABAY
PHARMACEUTICALS, INC.
 (a
development stage company)
 
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
   
 Three
      Months Ended
                March
      31,Assumption
              
              2009Expected
      price volatility
              
              
              83
              %Expected
      term (in years)
              
              
              6.1Risk-free
      interest rate
              
              
              1.4
              %Dividend
      yield
              
              
              0.0
              %Weighted-average
      fair value of options granted during the period
              
              $
              .94
  For the
three months ended March 31, 2009, the Company recognized stock-based
compensation expense of $56,000 related to non-employee option grants. For the
three months ended March 31, 2008 the Company reversed previously
recognized expense of $20,000 due to the required revaluation of unvested
non-employee grants.
 
 NOTE
11. COLLABORATION AND LICENSE AGREEMENTS
 
 Alcon
Manufacturing, Ltd.
 
 In August
2006, the Company entered into a collaboration and license agreement with Alcon
Manufacturing, Ltd. (“Alcon”) to license to Alcon the exclusive rights to
develop, manufacture and commercialize products incorporating the Aganocide
compounds for application in connection with the eye, ear and sinus and for use
in contact lens solution. Under the terms of the agreement, Alcon agreed to pay
an up-front, non-refundable, non-creditable technology access fee of $10.0
million upon the effective date of the agreement. This up-front fee was recorded
as deferred revenue and is being amortized into revenue on a straight-line basis
over the four-year funding term of the agreement, through August 2010.
Additionally, the Company will receive semi-annual payments to support on-going
research and development activities over the four year funding term of the
agreement. The research and development support payments include amounts to fund
a specified number of personnel engaged in collaboration activities and to
reimburse for qualified equipment, materials and contract study costs. The
Company's  obligation to perform research and development activities under
the agreement expires at the end of the four year funding term. As product
candidates are developed and proceed through clinical trials and approval, the
Company will receive milestone payments. If the products are commercialized, the
Company will also receive royalties on any sales of products containing the
Aganocide compound. Alcon has the right to terminate the agreement in its
entirety upon nine months’ notice, or terminate portions of the agreement upon
135 days’ notice, subject to certain provisions. Both parties have the right to
terminate the agreement for breach upon 60 days’ notice.
 
 Revenue
has been recognized under the Alcon agreement as follows:
 March
      31,(in
      thousands)
              
              2008
              
              
              2009Amortization
      of Upfront Technology Access Fee
              
              $
              625
              
              
              $
              625On-going
      Research and Development(FTE)
              
              
              675
              
              
              
              736Materials,
      Equipment, and Contract Study Costs
              
              
              133
              
              
              
              -Milestone
      Payments
              
              
              -
              
              
              
              1,000$
              1,433
              
              
              $
              2,361
 
 
 At
March 31, 2008 and 2009, the Company had deferred revenue balances of $7.4
million and $4.2 million, respectively, related to the Alcon agreement which was
comprised of $6.0 million and $3.5 million, respectively, for the upfront
technology access fee and $0.7 million and $0.7, respectively, for other prepaid
reimbursements. In January 2009, the Company received a $1.0 million milestone
payment under the Alcon agreement for non-rejection of the IND application for
the Company’s Otic indication.
 
 
 
 Table of Contents
 -18-
 
 
 
 NOVABAY
PHARMACEUTICALS, INC.
 (a
development stage company)
 
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
 
 Galderma
 
 On March 25, 2009, the Company
announced that it entered into an agreement with Galderma S.A. to develop and
commercialize the Company's Aganocide® compounds, which covers acne and
impetigo and potentially other major dermatological conditions,
excluding onychomycosis (nail fungus) and orphan drug indications. The
agreement is exclusive and worldwide in scope, with the exception of Asian
markets. Galderma will be responsible for the development costs of the acne and
other indications, except in Japan, where they will be shared, and for the
ongoing development program for impetigo, upon the achievement of a specified
milestone. Galderma will also reimburse NovaBay for the use of its
personnel in support of the collaboration. NovaBay retains the right to
co-market products resulting from the agreement in Japan. In addition,
NovaBay has retained all rights in other Asian markets outside Japan, and
has exclusive rights to promote the products developed under the agreement
in the hospital and other healthcare institutions in
North America.
 
 Galderma
will pay to Novabay certain upfront fees, ongoing fees, reimbursements, and
milestone payments related to achieving
development and commercialization of its Aganocide® compounds. The Company
received a $1.0 Million upfront payment in the first quarter 2009.
 
 Revenue
has been recognized under the Galderma agreement as follows:
 March
      31,2008
              
              
              2009(in
      thousands)Amortization
      of Upfront Technology Access Fee
              
              $
              -
              
              
              $
              250On-going
      Research and Development
              
              
              -
              
              
              
              -Materials,
      Equipment, and Contract Study Costs
              
              
              -
              
              
              
              -Milestone
      Payments$
              -
              
              
              $
              250
 
 
 The
Company had deferred revenue balances of $0 and $0.9 million respectively, at
December 31, 2008 and March 31, 2009, related to the Galderma agreement, which
consisted of the remaining amount to be amortized for the upfront technology
access fee. As of March 31, 2009, the Company had not earned or received
any milestone or royalty payments under the Galderma agreement.
 
 KCI
International VOF GP
 
 In June
2007, the Company entered into a license agreement with an affiliate of Kinetic
Concepts, Inc. (“KCI”), under which the Company granted KCI the exclusive rights
to develop, manufacture and commercialize NVC-101, or NeutroPhase, as well as
other products containing hypochlorous acid as the principal active ingredient,
worldwide for use in wound care in humans, other than products or uses intended
for the eye, ear or nose. Under the terms of the agreement, KCI paid to the
Company a non-refundable technology access fee of $200,000. The
up-front technology access fee was recorded as deferred revenue and has
been amortized into revenue on a straight-line basis over the 18-month
performance obligation period, through December 2008. Under the agreement, the
Company is also entitled to receive reimbursements for qualified
consulting, materials and contract study costs. In addition, the Company is
entitled to receive payments of up to $1.25 million if certain milestones are
met. If products covered by the license are commercially launched, the
Company will also receive royalty payments based on net revenues from sales
by KCI of such products. KCI has the right to terminate the agreement without
penalty upon 60 days’ notice. The Company has the right to terminate the
agreement if KCI has not commercially launched a product incorporating NVC-101,
or any other product containing hypochlorous acid, within 18 months of the date
of the agreement. Both parties have the right to terminate the agreement for
breach upon 60 days’ notice. As of December 31,2008 all of the upfront fees
related to KCI have been fully amortized.
 
 
 NOTE
12. EMPLOYEE BENEFIT PLAN
 
 The
Company has a 401(k) plan covering all eligible employees. The
Company is not required to contribute to the plan and have made no
contributions through March 31, 2009.
 
 NOTE
13. INCOME TAXES
  As of
December 31, 2008 the Company had net operating loss carryforwards for both
federal and state income tax purposes of $20.0 million. If not utilized, the
federal and state net operating loss carryforwards will begin expiring at
various dates between 2014 and 2027. Current federal and California tax laws
include substantial restrictions on the utilization of net operating loss
carryforwards
 
 
 Table of Contents
 -19-
 NOVABAY
PHARMACEUTICALS, INC.
 (a
development stage company)
 
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
  
  in the
event of an ownership change of a corporation. Accordingly, our ability to
utilize net operating loss carryforwards may be limited as a result of such
ownership changes. Such a limitation could result in the expiration of
carryforwards before they are utilized.
  The
Company tracks the portion of our federal and state net operating loss
carryforwards attributable to stock option benefits in a separate memo account
pursuant to SFAS No. 123R. Therefore, these amounts are not included in
gross or net deferred tax assets. Pursuant to SFAS No. 123R, the benefit of
these net operating loss carryforwards will only be recorded to equity when they
reduce cash taxes payable. We elected to use the “with-and-without” approach for
utilizing the tax benefits of stock option exercises under SFAS No. 123R.
These benefits would result in a credit to additional paid-in-capital when they
reduce income taxes payable.
 
 Uncertain
Income Tax Positions
 
 In
July 2006, the FASB released Interpretation No. 48 “Accounting for
Uncertainty in Income Taxes” (“FIN 48”). FIN 48 prescribes the minimum
recognition threshold a tax position is required to meet before being recognized
in the financial statements. FIN 48 also requires additional disclosure of the
beginning and ending unrecognized tax benefits and details regarding the
uncertainties that may cause the unrecognized benefits to increase or decrease
within a twelve month period.
 
 The
Company adopted the provisions of FIN 48 on January 1, 2007. There was no
impact on our consolidated financial position, results of operations and cash
flows as a result of adoption. We have no unrecognized tax benefit as of
December 31, 2008, including no accrued amounts for interest and penalties.
Our policy will be to recognize interest and penalties related to income taxes
as a component of income tax expense. We are subject to income tax examinations
for U.S. incomes taxes and state income taxes from 2002 forward. We do not
anticipate that total unrecognized tax benefits will significantly change prior
to December 31, 2009.
 
 NOTE
14. SUBSEQUENT EVENTS
  In April
2009, NovaBay announced an exclusive agreement with Professors Markus Nagl M.D.
and Waldemar Gottardi, Ph.D. of the Medical University of Innsbruck, Austria
that broadens NovaBay’s intellectual property portfolio and could expand
clinical opportunities and accelerate clinical timelines for the Aganocide
compounds.  Under the terms of the agreement, Novabay has an exclusive
license to a broad portfolio of patent applications, as well
as pre-clinical and clinical research data on N-chlorotaurine
(NCT), a natural antimicrobial produced by the body’s white blood cells and the
biological basis for NovaBay’s Aganocides, in multiple disease
indications.  In addition, NovaBay also owns the rights to successful
human proof of concept trials of NCT in otitis externa (ear infection) and viral
conjunctivitis (pink eye) that is expected to provide guidance for NovaBay’s and
its partners’ future clinical programs.
 
 -20-
 
 ITEM 2.
              MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
      RESULTS OF OPERATIONS
 
 The following discussion of our
financial condition and results of operations should be read together with our
consolidated financial statements and related notes included in Part I, Item
1 of this report. This discussion contains forward-looking statements that
involve risks and uncertainties. Words such as “expects,” “anticipates,”
“targets,” “goals,” “projects,” “intends,” “plans,” “believes,” “seeks,”
“estimates,” variations of these words, and similar expressions are
intended to identify these forward-looking statements. As a result of many factors, such as
those set forth under the section entitled “Risk Factors” in Part II,
Item 1A and elsewhere in this report, our actual results may differ
materially from those anticipated in these forward-looking statements Readers
are cautioned that these forward-looking statements are only predictions based
upon assumptions made that we believed to be reasonable at the time, and are
subject to risks and uncertainties. Therefore, actual results may differ
materially and adversely from those expressed in any forward-looking statements.
Except as required by law, we undertake no obligation to revise or update
publicly any forward-looking statements.
  Overview
 
 We
are a clinical stage biopharmaceutical company focused on developing innovative
product candidates for the treatment or prevention of a wide range of infections
in hospital and non-hospital environments. Many of these infections have become
increasingly difficult to treat because of the rapid rise in drug resistance. We
have discovered and are developing a new class of non-antibiotic anti-infective
compounds, which we have named Aganocide® compounds. These compounds are based
upon small molecules that are naturally generated by white blood cells when
defending the body against invading pathogens. We believe that our Aganocide
compounds could form a platform on which to create a variety of products to
address differing needs in the treatment and prevention of bacterial and viral
infections. In laboratory testing, our Aganocide compounds have demonstrated the
ability to destroy all bacteria against which they have been tested.
Furthermore, because of their mechanism of action, we believe that bacteria are
unlikely to develop resistance to our Aganocide compounds.
  Our
business model is to develop our Aganocide compounds internally through phase II
clinical trials for selected indications and enter into agreements with third
parties for phase III clinical development and commercialization. 
We may also partner with certain indications at earlier stages of
development.
  In
August 2006, we entered into a collaboration and license agreement with Alcon,
that provided Alcon the exclusive rights to develop, manufacture and
commercialize products incorporating the Aganocide compounds for applications in
connection with the eye, ear and sinus and for use in contact lens disinfecting
solutions. Under the terms of the agreement, Alcon agreed to pay an up-front,
non-refundable, non-creditable technology access fee of $10.0 million upon the
effective date of the agreement. In addition to the technology access fee, we
are entitled to receive semi-annual payments from Alcon to support on-going
research and development activities over the four year funding term of the
agreement. The research and development support payments include amounts to fund
a specified number of personnel engaged in collaboration activities and to
reimburse for qualified equipment, materials and contract study costs. As
product candidates are developed and proceed through clinical trials and
approval, we will receive milestone payments. If the products are
commercialized, we will also receive royalties on any sales of products
containing the Aganocide compounds. Alcon has the right to terminate the
agreement in its entirety upon nine months’ notice, or terminate portions of the
agreement upon 135 days’ notice, subject to certain provisions. Both parties
have the right to terminate the agreement for breach upon 60 days’
notice.
 Table of Contents
 -21-
 
 Alcon is
responsible for all of the costs that it incurs in developing the products using
the Aganocide compounds. We announced the clearance of an Investigational New
Drug (IND) application submitted by Alcon to the FDA to permit the clinical
development of Novabay’s NVC-422 for infection of the eye. The IND clearance has
triggered the immediate payment of the first milestone of $1,000,000 from Alcon
to Novabay. The achievement of the milestones and product commercialization is
subject to many risks and uncertainties, including, but not limited to Alcon’s
ability to obtain regulatory approval from the FDA and Alcon’s ability to
execute its clinical initiatives. Therefore, we cannot predict when, if ever,
the milestones specified in the Alcon agreement will be achieved or when we will
receive royalties on sales of commercialized product.
 
