UNITED
STATES


SECURITIES
AND EXCHANGE COMMISSION


Washington,
D.C. 20549





FORM
10-Q





(Mark
One)


T
            QUARTERLY
      REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT
      OF 1934EXCHANGE
      ACT OF 1934





For the
quarterly period ended March 31, 2010





OR





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





For the
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. Yes x  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 during the
preceding 12 months (or for such shorter period that the registrant was
required to submit and post such files). Yes o  No o





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 Exchange Act. (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 x





As of May
7, 2010, there were 23,309,188 shares of the registrant’s common stock
outstanding.





1


NOVABAY
PHARMACEUTICALS, INC.





TABLE
OF CONTENTS


PART
      IFINANCIAL
      INFORMATIONItem 1.
              
              Financial
      Statements and Notes (unaudited)The
      following Consolidated Financial Statements are presented for NovaBay
      Pharmaceuticals, Inc, and its subsidiaries.1.
              Consolidated
      Statements of Operations:
              3Three
      months ended March 31, 2010 and 20092.
              Consolidated
      Balance Sheets:
              4March
      31, 2010 and December 31, 20093.
              Consolidated
      Statements of Cash Flows:
              5Three
      months ended March 31, 2010 and 20094.
              Notes
      to Consolidated Financial Statements
              6Item 2.
              
              Management’s
      Discussion and Analysis of Financial Condition and Results of
      Operations
              21Item 3.
              
              Quantitative
      and Qualitative Disclosures About Market Risk
              27Item 4.
              
              Controls
      and Procedures
              27Item 4T.
              
              Controls
      and Procedures
              27PART
      IIOTHER
      INFORMATIONItem 1A.
              
              Risk
      Factors
              28Item 6.
              
              Exhibits
              43SIGNATURES
              44




Unless
the context requires otherwise, all references in this report to “we,” “our,”
“us,” the “Company” and “NovaBay” refer to NovaBay Pharmaceuticals, Inc. and its
subsidiaries.





NovaBay
Pharma®,
Aganocide®,
NovaBayTM, AgaDermTM, AgaNaseTM, and NeutroPhaseTM are trademarks of NovaBay
Pharmaceuticals, Inc. All other trademarks and trade names are the property of
their respective owners.





2


PART
I


FINANCIAL INFORMATION


ITEM 1.
            FINANCIAL
      STATEMENTS





NOVABAY
PHARMACEUTICALS, INC.


(a
development stage company)


CONSOLIDATED
BALANCE SHEETS




March
      31,
              
              
              December
      31,2010
              
              
              2009(in thousands, except per share
      data)
              
              (unaudited)
              
              
              (Note
      2)ASSETSCurrent
      assets:Cash
      and cash equivalents
              
              $
              12,890
              
              
              $
              10,992Short-term
      investments
              
              
              854
              
              
              
              300Accounts
      receivable and other receivables
              
              
              51
              
              
              
              3,801Deferred
      tax asset
              
              
              —
              
              
              
              34Prepaid
      expenses and other current assets
              
              
              411
              
              
              
              479Total
      current assets
              
              
              14,206
              
              
              
              15,606Other
      assets
              
              
              225
              
              
              
              105Property
      and equipment, net
              
              
              1,736
              
              
              
              1,812TOTAL
      ASSETS
              
              $
              16,167
              
              
              $
              17,523LIABILITIES
      AND STOCKHOLDERS' EQUITYLiabilities:Current
      liabilities:Accounts
      payable
              
              $
              227
              
              
              $
              272Accrued
      liabilities
              
              
              681
              
              
              
              1,228Capital
      lease obligation
              
              
              —
              
              
              
              7Equipment
      loan
              
              
              330
              
              
              
              364Deferred
      revenue
              
              
              2,701
              
              
              
              2,167Total
      current liabilities
              
              
              3,939
              
              
              
              4,038Deferred
      tax liability
              
              
              —
              
              
              
              34Equipment
      loan - non-current
              
              
              42
              
              
              
              106Total
      liabilities
              
              
              3,981
              
              
              
              4,178Stockholders'
      Equity:Common
      stock, $0.01 par value; 65,000 shares authorized at March 31, 2010 and
      December 31, 2009;  23,306 and 23,254 issued and outstanding at
      March 31, 2010 and December 31, 2009, respectively
              
              
              233
              
              
              
              233Additional
      paid-in capital
              
              
              37,475
              
              
              
              37,003Accumulated
      other comprehensive loss
              
              
              (2
              )
              
              
              —Accumulated
      deficit during development stage
              
              
              (25,520
              )
              
              
              (23,891
              )Total
      stockholders' equity
              
              
              12,186
              
              
              
              13,345TOTAL
      LIABILITIES AND STOCKHOLDERS' EQUITY
              
              $
              16,167
              
              
              $
              17,523


The
accompanying notes are an integral part of these consolidated financial
statements.




3





NOVABAY
PHARMACEUTICALS, INC.


