UNITED
STATES
 SECURITIES
AND EXCHANGE COMMISSION
 Washington,
D.C. 20549
 
 FORM
10-Q
 
 (Mark
One)
 x
              QUARTERLY
      REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT
      OF 1934
                
                
                EXCHANGE
      ACT OF 1934
 
 For the
quarterly period ended June 30, 2009
 
 OR
 
 o
              TRANSITION
      REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT
      OF 1934
 
 For the
transition period
from                     to
 
 Commission
file number 001-33678
 
 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
 
 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. Yesx   No
o
 
 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 o  No
x
 
 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
              o
              Accelerated
      filer
              oNon-accelerated
      filer
              o
              Smaller
      reporting company
              x
 (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 o No o
 
 
 As of
August 7, 2009, there were 21,975,097 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
              26Item 3.
              Quantitative and Qualitative Disclosures About Market
      Risk
              35Item 4.
              Controls and Procedures
              36Item 4T.
              Controls and Procedures
              36II. Other InformationItem 1.
              Legal Proceedings
              37Item 1A.
              Risk Factors
              37Item 2.
              Unregistered Sales of Equity Securities and Use of
      Proceeds
              56Item 4.
              Submission of Matters to a Vote of Security
      Holders
              57Item 6.
              Exhibits
              57
 
 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 ®and Design
Trademark,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.
 
 
   -1-
  
 
 PART
I
 FINANCIAL
INFORMATION
 
 ITEM1.
              FINANCIAL
      STATEMENTS
 
 NOVABAY
PHARMACEUTICALS, INC.
 (a
development stage company)
 CONDENSED
CONSOLIDATED BALANCE SHEETS
 (in
thousands, except per share data)
 
 
 December
      31,
              
              
              June
      30,2008
              
              
              2009(unaudited)ASSETSCurrent
      assets:Cash
      and cash equivalents
              
              $
              12,099
              
              
              $
              8,000Short-term
      investments (Note 3)
              
              
              
              
              
              
              2,685Prepaid
      expenses and other current assets
              
              
              414
              
              
              
              769Total
      current assets
              
              
              12,513
              
              
              
              11,454Property
      and equipment, net (Note 4)
              
              
              1,456
              
              
              
              1,575TOTAL
      ASSETS
              
              $
              13,969
              
              
              $
              13,029LIABILITIES
      AND STOCKHOLDERS' EQUITYLiabilities:Current
      liabilities:Accounts
      payable
              
              $
              406
              
              
              $
              533Accrued
      liabilities (Note 5)
              
              
              1,166
              
              
              
              636Capital
      lease obligation (Note 4)
              
              
              42
              
              
              
              29Equipment
      loan (Note 6)
              
              
              366
              
              
              
              387Deferred
      revenue
              
              
              2,500
              
              
              
              3,100Total
      current liabilities
              
              
              4,480
              
              
              
              4,685Capital
      lease obligation - non-current (Note 4)
              
              
              7Equipment
      loan - non-current (Note 6)
              
              
              470
              
              
              
              271Deferred
      revenue - non-current
              
              
              1,667
              
              
              
              617Total
      liabilities
              
              
              6,624
              
              
              
              5,573Stockholders'
      Equity:Common
      stock, $0.01 par value; 65,000 and 65,000 shares authorized at December
      31, 2008 and June 30, 2009, respectively, 21,471 and 21,980 issued and
      outstanding at December 31, 2008 and June 30, 2009,
      respectively
              
              
              215
              
              
              
              220Additional
      paid-in capital
              
              
              33,718
              
              
              
              34,434Accumulated
      other comprehensive income (loss)
              
              
              
              
              
              
              (3
              )Accumulated
      deficit during development stage
              
              
              (26,588
              )
              
              
              (27,195
              )Total
      stockholders' equity
              
              
              7,345
              
              
              
              7,456TOTAL
      LIABILITIES AND STOCKHOLDERS' EQUITY
              
              $
              13,969
              
              
              $
              13,029
 
 
 
 
 The
accompanying notes are an integral part of these condensed consolidated
financial statements.
  Table of Contents
 -2-
  
 
 
 
 NOVABAY
PHARMACEUTICALS, INC.
 (a
development stage company)
 CONDENSED
CONSOLIDATED STATEMENTS OF OPERATIONS
 (in
thousands, except per share data)
 
 Cumulative Periodfrom
      July 1, 2002(date
      ofdevelopment stageinception)
      toThree
      Months Ended June 30,
              
              
              Six
      Months Ended June 30,
              
              
              June
      30,2008
              
              
              2009
              
              
              2008
              
              
              2009
              
              
              2009(unaudited)
              
              
              (unaudited)
              
              
              (unaudited)
              
              
              (unaudited)
              
              
              (unaudited)REVENUELicense
      and collaboration revenue
              
              $
              1,442
              
              
              $
              2,357
              
              
              $
              2,933
              
              
              $
              4,968
              
              
              $
              19,136EXPENSESOperating
      Expenses:Research
      and development
              
              
              2,371
              
              
              
              1,444
              
              
              
              5,246
              
              
              
              2,805
              
              
              
              27,812General
      and administrative
              
              
              1,575
              
              
              
              1,191
              
              
              
              3,031
              
              
              
              2,769
              
              
              
              19,734Total
      operating expenses
              
              
              3,946
              
              
              
              2,635
              
              
              
              8,277
              
              
              
              5,574
              
              
              
              47,546Interest
      expense
              
              
              (24
              )
              
              
              (20
              )
              
              
              (49
              )
              
              
              (43
              )
              
              
              (188
              )Other
      income (expense), net
              
              
              118
              
              
              
              9
              
              
              
              306
              
              
              
              42
              
              
              
              1,417Total
      Other income (expense), net
              
              
              94
              
              
              
              (11
              )
              
              
              257
              
              
              
              (1
              )
              
              
              1,229Net
      loss before income taxes
              
              
              (2,410
              )
              
              
              (289
              )
              
              
              (5,087
              )
              
              
              (607
              )
              
              
              (27,181
              )Provision
      for income taxes
              
              
              
              
              
              
              
              
              
              
              2
              
              
              
              
              
              
              
              14Net
      loss
              
              $
              (2,410
              )
              
              $
              (289
              )
              
              $
              (5,089
              )
              
              $
              (607
              )
              
              $
              (27,195
              )Net
      loss per share:Basic
      and diluted
              
              $
              (0.11
              )
              
              $
              (0.01
              )
              
              $
              (0.24
              )
              
              $
              (0.03
              )Shares
      used in per share calculations:Basic
      and diluted
              
              
              21,334
              
              
              
              21,931
              
              
              
              21,311
              
              
              
              21,775
 
 
 The
accompanying notes are an integral part of these condensed consolidated
financial statements.
 