 In June
2007 we entered into a license agreement with Kinetic Concepts, Inc. (“KCI”)
under which KCI paid us a non-refundable technology access fee of
$200,000.  If products covered by this agreement are commercially launched,
we will also receive royalty payments based on net revenues from sales by KCI of
such products.  We have not received any milestones of other payments under
this agreement since the initial technology access fee.
 
 On March
25, 2009, we announced that we entered into an agreement with Galderma S. A. to
develop and commercialize our Aganocide compounds, which covers acne and
impetigo and potentially other major dermatological conditions, excluding
onychomycosis (nail fungus) and orphan drug indications. The agreement is
exclusive and worldwide in scope, with the exception of Asian markets. Galderma
will be responsible for the development costs of the acne and other indications,
except in Japan, where they will be shared, and for the ongoing development
program for impetigo, upon the achievement of a specified milestone. Galderma
will also reimburse NovaBay for the use of its personnel in support of the
collaboration. NovaBay retains the right to co-market products resulting from
the agreement in Japan. In addition, NovaBay has retained all rights in other
Asian markets outside Japan, and has exclusive rights to promote the products
developed under the agreement in the hospital and other healthcare institutions
in North America. Galderma will pay to Novabay certain upfront fees, ongoing
fees, reimbursements, and milestone payments related to achieving development
and commercialization of its Aganocide compounds. If products are commercialized
under this agreement then NovaBay will receive royalties whose rates escalate as
sales increase.
 
 
 To date,
we have generated no revenue from product sales, and we have financed our
operations and internal growth primarily through the sale of our capital stock,
and the technology access fee from Alcon. We are a development stage company and
have incurred significant losses since commencement of our operations in July
2002, as we have devoted substantially all of our resources to research and
development. As of March 31, 2009, we had an accumulated deficit of $26.9
million. Our accumulated deficit resulted from research and development expenses
and general and administrative expenses. We expect to continue to incur net
losses over the next several years as we continue our clinical and research and
development activities and as we apply for patents and regulatory
approvals.
 Table of Contents
 -22-
 Critical
Accounting Policies and Estimates
 
 Our
financial statements have been prepared in accordance with generally accepted
accounting principles in the United States. The preparation of these financial
statements requires us to make estimates and assumptions that affect the
reported amounts of assets and liabilities and the disclosure of contingent
assets and liabilities at the date of the financial statements as well as the
reported revenues and expenses during the reporting periods. In preparing
these financial statements, management has made its best estimates and judgments
of certain amounts included in the financial statements giving due consideration
to materiality. On an ongoing basis, we evaluate our estimates and judgments
related to revenue recognition, income taxes, intangible assets, long-term
service contracts and other contingencies. We base our estimates on historical
experience and on various other factors that we believe are reasonable under the
circumstances, the results of which form the basis for making judgments about
the carrying value of assets and liabilities that are not readily apparent from
other sources. Actual results may differ from these estimates under different
assumptions or conditions.
 
 While our
significant accounting policies are more fully described in Note 2 of the Notes
to Consolidated Financial Statements, included in Part I, Item 1  of
this report, we believe that the following accounting policies are most critical
to aid you in fully understanding and evaluating our reported financial
results.
 
 Revenue
Recognition
 
 License
and collaboration revenue is primarily generated through agreements with
strategic partners for the development and commercialization of our product
candidates. The terms of the agreements typically include non-refundable upfront
fees, funding of research and development activities, payments based upon
achievement of certain milestones and royalties on net product sales. In
accordance with Emerging Issues Task Force (“EITF”) Issue No. 00-21, “Revenue
Arrangements with Multiple Deliverables”, we analyze our multiple element
arrangements to determine whether the elements can be separated. We perform our
analysis at the inception of the arrangement and as each product or service is
delivered. If a product or service is not separable, the combined deliverables
are accounted for as a single unit of accounting and recognized over the
performance obligation period. We recognize revenue in accordance with SEC Staff
Accounting Bulletin (“SAB”) No. 101, “Revenue Recognition in Financial
Statements”, as amended by SAB No. 104 (together, SAB 104). In accordance
with SAB 104, revenue is recognized when the following criteria have been met:
persuasive evidence of an arrangement exists; delivery has occurred and risk of
loss has passed; the seller’s price to the buyer is fixed or determinable; and
collectibility is reasonably assured.
 
 Assuming
the elements meet the EITF No. 00-21 criteria for separation and the SAB 104
requirements for recognition, the revenue recognition methodology prescribed for
each unit of accounting is summarized below:
 
 Upfront Fees—We defer
recognition of non-refundable upfront fees if we have continuing performance
obligations without which the technology licensed has no utility to the
licensee. If we have continuing involvement through research and development
services that are required because our know-how and expertise related to the
technology is proprietary to us, or can only be performed by us, then such
up-front fees are deferred and recognized over the period of continuing
involvement.
 
 Funded Research and
Development—Revenue from research and development services is recognized
during the period in which the services are performed and is based upon the
number of full-time-equivalent personnel working on the specific project at the
agreed-upon rate. The full-time equivalent amount can vary each year if the
contracts allow for a percentage increase determined by relevant salary surveys,
if applicable. Reimbursements from collaborative partners for agreed upon direct
costs including direct materials and outsourced, or subcontracted, pre-clinical
studies are classified as revenue in accordance with EITF Issue No. 99-19,
“Reporting Revenue Gross as a Principal versus Net as an Agent,” and recognized
in the period the reimbursable expenses are incurred. Payments received in
advance are recorded as deferred revenue until the research and development
services are performed or costs are incurred.
 
 Milestones—Substantive
milestone payments are considered to be performance bonuses that are recognized
upon achievement of the milestone only if all of the following conditions are
met: the milestone payments are non-refundable; achievement of the milestone
involves a degree of risk and was not reasonably assured at the inception of the
arrangement; substantive effort is involved in achieving the milestone; the
amount of the milestone is reasonable in relation to the effort expended or the
risk associated with achievement of the milestone; and a reasonable amount of
time passes between the up-front license payment and the first
milestone payment as well as between each subsequent milestone payment. If
any of these conditions are not met, the milestone payments are deferred and
recognized as revenue over the term of the arrangement as we complete our
performance obligations.
 
 Royalties—We recognize
royalty revenues from licensed products upon the sale of the related
products.
  Table of Contents
 -23-
 Research
and Development Costs
 
 We charge
research and development costs to expense as incurred. These costs include
salaries and benefits for research and development personnel, costs associated
with clinical trials managed by contract research organizations, and other costs
associated with research, development and regulatory activities. We use external
service providers to conduct clinical trials, to manufacture supplies of product
candidates and to provide various other research and development-related
products and services. Research and development costs may vary depending on the
type of item or service incurred, location of performance or production, or lack
of availability of the item or service, and specificity required in production
for certain compounds.
 
 Patent
Costs
 
 We
expense patent costs, including legal expenses, in the period in which they are
incurred. Patent expenses are included as general and administrative expenses in
our statements of operations. Patent costs may vary depending on the location,
domestic of foreign, in which the patent is being secured.
 
 Stock-Based
Compensation
 
 On
January 1, 2006, we adopted the fair value recognition provisions of
Statement of Financial Accounting Standards (“SFAS”) No. 123R, “Share-Based
Payment”. SFAS No. 123R replaced SFAS No. 123 and superseded
Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock
Issued to Employees” and related interpretations. Under the fair value
recognition provisions of SFAS No. 123R, stock-based compensation expense
is measured at the grant date for all stock-based awards to employees and
directors and is recognized as expense over the requisite service period, which
is generally the vesting period. We were required to utilize the prospective
application method prescribed by SFAS No. 123R, under which prior periods
are not revised for comparative purposes. Under SFAS No. 123R, forfeitures are
estimated at the time of grant and reduce compensation expense ratably over the
vesting period. This estimate is adjusted periodically based on the extent to
which actual forfeitures differ, or are expected to differ, from the previous
estimate. Under the prospective application transition method, non-public
entities that previously used the minimum value method of SFAS No. 123
should continue to account for non-vested equity awards outstanding at the date
of adoption of SFAS No. 123R in the same manner as they had been accounted
for prior to adoption. SFAS No. 123R specifically prohibits pro forma
disclosures for those awards valued using the minimum value method. The
valuation and recognition provisions of SFAS No. 123R apply to new awards
and to awards outstanding as of the adoption date that are subsequently
modified. The adoption of SFAS No. 123R had a material effect on our
financial position and results of operations. See Note 10 for further
information regarding stock-based compensation expense and the assumptions used
in estimating that expense.
 
 Prior to
the adoption of SFAS No. 123R, we valued our stock-based awards using the
minimum value method and provided pro-forma information regarding stock-based
compensation and net income required by SFAS No. 123. We did not recognize
stock-based compensation expense in our statements of operations for option
grants to our employees or directors for the periods prior to our adoption of
SFAS No. 123R because the exercise price of options granted was generally
equal to the fair market value of the underlying common stock on the date of
grant.
 
 We
account for stock compensation arrangements with non-employees in accordance
with SFAS No. 123R and EITF Issue No. 96-18, “Accounting for Equity
Instruments That Are Issued to Other Than Employees for Acquiring, or in
Conjunction with Selling, Goods or Services”, which require that such equity
instruments are recorded at their fair value on the measurement date. The
measurement of stock-based compensation is subject to periodic adjustment as the
underlying equity instruments vest. Non-employee stock-based compensation
charges are amortized over the vesting period on a straight-line basis. For
stock options granted to non-employees, the fair value of the stock options is
estimated using a Black-Scholes-Merton valuation model.
 
 The
adoption of SFAS No.123R had a material effect on our financial position and
results of operations. See Note 10 of the Notes to Consolidated Financial
Statements, included in Part I, Item 1 of this report, for further information
regarding stock-based compensation expense and the assumptions used in
estimating that expense.
 