(a
development stage company)


CONSOLIDATED
STATEMENTS OF OPERATIONS


(unaudited)





March
      31,
                Three
      Months Ended
              
              
              Cumulative Period
      from July 1, 2002 (date of development stage inception)
      to
                March
      31,(in thousands, except per share
      data)
              
              2010
              
              
              2009
              
              
              2010Revenue:License
      and collaboration revenue
              
              $
              2,084
              
              
              $
              2,611
              
              
              $
              31,936Operating
      Expenses:Research
      and development
              
              
              2,233
              
              
              
              1,361
              
              
              
              34,577General
      and administrative
              
              
              1,469
              
              
              
              1,579
              
              
              
              24,040Total
      operating expenses
              
              
              3,702
              
              
              
              2,940
              
              
              
              58,617Other
      income (expense), net
              
              
              (11
              )
              
              
              11
              
              
              
              1,182Loss
      before income taxes
              
              
              (1,629
              )
              
              
              (318
              )
              
              
              (25,499
              )Provision
      for income taxes
              
              
              —
              
              
              
              —
              
              
              
              (21
              )Net
      loss
              
              $
              (1,629
              )
              
              $
              (318
              )
              
              $
              (25,520
              )Net
      loss per share:Basic
      and diluted
              
              $
              (0.07
              )
              
              $
              (0.01
              )Shares
      used in per share calculations:Basic
      and diluted
              
              
              23,300
              
              
              
              21,620


The
accompanying notes are an integral part of these consolidated financial
statements.





4




NOVABAY
PHARMACEUTICALS, INC.


(a
development stage company)


CONSOLIDATED
STATEMENTS OF CASH FLOWS


(unaudited)




Three
      Months Ended
                March
      31,
              
              
              Cumulative
      Period from July 1, 2002 (date of development stage inception) to March
      31, 2010(in
      thousands)
              
              2010
              
              
              2009Cash
      flows from operating activities:Net
      loss
              
              $
              (1,629
              )
              
              $
              (318
              )
              
              $
              (25,520
              )Adjustments
      to reconcile net loss to net cash used in operating
      activities:Depreciation
      and amortization
              
              
              106
              
              
              
              84
              
              
              
              1,183Accretion
      of discount on short-term investments
              
              
              —
              
              
              
              —
              
              
              
              (259
              )Net
      realized gain (loss) on sales of short-term investments
              
              
              —
              
              
              
              —
              
              
              
              (3
              )Loss
      on disposal of property and equipment
              
              
              —
              
              
              
              —
              
              
              
              121Stock-based
      compensation expense for options issued to employees and
      directors
              
              
              304
              
              
              
              305
              
              
              
              2,686Compensation
      expense for warrants and stock issued for services
              
              
              82
              
              
              
              74
              
              
              
              270Stock-based
      compensation expense for options and stock issued to
      non-employees
              
              
              48
              
              
              
              56
              
              
              
              846Taxes
      paid by LLC
              
              
              —
              
              
              
              —
              
              
              
              1Changes
      in operating assets and liabilities:(Increase)
      decrease in accounts receivable
              
              
              3,714
              
              
              
              —
              
              
              
              (87
              )Increase
      in prepaid expenses and other assets
              
              
              27
              
              
              
              (269
              )
              
              
              (586
              )Increase
      (decrease) in accounts payable and accrued liabilities
              
              
              (594
              )
              
              
              (131
              )
              
              
              933(Increase)
      decrease in deferred revenue
              
              
              534
              
              
              
              1,061
              
              
              
              2,700Increase
      in deferred tax
              
              
              (34
              )
              
              
              —
              
              
              
              —Net
      cash provided by (used in) operating activities
              
              
              2,558
              
              
              
              862
              
              
              
              (17,715
              )Cash
      flows from investing activities:Purchases
      of property and equipment
              
              
              (30
              )
              
              
              (27
              )
              
              
              (2,921
              )Proceeds
      from disposal of property and equipment
              
              
              —
              
              
              
              —
              
              
              
              46Purchases
      of short-term investments
              
              
              (862
              )
              
              
              (3,015
              )
              
              
              (99,381
              )Proceeds
      from maturities and sales of short-term investments
              
              
              300
              
              
              
              375
              
              
              
              98,782Cash
      acquired in purchase of LLC
              
              
              —
              
              
              
              —
              
              
              
              516Net
      cash used in investing activities
              
              
              (592
              )
              
              
              (2,667
              )
              
              
              (2,958
              )Cash
      flows from financing activities:Proceeds
      from preferred stock issuances, net
              
              
              —
              
              
              
              —
              
              
              
              11,160Proceeds
      from common stock issuances
              
              
              —
              
              
              
              —
              
              
              
              17Proceeds
      from exercise of options and warrants
              
              
              37
              
              
              
              47
              
              
              
              1,872Proceeds
      from initial public offering, net of costs
              
              
              —
              
              
              
              —
              
              
              
              17,077Proceeds
      from shelf offering, net of costs
              
              
              —
              
              
              
              —
              
              
              
              1,944Proceeds
      from stock subscription receivable
              
              
              —
              
              
              
              —
              
              
              
              873Proceeds
      from issuance of notes
              
              
              —
              
              
              
              —
              
              
              
              405Principal
      payments on capital lease
              
              
              (7
              )
              
              
              (10
              )
              
              
              (157
              )Proceeds
      from borrowings  under equipment loan
              
              
              —
              
              
              
              —
              
              
              
              1,216Principal
      payments on equipment loan
              
              
              (98
              )
              
              
              (88
              )
              
              
              (844
              )Net
      cash provided by (used in) financing activities
              
              
              (68
              )
              
              
              (51
              )
              
              
              33,563Net
      increase (decrease) in cash and cash equivalents
              
              
              1,898
              
              
              
              (1,856
              )
              
              
              12,890Cash
      and cash equivalents, beginning of period
              
              
              10,992
              
              
              
              12,099
              
              
              
              —Cash
      and cash equivalents, end of period
              
              $
              12,890
              
              
              $
              10,243
              
              
              $
              12,890


The
accompanying notes are an integral part of these consolidated financial
statements.