 
 Table of Contents
 -3-
 NOVABAY
PHARMACEUTICALS, INC.
 (a
development stage company)
 CONDENSED
CONSOLIDATED STATEMENTS OF CASH FLOWS
 (in
thousands)
  Six
      Months EndedJune
      30,
              
              Cumulative Period from July 1,
      2002 (date of development stage inception) to
                June 30,2008
              
              
              2009
              
              
              2009(unaudited)
              
              
              (unaudited)
              
              
              (unaudited)Cash
      flows from operating activities:Net
      loss
              
              $
              (5,089
              )
              
              $
              (607
              )
              
              $
              (27,195
              )Adjustments
      to reconcile net loss to net cashused
      in operating activities:Depreciation
      and amortization
              
              
              143
              
              
              
              172
              
              
              
              876Accretion
      of discount on short-term investments
              
              
              (24
              )
              
              
              
              
              
              
              (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
              
              
              632
              
              
              
              340
              
              
              
              1,802Compensation
      expense for warrants and stockissued for services
              
              
              
              
              
              
              245
              
              
              
              345Stock-based
      compensation expense for optionsand stock issued to
      non-employees
              
              
              (11
              )
              
              
              79
              
              
              
              604Taxes
      paid by LLC
              
              
              
              
              
              
              
              
              
              
              1Changes
      in operating assets and liabilities:Increase
      in prepaid expenses and other current assets
              
              
              (306
              )
              
              
              (355
              )
              
              
              (764
              )Increase
      (decrease) in accounts payable and accrued liabilities
              
              
              699
              
              
              
              (403
              )
              
              
              1,194(Increase)
      decrease in deferred revenue
              
              
              (1,327
              )
              
              
              (450
              )
              
              
              3,716Net
      cash used in operating activities
              
              
              (5,283
              )
              
              
              (979
              )
              
              
              (19,604
              )Cash
      flows from investing activities:Purchases
      of property and equipment
              
              
              (493
              )
              
              
              (291
              )
              
              
              (2,451
              )Proceeds
      from disposal of property and equipment
              
              
              
              
              
              
              
              
              
              
              44Purchases
      of short-term investments
              
              
              (25,123
              )
              
              
              (2,688
              )
              
              
              (97,232
              )Proceeds
      from maturities and sales of short-term investments
              
              
              29,681
              
              
              
              
              
              
              
              94,847Cash
      acquired in purchase of LLC
              
              
              
              
              
              
              
              
              
              
              516Net
      cash provided by (used in) investing activities
              
              
              4,065
              
              
              
              (2,979
              )
              
              
              (4,276
              )Cash
      flows from financing activities:Proceeds
      from preferred stock issuances, net
              
              
              
              
              
              
              
              
              
              
              11,160Proceeds
      from common stock issuances
              
              
              
              
              
              
              
              
              
              
              17Proceeds
      from exercise of options and warrants
              
              
              2
              
              
              
              57
              
              
              
              1,818Proceeds
      from initial public offering, net of costs
              
              
              
              
              
              
              
              
              
              
              17,077Proceeds
      from stock subscription receivable
              
              
              
              
              
              
              
              
              
              
              873Proceeds
      from issuance of notes
              
              
              
              
              
              
              
              
              
              
              405Principal
      payments on capital lease
              
              
              (18
              )
              
              
              (20
              )
              
              
              (128
              )Proceeds
      from borrowings  under equipment loan
              
              
              422
              
              
              
              
              
              
              
              1,216Principal
      payments on equipment loan
              
              
              (131
              )
              
              
              (178
              )
              
              
              (558
              )Net
      cash provided by (used in) financing activities
              
              
              275
              
              
              
              (141
              )
              
              
              31,880Net
      increase (decrease) in cash and cash equivalents
              
              
              (943
              )
              
              
              (4,099
              )
              
              
              8,000Cash
      and cash equivalents, beginning of period
              
              
              10,941
              
              
              
              12,099Cash
      and cash equivalents, end of period
              
              $
              9,998
              
              
              $
              8,000
              
              
              $
              8,000
 
 The
accompanying notes are an integral part of these condensed consolidated
financial statements.
 -4-
  NOVABAY
PHARMACEUTICALS, INC.
 (a
development stage company)
 CONDENSED
CONSOLIDATED STATEMENTS OF CASH FLOWS
 (in
thousands)
 Six
      Months Ended
              
              
              Cumulative Period from July 1,
      2002 (date of development stage inception) toJune
      30,
              
              
              June 30,2008
              
              
              2009
              
              
              2009Supplemental
      disclosure of cash flow information:
              
              (unaudited)
              
              
              (unaudited)
              
              
              (unaudited)Interest
      paid
              
              $
              49
              
              
              $
              42
              
              
              $
              188Income
      taxes paid
              
              
              —
              
              
              
              —
              
              
              
              —Non-cash
      activities:Issuance
      of stock, options and warrants for stock offering costs
              
              
              —
              
              
              
              —
              
              
              $
              801Property
      and equipment acquired under capital lease obligation
              
              $
              62
              
              
              
              —
              
              
              $
              229
 
 
  Table of Contents
 -5-
  
 
 NOVABAY
PHARMACEUTICALS, INC.
 (a
development stage company)
 
 NOTES
TO CONDENSED 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
has 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 operates 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 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. 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 condensed consolidated financial statements of
NovaBay Pharmaceuticals, Inc. have been prepared in accordance with the
rules and regulations of the Securities and Exchange Commission (“SEC”) for
interim reporting including the instructions to Form 10-Q and Rule 8-03 of
Regulation S-X. These condensed statements do not include all disclosures for
annual audited financial statements required by accounting principles generally
accepted in the United States of America (“U.S. GAAP”) and should be read in
conjunction with the Company’s audited consolidated financial statements
and related notes included in the Company’s Annual Report on Form 10-K for the
year ended December 31, 2008.
 
 
 Table of Contents
 -6-
 NOVABAY PHARMACEUTICALS,
INC.
 (a
development stage company)
 
 NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
 
 The
Company believes these condensed consolidated financial statements reflect all
adjustments (consisting only of normal, recurring adjustments) that are
necessary for a fair presentation of the financial position and results of
operations for the periods presented. Results of operations for the interim
periods presented are not necessarily indicative of results to be expected for
the year. Certain prior period amounts have been reclassified to conform to the
current period presentation.
 
 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 there from. As of June 30,
2009, the Company had not commenced its planned principal
operations.
 
 
 Principles
of Consolidation
 
 The
accompanying condensed 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.
 
 
 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 approximates their fair value. As of June 30, 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.
 