 Income
Taxes
 
 We
account for income taxes under the asset and liability method. Deferred tax
assets and liabilities are recognized for the future tax consequences
attributable to differences between the financial statement carrying amounts of
existing assets and liabilities and their respective tax bases and operating
loss and tax credit carryforwards. Deferred tax assets and liabilities are
measured using enacted tax rates expected to apply to taxable income in the
years in which those temporary differences are expected to be recovered or
settled. The effect on deferred tax assets and liabilities of a change in tax
rates is recognized in income in the period that includes the enactment date. A
valuation allowance is recognized if it is more likely than not that some
portion or all of the deferred tax asset will not be recognized.
 Table of Contents
 -24-
 Results
of Operations
 Comparison
of the Three Months  Ended March 31, 2008  and March 31,
2009
 
 License
and Collaboration Revenue
  Total
license and collaboration revenue was $2.6 million for the three months ended
March 31, 2009, compared to $1.5 million for the three months ended March 31,
2008. License and collaboration revenue consisted almost exclusively of amounts
earned under the license and collaboration agreements with Alcon and Galderma
for amortization of the upfront technology access fees, milestones, and other
amounts that have been or will be reimbursed for the funding of research and
development activities performed during the period. The upfront technology
access fee of $10.0 million from Alcon is being amortized into revenue on a
straight-line basis over the four year funding term of the agreement, through
August 2010. The upfront fee of $1.0 million from Galderma is being amortized
into revenue on a straight-line basis over the 20 month funding term of the
agreement, through October 2010.  The upfront technology access fee from
KCI of $200,000 has been amortized on a straight-line basis over 18 months
through December 2008.
  To
the extent we earn milestone payments under the Alcon and Galderma
collaborations, we would expect revenues to increase. We expect to receive
approximately $4.0 million during the 20 month initial period of the Galderma
agreement, inclusive of the $1.0 million initial payment received in March 2009.
However, we cannot predict if and when we will receive any milestone or royalty
payments from these collaborations.
  Research
and Development
  Total
research and development expenses decreased by 47% to $1.4 million for the three
months ended March 31, 2009 from $2.6 million for the three months ended March
31, 2008. The decrease was due to budget reductions at year end 2008 resulting
in decreased headcount, and delayed research, development, and clinical
expenses.  We allocated $208,000 of overhead expenses to research and
development for the first quarter of 2009.
  We
expect to incur increased research and development expenses in 2009 and in
subsequent years as we continue to increase our focus on developing product
candidates, both independently and in collaboration with Alcon and Galderma. In
particular, we expect to incur ongoing clinical, chemistry, and manufacturing
expenses during 2009 in connection with the common cold, dermatology, and
catheter associated urinary tract infections programs.
  General
and Administrative
  Total
general and administrative expenses decreased by 6% to $1.6 million for the
three months ended March 31, 2009 compared to $1.7 million for the three months
ended March 31, 2008. Employee costs decreased as a result of staff reductions
at year end 2008. Professional services costs increased primarily as a result of
increased Sarbanes-Oxley implementation and year end audit costs.
  We
expect that general and administrative expenses will increase during 2009 and in
subsequent years due to increasing public company expenses and business
development costs and our expanding operational infrastructure. In particular,
we expect to incur increasing legal, accounting, investor relations, equity
administration and insurance costs in order to operate as a growing public
company.
  Other
Income, Net
  Other
income, net decreased to $11,000 for the three months ended March 31, 2009 from
$163,000 for the three months ended March 31, 2008. This decrease was
primarily attributable to the liquidation of short term investments in the
fourth quarter of 2008, resulting in less interest income in the first two
months of 2009, until short-term investments were repurchased at the end of
February 2009. Interest income relates primarily to interest earned on cash,
cash equivalents and investments in marketable securities. See “Note 3-Short
Term Investments.”
  We expect that other income, net will vary based on
fluctuationsin our cash balances and borrowings under equipment
loans and the interest rate paid on such balances and
borrowings.
 Table of Contents
 -25-
 Liquidity
and Capital Resources
 
 We
have incurred cumulative net losses of $26.9 million since inception through
March 31, 2009. We do not expect to generate significant revenue from product
candidates for several years. Since inception, we have funded our operations
primarily through the private placement of our preferred stock. We raised total
net proceeds of $12.6 million from sales of our preferred stock in 2002 through
2006. In October 2007, we completed our IPO in which we raised a total of $20.0
million, or approximately $17.1 million in net cash proceeds after deducting
underwriting discounts and commissions of $1.4 million and other offering costs
of $1.5 million.
  In
August 2006, we entered into a collaboration and license agreement with Alcon.
Under the terms of this agreement, we received an up-front technology access fee
of $10.0 million in September 2006. Additionally, we are entitled to receive
semi-annual payments each January and July over the four year term of the
agreement to support on-going research and development efforts. In both January
and July 2007, we received a payment of $1.4 million to support the performance
of research and development activities throughout 2007. The Alcon agreement also
provides for milestone payments upon the achievement of specified milestones in
each field of use and royalty payments upon the sale of commercialized products.
The aggregate milestone payments payable in connection with the ophthalmic, otic
and sinus fields are $19.0 million, $12.0 million and $39.0 million,
respectively. In January 2009, we received $1.0 million for the non-rejection of
an IND application related to its otic indication. However, we cannot predict
when, if ever, future milestones specified in the Alcon agreement will be
achieved or when we will receive royalties on sales of commercialized
products.
  During
April 2007, we entered into a master security agreement to establish a $1.0
million equipment loan facility with a financial institution. The purpose of the
loan is to finance equipment purchases, principally in the build-out of our
laboratory facilities. Borrowings under the loan are secured by eligible
equipment purchased from January 2006 through April 2008 and will be repaid over
40 months at an interest rate equal to the greater of 5.94% over the three year
Treasury rate in effect at the time of funding or 10.45%. There are no loan
covenants specified in the agreement. As of March 31, 2009, we had an
outstanding equipment loan balance of $836,291 carrying a weighted-average
interest rate of 10.95%. The principal and interest due under the loan will be
repaid in equal monthly installments through April 2011. As of March 31,
2009 there was $216,253 available for borrowing under this equipment loan
facility.
  In
March 2009, we entered into a license agreement with Galderma. Under the terms
of the agreement, we have received an initial upfront payment. In addition,
Galderma will pay to Novabay certain upfront fees, ongoing fees, reimbursements,
and milestone payments related to achieving development and commercialization of
its Aganocide® compounds.
  Cash
and Cash Equivalents
  As
of March 31, 2009, we had cash, cash equivalents, and short-term investments of
$12.9 million compared to $12.1 million at December 31, 2008.
  Cash
Flows
  The
following table provides information regarding our cash flows and our capital
expenditures for the three months ended March 31, 2008 and
2009.
 Three
      Months EndedMarch
      31,(in
      thousands)
              
              2008
              
              
              2009Cash
      provided by (used in):Operating
      activities
              
              $
              (1,943
              )
              
              $
              862Investing
      activities
              
              
              2,183
              
              
              
              (2,667
              )Financing
      activities
              
              
              128
              
              
              
              (51
              )Capital
      expenditures (included in investing activities above)
              
              
              (372
              )
              
              
              (27
              )
 
 Cash
Provided by (Used in) Operating Activities
 
 For the three months ended
March 31, 2008 cash used in operating activities of $(2.0 million) was
primarily attributable to our research and development and general
administrative expenses in running our company. For the three months ended March
31, 2009, cash provided by operating activities of $0.9 million, included the
receipt of milestone and other cash payments from collaborative agreements,
which more than offset the expenses in running our
company.
 Table of Contents
 -26-
 Cash
Used in (Provided by)  Investing Activities
 
 For the
three months ended March 31, 2009, cash used in investing activities of
$2.7 million was attributable to purchases of short-term investments (net of
maturities or sales) of $2.7 million and purchases of property and equipment of
$27,000.
 
 For the
three months ended March 31, 2008, cash provided by investing activities of
$2.2 million was attributable to sales or maturities of short-term
investments (net of purchases) of $2.6 million and purchases of property
and equipment of $372,000.
 
 
 Cash
Provided by( Used in) Financing Activities
 
 Net cash
used in financing activities of $51,000 for the three months ended
March 31, 2009 was primarily attributable to the payments on the equipment
loan and capital lease, offset by proceeds from stock issuances related to the
exercise of stock options.
 
 Our
financing activities provided cash of $128,000 in the three months ended March
31, 2008. Our financing activities for the three months ended March 31,
2008 included $202,000 from borrowings under an equipment loan, offset by
$65,000 in principal payments on an equipment loan and $9,000 in payments
on capital leases.
 
 Net
Operating Losses and Tax Credit Carryforwards
 
 As of
December 31, 2008 we had net operating loss carryforwards for both federal and
state income tax purposes of $20 million. If not utilized, the federal and state
net operating loss carryforwards will begin expiring at various dates between
2014 and 2028.
 
 Current
federal and California tax laws include substantial restrictions on the
utilization of net operating loss carryforwards in the event of an ownership
change of a corporation. Accordingly, our ability to utilize net operating loss
carryforwards may be limited as a result of such ownership changes. Such a
limitation could result in the expiration of carryforwards before they are
utilized
 
 Inflation
 
 We do not
believe that inflation has had a material impact on our business and operating
results during the periods presented, and we do not expect it to have a material
impact in the near future. There can be no assurances, however, that our
business will not be affected by inflation.
 
 Off-Balance
Sheet Arrangements
 
 We have no
off-balance sheet arrangements.
 
 Contractual
Obligations
 
 Our
contractual cash commitments as of March 31, 2009 were as follows:
  Less
      than 1
              
              
              
              
              
              
              
              
              More
      than 5Contractual
      Obligations
              
              Total
              
              
              Year
              
              
              1-3
      Years
              
              
              3-5
      Years
              
              
              Years(in
      thousands)Operating
      leases
              
              $
              6,380
              
              
              $
              646
              
              
              $
              2,787
              
              
              $
              2,048
              
              
              $
              899Capital
      leases
              
              
              41
              
              
              
              34
              
              
              
              7
              
              
              
              -
              
              
              
              -Equipment
      loans
              
              
              835
              
              
              
              -
              
              
              
              835
              
              
              
              -
              
              
              
              -$
              7,256
              
              
              $
              680
              
              
              $
              3,629
              
              
              $
              2,048
              
              
              $
              899
 
 
 Our
commitments under the operating leases shown above consist of payments relating
to five leases for laboratory and office space in one office building in
Emeryville, California. These leases expire on various dates through October 31,
2015.
 
 Our
commitment under the capital lease shown above consists of the total payments
due under one lease of laboratory equipment. This amount includes $2,159 of
interest payments over the remaining term of the lease.
 
 Our
commitment under the equipment loan shown above consists of the total payments
due under the loan facility. This amount includes $86,590 of interest payments
over the remaining term of the loan.
 
 We
believe our cash balance at March 31, 2009 is sufficient to fund our projected
operating requirements through at least the next twelve months. However, we will
need to raise additional capital or incur indebtedness to continue to fund our
operations in the future. Our future capital requirements will depend on many
factors, including:
 
 Table of Contents
 -27-
 •
              the
      scope, rate of progress and cost of our pre-clinical studies and clinical
      trials and other research and development
  activities;
 
 •
              future
      clinical trial results;
 
 •
              the
      terms and timing of any collaborative, licensing and other arrangements
      that we may establish;
 
 •
              the
      cost and timing of regulatory
approvals;
 
 •
              the
      cost of establishing clinical and commercial supplies of our product
      candidates and any products that we may
develop;
 
 •
              the
      effect of competing technological and market
  developments;
 
 •
              the
      cost of filing, prosecuting, defending and enforcing any patent claims and
      other intellectual property rights;
and
 
 •
              the
      extent to which we acquire or invest in businesses, products and
      technologies, although we currently have no commitments or agreements
      relating to any of these types of
transactions.
 
 We do not
anticipate that we will generate significant product revenue for a number of
years. Until we can generate a sufficient amount of product revenue, if ever, we
expect to finance future cash needs through public or private equity offerings,
debt financings or corporate collaboration and licensing arrangements, as well
as through interest income earned on cash balances and short-term investments.
To the extent that we raise additional funds by issuing equity securities, our
shareholders may experience dilution. In addition, debt financing, if available,
may involve restrictive covenants. To the extent that we raise additional funds
through collaboration and licensing arrangements, it may be necessary to
relinquish some rights to our technologies or product candidates, or grant
licenses on terms that are not favorable to us. If adequate funds are not
available, we may be required to delay, reduce the scope of or eliminate one or
more of our research or development programs or to obtain funds through
collaborations for some of our technologies or product candidates that we would
otherwise seek to develop on our own. Such collaborations may not be on
favorable terms or they may require us to relinquish rights to our technologies
or product candidates.
 
 ITEM 3.
              QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET
      RISK
 
 Our
market risk consists principally of interest rate risk on our cash, cash
equivalents, and short-term investments. Our exposure to market risk is limited
primarily to interest income sensitivity, which is affected by changes in
interest rates, particularly because the majority of our investments are in
short-term debt securities.
 
 Our
investment policy restricts our investments to high-quality investments and
limits the amounts invested with any one issuer, industry, or geographic area.
The goals of our investment policy are as follows: preservation of capital;
assurance of liquidity needs; best available return on invested capital; and
minimization of capital taxation. Some of the securities in which we invest may
be subject to market risk. This means that a change in prevailing interest rates
may cause the principal amount of the investment to fluctuate. For example, if
we hold a security that was issued with an interest rate fixed at the
then-prevailing rate and the prevailing interest rate later rises, the principal
amount of our investment will probably decline. To minimize this risk, in
accordance with our investment policy, we maintain our cash and cash equivalents
in short-term marketable securities, including money market mutual funds,
Treasury bills, Treasury notes, commercial paper, and corporate and municipal
bonds. The risk associated with fluctuating interest rates is limited to our
investment portfolio. Due to the short term nature of our investment portfolio,
we believe we have minimal interest rate risk arising from our investments. We
do not use derivative financial instruments in our investment portfolio. We do
not hold any instruments for trading purposes.
 