5
 
 NOVABAY
PHARMACEUTICALS, INC.
 (a
development stage company)
 
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 (unaudited)


NOTE
1. ORGANIZATION





NovaBay
Pharmaceuticals, Inc. (the “Company”) is a clinical stage biotechnology company
developing first-in-class anti-infectives for the treatment and prevention of
infections due to bacteria, fungi and virus, including antibiotic-resistant
infections.  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, fungal 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.





The
Company was incorporated under the laws of the State of California on
January 19, 2000 as NovaCal Pharmaceuticals, Inc.  We had no
operations until July 1, 2002, on which date we acquired all of the
operating assets of NovaCal Pharmaceuticals, LLC, a California limited liability
company.  In February 2007, we changed our name from NovaCal
Pharmaceuticals, Inc. to NovaBay Pharmaceuticals, Inc.  In August
2007, we 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.  We currently operate in one business
segment.





In
October 2007, we completed an initial public offering of our common stock
(“IPO”) in which we sold and issued 5,000,000 shares of our common stock at a
price to the public of $4.00 per share.  We 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, we 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
were exercisable on or after October 31, 2008 and expire on
October 31, 2010.





In August
2009, the Company completed a sale of equity securities from its shelf
registration statement (“Shelf Registration Offering”) in which the Company sold
and issued 1,225,000 units, with each unit consisting of one share of the
Company’s common stock and a warrant to purchase one share of the Company’s
common stock.  The purchase price for each unit was
$2.00.  Each warrant has an exercise price of $2.75 per share, and
will be exercisable 180 days after issuance and will expire five years from the
date of issuance.  The shares of common stock and the warrants were
immediately separable and were issued separately, but were purchased together in
the Shelf Registration Offering.  The Company raised a total of $2.5
million from the Shelf Registration Offering, or approximately $ 1.9 million in
net proceeds after deducting underwriting commissions of $156,000 and other
offering costs of approximately $350,000.


NOTE
2.  SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES





Basis
of Presentation





The
accompanying unaudited consolidated financial statements of NovaBayPharmaceuticals,
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  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, 2009.  The consolidated balance sheet at December
31, 2009 has been derived from the audited financial statements at that date,
but does not include all of the information and footnotes required by U.S.
generally accepted accounting principles for complete financial
statements.





6
 
 NOVABAY
PHARMACEUTICALS, INC.
 (a
development stage company)
 
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
 (unaudited)


The
Company believes these 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 for 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
March 31, 2010, the Company had not commenced its planned principal
operations.





Principles
of Consolidation





The
accompanying consolidated financial statements include the accounts of the
Company and its wholly-owned subsidiaries, NovaBay Pharmaceuticals Canada, Inc.
and DermaBay, Inc.  All inter-company accounts and transactions have
been eliminated in consolidation.





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,
Cash Equivalents and Short-Term Investments





The
Company considers all highly liquid instruments with a stated maturity of three
months or less at the date of purchase to be cash and cash
equivalents.  Cash and cash equivalents are stated at cost, which
approximates their fair value.  As of March 31, 2010, the Company’s
cash and cash equivalents were held in financial institutions in the United
States and include deposits in money market funds, which were unrestricted as to
withdrawal or use.





The
Company classifies all highly liquid investments with a stated maturity of
greater than three months at the date of purchase 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.  The 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.





Concentrations
of Credit Risk and Major Partners





Financial
instruments which potentially subject us to significant concentrations of credit
risk consist primarily of cash and cash equivalents and short-term
investments.  We maintain 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.  We do not believe we are exposed to significant credit risk
due to the financial position of the financial institutions in which these
deposits are held.  Additionally, we have established guidelines
regarding diversification and investment maturities, which are designed to
maintain safety and liquidity.





During
the quarters ended March 31, 2010 and 2009, 100% of our operating revenues were
derived from two of our collaborative partners.  As of December 31,
2009, 100% of our accounts receivables were from one of our collaborative
partners.





7
 
 NOVABAY
PHARMACEUTICALS, INC.
 (a
development stage company)
 
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
 (unaudited)


Comprehensive
Loss





Comprehensive loss consists of net loss
plus the change in unrealized gains and losses on available-for-sale
securities.  At each balance sheet date presented, the Company’s other
comprehensive loss consists solely of unrealized gains and losses on
available-for-sale securities.  Comprehensive loss for the three
months ended March 31, 2010 and 2009 are as follows (in thousands):





Three
      Months Ended March 31,2010
              
              
              2009Net
      loss
              
              $
              (1,629
              )
              
              $
              (318
              )Other
      comprehensive income:Change
      in unrealized gains (losses) on available-for-sale
    securities
              
              
              (2
              )
              
              
              (8
              )Comprehensive
      loss
              
              $
              (1,631
              )
              
              $
              (326
              )








Fair
Value Measurement 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
authoritative guidance 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 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
for non-financial assets and liabilities that are required to be measured at
fair value.  The adoption of these provisions did not materially
impact the Company’s consolidated financial position and results of
operations.