 
 Table of Contents
 -7-
 NOVABAY
PHARMACEUTICALS, INC.
 (a
development stage company)
 
 NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
 
 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 sells 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 and
six months ended June 30, 2008 and 2009 are as follows (in
thousands):
 
 
 Three
      Months Ended June 30,
              
              
              Six
      Months Ended June 30,2008
              
              
              2009
              
              
              2008
              
              
              2009Net
      loss
              
              $
              (2,410
              )
              
              $
              (289
              )
              
              $
              (5,089
              )
              
              $
              (607
              )Change
      in unrealized gains (losses) on investments
              
              
              10
              
              
              
              5
              
              
              
              27
              
              
              
              (3
              )Comprehensive
      loss
              
              $
              (2,400
              )
              
              $
              (284
              )
              
              $
              (5,062
              )
              
              $
              (610
              )
 
 
 
 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.
 
 
 Table of Contents
 -8-
  
 NOVABAY
PHARMACEUTICALS, INC.
 (a
development stage company)
 
 NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
 
 
 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 SFAS No. 157, “Fair Value Measurements ,”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 provisions of SFAS 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. Effective January 1, 2009, the
Company adopted the provisions of SFAS No. 157 for non-financial assets and
liabilities that are required to be measured at fair value. The adoption of the
provisions of SFAS No. 157 did not materially impact the
Company’s consolidated financial position and results of
operations.
 
 SFAS 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. SFAS 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. SFAS 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 over the shorter of their
useful life or the life of the lease term. Amortization 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 discounted 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.
 
 Table of Contents
 -9-
 
 
 NOVABAY
PHARMACEUTICALS, INC.
 (a
development stage company)
 
 NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
 
 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 performs 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”) Topic 13, “Revenue Recognition.” In
accordance with SAB Topic 13, 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 collectability is reasonably assured.
 
 Assuming
the elements meet the EITF No. 00-21 criteria for separation and the SAB Topic
13 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 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 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.
 
 
 
 Table of Contents
 -10-
  
 NOVABAY
PHARMACEUTICALS, INC.
 (a
development stage company)
 
 NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
 
 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 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 9 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 consolidated
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.
 
 
 
 Table of Contents
 -11-
 
 NOVABAY
PHARMACEUTICALS, INC.
 (a
development stage company)
 
 NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
 
 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 measurement date. The measurement of
stock-based compensation is subject to periodic adjustment as the underlying
equity instruments vest. Nonemployee
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:
 
 
 Six
      Months EndedJune
      30,(In
      thousands)
              
              2008
              
              
              2009Convertible
      preferred stock
              
              
              -
              
              
              
              -Stock
      options
              
              
              3,005
              
              
              
              3,725Stock
      warrants
              
              
              350
              
              
              
              650
  
 Recent
Accounting Pronouncements
 
 In November
2007, the Financial Accounting Standards Board (“FASB”) ratified Emerging Issues
Task Force Issue No. 07-1, “Accounting for Collaborative Arrangements,” (“EITF
07-1”) which definescollaborative arrangements and establishes reporting and
disclosure requirements for such arrangements. EITF 07-1 is effective for fiscal
years beginning after December 15, 2008. The adoption of EITF 07-1 did not have
a material effect on the Company’s results of operations, financial position,
and cash flows.
 
 Table of Contents
 -12-
 NOVABAY
PHARMACEUTICALS, INC.
 (a
development stage company)
 
 NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
 
 In June 2008,
the FASB ratified Emerging Issues Task Force Issue No. 07-5, “Determining
Whether an Instrument (or an Embedded Feature) Is Indexed to an Entity’s Own
Stock” (“EITF 07-5”). EITF 07-5 provides that an entity should use a two step
approach to evaluate whether an equity-linked financial instrument (or embedded
feature) is indexed to its own stock, including evaluating the instrument’s
contingent exercise and settlement provisions. It also clarifies the impact of
foreign currency denominated strike prices and market-based employee stock
option valuation instruments on the evaluation. EITF 07-5 is effective for
fiscal years beginning after December 15, 2008. The adoption of EITF 07-5 did
not have a material effect on the Company’s results of operations, financial
position, and cash flows.
 
 In April
2009, the FASB issued FASB Staff Position FAS 157-4, “Determining Fair Value
When the Volume and Level of Activity for the Asset or Liability Have
Significantly Decreased and Identifying Transactions That Are Not Orderly” (“FSP
157-4”). FSP 157-4 provides significant guidance for determining when a market
has become inactive as well as guidance for determining whether transactions are
not orderly. FSP 157-4 also provides guidance on the use of valuation techniques
and the use of broker quotes and pricing services. It reiterates that fair value
is based on an exit price and also that fair value is market-driven and not
entity-specific. FSP 157- 4 applies to all assets and liabilities within the
scope of SFAS No. 157. FSP 157-4 is effective for all interim and annual periods
ending after June 15, 2009. The adoption of FSP 157-4 did not have a material
effect on the Company’s results of operations, financial position, and cash
flows.
 
 In April
2009, the FASB issued FASB Staff Position FAS 115-2, FAS 124-2 and EITF 99-20-2,
“Recognition and Presentation of Other-Than-Temporary Impairments” (“FSP
115-2”). FSP 115-2 provides guidance related to determining the amount of an
other-than-temporary impairment (OTTI) of debt securities and prescribes the
method to be used to present information about an OTTI in the financial
statements. FSP 115-2 is effective for all interim and annual periods ending
after June 15, 2009. The adoption of FSP 115-2 did not have a material effect on
the Company’s results of operations, financial position, and cash
flows.
 
 In April
2009, the FASB issued FASB Staff Position FAS 107-1 and APB 28-1, “Interim
Disclosures about Fair Value of Financial Instruments” (“FSP 107-1”), which
increases the frequency of fair value disclosures to a quarterly basis instead
of an annual basis. The guidance relates to fair value disclosures for any
financial instruments that are not currently reflected on the balance sheet at
fair value. FSP 107-1 is effective for interim and annual periods ending after
June 15, 2009. The adoption of FSP 107-1 did not have a material effect on the
Company’s results of operations, financial position, and cash
flows.
 
 In June 2009,
the FASB issued SFAS No. 165, Subsequent Events. SFAS No.
165 provides guidance as to the period after the balance sheet date during which
management must evaluate events or transactions that may occur for potential
recognition or disclosure in the financial statements, the circumstances under
which an entity shall recognize events or transactions occurring after the
balance sheet date in its financial statements, and the disclosures that an
entity must make about events or transactions that occurred after the balance
sheet date. SFAS No. 165 is effective for periods ending after June 15, 2009.
The adoption of SFAS No. 165 did not have a material effect on the Company’s
results of operations, financial position, and cash flows.
 