 To date,
we have operated exclusively in the United States and have not had any material
exposure to foreign currency rate fluctuations. We have recently formed a
wholly-owned subsidiary, which is incorporated under the laws of British
Columbia (Canada), which may conduct research and development activities in
Canada. To the extent we conduct operations in Canada, fluctuations in the
exchange rates of the U.S. and Canadian currencies may affect our operating
results.
 
 Table of Contents
 -28-
 ITEM4. CONTROLS AND PROCEDURES
 
 Evaluation
of Disclosure Controls and Procedures
 
 As of the
end of the period covered by this report, the Company carried out an evaluation,
under the supervision and with the participation of our management, including
our Chief Executive Officer and Chief Financial Officer, of the effectiveness of
our disclosure controls and procedures pursuant to Rule 13a-15 and 15d-15 of the
Securities Exchange Act of 1934, as amended (the “Exchange Act”). Based upon
that evaluation, our Chief Executive Officer and our Chief Financial Officer
concluded that our disclosure controls and procedures were effective to ensure
that information required to be disclosed by us in the reports that we file or
submit under the Exchange Act is recorded, processed, summarized and reported
within the time periods specified in the SEC’s rules and forms and were
effective in ensuring that information required to be disclosed by us in the
reports that we file or submit under the Exchange Act was accumulated and
communicated to our management, including our Chief Executive Officer and Chief
Financial Officer, as appropriate, to allow timely decisions regarding required
disclosure.
 
 
 A control
system, no matter how well conceived and operated, can provide only reasonable,
not absolute, assurance that the objectives of the control system are met.
Further, the design of a control system must reflect the fact that there are
resource constraints, and the benefits of controls must be considered relative
to their costs. Assessing the costs and benefits of such controls and procedures
necessarily involves the exercise of judgment by management. Because of the
inherent limitations in all control systems, no evaluation of controls can
provide absolute assurance that all control issues and instances of fraud, if
any, have been detected.
 
 Changes
in Internal Control Over Financial Reporting
 
 Our
management, including our Chief Executive Officer and Chief Financial Officer,
has evaluated any changes in our internal control over financial reporting
that occurred during the quarter ended March 31, 2009, and has concluded that
there was no change during the quarter that has materially affected, or is
reasonably likely to materially affect, our internal control over financial
reporting.
 PART II. OTHER INFORMATION
 
 ITEM 1. LEGAL PROCEEDINGS
 Novabay is currently not a party to, nor is its property the subject
matter of, any pending or, to its knowledge, contemplated material legal
proceedings.  From time to time, it may become party to litigation and
subject to claims arising in the ordinary course of its
business.
 
 ITEM
1A. RISK FACTORS
 
 The
risk factors facing our company have not changed materially from those set forth
in Part I, Item 1A of our Annual Report on Form 10-K for the year ended December
31, 2008, as filed with the SEC on March 31, 2009.
 
 Our
business is subject to a number of risks, the most important of which are
discussed below. You should consider carefully the following risks in addition
to the other information contained in this report and our other filings with the
SEC when assessing our business and the forward-looking statements made in this
Quarterly Report on Form 10-Q.  The risks and uncertainties described
below are not the only ones facing our business.. Additional risks and
uncertainties not presently known to us or that we currently believe are not
important may also impair our business operations. If any of the following risks
actually occur, our business, financial condition or results of operations could
be materially adversely affected.
 Table of Contents
 -29-
  Risks
Relating to Our Business
 
 Current
worldwide economic conditions may limit our access to capital, adversely affect
our business and financial condition, as well as further decrease our stock
price.
 
 General
worldwide economic conditions have experienced a downturn due to the effects of
the subprime lending crisis, general credit market crisis, collateral effects on
the finance and banking industries, concerns about inflation, slower economic
activity, decreased consumer confidence, reduced corporate profits and capital
spending, adverse business conditions and liquidity concerns. Although the
impact of the downturn on our business is uncertain at this time, downturn may
adversely affect our business and operations in a number of ways, including it
more difficult for us to raise capital as well as make it more difficult to
enter into collaboration agreements with other parties. Like many other stocks,
our stock price has been subject to fluctuations and has decreased substantially
in recent months. Our stock price could further decrease due to concerns that
our business, operating results and financial condition will be negatively
impacted by a worldwide economic downturn.
 We
may be unable to raise additional capital on acceptable terms in the future
which may in turn limit our ability to develop and commercialize products and
technologies.
 
 We expect
our capital outlays and operating expenditures to substantially increase over at
least the next several years as we expand our product pipeline and increase
research and development efforts and clinical and regulatory activities.
Conducting clinical trials is very expensive, and we expect that we will need to
raise additional capital, through future private or public equity offerings,
strategic alliances or debt financing, before we achieve commercialization of
any of our Aganocide compounds. In addition, we may require even more
significant capital outlays and operating expenditures if we do not continue
to  partner with third parties to develop and commercialize our
products.
 
 Our
future capital requirements will depend on many factors, including:
 
 •
                the
      scope, rate of progress and cost of our pre-clinical studies and clinical
      trials and other research and development activities;•
                future
      clinical trial results;•
                the
      terms and timing of any collaborative, licensing and other arrangements
      that we may establish;•
                the
      cost and timing of regulatory approvals;•
                the
      cost of establishing clinical and commercial supplies of our product
      candidates and any products that we may develop;•
                the
      effect of competing technological and market developments;•
                the
      cost of filing, prosecuting, defending and enforcing any patent claims and
      other intellectual property rights; and•
                the
      extent to which we acquire or invest in businesses, products and
      technologies, although we currently have no commitments or agreements
      relating to any of these types of
transactions.
  Table of Contents
 -30-
  We do not
currently have any commitments for future external funding. Additional financing
may not be available on favorable terms, or at all. Our ability to obtain
additional financing may be negatively affected by the recent volatility in the
financial markets and the credit crisis, as well as the general downturn in the
economy and decreased consumer confidence. Even if we succeed in selling
additional securities to raise funds, our existing shareholders’ ownership
percentage would be diluted and new investors may demand rights, preferences or
privileges senior to those of existing shareholders. If we raise additional
capital through strategic alliance and licensing arrangements, we may have to
trade our rights to our technology, intellectual property or products to others
on terms that may not be favorable to us. If we raise additional capital through
debt financing, the financing may involve covenants that restrict our business
activities.
 
 In
addition, it is often the case that the cost of pharmaceutical development can
be significantly greater than initially anticipated. This may be due to any of a
large number of possible reasons, some of which could have been anticipated,
while others may be caused by unpredictable circumstances. A significant
increase in our costs would cause the amount of financing that would be required
to enable us to achieve our goals to be likewise increased.
 
 If we
determine that we need to raise additional funds and we are not successful in
doing so, we may be unable to complete the clinical development of some or all
of our product candidates or to seek or obtain FDA approval of our product
candidates. Such events could force us to discontinue product development, enter
into a relationship with a strategic partner earlier than currently intended,
reduce sales and marketing efforts or forego attractive business
opportunities.
 We
are an early stage company with a history of losses. We expect to incur net
losses for the foreseeable future and we may never achieve or maintain
profitability.
 
 We have incurred net losses since our
 inception. For the years ended December 31, 2006, 2007 and
2008 we had net losses of approximately $5.3 million, $5.4 million, and
$8.1 million, respectively. Through March 31, 2009, we had an accumulated
deficit of approximately $26.9 million. We have been, and expect to remain for
the foreseeable future, mostly in a research and development stage. Since our
inception, we have not generated revenue, except for modest revenue in 2006,
2007, 2008 and first three months of 2009 relating to three research and
development collaboration and license agreements. We have incurred substantial
research and development expenses, which were approximately $4.1 million, $7.4
million, and $9.6 million for the years ended December 31, 2006, 2007, and
2008, respectively and $1.4 million for the three months ended March 31,
2009.  We expect to continue to make, for at least the next several
years, significant expenditures for the development of products that incorporate
our Aganocide compounds, as well as continued research into the biological
activities of our Aganocide compounds, which expenditures are accounted for as
research and development expenses. We do not expect any of our current
product candidates to be commercialized within the next several years, if at
all.  We expect to continue to incur substantial losses for the
foreseeable future, and we may never become profitable. We anticipate that our
expenses will increase substantially in the foreseeable future as
we:
 •
                  conduct
      pre-clinical studies and clinical trials for our product candidates in
      different indications;•
                  conduct
      pre-clinical studies and clinical trials for our product candidates in
      different indications;•
                  develop,
      formulate, manufacture and commercialize our product candidates either
      independently or with partners;•
                  pursue,
      acquire or in-license additional compounds, products or technologies, or
      expand the use of our technology;•
                  maintain,
      defend and expand the scope of our intellectual property; and•
                  hire
      additional qualified personnel.
 We will
need to generate significant revenues to achieve and maintain profitability. If
we cannot successfully develop, obtain regulatory approval for and commercialize
our product candidates, either independently or with partners, we will not be
able to generate such revenues or achieve or maintain profitability in the
future. Our failure to achieve and subsequently maintain profitability could
have a material adverse impact on the market price of our common
stock.
 Table of Contents
 -31-
 
 We
have very limited data on the use of our products in humans and will need to
perform costly and time consuming clinical trials in order to bring our products
to market.
 
 Most of
the data that we have on our products is from in-vitro (laboratory) studies or
in-vivo animal studies and our human data is from Phase I safety studies or
small-scale Phase IIa exploratory- studies. We will need to conduct Phase I, II
and III human clinical trials to confirm such results in order to obtain
approval from the FDA of our drug product candidates. Often, positive in-vitro
or in-vivo animal studies arc not followed by positive results in human clinical
trials, and we may not be able to demonstrate that our products arc safe and
effective for indicated uses in humans. In addition, for each indication, we
estimate that it will take between three and five years to conduct the necessary
clinical trials.
 
 We
currently do not have any marketable products, and if we are unable to develop
and obtain regulatory approval for products that we develop, we may never
generate product revenues.
 
 To date,
our revenues have been derived solely from research and development
collaboration and license agreements. We have never generated revenues from
sales of products and we cannot guarantee that we will ever have marketable
drugs or other products. Satisfaction of all regulatory requirements applicable
to our product candidates typically takes many years, is dependent upon the
type, complexity, novelty and classification of the product candidates, and
requires the expenditure of substantial resources for research and development
and testing. Before proceeding with clinical trials, we will conduct
pre-clinical studies, which may, or may not be, valid predictors of potential
outcomes in humans. If pre-clinical studies are favorable, we will then begin
clinical trials. We must demonstrate that our product candidates satisfy
rigorous standards of safety and efficacy before we can submit for and gain
approval from the FDA and regulatory authorities in other countries. In
addition, to compete effectively, our products will need to be easy to use,
cost-effective and economical to manufacture on a commercial scale. We may not
achieve any of these objectives. We cannot be certain that the clinical
development of any of our current product candidates or any other product that
we may develop in the future will be successful, that they will receive the
regulatory approvals required to commercialize them, or that any of our other
in-licensing efforts or pre-clinical testing will yield a product suitable for
entry into clinical trials. Our commercial revenues from sales of products will
be derived from sales of products that may not be commercially available for at
least the next several years, if at all.
 We
have limited experience in developing drugs and medical devices, and we may be
unable to commercialize any of the products we develop.
 
 Development
and commercialization of drugs and medical devices involves a lengthy and
complex process. We have limited experience in developing products and have
never commercialized, any of our product candidates. In addition, no one has
ever developed or commercialized a product based on our Aganocide compounds, and
we cannot assure you that it is possible to develop, obtain regulatory approval
for or commercialize any products based on these compounds or that we will be
successful in doing so.
 
 Before we
can develop and commercialize any new products, we will need to expend
significant resources to:
  •
                undertake and complete
      clinical trials to demonstrate the efficacy and safety of our product
      candidates;•
                maintain and expand our
      intellectual property rights;•
                obtain marketing and other
      approvals from the FDA and other regulatory agencies; and•
                select collaborative
      partners with suitable manufacturing and commercial
      capabilities.
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  The
process of developing new products takes several years. Our product development
efforts may fail for many reasons, including:
 
 •
              the
      failure of our product candidates to demonstrate safety and
      efficacy;
 
 •
              the
      high cost of clinical trials and our lack of financial and other
      resources; and
 
 •
              our
      inability to partner with firms with sufficient resources to assist us in
      conducting clinical trials.
 