Fair
value is defined 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.  A fair value hierarchy
is also established, which requires an entity to maximize the use of observable
inputs and minimize the use of unobservable inputs when measuring fair
value.  There are 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.





8
 
 NOVABAY
PHARMACEUTICALS, INC.
 (a
development stage company)
 
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
 (unaudited)


Impairment
of Long-Lived Assets





The
Company accounts for long-lived assets by considering 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.





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 authoritative guidance, the Company
analyzes its multiple element arrangements to determine whether the element 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.  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 revenue recognition guidelines 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 and recognized in
the period the reimbursable expenses are incurred.  Payments received
in advance are recorded as deferred revenue until the research and development
services are performed or costs are incurred.





Milestones—Substantive
milestone payments are considered to be performance bonuses that are recognized
upon achievement of the milestone only if all of the following conditions are
met: the milestone payments are non-refundable; achievement of the milestone
involves a degree of risk and was not reasonably assured at the inception of the
arrangement; substantive effort is involved in achieving the milestone; the
amount of the milestone is reasonable in relation to the effort expended or the
risk associated with achievement of the milestone; and a reasonable amount of
time passes between the up-front license payment and the first milestone payment
as well as between each subsequent milestone payment.  If any of these
conditions are not met, the milestone payments are deferred and recognized as
revenue over the term of the arrangement as the Company completes its
performance obligations.





Royalties—The Company
recognizes royalty revenues from licensed products upon the sale of the related
products.





Research
and Development Costs





Research
and development expenses consist of costs incurred for 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.  The Company charges
research and development costs to expense as incurred.





9
 
 NOVABAY
PHARMACEUTICALS, INC.
 (a
development stage company)
 
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
 (unaudited)


Stock-Based
Compensation





The
Company accounts for share-based compensation under the provisions of ASC 718,
“Compensation-Stock Compensation” which requires the recognition of compensation
expense using a fair-value based method.  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, 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 the provisions continue to account for non-vested equity awards
outstanding at the date of adoption of the provisions in the same manner as they
had been accounted for prior to adoption.  The provision specifically
prohibits pro forma disclosures for those awards valued using the minimum value
method.  The valuation and recognition provisions apply to new awards
and to awards outstanding as of the adoption date that are subsequently
modified.  The adoption of these provisions 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 ASC 718, 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.  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  ASC 718 because the exercise price of options granted was
generally equal to the fair market value of the underlying common stock on the
date of grant.





The
Company accounts for stock compensation arrangements with non-employees in
accordance with ASC 505-50, Equity - Equity-Based Payments to Non-Employees
which require that such equity instruments are recorded at their fair value on
the measurement date.  The measurement of stock-based compensation is
subject to periodic adjustment as the underlying equity instruments
vest.  Non-employee stock-based compensation charges are amortized
over the vesting period on a straight-line basis.  For stock options
granted to non-employees, the fair value of the stock options is estimated using
a Black-Scholes-Merton valuation model.





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
carry-forwards.  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 the entire deferred tax asset will not be
recognized.





Net
Loss per Share





Basic net
loss per share is computed using the weighted average number of common shares
outstanding during the period.  Diluted net loss per share 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 net loss per share, 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 net loss per share computation
in net loss periods if their effect would be anti-dilutive.  During
the three months ended March 31, 2010 and 2009, there is no difference between
basic and diluted net loss per share due to the Company’s net
losses.





10
 
 NOVABAY
PHARMACEUTICALS, INC.
 (a
development stage company)
 
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
 (unaudited)


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:





Three
      Months EndedMarch
      31,(In
      thousands)
              
              2010
              
              
              2009Stock
      options
              
              
              4,377
              
              
              
              3,651Stock
      warrants
              
              
              1,725
              
              
              
              6506,102
              
              
              
              4,301





Recent
Accounting Pronouncements





None





NOTE
3. INVESTMENTS AND FAIR VALUE MEASUREMENTS





Short-term
investments at March 31, 2010 and December 31, 2009 consisted of the
following:





March
      31, 2010Gross
              
              
              GrossAmortized
              
              
              Unrealized
              
              
              Unrealized
              
              
              Market(in
      thousands)
              
              Cost
              
              
              Gains
              
              
              (Losses)
              
              
              ValueCorporate
      bonds
              
              $
              306
              
              
              $
              —
              
              
              $
              (1
              )
              
              $
              305Municipal
      Bonds
              
              
              50
              
              
              
              —
              
              
              
              —
              
              
              
              50Certificates
      of Deposit
              
              
              500
              
              
              
              —
              
              
              
              (1
              )
              
              
              499$
              856
              
              
              $
              —
              
              
              $
              (2
              )
              
              $
              854December
      31, 2009Gross
              
              
              GrossAmortized
              
              
              Unrealized
              
              
              Unrealized
              
              
              Market(in
      thousands)
              
              Cost
              
              
              Gains
              
              
              (Losses)
              
              
              ValueCertificates
      of Deposit
              
              
              300
              
              
              
              —
              
              
              
              —
              
              
              
              300$
              300
              
              
              $
              —
              
              
              $
              —
              
              
              $
              300


All
short-term investments at March 31, 2010 and December 31, 2009 mature in less
than one year.  Unrealized holding gains and losses classified as
available-for-sale are recorded in accumulated other comprehensive income
(loss).