 In June 2009,
the FASB issued SFAS No. 168, “The FASB Accounting Standards
CodificationTM and the
Hierarchy of Generally Accepted Accounting Principles.” SFAS No. 168 replaces
SFAS No. 162, “The Hierarchy of Generally Accepted Accounting Principles,”and
establishes the FASB Accounting Standards CodificationTM as the
source of authoritative accounting guidance under U.S. GAAP. The rules and
interpretive releases of the Securities and Exchange Commission (SEC) under
authority of federalsecurities laws are also sources of authoritative U.S. GAAP
for SEC registrants. SFAS No. 168 is effective for periods ending after
September 15, 2009. The Company does not expect SFAS No. 168 to have a material
effect on its results of operations, financial position, and cash
flows.
 
 
 Table of Contents
 -13-
 
 NOVABAY
PHARMACEUTICALS, INC.
 (a
development stage company)
 
 NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
 
 NOTE
3. INVESTMENTS AND FAIR VALUE MEASUREMENTS
 
 There
were no short-term investments at December 31, 2008. Short-term investments at
June 30, 2009 consisted of the following:
  June
      30, 2009(in
      thousands)
                
                Cost
                
                
                Gross
      Unrealized
                  Gains
                
                
                Gross
      Unrealized Losses
                
                
                Other-Than
      Temporary Impairment
                
                
                Fair
      ValueCorporate
      bonds
                
                $
                753
                
                
                $
                -
                
                
                $
                (1
                )
                
                $
                -
                
                
                $
                752Certificates
      of Deposit
                
                
                1,935
                
                
                
                -
                
                
                
                (2
                )
                
                
                -
                
                
                
                1,933$
                2,688
                
                
                $
                -
                
                
                $
                (3
                )
                
                $
                -
                
                
                $
                2,685
 
 Contractual
maturities of short-term investments as of June 30, 2009 were as
follows:
 
 
 
 June
      30, 2009(in
      thousands)
              
              
              Cost
              
              Fair
      ValueDue
      in one year or less
              
              $
              2,688
              
              $  2,685Due
      after 1 year
              
              
              -
              
              -Total
              
              $
              2,688
              
              $
      2,685
 
 
 We did
not recognize any realized gains or losses for the three and six months ended
June 30, 2008 and 2009 respectively.  For the cumulative period from
July 1, 2002 (date of development stage inception) to June 30, 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.
 
 Table of Contents
 -14-
 
 
 
 NOVABAY
PHARMACEUTICALS, INC.
 (a
development stage company)
 
 NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
 
  
 The
following table presents the Company’s investments measured at fair value on a
recurring basis as of June 30, 2009 classified by the SFAS No. 157 valuation
hierarchy:
 
 
 Fair
      Value Measurements Using(in
      thousands)
              
              Total
              
              
              Level
      1
              
              
              Level
      2
              
              
              Level
      3Cash
      Equivalents
              
              $
              1,054
              
              
              $
              1,054
              
              
              $
              -
              
              
              $
              -Short-term
      investments:Corporate
      bonds
              
              
              752
              
              
              
              -
              
              
              
              752
              
              
              
              -Certificates
      of   Deposit
              
              
              1,933
              
              
              
              -
              
              
              
              1,933
              
              
              
              -Total
      short-term investments
              
              
              2,685
              
              
              
              -
              
              
              
              2,685
              
              
              
              -Total
              
              $
              3,739
              
              
              $
              1,054
              
              
              $
              2,685
              
              
              $
              -
 
 
 
 NOTE
4. PROPERTY AND EQUIPMENT
 
 Property
and equipment consisted of the following:
 
 December
      31,
              
              
              June
      30,(in
      thousands)
              
              2008
              
              
              2009Office
      and laboratory equipment
              
              $
              1,728
              
              
              $
              2,012Furniture
      and fixtures
              
              
              113
              
              
              
              113Software
              
              
              110
              
              
              
              114Leasehold
      improvement
              
              
              143
              
              
              
              146Total
      property and equipment, at cost
              
              
              2,094
              
              
              
              2,385Less:
      accumulated depreciation
              
              
              (638
              )
              
              
              (810
              )Total
      property and equipment, net
              
              $
              1,456
              
              
              $
              1,575
 
 
 Depreciation
expense was $304,000 and $171,656 for the year ended December 31, 2008 and the
six months ended June 30, 2009, respectively and $875,656 for the cumulative
period from July 1, 2002 (dateof development stage inception) to June 30,
2009.
 
 Table of Contents
 -15-
 
 NOVABAY
PHARMACEUTICALS, INC.
 (a
development stage company)
 
 NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
 
  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:
 December
      31,
              
              
              June
      30,(in
      thousands)
              
              2008
              
              
              2009Office
      and laboratory equipment
              
              $
              229
              
              
              $
              229Less:  accumulated
      depreciation
              
              
              (47
              )
              
              
              (64
              )Capital
      lease assets, net
              
              $
              182
              
              
              $
              165
 
 
 NOTE
5. ACCRUED LIABILITIES
 
 Accrued
liabilities consisted of the following:
 
 
 December
      31,
              
              
              June
      30,(in
      thousands)
              
              2008
              
              
              2009Research
      and development
              
              $
              509
              
              
              $
              109Employee
      payroll and benefits
              
              
              423
              
              
              
              201Professional
      fees
              
              
              182
              
              
              
              64Other
              
              
              52
              
              
              
              262Total
      accrued liabilities
              
              $
              1,166
              
              
              $
              636
 
 
 NOTE
6. 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%. In April
2008, the agreement was extended to April 2009, and as a result no further
borrowings are permitted on this loan.  There are no loan covenants
specified in the agreement.
 
 As of
June 30, 2009, the Company had an outstanding equipment loan balance of $658,095
carrying a weighted-average interest rate of 10.95%.
 
 
 Table of Contents
 -16-
 
 
 
 
 NOVABAY
PHARMACEUTICALS, INC.
 (a
development stage company)
 
 NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
 
 NOTE
7. 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 $189,288 and
$358,288 for the three and six months ended June 30, 2008. Rent expense was
$213,504 and $439,722 for the three and six months ended June 30,
2009.  For the cumulative period from July 1, 2002 (date of
development stage inception) to June 30, 2009, rent expense was
$2,381,254.
 
 
 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 June 30, 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
8. 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 June 30, 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 June 30, 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 condensed consolidated 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.
 
 Table of Contents
 -17-
 NOVABAY
PHARMACEUTICALS, INC.
 (a
development stage company)
 
 NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
 
 
 Stock
Warrants
 
 At June
30, 2009, there were outstanding warrants to purchase 650,000 shares of common
stock at a weighted-average exercise price of $4.00 per share.
 