 Success
in early clinical trials often is not replicated in later studies, and few
research and development projects result in commercial products. At any point,
we may abandon development of a product candidate or we may be required to
expend considerable resources repeating clinical trials, which would eliminate
or adversely impact the timing for revenues from those product candidates. If a
clinical study fails to demonstrate the safety and effectiveness of our product
candidates, we may abandon the development of the product or product feature
that was the subject of the clinical trial, which could harm our
business.
 
 Even if
we develop products for commercial use, these products may not be accepted by
the medical and pharmaceutical marketplaces or be capable of being offered at
prices that will enable us to become profitable. We cannot assure you that our
products will be approved by regulatory authorities or ultimately prove to be
useful for commercial markets, meet applicable regulatory standards, or be
successfully marketed.
 We
must maintain and expand expensive finance and accounting systems, procedures
and controls in order to grow our business and organization, which will increase
our costs and require additional management resources.
 
 We
completed our initial public offering, or IPO, in October 2007. As a public
reporting company, we are required to comply with the Sarbanes-Oxley Act of 2002
and the related rules and regulations of the SEC and Canadian securities
regulatory authorities, including expanded disclosure and accelerated reporting
requirements and more complex accounting rules. We are also required to comply
with marketplace rules and the heightened corporate governance standards of the
NYSE Amex. Compliance with these rules has been expensive, and there are
additional rules with which we have not yet needed to comply but which we will
need to comply with in the future.  For example, for this Form 10-K we
are not required to have our independent auditors audit our internal control
over financial reporting, but next year we will be required to do so. If our
independent registered public accounting firm is unable to provide us with an
unqualified report as to the effectiveness of our internal control over
financial reporting as of the date of our Annual Report on Form 10-K for 2009,
or our business grows and we are not able to comply with accelerated reporting
obligations, our ability to obtain additional financing could be impaired. In
addition, investors could lose confidence in the reliability of our internal
control over financial reporting and in the accuracy of our periodic reports
filed with the SEC and with Canadian securities regulatory authorities. A lack
of investor confidence in the reliability and accuracy of our public reporting
could cause our stock price to decline.
 
 If
we do not maintain our current research collaborations with Alcon and Galderma,
and enter into additional collaborations, a portion of our funding may decrease
and inhibit our ability to develop new products.
 
 We have
entered into a collaborative arrangement with Alcon, and we rely on Alcon for
joint intellectual property creation and for substantially all of our near-term
revenues. Under the agreement, we licensed to Alcon the exclusive rights (except
for certain retained marketing rights) to develop, manufacture and commercialize
products incorporating the Aganocide compounds for application in connection
with the eye, ear and sinus and for use in contact lens solutions. We also
recently entered into an agreement with Galderma S.A. to develop and
commercialize our Aganocide® compounds, which covers acne and impetigo and
potentially other major dermatological conditions, excluding onychomycosis (nail
fungus) and orphan drug indications.
 
 We cannot
assure you that our collaborations with Alcon or Galderma or any other
collaborative arrangement will be successful, or that we will receive the full
amount of research funding, milestone payments or royalties, or that any
commercially valuable intellectual property will be created, from these
arrangements. If Alcon or Galderma were to breach or terminate its agreement
with us or otherwise fail to conduct its collaborative activities successfully
and in a timely manner, the research contemplated by our collaboration with them
could be delayed or terminated and our costs of performing studies may increase.
We plan on entering into additional collaborations and licensing arrangements.
We may not be able to negotiate additional collaborations on acceptable terms,
if at all, and these collaborations may not be successful. Our current and
future success depends in part on our ability to enter into successful
collaboration arrangements and maintain the collaboration arrangement we
currently have. If we are unable to enter into, maintain or extend successful
collaborations, our business may be harmed.
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  Our
long-term success depends upon the successful development and commercialization
of other products from our research and development activities
 
 Our
long-term viability and growth will depend upon the successful development and
commercialization of other products from our research and development
activities. Product development and commercialization is very expensive and
involves a high degree of risk. Only a small number of research and development
programs result in the commercialization of a product. Success in early stage
clinical trials or preclinical work does not ensure that later stage or larger
scale clinical trials will be successful. Even if later stage clinical trials
are successful, the risk remains that unexpected concerns may arise from
additional data or analysis or that obstacles may arise or issues may be
identified in connection with review of clinical data with regulatory
authorities or that regulatory authorities may disagree with our view of the
data or require additional data or information or additional
studies.
 
 Conducting
clinical trials is a complex, time-consuming and expensive process. Our ability
to complete our clinical trials in a timely fashion depends in large part on a
number of key factors including protocol design, regulatory and institutional
review board approval, the rate of patient enrollment in clinical trials, and
compliance with extensive current good clinical practice requirements. We are in
many cases using the services of third-party contract clinical trial providers.
If we fail to adequately manage the design, execution and regulatory aspects of
our clinical trials, our studies and ultimately our regulatory approvals may be
delayed or we may fail to gain approval for our product candidates
altogether.
 
 If
we do not successfully execute our growth initiatives through the acquisition,
partnering and in-licensing of products, technologies or companies, our future
performance could be adversely affected.
 
 In
addition to the expansion of our pipeline through spending on internal
development projects, we anticipate growing through external growth
opportunities, which include the acquisition, partnering and in-licensing of
products, technologies and companies or the entry into strategic alliances and
collaborations. If we are unable to complete or manage these external growth
opportunities successfully, we may not be able to grow our business in the way
that we currently expect. The availability of high quality opportunities is
limited and we are not certain that we will be able to identify suitable
candidates or complete transactions on terms that are acceptable to us. In order
to pursue such opportunities, we may require significant additional financing,
which may not be available to us on favorable terms, if at all. The availability
of such financing is limited by the recent tightening of the global credit
markets.
 We
may acquire other businesses or form joint ventures or in-license compounds that
could disrupt our business, harm our operating results, dilute your ownership
interest in us, or cause us to incur debt or significant expense.
 
 As part
of our business strategy, we may pursue acquisitions of complementary businesses
and assets, and enter into technology or pharmaceutical compound licensing
arrangements. We also may pursue strategic alliances that leverage our core
technology and industry experience to enhance our ability to commercialize our
product candidates and expand our product offerings or distribution. We have no
experience with respect to acquiring other companies and limited experience with
respect to the formation of commercial partnering agreements, strategic
alliances, joint ventures or in-licensing of compounds. If we make any
acquisitions, we may not be able to integrate these acquisitions successfully
into our existing business, and we could assume unknown or contingent
liabilities. If we in-license any additional compounds, we may fail to develop
the product candidates, and spend significant resources before determining
whether a compound we have in-licensed will produce revenues. Any future
acquisitions or in-licensing by us also could result in significant write-offs
or the incurrence of debt and contingent liabilities, any of which could harm
our operating results. Integration of an acquired company also may require
management resources that otherwise would be available for ongoing development
of our existing business. We may not identify or complete these transactions in
a timely manner, on a cost-effective basis, or at all, and we may not realize
the anticipated benefits of any acquisition, technology license, strategic
alliance or joint venture.
 
 To
finance any acquisitions, we may choose to issue shares of our common stock as
consideration, which would dilute your interest in us. If the price of our
common stock is low or volatile, we may not be able to acquire other companies
for stock. Alternatively, it may be necessary for us to raise additional funds
for acquisitions by incurring indebtedness. Additional funds may not be
available on terms that are favorable to us, or at all.
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 -34-
  We
do not have our own manufacturing capacity, and we plan to rely on partnering
arrangements or third-party manufacturers for the manufacture of our potential
products.
 
 We do not
currently operate manufacturing facilities for clinical or commercial production
of our product NeutroPhase and other product candidates. We have no experience
in drug formulation or manufacturing, and we lack the resources and the
capabilities to manufacture NeutroPhase or any of our product candidates on a
clinical or commercial scale. As a result, we have partnered and expect to
partner with third parties to manufacture our products or rely on contract
manufacturers to supply, store and distribute product supplies for our clinical
trials. Any performance failure on the part of our commercial partners or
future manufacturers could delay clinical development or regulatory approval of
our product candidates or commercialization of our products, producing
additional losses and reducing the potential for product revenues.
 
 Our
products, if developed and commercialized, will require precise, high quality
manufacturing. The failure to achieve and maintain high manufacturing standards,
including the incidence of manufacturing errors, could result in patient injury
or death, product recalls or withdrawals, delays or failures in product testing
or delivery, cost overruns or other problems that could seriously harm our
business. Contract manufacturers and partners often encounter difficulties
involving production yields, quality control and quality assurance, as well as
shortages of qualified personnel. These manufacturers and partners are subject
to ongoing periodic unannounced inspection by the FDA and corresponding state
agencies to ensure strict compliance with current Good Manufacturing Practice
and other applicable government regulations and corresponding foreign standards;
however, we do not have control over third-party compliance with these
regulations and standards. If any of our manufacturers or partners fails to
maintain compliance, the production of our products could be interrupted,
resulting in delays, additional costs and potentially lost
revenues.
 
 In
addition, if the FDA or other regulatory agencies approve any of our product
candidates for commercial sale, we will need to manufacture them in larger
quantities. Significant scale-up of manufacturing will require validation
studies, which the FDA must review and approve. If we are unable to successfully
increase the manufacturing capacity for a product, the regulatory approval or
commercial launch of any drugs may be delayed or there may be a shortage in
supply and our business may be harmed as a result.
 
 We
depend on skilled and experienced personnel to operate our business effectively.
If we are unable to recruit, hire and retain these employees, our ability to
manage and expand our business will be harmed, which would impair our future
revenue and profitability.
 
 Our
success largely depends on the skills, experience and efforts of our officers,
especially our Chief Executive Officer, Chief Financial Officer, Vice President
of Research and Development, Vice President of Medical Affairs, and other key
employees. The efforts of each of these persons is critical to us as we continue
to develop our technologies and as we attempt to transition into a company with
commercial products. Any of our officers and other key employees may terminate
their employment at any time. The loss of any of our senior management team
members could weaken our management expertise and harm our ability to compete
effectively, develop our technologies and implement our business
strategies.
 
 Our
ability to retain our skilled labor force and our success in attracting and
hiring new skilled employees will be a critical factor in determining whether we
will be successful in the future. Our research and development programs and
collaborations depend on our ability to attract and retain highly skilled
scientists and technicians. We may not be able to attract or retain qualified
scientists and technicians in the future due to the intense competition for
qualified personnel among life science businesses, particularly in the San
Francisco Bay Area. We also face competition from universities and public and
private research institutions in recruiting and retaining highly qualified
scientific personnel. We have also encountered difficulties in recruiting
qualified personnel from outside the San Francisco Bay Area, due to the high
housing costs in the area.
 Table of Contents
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  If
we fail to manage our growth effectively, we may be unable to execute our
business plan.
 
 Our
future growth, if any, may cause a significant strain on our management, and our
operational, financial and other resources. Our ability to manage our growth
effectively will require us to implement and improve our operational, financial
and management information systems and to expand, train, manage and motivate our
employees. These demands may require the hiring of additional management
personnel and the development of additional expertise by management. Any
increase in resources devoted to research and product development without a
corresponding increase in our operational, financial and management information
systems could have a material adverse effect on our business, financial
condition, and results of operations.
 
 If
our facilities become inoperable, we will be unable to perform our research and
development activities, fulfill the requirements under our collaboration
agreement and continue developing products and, as a result, our business will
be harmed.
 
 We do not
have redundant laboratory facilities. We perform substantially all of our
research, development and testing in our laboratory located in Emeryville,
California. Emeryville is situated on or near active earthquake fault lines. Our
facility and the equipment we use to perform our research, development and
testing would be costly to replace and could require substantial lead time to
repair or replace. The facility may be harmed or rendered inoperable by natural
or man-made disasters, including earthquakes, flooding and power outages, which
may render it difficult or impossible for us to perform our research,
development and testing for some period of time. The inability to perform our
research and development activities may result in the loss of partners or harm
our reputation, and we may be unable to regain those partnerships in the future.
Our insurance coverage for damage to our property and the disruption of our
business may not be sufficient to cover all of our potential losses, including
the loss of time as well as the costs of lost opportunities, and may not
continue to be available to us on acceptable terms, or  at
all.
 
 Obtaining regulatory approval in the
United States does not ensure we will obtain regulatory approval in other
countries.
 