We did
not recognize any realized gains or losses for the three months ended March 31,
2010 and 2009.  For the cumulative period from July 1, 2002 (date
of development stage inception) to March 31, 2010, the Company recognized a net
realized loss of approx $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.





11
 
 NOVABAY
PHARMACEUTICALS, INC.
 (a
development stage company)
 
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
 (unaudited)


The
following table presents the Company’s investments measured at fair value on a
recurring basis as of March 31, 2010:




Fair
      Value Measurements Using(in
      thousands)
              
              Balance
      at
                March
      31, 2010
              
              
              Quoted
      Prices in Active Markets for Identical Items
                (Level
      1)
              
              
              Significant
      Other Observable Inputs
                (Level
      2)
              
              
              Significant
      Unobservable Inputs
                (Level
      3)Cash
      equivalents
              
              $
              12,890
              
              
              $
              12,890
              
              
              $
              —
              
              
              $
              —Short-term
      investments:Corporate
      bonds
              
              
              305
              
              
              
              —
              
              
              
              305
              
              
              
              —Municipal
      bonds
              
              
              50
              
              
              
              —
              
              
              
              50Certificates
      of deposit
              
              
              499
              
              
              
              —
              
              
              
              499
              
              
              
              —Total
      short-term investments
              
              
              854
              
              
              
              —
              
              
              
              854
              
              
              
              —Total
              
              $
              13,744
              
              
              $
              12,890
              
              
              $
              854
              
              
              $
              —




The
following table presents the Company’s investments measured at fair value on a
recurring basis as of December 31, 2009:




(in
      thousands)
              
              Balance
      at
                December
      31, 2009
              
              
              Quoted
      Prices in Active Markets for Identical Items
                (Level
      1)
              
              
              Significant
      Other Observable Inputs
                (Level
      2)
              
              
              Significant
      Unobservable Inputs
                (Level
      3)Cash
      equivalents
              
              $
              10,992
              
              
              $
              10,992
              
              
              $
              —
              
              
              $
              —Short-term
      investments:Certificates
      of deposit
              
              
              300
              
              
              
              —
              
              
              
              300
              
              
              
              —Total
      short-term investments
              
              
              300
              
              
              
              —
              
              
              
              300
              
              
              
              —Total
              
              $
              11,292
              
              
              $
              10,992
              
              
              $
              300
              
              
              $
              —





NOTE
4. PROPERTY AND EQUIPMENT





Property
and equipment consisted of the following:




March
      31,
              
              
              December
      31,(in
      thousands)
              
              2010
              
              
              2009Office
      and laboratory equipment
              
              $
              2,460
              
              
              $
              2,430Furniture
      and fixtures
              
              
              113
              
              
              
              113Software
              
              
              133
              
              
              
              133Leasehold
      improvement
              
              
              147
              
              
              
              147Total
      property and equipment, at cost
              
              
              2,853
              
              
              
              2,823Less:
      accumulated depreciation
              
              
              (1,117
              )
              
              
              (1,011
              )Total
      property and equipment, net
              
              $
              1,736
              
              
              $
              1,812





Depreciation
expense was $106,000 and $84,000 for the three months ended March 31, 2010 and
2009, respectively.





12
 
 NOVABAY
PHARMACEUTICALS, INC.
 (a
development stage company)
 
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
 (unaudited)


The
Company leases 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:




March
      31,
              
              
              December
      31,(in
      thousands)
              
              2010
              
              
              2009Office
      and laboratory equipment
              
              $
              147
              
              
              $
              147Less:  accumulated
      depreciation
              
              
              (85
              )
              
              
              (80
              )Capital
      lease assets, net
              
              $
              62
              
              
              $
              67





NOTE
5. ACCRUED LIABILITIES





Accrued
liabilities consisted of the following:


March
      31,
              
              
              December
      31,(in
      thousands)
              
              2010
              
              
              2009Research
      and development
              
              $
              63
              
              
              $
              118Employee
      payroll and benefits
              
              
              384
              
              
              
              744Professional
      fees
              
              
              116
              
              
              
              58Other
              
              
              118
              
              
              
              308Total
      accrued liabilities
              
              $
              681
              
              
              $
              1,228





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.  There are no loan
covenants specified in the agreement.





As of
March 31, 2010, the Company had an outstanding equipment loan balance of
approximately $372,000 carrying a weighted-average interest rate of
11.02%.  The principal and interest due under the loan will be repaid
in equal monthly installments through June 2011.





NOTE
7. COMMITMENTS AND CONTINGENCIES





Operating
Leases





The
Company leases laboratory facilities and office space under an operating lease
which will expire on October 31, 2015.  Rent expense was approximately
$240,000 and $226,000 for the three months ended March 31, 2010 and 2009,
respectively.