 NOTE
9. EQUITY-BASED COMPENSATION
 
 Equity
Compensation Plans
 
  Prior to the IPO,the Companyhad 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
Companyadopted 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.   Beginning in January 2009, the number
of shares of common stock authorized for issuance under the 2007 Plan increases
annually in an amount equal to the lesser of (a) 1,000,000 shares or (b) 4% of
the number of shares of the Company’s common stock outstanding on the last day
of the preceding year or (c) such lesser number as determined by the board of
directors.  Accordingly, an additional 858,766 shares of common stock
were authorized for issuance under the 2007 Plan in January 2009. As
ofJune 30, 2009, there were 1,135,952
shares available for future grant 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
June 30, 2009 and activity during the six month period then ended.
 
 
 Table of Contents
 -18-
  
  NOVABAY
PHARMACEUTICALS, INC.
 (a
development stage company)
 
 NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
 
 
 (in
      thousands, except per share data)
              Options
              Weighted-Average
                Exercise
      Price
              
              Weighted-Average
                Remaining
                Contractual
      Life (years)
              Aggregate
      Intrinsic
                ValueOutstanding
      at December 31, 2008
              3,371
              
              $
              1.71Options
      granted
              474
              
              $
              1.75Options
      exercised
              (89)
              
              $
              0.64Options
      forfeited/cancelled
              (128)
              
              $
              2.14Outstanding
      at June 30, 2009
              3,628
              
              $
              1.72
              
              6.7
              $
      2,688Vested
      and expected to vest at June 30, 2009
              3,581
              
              $
              1.70
              
              6.7
              $
      2,680Vested
      at June 30, 2009
              2,140
              
              $
              1.31
              
              5.5
              $
      2,311Exercisable
      at June 30, 2009
              2,381
              
              $
              1.48
              
              5.7
              $
      2,346
 
 
  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 June 30, 2009. The
Company received cash payments for the exercise of stock options in the amount
of $10,000 and $57,000 during the three and six months ended June 30, 2009,
respectively, and the aggregate intrinsic value of stock option awards exercised
was $101,000 and $110,000, respectively for the same periods, as determined at
the date of option exercise.  For both the three months and six months
ended June 30, 2008, the Company received cash payments in the amount of
$132,700 and the aggregate intrinsic value of stock option awards exercised was
$78,000.
  The
options outstanding and vested by exercise price at June 30, 2009 were as
follows (number of options in thousands):
  Options
      Outstanding
              
              
              Options
      VestedRange
      of Exercise Prices
              
              
              Number
      Outstanding
              
              
              Weighted-Average
      Remaining Contractual Life (years)
              
              
              Weighted-Average
      Exercise Price
              
              
              Number
      Vested
              
              
              Weighted-Average
      Exercise Price$
              0.20
              
              
              
              494
              
              
              
              2.6
              
              
              $
              0.20
              
              
              
              494
              
              
              $
              0.20$
              0.30
              
              
              
              318
              
              
              
              4.5
              
              
              $
              0.30
              
              
              
              318
              
              
              $
              0.30$
              0.56
              
              
              
              192
              
              
              
              4.9
              
              
              $
              0.56
              
              
              
              184
              
              
              $
              0.56$
              0.94-$1.56
              
              
              
              504
              
              
              
              8.2
              
              
              $
              1.35
              
              
              
              170
              
              
              $
              1.12$
              1.70-$1.95
              
              
              
              1,103
              
              
              
              7.8
              
              
              $
              1.81
              
              
              
              569
              
              
              $
              1.70$
              2.00-$2.41
              
              
              
              356
              
              
              
              6.0
              
              
              $
              2.27
              
              
              
              115
              
              
              $
              2.22$
              3.56-$4.00
              
              
              
              661
              
              
              
              8.5
              
              
              $
              3.27
              
              
              
              290
              
              
              $
              3.733,628
              
              
              
              6.7
              
              
              $
              1.72
              
              
              
              2,140
              
              
              $
              1.31
 
 
 Table of Contents
 -19-
 
 NOVABAY
PHARMACEUTICALS, INC.
 (a
development stage company)
 
 NOTES TOCONDENSEDCONSOLIDATED FINANCIAL
STATEMENTS—(Continued
 
 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:
  
 Six
      Months Ended June 30,Assumption
              
              2008
              
              
              2009Expected
      price volatility
              
              
              70
              %
              
              
              84
              %Expected
      term (in years)
              
              
              6.1
              
              
              
              6.1Risk-free
      interest rate
              
              
              3.2
              %
              
              
              1.9
              %Dividend
      yield
              
              
              0.0
              %
              
              
              0.0
              %Weighted-average
      fair value of options granted during the period
              
              $
              2.12
              
              
              $
              1.13
   Expected Price
Volatility—This is a measure of the amount by which the stock price has
fluctuated or is expected to fluctuate. 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. 110.
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.
  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.
  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 six months ended June 30, 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 June 30, 2009 and 2008, the Company recognized stock-based
compensation expense of $173,000 and $166,000, respectively, for option awards
to employees and directors.  For the six months ended June 30, 2009
and 2008, the Company recognized $340,000 and $343,000
respectively.  As of June 30, 2009, total unrecognized compensation
cost related to unvested stock options granted or modified on or after
January 1, 2006 was $1.6 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 2.7 years.
 
 Table of Contents
 -20-
 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 106,381 and 35,124 shares
of common stock to independent directors during the six months ended June 30,
2009 and 2008 respectively. 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 $32,687 and $170,370 for common stock awards to
directors during the three and six months ended June 30, 2009, and $39,170 and
$93,286 respectively, during the three and six months ended June 30,
2008.
  Summary
of Stock-Based Compensation Expense
 
 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, it does 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:
 
 Three
      Months Ended
              
              
              Six
      Months EndedJune
      30,
              
              
              June
      30,(in
      thousands)
              
              2008
              
              
              2009
              
              
              2008
              
              
              2009Research
      and development
              
              $
              96
              
              
              $
              92
              
              
              $
              205
              
              
              $
              178General
      and administrative
              
              
              109
              
              
              
              81
              
              
              
              232
              
              
              
              162Total
      stock-based compensation expense
              
              $
              205
              
              
              $
              173
              
              
              $
              437
              
              
              $
              340
 
  Stock-Based
Awards to Non-Employees
  During the
three months and six months ended June 30, 2009 the Company granted options to
purchase an aggregate of 120,000 and 180,000 shares of common stock,
respectively, to non-employees in exchange for advisory and consulting services.
There were no grants to non-employees in the six months ended June 30, 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
 -21-
  
 NOVABAY
PHARMACEUTICALS, INC.
 (a
development stage company)
 
 NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
  
 Six
      Months Ended June 30,Assumption
              
              2009Expected
      price volatility
              
              
              88
              %Expected
      term (in years)
              
              
              5.7Risk-free
      interest rate
              
              
              1.9
              %Dividend
      yield
              
              
              0.0
              %Weighted-average
      fair value of options granted during the period
              
              $
              1.47
 
 For the
three and six months ended June 30, 2009, the Company recognized stock-based
compensation expense of $23,000 and $79,000, respectively, related to
non-employee option grants. For the three months and six months ended June 30,
2008 the Company reversed previously recognized expense of $1,000 and $21,000
due to the required revaluation of unvested non-employee grants.  For
the first six months of 2008, there were no non-employee stock option
grants.
 