 We will
aim to obtain regulatory approval in the United States as well as in other
countries. To obtain regulatory approval to market our proposed products outside
of the United States, we and any collaborator must comply with numerous and
varying regulatory requirements in other countries regarding safety and
efficacy. Approval procedures vary among countries and can involve additional
product testing and additional administrative review periods. The time required
to obtain approval in other countries might differ significantly from that
required to obtain FDA approval. The regulatory approval process in other
countries include all of the risk associated with FDA approval as well as
additional, presently unanticipated risks. Regulatory approval in one country
does not ensure regulatory approval in another, but a failure or delay in
obtaining regulatory approval in one country may negatively impact the
regulatory process in others. Failure to obtain regulatory approval in other
countries or any delay or setback in obtaining such approval could have the same
adverse effects associated with regulatory approval in the United States,
including the risk that our product candidates may not be approved for all
indications requested and that such approval may be subject to limitations on
the indicated uses for which the product may be marketed. In addition, failure
to comply with applicable regulatory requirements in other countries can result
in, among other things, warning letters, fines, injunctions, civil penalties,
recall or seizure of products, total or partial suspension of production,
refusal of the government to renew marketing applications and criminal
prosecution.
 
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 -36-
 If
we are unable to design, conduct and complete clinical trials successfully, we
will not be able to obtain regulatory approval for our products.
 
 In order
to obtain FDA approval for our drug product candidates, we must submit to the
FDA a New Drug Application, or NDA, demonstrating that the product candidate is
safe and effective for its intended use. This demonstration requires significant
research and animal tests, which are referred to as preclinical studies, as well
as human tests, which are referred to as clinical trials.
 
 Any
clinical trials we conduct or that are conducted by our partners may not
demonstrate the safety or efficacy of our product candidates. Success in
pre-clinical testing and early clinical trials does not ensure that later
clinical trials will be successful. Results of later clinical trials may not
replicate the results of prior clinical trials and pre-clinical testing. Even if
the results of one or more of our clinical trials are positive, we may have to
commit substantial time and additional resources to conducting further
preclinical studies or clinical trials before we can submit NDAs or obtain FDA
approvals for our product candidates, and positive results of a clinical trial
may not be replicated in subsequent trials.
 
 Clinical
trials are very expensive and difficult to design and implement. The clinical
trial process is also time-consuming. Furthermore, if participating patients in
clinical studies suffer drug-related adverse reactions during the course of such
trials, or if we or the FDA believe that participating patients are being
exposed to unacceptable health risks, we will have to suspend or terminate our
clinical trials. Failure can occur at any stage of the trials, and we could
encounter problems that cause us to abandon clinical trials or to repeat
clinical studies.
 
 In
addition, the completion of clinical trials can be delayed by numerous factors,
including:
 
 •
              delays
      in identifying and agreeing on acceptable terms with prospective clinical
      trial sites;•
              slower
      than expected rates of patient recruitment and enrollment;•
              increases
      in time required to complete monitoring of patients during or after
      participation in a trial; and•
              unexpected
      need for additional patient-related
data.
 
 
 Any of
these delays, if significant, could impact the timing, approval and
commercialization of our product candidates and could significantly increase our
overall costs of drug development.
 
 Even if
our clinical trials are completed as planned, their results may not support our
expectations or intended marketing claims. The clinical trials process may fail
to demonstrate that our products are safe and effective for indicated uses. Such
failure would cause us to abandon a product candidate for some indications and
could delay development of other product candidates.
 
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 -37-
 Government
agencies may establish usage guidelines that directly apply to our proposed
products or change legislation or regulations to which we are
subject.
 
 Government
usage guidelines typically address matters such as usage and dose, among other
factors. Application of these guidelines could limit the use of products that we
may develop. In addition there can be no assurance that government regulations
applicable to our proposed products or the interpretation thereof will not
change and thereby prevent the marketing of some or all of our products for a
period of time or permanently. The FDA’s policies may change and additional
government regulations may be enacted that could prevent or delay regulatory
approval of our product candidates. We cannot predict the likelihood, nature or
extent of adverse government regulation that may arise from future legislation
or administrative action, either in the United States or in other
countries.
 
 Our
product candidates may be classified as a drug or a medical device, depending on
the mechanism of action, indication for use and prior precedent, and a change in
the classification may have an adverse impact on our revenues or our ability to
obtain necessary regulatory approvals.
 
 Several
potential indications for our product candidates may be regulated under the
medical device regulations of the FDA administered by the Center for Devices and
Radiological Health and the same physical product may be regulated by the FDA’s
Center for Drug Evaluation and Research for another indication. Our products may
be classified by the FDA as a drug or a medical device depending upon their
mechanism of action, indications for use or claims. For example, for NVC-422, if
the indication is for bladder lavage, we believe it would be classified as a
medical device, whereas we believe it would be considered a drug when it is
indicated for the prevention of urinary tract infection. Similarly, the use of
NVC-101 as a solution for cleansing and debriding wounds is considered a medical
device. The determination as to whether a particular indication is considered a
drug or a device is based in part upon prior precedent. A reclassification by
the FDA of an indication from a device to a drug indication during our
development for that indication could have a significant adverse impact due to
the more rigorous approval process required for drugs, as compared to medical
devices. Such a change in classification can significantly increase development
costs and prolong the time for development and approval, thus delaying revenues.
A reclassification of an indication after approval from a drug to a device could
result in a change in classification for reimbursement. In many cases,
reimbursement for devices is significantly lower than for drugs and there could
be a significant negative impact on our revenues.
 
 We
and our collaborators are and will be subject to ongoing FDA obligations and
continued regulatory review, such as continued safety reporting requirements,
and we and our collaborators may also be subject to additional FDA
post-marketing obligations or new regulations, all of which may result in
significant expense and which may limit our ability to commercialize our medical
device and drug products candidates.
 
 Any
regulatory approvals that we receive may also be subject to limitations on the
indicated uses for which the product may be marketed or contain requirements for
potentially costly post-marketing follow-up studies. The FDA may require us to
commit to perform lengthy Phase IV post-approval studies (as further described
below), for which we would have to expend additional resources, which could have
an adverse effect on our operating results and financial condition. In addition,
if the FDA approves any of our drug product candidates, the labeling, packaging,
adverse event reporting, storage, advertising, promotion and record keeping for
the drug will be subject to extensive regulatory requirements. The subsequent
discovery of previously unknown problems with the drugs, including adverse
events of unanticipated severity or frequency, may result in restrictions on the
marketing of the drugs or the withdrawal of the drugs from the market. If we are
not able to maintain regulatory compliance, we may be subject to fines,
suspension or withdrawal of regulatory approvals, product recalls, seizure of
products, operating restrictions and criminal prosecution. Any of these events
could prevent us from marketing any products we may develop and our business
could suffer.
 
 Conducting
clinical trials of our product candidates may expose us to expensive liability
claims, and we may not be able to maintain liability insurance on reasonable
terms or at all.
 
 The risk
of clinical trial liability is inherent in the testing of pharmaceutical and
medical device products. If we cannot successfully defend ourselves against any
clinical trial claims, we may incur substantial liabilities or be required to
limit or terminate testing of one or more of our product candidates. Our
inability to obtain sufficient clinical trial insurance at an acceptable cost to
protect us against potential clinical trial claims could prevent or inhibit the
commercialization of our product candidates. Our current clinical trial
insurance covers individual and aggregate claims up to $3.0 million. This
insurance may not cover all claims and we may not be able to obtain additional
insurance coverage at a reasonable cost, if at all, in the future. In addition,
if our agreements with any future corporate collaborators entitle us to
indemnification against product liability losses and clinical trial liability,
such indemnification may not be available or adequate should any claim
arise.
  Table of Contents
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 If
we use biological and hazardous materials in a manner that causes injury, we
could be liable for damages. Compliance with environmental regulations can
be expensive, and noncompliance with these regulations may result in adverse
publicity and potentially significant monetary damages and fines.
 
 Our
activities currently require the controlled use of potentially harmful
biological materials and other hazardous materials and chemicals and may in the
future require the use of radioactive compounds. We cannot eliminate the risk of
accidental contamination or injury to employees or third parties from the use,
storage, handling or disposal of these materials. In the event of contamination
or injury, we could be held liable for any resulting damages, and any liability
could exceed our resources or any applicable insurance coverage we may have.
Additionally, we are subject, on an ongoing basis, to U.S. federal, state and
local laws and regulations governing the use, storage, handling and disposal of
these materials and specified waste products. The cost of compliance with these
laws and regulations might be significant and could negatively affect our
operating results. In addition, if more stringent laws and regulations are
adopted in the future, the costs of compliance with these new laws and
regulations could be substantial or could impose significant changes in our
testing and production process.
 
 The
pharmaceutical and biopharmaceutical industries are characterized by patent
litigation and any litigation or claim against us may cause us to incur
substantial costs, and could place a significant strain on our financial
resources, divert the attention of management from our business and harm our
reputation.
 
 There has
been substantial litigation in the pharmaceutical and biopharmaceutical
industries with respect to the manufacture, use and sale of new products that
are the subject of conflicting patent rights. For the most part, these lawsuits
relate to the validity, enforceability and infringement of patents. Generic
companies are encouraged to challenge the patents of pharmaceutical products in
the United States because a successful challenger can obtain nine months of
exclusivity as a generic product under the Waxman-Hatch Act. We expect that we
will rely upon patents, trade secrets, know-how, continuing technological
innovations and licensing opportunities to develop and maintain our competitive
position and we may initiate claims to defend our intellectual property rights
as a result. Other parties may have issued patents or be issued patents that may
prevent the sale of our products or know-how or require us to license such
patents and pay significant fees or royalties in order to produce our products.
In addition, future patents may issue to third parties which our technology may
infringe. Because patent applications can take many years to issue, there may be
applications now pending of which we are unaware that may later result in issued
patents that our products may infringe.
 
 Intellectual
property litigation, regardless of outcome, is expensive and time-consuming,
could divert management’s attention from our business and have a material
negative effect on our business, operating results or financial condition. If
such a dispute were to be resolved against us, we may be required to pay
substantial damages, including treble damages and attorneys fees if we were to
be found to have willfully infringed a third party’s patent, to the party
claiming infringement, develop non-infringing technology, stop selling any
products we develop, cease using technology that contains the allegedly
infringing intellectual property or enter into royalty or license agreements
that may not be available on acceptable or commercially practical terms, if at
all. Our failure to develop non-infringing technologies or license the
proprietary rights on a timely basis could harm our business. Modification of
any products we develop or development of new products thereafter could require
us to conduct additional clinical trials and to revise our filings with the FDA
and other regulatory bodies, which would be time-consuming and expensive. In
addition, parties making infringement claims may be able to obtain an injunction
that would prevent us from selling any products we develop, which could harm our
business.
 
 
 We
may be subject to damages resulting from claims that we or our employees have
wrongfully used or disclosed alleged trade secrets of their former
employers.
 
 Some of
our employees may have been previously employed at universities or other
biotechnology or pharmaceutical companies, including our competitors or
potential competitors. Although no claims against us are currently pending, we
may be subject to claims that these employees or we have inadvertently or
otherwise used or disclosed trade secrets or other proprietary information of
their former employers. Litigation may be necessary to defend against these
claims. Even if we are successful in defending against these claims, litigation
could result in substantial costs and be a distraction to management. If we fail
in defending such claims, in addition to paying money damages, we may lose
valuable intellectual property rights or personnel. A loss of key research
personnel or their work product could hamper or prevent our ability to
commercialize product candidates, which could severely harm our
business.
 
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 If
product liability lawsuits are brought against us, they could result in costly
litigation and significant liabilities.
 
 The
product candidates we are developing or attempting to develop will, in most
cases, undergo extensive clinical testing and will require approval from the
applicable regulatory authorities prior to sale. However, despite all reasonable
efforts to ensure safety, it is possible that we or our collaborators will sell
products which are defective, to which patients react in an unexpected manner,
or which are alleged to have side effects. The manufacture and sale of such
products may expose us to potential liability, and the industries in which our
products are likely to be sold have been subject to significant product
liability litigation. Any claims, with or without merit, could result in costly
litigation, reduced sales, significant liabilities and diversion of our
management’s time and attention and could have a material adverse effect on our
financial condition, business and results of operations.
 