Legal
Matters





From time
to time, the Company may be involved in various legal proceedings arising in the
ordinary course of business. There are no matters at March 31, 2010 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 March 31, 2010 and December 31, 2009 there were no shares of
preferred stock outstanding.





13
 
 NOVABAY
PHARMACEUTICALS, INC.
 (a
development stage company)
 
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
 (unaudited)


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 March 31,
2010.





In
August 2007, the Company filed an amendment to its articles of incorporation to
affect a 1-for-2 reverse stock split of its common stock. All share and per
share amounts relating to the common stock, stock options and warrants and the
conversion ratios of preferred stock included in the financial statements and
footnotes have been restated to reflect the reverse stock split.





In
October 2007, the Company completed an initial public offering of its common
stock in which 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.





In August 2009, the Company sold and
issued 1,225,000 units of its common stock at a price of $2.00 per unit from a
Shelf Registration Offering.  Each unit consisted of one share of the
Company’s common stock and a warrant to purchase one share of the Company’s
common stock.  The Company raised a total of $2.5 million from the
Shelf Registration Offering, or approximately $1.9 million in net proceeds after
deducting underwriting commissions of $156,000 and other offering costs of
approximately $350,000.





Stock
Warrants





Warrants
to acquire shares of common stock were issued in connection with the sales of
the Series A and Series B Convertible Preferred Stock and certain convertible
notes. Additionally, in October 2007, warrants were issued to the underwriters
in connection with the IPO. In 2009 warrants were issued to investors as part of
our Shelf Registration Offering.  The significant terms of the Series
A, Series B, Note, Underwriter and Investor warrants were as
follows:





Series A Warrants—The
warrants issued with the sale of Series A Preferred Stock were issued on the
basis of 0.20 of a warrant for every share of Series A Preferred Stock
purchased. The exercise price of these warrants was $1.20 per share. We extended
a limited-time offer to holders of the warrants to exercise them at a price of
$0.80 per share. Any unexercised warrants expired on July 1, 2005, except for
warrants issued in connection with later purchases of the Series A Preferred
Stock for which the expiration date was extended to July 1, 2006.





Series B Warrants—The
warrants issued with the sale of Series B Preferred Stock were issued on the
basis of 0.175 of a warrant for every share of Series B Preferred Stock
purchased. The exercise price of these warrants was $0.80 per share. Any
unexercised warrants expired on June 30, 2006.





Note Warrants—Warrants were
granted in connection with promissory notes issued to certain of our
shareholders in 2002 and 2003. The warrants issued to these shareholders had an
exercise price of $1.20 per share. Any unexercised warrants expired on June 30,
2006.





Underwriter Warrants—In
connection with the IPO, the Company 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 were exercisable on or after October 31, 2008 and
expire on October 31, 2010. The warrants were valued at approximately $524,000
using the Black-Scholes-Merton option-pricing model based upon the following
assumptions: (1) expected price volatility of 50.0%, (2) a risk-free interest
rate of 3.94% and (3) a contractual life of 3 years. The Company accounted for
the fair value of the Underwriter Warrants as an expense of the IPO resulting in
a charge to stockholders’ equity.





14
 
 NOVABAY
PHARMACEUTICALS, INC.
 (a
development stage company)
 
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
 (unaudited)


Advisory Services Warrants -
In April 2008, the Company issued a two year warrant and a four year warrant to
purchase an aggregate of 300,000 shares of common stock to PM Holdings Ltd. as
part of our consideration for the revision of the agreement dated February 13,
2007 with PM Holdings.  Under the terms of the original agreement, the
Company agreed to pay PM Holdings $28,000 per month through February 2010 for
financial and investor relations advisory services. The amendment to this
agreement eliminated the monthly cash payment obligation and instead provided
for a one-time, upfront cash payment of $264,000 and the issuance of warrants to
purchase 300,000 shares of common stock at an exercise price of $4.00 per share.
The warrants were valued at approximately $162,000 using the
Black-Scholes-Merton option-pricing model based upon the following assumptions:
(1) expected price volatility of 50.0%, (2) a risk-free interest rate of 3.94%
and (3) a contractual life of 2 years.   The Company accounts for
the fair value of the Advisory Services Warrants as an expense amortized over
the life of the warrants.








Investor Warrants—In August
2009, in connection with the Shelf Registration Offering, the Company issued
warrants to the investors to purchase an aggregate of 1,225,000 shares of common
stock at an exercise price of $2.75 per share. The warrants are exercisable on
or after February 17, 2010 and expire on August 21, 2014.





At March
31, 2010, there were outstanding warrants to purchase 500,000 shares of common
stock at a weighted-average exercise price of $4.00 per
share.  Additionally, there were outstanding warrants to purchase
1,225,000 shares of common stock from the Shelf Registration Offering at the
exercise price of $2.75 per share. All outstanding warrants were exercisable at
March 31, 2010.





The
following table summarizes information about the Company’s warrants outstanding
at March 31, 2010 and activity during the three months then ended.




(in
      thousands, except per share data)
              
              Warrants
              
              
              Weighted-Average
      Exercise PriceOutstanding
      at December 31, 2009
              
              
              1,875
              
              
              $
              3.18Warrants
      expired
              
              
              (150
              )
              
              $
              4.00Outstanding
      at March 31, 2010
              
              
              1,725
              
              
              $
              3.11





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
930,177 and 858,766 shares of common stock were authorized for issuance under
the 2007 Plan in January 2010 and January 2009, respectively.  As
ofMarch 31, 2010, there were 1,232,871
shares available for future grant under the 2007 Plan.