 NOTE
10. 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.
 
 
 
 Table of Contents
 -22-
 NOVABAY
PHARMACEUTICALS, INC.
 (a
development stage company)
 
 NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
 
 
 Revenue
has been recognized under the Alcon agreement as follows:
 
 Three
      Months Ended June 30,
              
              
              Six
      Months Ended June 30,(in
      thousands)
              
              2008
              
              
              2009
              
              
              2008
              
              
              2009Amortization
      of Upfront Technology Access Fee
              
              $
              625
              
              
              $
              625
              
              
              $
              1,250
              
              
              $
              1,250On-going
      Research and Development (FTE)
              
              
              675
              
              
              
              982
              
              
              
              1,350
              
              
              
              1,718Materials,
      Equipment, and Contract Study Costs
              
              
              108
              
              
              
              -
              
              
              
              260Milestone
      payments
              
              
              -
              
              
              
              -
              
              
              
              
              
              
              
              1,000Total
              
              $
              1,408
              
              
              $
              1,607
              
              
              $
              2,860
              
              
              $
              3,968
 
 
 At
December 31, 2008 and June 30, 2009, the Company had deferred revenue balances
of $4.2 million and $2.9 million, respectively, related to the Alcon agreement
which was comprised of  the upfront technology access fee for all
periods shown.
 
 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 where the Company has
commercialization rights, and North America, where the Compnay has an option to
exercise co-promotion rights.   Galderma will be responsible for
the development costs of the acne and other indications, except in Japan, in
which Galderma has the option to request that we share such development costs,
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 the right
to co-promote the products developed under the agreement in the hospital and
other healthcare institutions in North America. Upon the termination of the
agreement under certain circumstances, Galderma will grant NovaBay certain
technology licenses which would require NovaBay to make royalty payments to
Galderma for such licenses with royalty rates in the low- to mid-single
digits.
 
 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 the
agreement, NovaBay’s royalties will escalate as sales
increase. .  The Company received a $1.0 million upfront
technology access fee payment in the first quarter of 2009.
 
 
 Revenue
has been recognized under the Galderma agreement as follows:
 
 Three
      Months Ended June 30,
              
              
              Six
      Months Ended June 30,(in
      thousands)
              
              2008
              
              
              2009
              
              
              2008
              
              
              2009Amortization
      of Upfront Technology Access Fee
              
              $
              -
              
              
              $
              150
              
              
              $
              -
              
              
              $
              200On-going
      Research and Development (FTE)
              
              
              -
              
              
              
              600
              
              
              
              -
              
              
              
              800Materials,
      Equipment, and Contract Study Costs
              
              
              -
              
              
              
              -
              
              
              
              -Milestone
      payments
              
              
              -
              
              
              
              -
              
              
              
              
              
              
              
              -Total
              
              $
              -
              
              
              $
              750
              
              
              $
              -
              
              
              $
              1,000
 
 
 The
Company had deferred revenue balances of $0 and $.8 million respectively, at
December 31, 2008
and June 30, 2009, related to the Galderma agreement, which consisted of the
remaining amount to be amortized for the upfront technology access fee. As of
June 30, 2009, the Company had not earned or received any milestone or royalty
payments under the Galderma agreement.
 
 
 Table of Contents
 -23-
 
 NOVABAY
PHARMACEUTICALS, INC.
 (a
development stage company)
 
 NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
 
 
 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
11. 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 has made no contributions through June
30, 2009.
 
 NOTE
12. 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 in the event of an ownership change of a corporation. Accordingly,
the Company’s 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 its 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. The Company 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
thebeginning 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.
 
 Table of Contents
 -24-
 NOVABAY PHARMACEUTICALS,
INC.
 (a
development stage company)
 
 NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
 
 The
Company adopted the provisions of FIN 48 on January 1, 2007. There was no
impact on the Company’s consolidated financial position, results of operations
and cash flows as a result of adoption. The Company has no unrecognized tax
benefit as of December 31, 2008, including no accrued amounts for interest
and penalties. The Company’s policy will be to recognize interest and penalties
related to income taxes as a component of income tax expense. The Company is
subject to income tax examinations for U.S. incomes taxes and state income taxes
from 2002 forward. The Company does not anticipate that total unrecognized tax
benefits will significantly change prior to December 31, 2009.
 
 NOTE
13. SUBSEQUENT EVENTS
 
 In June 2009 the Company filed a shelf
registration statement on Form S-3 registering up to $20,000,000 of its
securities, which may be in the form of common stock, preferred stock, warrants
or debt securities, or units comprising a combination of such
securities.  The shelf registration statement was declared effective
in August 2009.
  On July 6,
2009, Pathogenics, Inc. filed a complaint against the Company in the United
States District Court for the District of Massachusetts, asserting that the
Company breached a contract, dated April 7, 2009, between the Company and
Pathogenics because the Company did not register 250,000 shares of Company
common stock issued to Pathogenics pursuant to such agreement on the Company’s
recently filed universal shelf registration statement referred to above. Under
such agreement, the Company terminated its commercial relationship with
Pathogenics for consideration, including the issuance of such 250,000 shares of
common stock. The agreement provides Pathogenics with registration rights in
certain circumstances. Pathogenic’s compliant seeks monetary damages and certain
injunctive relief, including an order to compel registration of the shares held
by Pathogenics and enjoin the Company’s registration of stock. The Company has
not been served with the complaint, and on August 13, 2009 the parties entered
into a settlement agreement, settling the matter.
  In July
2009, the Company announced that Alcon has begun treating patients in a Phase 2
clinical trial of NovaBay’s patented lead Aganocide®
compound, NVC-422, for viral conjunctivitis, a type of “pink
eye.”
 
 The Company
has evaluated events that occurred through August 14, 2009, the date of issuance
of these condensed consolidated financial statements, for inclusion or
disclosure in its condensed consolidated financial
statements.
 Table of Contents
 -25-
 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 statementsReaders 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
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. We
have discovered and are developing a 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.
 
 Table of Contents
 -26-
 In August
2006, we entered into a collaboration and license agreement with 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 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.
 
 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.
 
 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, , where
we have has commercialization rights, and North America, where we have an option
to exercise co-promotion rights.  Galderma will be responsible for the
development costs of  acne and other indications, except in Japan, in
which Galderman has the option to request that we share such development costs,
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  right 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. Upon
the termination of the agreement under certain circumstances, Galderma will
grant NovaBay certain technology licenses which would require NovaBay to make
royalty payments to Galderma for such licenses with royalty rates in the low- to
mid-single digits.
 