 If a
product liability claim is brought against us, we may be required to pay legal
and other expenses to defend the claim and, if the claim is successful, damage
awards may not be covered, in whole or in part, by our insurance. We may not
have sufficient capital resources to pay a judgment, in which case our creditors
could levy against our assets. We may also be obligated to indemnify our
collaborators and make payments to other parties with respect to product
liability damages and claims. Defending any product liability claims, or
indemnifying others against those claims, could require us to expend significant
financial and managerial resources.
 
 Failure
to obtain sufficient quantities of products and substances necessary for
research and development, pre-clinical trials, human clinical trials and product
commercialization that are of acceptable quality at reasonable prices or at all
could constrain our product development and have a material adverse effect on
our business.
 
 We have
relied and will continue to rely on contract manufacturers for the foreseeable
future to produce quantities of products and substances necessary for research
and development, pre-clinical trials, human clinical trials and product
commercialization. It will be important to us that such products and substances
can be manufactured at a cost and in quantities necessary to make them
commercially viable. At this point in time, we have not attempted to identify,
and do not know whether there will be, any third party manufacturers which will
be able to meet our needs with respect to timing, quantity and quality for
commercial production. In addition, if we are unable to contract for a
sufficient supply or required products and substances on acceptable terms, or if
we should encounter delays or difficulties in our relationships with
manufacturers, our research and development, pre-clinical and clinical testing
would be delayed, thereby delaying the submission of product candidates for
regulatory approval or the market introduction and subsequent sales of products.
Any such delay may have a material adverse effect on our business, financial
condition and results of operations.
 
 Because
our clinical development activities rely heavily on sensitive and personal
information, an area which is highly regulated by privacy laws, we may not be
able to generate, maintain or access essential patient samples or data to
continue our research and development efforts in the future on reasonable terms
and conditions, which may adversely affect our business.
 
 As a
result of our clinical development, we will have access to very sensitive data
regarding the patients enrolled in our clinical trials. This data will contain
information that is personal in nature. The maintenance of this data is subject
to certain privacy-related laws, which impose upon us administrative and
financial burdens, and litigation risks. For instance, the rules promulgated by
the Department of Health and Human Services under the Health Insurance
Portability and Accountability Act, or HIPAA, creates national standards to
protect patients’ medical records and other personal information in the United
States. These rules require that healthcare providers and other covered entities
obtain written authorizations from patients prior to disclosing protected health
care information of the patient to companies like NovaBay. If the patient fails
to execute an authorization or the authorization fails to contain all required
provisions, then we will not be allowed access to the patient’s information and
our research efforts can be substantially delayed. Furthermore, use of protected
health information that is provided to us pursuant to a valid patient
authorization is subject to the limits set forth in the authorization (i.e., for
use in research and in submissions to regulatory authorities for product
approvals). As such, we are required to implement policies, procedures and
reasonable and appropriate security measures to protect individually
identifiable health information we receive from covered entities, and to ensure
such information is used only as authorized by the patient. Any violations of
these rules by us could subject us to civil and criminal penalties and adverse
publicity, and could harm our ability to initiate and complete clinical studies
required to support regulatory applications for our proposed products. In
addition, HIPAA does not replace federal, state, or other laws that may grant
individuals even greater privacy protections. We can provide no assurance that
future legislation will not prevent us from generating or maintaining personal
data or that patients will consent to the use of their personal information,
either of which may prevent us from undertaking or publishing essential
research. These burdens or risks may prove too great for us to reasonably bear,
and may adversely affect our ability to function profitably in the
future.
 
 Table of Contents
 -40-
 We
may be subject to fines, penalties, injunctions and other sanctions if we are
deemed to be promoting the use of our products for non-FDA-approved, or
off-label, uses.
 
 Our
business and future growth depend on the development, use and ultimate sale of
products that are subject to FDA regulation, clearance and approval. Under the
U.S. Federal Food, Drug, and Cosmetic Act and other laws, we are prohibited from
promoting our products for off-label uses. This means that we may not make
claims about the safety or effectiveness of our products and may not proactively
discuss or provide information on the use of our products, except as allowed by
the FDA.
 
 There is
a risk that the FDA or other federal or state law enforcement authorities could
determine that the nature and scope of our sales and marketing activities may
constitute the promotion of our products for a non-FDA-approved use in violation
of applicable law. We also face the risk that the FDA or other regulatory
authorities might pursue enforcement based on past activities that we have
discontinued or changed, including sales activities, arrangements with
institutions and doctors, educational and training programs and other
activities.
 
 Government
investigations concerning the promotion of off-label uses and related issues are
typically expensive, disruptive and burdensome and generate negative publicity.
If our promotional activities are found to be in violation of applicable law or
if we agree to a settlement in connection with an enforcement action, we would
likely face significant fines and penalties and would likely be required to
substantially change our sales, promotion, grant and educational activities. In
addition, were any enforcement actions against us or our senior officers to
arise, we could be excluded from participation in U.S. government healthcare
programs such as Medicare and Medicaid.
 
 If
we are unable to protect our intellectual property, our competitors could
develop and market products similar to ours that may reduce demand for our
products.
 
 Our
success, competitive position and potential future revenues will depend in
significant part on our ability to protect our intellectual property. We rely on
the patent, trademark, copyright and trade secret laws of the United States and
other countries, as well as confidentiality and nondisclosure agreements, to
protect our intellectual property rights. We apply for patents covering our
technologies as we deem appropriate.
 
 NovaBay
aggressively protects and enforces its patent rights
worldwide.  However, certain risks remain.  There is no
assurance that patents will issue from any of our applications or, for those
patents we have or that do issue, that the claims will be sufficiently broad to
protect our proprietary rights, or that it will be economically possible to
pursue sufficient numbers of patents to afford significant protection. For
example, we do not have any composition of matter patent directed to the NVC-101
composition. If a potential competitor introduces a similar method of using
NVC-101 with a similar composition that does not fall within the scope of the
method of treatment claims, then we or a potential marketing partner would be
unable to rely on the allowed claims to protect its market position for the
method of using the NVC-101 composition, and any revenues arising from such
protection would be adversely impacted.
 
 In
addition, there is no assurance that any patents issued to us or licensed or
assigned to us by third parties will not be challenged, invalidated, found
unenforceable or circumvented, or that the rights granted thereunder will
provide competitive advantages to us. If we or our collaborators or licensors
fail to file, prosecute or maintain certain patents, our competitors could
market products that contain features and clinical benefits similar to those of
any products we develop, and demand for our products could decline as a result.
Further, although we have taken steps to protect our intellectual property and
proprietary technology, third parties may be able to design around our patents
or, if they do infringe upon our technology, we may not be successful or have
sufficient resources in pursuing a claim of infringement against those third
parties. Any pursuit of an infringement claim by us may involve substantial
expense and diversion of management attention.
 
 We also
rely on trade secrets and proprietary know-how that we seek to protect by
confidentiality agreements with our employees, consultants and collaborators. If
these agreements are not enforceable, or are breached, we may not have adequate
remedies for any breach, and our trade secrets and proprietary know-how may
become known or be independently discovered by competitors.
 
 We
operate in the State of California.  The laws of the State prevent us
from imposing a delay before an employee who may have access to trade secrets
and proprietary know-how can commence employment with a competing company.
Although we may be able to pursue legal action against competitive companies
improperly using our proprietary information, we may not be aware of any use of
our trade secrets and proprietary know-how until after significant damage has
been done to our company.
 
 Furthermore,
the laws of foreign countries may not protect our intellectual property rights
to the same extent as the laws of the United States. If our intellectual
property does not provide significant protection against foreign or domestic
competition, our competitors, including generic manufacturers, could compete
more directly with us, which could result in a decrease in our market share. All
of these factors may harm our competitive position.
 
 Table of Contents
 -41-
 If
bacteria develop resistance to Aganocide compounds, our revenues could be
significantly reduced.
 
 Based on
our understanding of the hypothesis of the mechanism of action of our Aganocide
compounds, we do not expect bacteria to be able to develop resistance to
Aganocide compounds. However, we cannot assure you that one or more strains of
bacteria will not develop resistance to our compounds, either because our
hypothesis of the mechanism of action is incorrect or because a strain of
bacteria undergoes some unforeseen genetic mutation that permits it to survive.
Since we expect lack of resistance to be a major factor in the commercialization
of our product candidates, the discovery of such resistance would have a major
adverse impact on the acceptability and sales of our products.
 
 If
physicians and patients do not accept and use our products, we will not achieve
sufficient product revenues and our business will suffer.
 
 Even if
the FDA approves product candidates that we develop, physicians and patients may
not accept and use them. Acceptance and use of our products may depend on a
number of factors including:
 
 •
              perceptions
      by members of the healthcare community, including physicians, about the
      safety and effectiveness of our
products;
 
 •
              published
      studies demonstrating the cost-effectiveness of our products relative to
      competing products;
 
 •
              availability
      of reimbursement for our products from government or healthcare payers;
      and
 
 •
              effectiveness
      of marketing and distribution efforts by us and our licensees and
      distributors, if any.
 
 The
failure of any of our products to find market acceptance would harm our business
and could require us to seek additional financing.
 
 If
we are unable to develop our own sales, marketing and distribution capabilities,
or if we are not successful in contracting with third parties for these services
on favorable terms, or at all, revenues from any products we develop could be
disappointing.
 
 We
currently have no internal sales, marketing or distribution capabilities. In
order to commercialize any product candidates approved by the FDA, we will
either have to develop such capabilities internally or collaborate with third
parties who can perform these services for us. If we decide to commercialize any
products we develop, we may not be able to hire the necessary experienced
personnel and build sales, marketing and distribution operations which are
capable of successfully launching new products and generating sufficient product
revenues. In addition, establishing such operations will take time and involve
significant expense.
 
 If we
decide to enter into co-promotion or other licensing arrangements with third
parties, we may be unable to identify acceptable partners because the number of
potential partners is limited and because of competition from others for similar
alliances with potential partners. Even if we are able to identify one or more
acceptable partners, we may not be able to enter into any partnering
arrangements on favorable terms, or at all. If we enter into any partnering
arrangements, our revenues are likely to be lower than if we marketed and sold
our products ourselves.
 
 In
addition, any revenues we receive would depend upon our partners’ efforts which
may not be adequate due to lack of attention or resource commitments, management
turnover, change of strategic focus, further business combinations or other
factors outside of our control. Depending upon the terms of our agreements, the
remedies we have against an under-performing partner may be limited. If we were
to terminate the relationship, it may be difficult or impossible to find a
replacement partner on acceptable terms, or at all.
 
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 -42-
 If
we cannot compete successfully for market share against other companies, we may
not achieve sufficient product revenues and our business will
suffer.
 
 The
market for our product candidates is characterized by intense competition and
rapid technological advances. If our product candidates receive FDA approval and
are launched they will compete with a number of existing and future drugs,
devices and therapies developed, manufactured and marketed by others. Existing
or future competing products may provide greater therapeutic convenience or
clinical or other benefits for a specific indication than our products, or may
offer comparable performance at a lower cost. If our products are unable to
capture and maintain market share, we may not achieve sufficient product
revenues and our business will suffer.
  We will
compete for market share against fully integrated pharmaceutical and medical
device companies or other companies that develop products independently or
collaborate with larger pharmaceutical companies, academic institutions,
government agencies and other public and private research organizations. In
addition, many of these competitors, either alone or together with their
collaborative partners, have substantially greater capital resources, larger
research and development staffs and facilities, and greater financial resources
than we do, as well as significantly greater experience in:
 
 •
              developing
      drugs and devices;
 
 •
              conducting
      preclinical testing and human clinical
trials;
 
 •
              obtaining
      FDA and other regulatory approvals of product
  candidates;
 
 •
              formulating
      and manufacturing products; and
 
 •
              launching,
      marketing, distributing and selling
products.
 
 
 Our
competitors may:
 
 •
              develop
      and patent processes or products earlier than we
  will;
 
 •
              develop
      and commercialize products that are less expensive or more efficient than
      any products that we may develop;
 
 •
              obtain
      regulatory approvals for competing products more rapidly than we will;
      and
 
 •
              improve
      upon existing technological approaches or develop new or different
      approaches that render any technology or products we develop obsolete or
      uncompetitive.
 
 We cannot
assure you that our competitors will not succeed in developing technologies and
products that are more effective than any developed by us or that would render
our technologies and any products we develop obsolete. If we are unable to
compete successfully against current or future competitors, we may be unable to
obtain market acceptance for any product candidates that we create, which could
prevent us from generating revenues or achieving profitability and could cause
the market price of our common stock to decline.
 
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 -43-
 Our
ability to generate revenues from any products we develop will be diminished if
we fail to obtain acceptable prices or an adequate level of reimbursement for
our products from healthcare payers.
 