15
 
 NOVABAY
PHARMACEUTICALS, INC.
 (a
development stage company)
 
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
 (unaudited)


Under the
terms of the 2007 Plan, the exercise price of incentive stock options may not be
less than 100% of the fair market value of the common stock on the date of grant
and, if granted to an owner of more than 10% of the Company’s stock, then not
less than 110%.  Stock options granted under the 2007 Plan expire no
later than ten years from the date of grant.  Stock options granted to
employees generally vest over four years while options granted to directors and
consultants typically vest over a shorter period, subject to continued
service.  All of the options granted prior to October 2007 include
early exercise provisions that allow for full exercise of the option prior to
the option vesting, subject to certain repurchase provisions.  The
Company issues new shares to satisfy option exercises under the
plans.





Stock
Option Summary





The
following table summarizes information about the Company’s stock options
outstanding at March 31, 2010 and activity during the three-month period then
ended.




(in
      thousands, except per share data)
              
              Options
              
              
              Weighted-Average
      Exercise Price
              
              
              Weighted-Average
      Remaining Contractual Life (years)
              
              
              Aggregate
      Intrinsic ValueOutstanding
      at December 31, 2009
              
              
              4,147
              
              
              $
              1.71Options
      granted
              
              
              291
              
              
              $
              2.06Options
      exercised
              
              
              (18
              )
              
              $
              2.02Options
      forfeited/cancelled
              
              
              (42
              )
              
              $
              2.07Outstanding
      at March 31, 2010
              
              
              4,377
              
              
              $
              1.73
              
              
              
              6.9
              
              
              $
              2,944Vested
      and expected to vest at March 31, 2010
              
              
              4,213
              
              
              $
              1.71
              
              
              
              6.8
              
              
              $
              2,899Vested
      at March 31, 2010
              
              
              2,583
              
              
              $
              1.46
              
              
              
              5.5
              
              
              $
              2,436Exercisable
      at March 31, 2010
              
              
              2,880
              
              
              $
              1.58
              
              
              
              5.8
              
              
              $
              2,478





The
aggregate intrinsic value is calculated as the difference between the exercise
price of the underlying stock option awards and the closing market price of the
Company’s common stock as quoted on the NYSE Amex as of March 31, 2010. The
Company received cash payments for the exercise of stock options in the amount
of approximately $37,000 during the three months ended March 31, 2010, and the
aggregate intrinsic value of stock option awards exercised was $0 for the same
period, as determined at the date of option exercise.  For the three
months ended March 31, 2009, the Company received cash payments in the amount of
approximately $47,000 and the aggregate intrinsic value of stock option awards
exercised was $9,000 for the same period.





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.





16
 
 
 NOVABAY
PHARMACEUTICALS, INC.
 (a
development stage company)
 
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
 (unaudited)


The
weighted-average assumptions used in determining the value of options granted
and a summary of the methodology applied to develop each assumption are as
follows:




Three
      Months Ended March 31,Assumption
              
              2010
              
              
              2009Expected
      price volatility
              
              
              86
              %
              
              
              83
              %Expected
      term (in years)
              
              
              5.45
              
              
              
              6.1Risk-free
      interest rate
              
              
              2.67
              %
              
              
              1.80
              %Dividend
      yield
              
              
              0.00
              %
              
              
              0.00
              %Weighted-average
      fair value of options granted during the period
              
              $
              1.46
              
              
              $
              1.07





For the
three months ended March 31, 2010 and 2009, the Company recognized stock-based
compensation expense of $304,000 and $167,000, respectively, for option awards
to employees and directors.  As of March 31, 2010, total unrecognized
compensation cost related to unvested stock options granted or modified on or
after January 1, 2006 was $2.0 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 1.9
years.





Common
Stock Awards to Directors





In
connection with the close of the IPO in October 2007, the Company adopted a new
plan to compensate the independent members of the Board of Directors for their
services. Under the terms of the Director Compensation Plan, each independent
member is entitled to a combination of cash and unrestricted common stock for
each board and committee meeting attended, up to specified annual
maximums.





In
accordance with these provisions, the Company issued 93,384 shares of common
stock to independent directors during the three months ended March 31,
2009.  These shares were issued out of the 2007 Plan.  The
fair market value of the stock issued to directors was recorded as an operating
expense in the period in which the meeting occurred, resulting in total
compensation expense of approximately $138,000 for common stock awards to
directors during the three months March 31, 2009.





In
December 2009, 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 stock options, at their discretion, for their
participation in the board and various committees. If the director elects to
receive stock options these are issued to the director at the beginning of the
year and vest over the term of the year. Cash payments are made quarterly at the
beginning of each quarter.  In accordance with these provisions, the
Company did not issue any common stock to independent directors during the three
months ended March 31, 2010.