 Table of Contents
 -27-
 Our
business model is to develop our Aganocide compounds and enter into
collaboration and license agreements with other entities for different
indications using our Aganocide compounds.  For example, in June 2007,
we entered into a license agreement with Kinetic Concepts, Inc. ( KCI), under
which KCI paid to us a non-refundable technology access fee of $200,000. If
products covered by the license 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 milestone or other payments under this agreement since the
initial technology access fee.
 
 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 June 30, 2009, we had an accumulated deficit of $27.2
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.
  
 Recent
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 gains access to
clinical research, publications and patents on the uses of 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 June
2009 we filed a shelf registration statement on Form S-3 registering up to
$20,000,000 of  our securities, which may be in the form of common
stock, preferred stock, warrants or debt securities, or units comprising a
combination of such securities.  The shelf registration statement was
declared effective in August 2009.
 In July
2009, we announced that Alcon has begun treating patients in a Phase 2 clinical
trial of NovaBay’s patented lead Aganocide®
compound, NVC-422, for viral conjunctivitis, a type of “pink eye.”
 
 Table of Contents
 -28-
 
 Critical
Accounting Policies and Estimates
 Our
condensed consolidated financial statements have been prepared in accordance
with generally accepted accounting principles in the United States for interim
reporting. The preparation of these condensed consolidated 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
condensed consolidated 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.
 
 Our
significant accounting policies are more fully described in Note 2 of the Notes
to Condensed Consolidated Financial Statements, included in Part I, Item
1 of this report, , and are also described in Item 7 of our Annual Report
on Form 10-K for the year ended December 31, 2008.  We have not
materially changed these policies from those reported in our Annual Report on
Form 10-K for the year ended December 31, 2008.
 
 
 Results
of Operations
 
 Comparison
of the Three and Six Months Ended June 30, 2008  and June 30,
2009
 
 License
and Collaboration Revenue
 
 Total
license and collaboration revenue was $2.4 million for the three months ended
June 30, 2009, compared to $1.4 million for the three months ended June 30,
2008, and was $5.0 million for the six months ended June 30, 2009, compared to
$2.9 million for the six months ended June 30, 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.
 
 Table of Contents
 -29-
 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 39% to $1.4 million for the three
months ended June 30, 2009 from $2.4 million for the three months ended June 30,
2008.  Total research and development expenses decreased by 47% to
$2.8 million for the six months ended June 30, 2009 from $5.2 million for the
six months ended June 30, 2008. The decreases for each of the three and six
month periods  were primarily due to delayed research, development,
and clinical expenses.
 
 We expect
to incur increased research and development expenses in the second half of 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 the latter half of 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 24% to $1.2 million for
the three months ended June 30, 2009 compared to $1.6 million for the three
months ended June 30, 2008.   Total general and administrative
expenses decreased by 9% to $2.8 million for the six months ended June 30,
2009 compared to $3.0 million for the six months ended June 30,
2008.  General and administrative expenses were lower overall for each
of the three and six month periods due to decreased headcount and unfilled
positions offset by increases in spending on legal costs and Sarbanes-Oxley
implementation.
 
 We expect
that general and administrative expenses will increase during the second half of
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 (Expense), Net
 
 Other
income(expense), net decreased to $ (11,000) for the three months ended June 30,
2009 from $94,000 for the three months ended June 30, 2008. Other
income/(expense), net decreased to ($1,000) for the six months ended June 30,
2009 from $257,000 for the six months ended June 30, 2008. This decrease
was primarily attributable to the liquidation of short term investments in the
fourth quarter of 2008, with repurchases of short term investments in February
2009 with lower rates of return which resulted in less interest income in the
first six months of 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 (expense), net will vary based on fluctuations in our cash
balances and borrowings under equipment loans and the interest rate paid on such
balances and borrowings.
 
 Table of Contents
 -30-
 Liquidity
and Capital Resources
 
 We have
incurred cumulative net losses of $27.2 million since inception through June 30,
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 and our initial public
offering. 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,
optic 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 optic 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 2009 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%. In April 2008, the
agreement was extended through April 2009 , and as a result no further
borrowings are permitted on this loan.  There are no loan
covenants specified in the agreement. As of June 30, 2009, we had an
outstanding equipment loan balance of $658,095 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 June 2011.
 
 In March
2009, we entered into a license agreement with Galderma. Under the terms of the
agreement, we have received an initial upfront payment of $1.0 million. 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
June 30, 2009, we had cash, cash equivalents, and short-term investments of
$10.7 million compared to $12.1 million at December 31,
2008.
 
 Table of Contents
 -31-
 Cash
Flows
 
 The
following table provides information regarding our cash flows and our capital
expenditures for the six months ended June 30, 2008 and 2009.
 
 
 Six
      Months EndedJune
      30,(in
      thousands)
              
              2008
              
              
              2009Cash
      provided by (used in):Operating
      activities
              
              $
              5,283
              )
              
              $
              (979
              )Investing
      activities
              
              
              4,065
              
              
              
              (2,979
              )Financing
      activities
              
              
              275
              
              
              
              (141
              )Capital
      expenditures (included in investing activities above)
              
              
              (493
              )
              
              
              (291
              )
 
 
 Cash
Used in Operating Activities
 
 For the
six months ended June 30, 2008 cash used in operating activities of $5.3 million
was primarily attributable to our research and development and general and
administrative expenses in running our company. For the six months ended June
30, 2009, cash used in operating activities was only $1.0 million, due
to  the receipt of milestone and other cash payments from
collaborative agreements, which  offset for the most part our research
and development and general and administrative expenses.
 
 
 Cash
Used in (Provided by) Investing Activities
 
 For the
six months ended June 30, 2008, cash provided by investing activities of
$4.1 million was attributable to sales or maturities of short-term investments
(net of purchases) of $4.6 million and purchases of property and equipment of
$493,000.
 
 For the
six months ended June 30, 2009, cash used in investing activities of $2.9
million was attributable to purchases of short-term investments of $2.7 million
and purchases of property and equipment of $291,000.
 
 Table of Contents
 -32-
 
 
 Cash
Provided by( Used in) Financing Activities
 
 Our
financing activities provided cash of $275,000 in the six months ended June 30
2008. Our financing activities for the six months ended June 30, 2008 primarily
consisted of $422,000 from borrowings under an equipment loan, offset by
$131,000 in principal payments on an equipment loan and $18,000 in payments on
capital leases.
 
 Net cash
used in financing activities of $141,000 for the six months ended June 30, 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.
 
 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 $20.0 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 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.
 