 Our
ability to commercialize our product candidates will depend, in part, on the
extent to which health insurers, government authorities and other third-party
payers will reimburse the costs of products which may be developed by us or our
partners. We expect that a portion of our economic return from partnering
arrangements with pharmaceutical companies and other collaborators will be
derived from royalties, fees or other revenues linked to final sales of products
that we or our partners develop. Newly-approved pharmaceuticals and other
products which are developed by us or our partners will not necessarily be
reimbursed by third-party payers or may not be reimbursed at levels sufficient
to generate significant sales. Government and other third-party payers are
increasingly attempting to contain health care costs by limiting both coverage
and the level of reimbursement for new drugs or medical devices. Cost control
initiatives such as these could adversely affect our or our collaborators’
ability to commercialize products. In addition, real or anticipated cost control
initiatives for final products may reduce the willingness of pharmaceutical
companies or other potential partners to collaborate with us on the development
of new products.
 
 Significant
uncertainty exists as to the reimbursement status of newly-approved healthcare
products. Healthcare payers, including Medicare, health maintenance
organizations and managed care organizations, are challenging the prices charged
for medical products or are seeking pharmacoeconomic data to justify formulary
acceptance and reimbursement practices. We currently have not generated
pharmacoeconomic data on any of our product candidates. Government and other
healthcare payers increasingly are attempting to contain healthcare costs by
limiting both coverage and the level of reimbursement for drugs and medical
devices, and by refusing, in some cases, to provide coverage for uses of
approved products for disease indications for which the FDA has or has not
granted labeling approval. Adequate third-party insurance coverage may not be
available to patients for any products we discover and develop, alone or with
collaborators. If government and other healthcare payers do not provide adequate
coverage and reimbursement levels for our products, market acceptance of our
product candidates could be limited.
 
 Risks
Relating to Owning Our Common Stock
 
 The
price of our common stock may fluctuate substantially, which may result in
losses to our shareholders.
 
 The stock
prices of many companies in the pharmaceutical and biotechnology industry have
generally experienced wide fluctuations, which are often unrelated to the
operating performance of those companies. The market price of our common stock
is likely to be volatile and could fluctuate in response to, among other
things:
 
 •
              the
      results of preclinical or clinical trials relating to our product
      candidates;
 
 •
              the
      announcement of new products by us or our
  competitors;
 
 •
              announcement
      of partnering arrangements by us or our
  competitors;
 
 •
              quarterly
      variations in our or our competitors’ results of
    operations;
 
 •
              announcements
      by us related to litigation;
 
 •
              changes
      in our earnings estimates, investors’ perceptions, recommendations by
      securities analysts or our failure to achieve analysts’ earning
      estimates;
 
 •
              developments
      in our industry; and
 
 •
              General,
      economic and market conditions, including the recent volatility in the
      financial markets and decrease in consumer confidence  and other
      factors unrelated to our operating performance or the operating
      performance of our competitors.
 
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 -44-
 The
volume of trading of our common stock may be low, leaving our common stock open
to risk of high volatility.
 
 The
number of shares of our common stock being traded may be very low. Any
shareholder wishing to sell his/her stock may cause a significant fluctuation in
the price of our stock. In addition, low trading volume of a stock increases the
possibility that, despite rules against such activity, the price of the stock
may be manipulated by persons acting in their own self-interest. We may not have
adequate market makers and market making activity to prevent
manipulation.
 
 Our
directors, executive officers and principal shareholders have significant voting
power and may take actions that may not be in the best interests of our other
shareholders.
 
 As of
March 31, 2009, our officers and directors collectively controlled approximately
3.979,097 shares of our outstanding common stock (and approximately 4,997,067
shares of our common stock when including options held by them which were
exercisable as of or within 60 days of March 31, 2009). Furthermore, as of March
31, 2009, our largest shareholder, a family trust established and controlled by
Dr. Ramin ("Ron") Najafi, our Chairman and Chief Executive Officer,
beneficially owned 3,126,700 shares or 14.44% of our outstanding common stock.
As a result, Dr. Najafi can significantly influence the management and
affairs of our company and most matters requiring shareholder approval,
including the election of directors and approval of significant corporate
transactions. This concentration of ownership may have the effect of delaying or
preventing a change in control and might adversely affect the market price of
our common stock. This concentration of ownership may not be in the best
interests of our other shareholders.
  
 Future
sales of shares by our shareholders could cause the market price of our common
stock to drop significantly, even if our business is doing well.
 
 Up to
2,972,275 shares held by certain of our officers and directors will become
eligible for sale in the public market over the period ending October 25, 2009,
as the shares are released from lock-up agreements with the underwriters in our
initial public offering.
 
 In
addition, at any time and without public notice, we and the underwriters may
release, at our respective discretions, all or some of the securities subject to
our respective lock-up agreements, subject to applicable regulatory
requirements. As restrictions on resale end, the market price of our stock could
drop significantly if the holders of those shares sell them or are perceived by
the market as intending to sell them. These declines in our stock price could
occur even if our business is otherwise doing well.
 
 Our
limited operating history may make it difficult for you to evaluate our business
and to assess our future viability.
 
 Our
operations to date have been limited to organizing and staffing our company,
developing our technology, researching and developing our compounds, and
conducting preclinical studies and early-stage clinical trials of our compounds.
We have not demonstrated the ability to succeed in achieving clinical endpoints,
obtain regulatory approvals, formulate and manufacture products on a commercial
scale or conduct sales and marketing activities. Consequently, any predictions
you make about our future success or viability are unlikely to be as accurate as
they could be if we had a longer operating history.
 
 Table of Contents
 -45-
 Our
amended and restated articles of incorporation and bylaws and California law,
contain provisions that could discourage a third party from making a takeover
offer that is beneficial to our shareholders.
 
 Anti-takeover
provisions of our amended and restated articles of incorporation, amended and
restated bylaws and California law may have the effect of deterring or delaying
attempts by our shareholders to remove or replace management, engage in proxy
contests and effect changes in control. The provisions of our charter documents
include:
 
 
 •
              a
      classified board so that only one of the three classes of directors on our
      Board of Directors is elected eachyear;
 
 •
              elimination
      of cumulative voting in the election of
  directors;
 
 •
              procedures
      for advance notification of shareholder nominations and
      proposals;
 
 •
              the
      ability of our Board of Directors to amend our bylaws without shareholder
      approval; and
 
 
 •
              the
      ability of our Board of Directors to issue up to 5,000,000 shares of
      preferred stock without shareholder approval upon the terms and conditions
      and with the rights, privileges and preferences as our Board of Directors
      may determine.
 
 In
addition, as a California corporation, we are subject to California law, which
includes provisions that may have the effect of deterring hostile takeovers or
delaying or preventing changes in control or management of our company.
Provisions of the California Corporations Code could make it more difficult for
a third party to acquire a majority of our outstanding voting stock by
discouraging a hostile bid, or delaying, preventing or deterring a merger,
acquisition or tender offer in which our shareholders could receive a premium
for their shares, or effect a proxy contest for control of NovaBay or other
changes in our management.
 
 
 We
have not paid dividends in the past and do not expect to pay dividends in the
future, and any return on investment may be limited to the value of our
stock.
 
 We have
never paid cash dividends on our common stock and do not anticipate paying cash
dividends on our common stock in the foreseeable future. The payment of
dividends on our common stock will depend on our earnings, financial condition
and other business and economic factors affecting us at such time as our Board
of Directors may consider relevant. If we do not pay dividends, you will
experience a return on your investment in our shares only if our stock price
appreciates. We cannot assure you that you will receive a return on your
investment when you do sell your shares or that you will not lose the entire
amount of your investment.
 
 We
may be considered a “foreign investment entity” which may have adverse Canadian
tax consequences for our Canadian investors.
 
 Although
we believe that we are not currently a “foreign investment entity” within the
meaning of the FIE Tax Proposals (as defined in “Material Canadian Federal
Income Tax Considerations—Foreign Investment Entity Status”), no assurances can
be given in this regard or as to our status in the future. If we become a
“foreign investment entity” within the meaning of the FIE Tax Proposals, there
may be certain adverse tax consequences for our Canadian investors.
 
 Table of Contents
 -46-
 ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF
PROCEEDS
 
 None
 
 Use
of Proceeds from Sales of Registered Securities
 
 On
October 24, 2007, a Registration Statement on Form S-1 (File. No. 333-140714)
relating to our initial public offering was declared effective by the SEC. The
closing was held October 31, 2007.   The net proceeds to NovaBay
from the offering were approximately $17.1 million.   From the
effective date of the registration statement until March 31, 2009, we estimate
we had used $8.0 million for research and development, $2.0 million for working
capital and $4.7 million for other general purposes. The remaining estimated
$5.4 million have been invested in various interest-bearing money market
accounts and marketable securities.
 
 The
amounts reflected above included expenditures for:  the Phase I and II
clinical development of NVC-422 in pre-surgical nasal
preparation;  pre-clinical, Phase I and initial Phase II studies of
NVC-422 in the prevention of catheter associated urinary tract infections; and
pre-clinical studies to select among additional indications to be taken into
development.  These expenditures did not represent a material change
from the use of proceeds described in the prospectus related to the
offering.
  
 ITEM 3.     DEFAULTS UPON SENIOR
SECURITIES
 
 None.
 
 
 ITEM 4.
              SUBMISSION OF MATTERS TO A VOTE OF SECURITY
      HOLDERS
 None.
 
 
 ITEM 5.
              OTHER INFORMATION
 None.
 
 ITEM
      6.
              EXHIBITS
 
 See the
Exhibit Index which follows the signature page of this Quarterly
Report on Form 10-Q, which is incorporated here by reference.
  
 Table of Contents
 -47-
 SIGNATURES
 
  Pursuant
to the requirements of the Securities Exchange Act of 1934, the registrant has
duly caused this report to be signed on its behalf by the undersigned thereunto
duly authorized.
  Date:
      May 15, 2009
              NOVABAY
      PHARMACEUTICALS, INC./s/
      Ramin ("Ron") NajafiRamin
      (“Ron”) NajafiPresident
      and Chief Executive Officer
                (duly
      authorized officer)Date:
      May 15, 2009
              /s/
      Thomas J. PaulsonThomas
      J. PaulsonChief
      Financial Officer
                (principal
      financial officer)
 
 
 
 
 Table of Contents
 -48-
 
  
 EXHIBIT INDEX
 
 
 ExhibitNo.
              Description3.1
              Amended
      and Restated Articles of Incorporation of
      registrant  (Incorporated by reference to the exhibit of the
      same number from the Company’s quarterly report on Form 10-Q for the
      quarter ended September 30, 2007 as filed with the SEC on November 15,
      2007.)3.2
              Amended
      and Restated Bylaws of registrant (Incorporated by reference to the
      exhibit of the same number from the Company’s quarterly report on
      Form 10-Q for the quarter ended September 30, 2007 as filed with the
      SEC on November 15, 2007.)4.1*
              Specimen
      common stock certificate4.2*
              Form
      of Registration Rights Agreement by and between the Registrant and the
      underwriters10.1
              Retirement
      and Consulting Agreement dated January 1, 2009 by and Between the
      Registrant and John (“Jack”) O’Reilly (Incorporated by reference to
      Exhibit 10.9 of the Company’s Annual Report on Form 10-K for the year
      ended December 31, 2009as filed with the SEC on March 31,
      2009.)10.2†
              Collaboration
      and License Agreement between  NovaBay Pharmaceuticals and
      Galderma S.A. dated March 20, 200931.1
              Certification
      of the principal executive officer pursuant to Section 302 of the
      Sarbanes-Oxley Act of 200231.2
              Certification
      of the principal financial officer pursuant to Section 302 of the
      Sarbanes-Oxley Act of 200232.1
              Certification
      of the chief executive officer pursuant to Section 906 of the
      Sarbanes-Oxley Act of 200232.2
              Certification
      of the chief financial officer pursuant to Section 906 of the
      Sarbanes-Oxley Act of 2002
 
 
 
 
 *
              Incorporated
      by reference to the exhibit of the same number from the Company’s
      registration statement of Form S-1 (File No. 333-138379) initially
      filed with the Securities and Exchange Commission on November 2,
      2006, as amended.
 
 
 †
              NovaBay
      Pharmaceuticals, Inc. has requested confidential treatment with respect to
      certain portions of this exhibit (indicated by asterisks), which has been
      separately filed with the Securities and Exchange
    Commission.
   
 -49-