 Table of Contents
 -33-
 Contractual
Obligations
 
 Our
commitments consist of an operating lease, a capital lease, and an equipment
loan.  The operating lease consists of payments relating to the lease
for various laboratory and office space in one office building in Emeryville,
California. This lease expires on October 31, 2015. Our commitment for a
capital lease consists of the total payments due under one lease of laboratory
equipment. The capital lease amount of $33,589 includes $1,482 of interest
payments over the remaining term of the lease. Our commitment for the
equipment loan consists of the total payments due under the loan facility of
$725,001. This amount includes $66,906 of interest payments over the remaining
term of the loan.
 
 We expect the
total cash, cash equivalents and short-term investments, along with committed
funding under our license agreement from Alcon, will be sufficient to fund cash
requirements for the next twelve months.
  •
              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.
 
 Table of Contents
 -34-
 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
 -35-
 ITEM 4. CONTROLS AND PROCEDURES
 
 Evaluation
of Disclosure Controls and Procedures
 
 As of the
end of the period covered by this report, we 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 June 30, 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.
 
 ITEM 4T. CONTROLS AND PROCEDURES
 
 Not
applicable.
 
 Table of Contents
 -36-
 PART II. OTHER INFORMATION
 
 ITEM
1. LEGAL PROCEEDINGS
 
  On July 6,
2009, Pathogenics, Inc. filed a complaint against our company in the United
States District Court for the District of Massachusetts, Case No.
09-CV-11142-RGS. The complaint asserts that we breached a contract, dated April
7, 2009, between Novabay and Pathogenics because we did not register 250,000
shares of Novabay common stock issued to Pathogenics pursuant to such
agreement on the our recently filed universal shelf registration statement.
Under such agreement, Novabay terminated its commercial relationship with
Pathogenics for consideration, including the issuance of such 250,000 shares of
common stock. The agreement provides Pathogenics with registration rights in
certain circumstances. Pathogenic’s compliant seeks monetary damages and certain
injunctive relief, including an order to compel registration of the shares held
by Pathogenics and enjoin our registration of stock. We have not been served
with the complaint, and on August 13, 2009 the parties entered into a settlement
agreement settling the matter. Novabay does not consider this matter to be
material.
  ITEM1A. 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, except that
the risk factor relating to shares subject to lock up agreements held by
certain of our officers and directors has been revised to reflect the
previous release of the majority of these shares from the lock up
agreements.
 
 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.
 
 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, the downturn
may adversely affect our business and operations in a number of ways, including
making it more difficult for us to raise capital as well as making  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.
 
 Table of Contents
 -37-
 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.
 
 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.
 
 Table of Contents
 -38-
 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 $8.1million,
respectively. Through June 30, 2009, we had an accumulated deficit of
approximately $27.2 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 six 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 $2.8 million for the six months ended June 30,
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.
 
 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 are 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.
 
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 -39-
 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
 
 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.
 
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 -40-
 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 the 2008 Annual
Report on  Form 10-K we were not required to have our independent
auditors audit our internal control over financial reporting, but in the current
year we are 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 our shareholders’ interests 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.
 
 Table of Contents
 -42-
 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.
 
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 -43-
 
 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.
 
 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.
 
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 -44-
 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 includes 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.
 
 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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 -45-
 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.
 
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 -46-
 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.
  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.
 
 
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 -47-
 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.
 
 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.
 
 Table of Contents
 -48-
 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, create 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.
 
 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.
 
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 -49-
 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.
 
 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.
 
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 -50-
 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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 -51-
 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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 -52-
 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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 -53-
 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 June
30, 2009, our officers and directors collectively controlled approximately
4,085,037 shares of our outstanding common stock (and approximately 5,033,130
shares of our common stock when including options held by them which were
exercisable as of or within 60 days of June 30, 2009). Furthermore, as of June
30, 2009, our largest shareholder, a family trust established and controlled by
Dr. Ramin Najafi, our Chairman and Chief Executive Officer, beneficially
owned3,127,700
shares or 14.2% of our outstandingcommonstock. 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 chief
executive officercould cause the market price of our common
stock to drop significantly, even if our business is doing
well.
 
 A total of
935,250shares held
by our chief executive officer will become eligible for sale in the
public market on October 25, 2009, as the shares are released from a lock-up
agreement 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 the lock-up
agreement, subject to applicable regulatory requirements. As the restriction on
resale ends, the market price of our stock could drop significantly if our chief
executive officer sells the shares or is 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.
 
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 -54-
 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 each
year;
 ·
              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 Canadian tax laws, 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 Canadian tax laws, there may be certain adverse tax
consequences for our Canadian investors.
 
 Table of Contents
 -55-
 ITEM
2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF
PROCEEDS
 
 Unregistered
Sales of Equity Securities
 
 On April
24, 2009, we issued an aggregate of 250,000 shares of our common stock to
Pathogenics, Inc. in exchange for the termination of an agreement between
NovaBay and Pathogenics.  These shares were issued in reliance on
Section 4(2) of the Securities Act of 1933, as amended, and Pathogenics
represented that it was an “accredited investor” as that term is defined in the
rules promulgated under the Securities Act of 1933, as amended.
 
 
 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 June 30, 2009, we estimate we
have used $9.35 million for research and development, $2.1 million for working
capital and $2.6 million for other general purposes. The remaining estimated
$2.7 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.
  Table of Contents
 -56-
 
 
 ITEM 4.
              SUBMISSION OF MATTERS TO A VOTE OF SECURITY
      HOLDERS
 We
held an Annual Meeting of our Stockholders on June 4, 2009, at which the
following occurred:
 
 ELECTION
OF CLASS II DIRECTORS TO THE BOARD OF DIRECTORS: The stockholders elected
Charles Cashion, Alex McPherson and Tony Wicks as Class II directors to serve
for a three-year term.  The votes on the matters were as
follows:
 
 NOMINEE
              FOR
              WITHHELDCharles
      Cashion
              15,348,223
              8,831Alex
      T. McPherson
              15,344,235
              12,819Tony
      Wicks
              15,348,140
              8,914
 
 
 
 The terms
of office of our other directors continued after the meeting.  These
directors are:  Ramin (“Ron”) Najafi, Ph.D., Anthony Dailley, D.D.S.,
Paul E. Freiman, Harry F. Hixson, Jr., and Robert R. Tufts.
 
 
 
 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
 -57-
 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:
      August 13, 2009
              NOVABAY
      PHARMACEUTICALS, INC./s/
      Ramin NajafiRamin
      (“Ron”) NajafiPresident
      and Chief Executive Officer
                (duly
      authorized officer)Date: August
      13, 2009
              /s/
      Thomas J. PaulsonThomas
      J. PaulsonChief
      Financial Officer
                (principal
      financial officer)
 
 
 
 
 Table of Contents
 -58-
 
 
 
 
 EXHIBIT
INDEX
 
 Exhibit No.
                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 certificate31.1
                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.