Summary
of Stock-Based Compensation Expense





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 EndedMarch
      31,(in
      thousands)
              
              2010
              
              
              2009Research
      and development
              
              $
              112
              
              
              $
              91General
      and administrative
              
              
              192
              
              
              
              214Total
      stock-based compensation expense
              
              $
              304
              
              
              $
              305


Stock-Based
Awards to Non-Employees





During
the three months ended March 31, 2010 and 2009, the Company granted options to
purchase an aggregate of 45,000 and 60,000 shares of common stock, respectively,
to non-employees in exchange for advisory and consulting
services.   Additionally, during the three months ended March 31,
2010 the Company issued 32,893 shares of common stock to
non-employees.  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
weighted-average assumptions:





17
 
 NOVABAY
PHARMACEUTICALS, INC.
 (a
development stage company)
 
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
 (unaudited)


Three
      Months Ended March 31,Assumption
              
              2010
              
              
              2009Expected
      price volatility
              
              
              87
              %
              
              
              83
              %Expected
      term (in years)
              
              
              6.1
              
              
              
              6.1Risk-free
      interest rate
              
              
              2.48
              %
              
              
              1.40
              %Dividend
      yield
              
              
              0.00
              %
              
              
              0.00
              %Weighted-average
      fair value of options granted during the period
              
              $
              2.19
              
              
              $
              0.94





For the
three months ended March 31, 2010 and 2009, the Company recognized stock-based
compensation expense of $48,000 and $56,000, respectively, related to
non-employee stock and option grants.





NOTE
10. COLLABORATION AND LICENSE AGREEMENTS





Alcon
Manufacturing, Ltd.





In August
2006, we 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, we 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. Our 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, we will receive milestone
payments. If the products are commercialized, we will also receive royalties on
any sales of products containing the Aganocide compound.  Alcon has
the right to terminate the agreement in its entirety upon nine months’ notice,
or terminate portions of the agreement upon 135 days’ notice, subject to certain
provisions. Both parties have the right to terminate the agreement for breach
upon 60 days’ notice.





Revenue
has been recognized under the Alcon agreement as follows:




Three
      Months Ended March 31,(in
      thousands)
              
              2010
              
              
              2009Amortization
      of Upfront Technology Access Fee
              
              $
              625
              
              
              $
              625On-going
      Research and Development (FTE)
              
              
              1,309
              
              
              
              736Milestone
      Payment
              
              
              —
              
              
              
              1,000$
              1,934
              
              
              $
              2,361


At
March 31, 2010 and December 31, 2009, the Company had deferred revenue
balances of $2.4 million and $1.7 million, respectively, related to the Alcon
agreement which was comprised of $1.1 million and $1.7 million, respectively,
for the upfront technology access fee and $1.3 million and $0, respectively, for
other prepaid reimbursements.  In January 2009, the Company received a
$1.0 million milestone payment under the Alcon agreement for non-rejection of
the IND application for the Company’s otic indication.





18
 
 NOVABAY
PHARMACEUTICALS, INC.
 (a
development stage company)
 
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
 (unaudited)


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 Company amended this agreement on
December 17, 2009.  This agreement is exclusive and worldwide in
scope, with the exception of Asian markets where the Company has
commercialization rights, and North America, where the Company 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.    The upfront fee is being amortized
into revenue on a straight-line basis over the 20 month funding term of the
agreement, through October 2010.  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.





Revenue
has been recognized under the Galderma agreement as follows:


Three
      Months Ended March 31,(in
      thousands)
              
              2010
              
              
              2009Amortization
      of Upfront Technology Access Fee
              
              $
              150
              
              
              $
              250Total
              
              $
              150
              
              
              $
              250





The
Company had deferred revenue balances of $350,000 and $500,000 respectively, at
March 31, 2010 and December 31, 2009, related to the Galderma agreement, which
consisted of the remaining amount to be amortized for the upfront technology
access fee.  As of March 31, 2010, the Company has earned $3.75
million in milestone payments and has not earned or received any royalty
payments under the Galderma agreement.





NOTE
12. INCOME TAXES





As of
December 31, 2009 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 2016 and 2029.  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.  Therefore, these amounts are not included in gross or net
deferred tax assets.  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. These benefits would
result in a credit to additional paid-in-capital when they reduce income taxes
payable.





19
 
 
 NOVABAY
PHARMACEUTICALS, INC.
 (a
development stage company)
 
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
 (unaudited)


Uncertain
Income Tax Positions





The
Company follows authoritative guidance for uncertain tax
positions.  This accounting guidance prescribes the minimum
recognition threshold a tax position is required to meet before being recognized
in the financial statements and it also requires additional disclosure of the
beginning and ending unrecognized tax benefits and details regarding the
uncertainties that may cause the unrecognized benefits to increase or decrease
within a twelve month period.





The
Company adopted the relevant accounting guidance 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, 2009, 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, 2010.





NOTE 13. SUBSEQUENT
EVENTS





We are
not aware of any significant events that occurred subsequent to the balance
sheet date but prior to the filing of this Quarterly Report on Form 10-Q that
would have a material impact on our Consolidated Financial
Statements.





20


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





The following discussion of our
financial condition and results of operations should be read together with our
consolidated financial statements and related notes included in Part I, Item
1  of this report. This discussion contains forward-looking statements
that involve risks and uncertainties. Words such as “expects,” “anticipates,”
“targets,” “goals,” “projects,” “intends,” “plans,” “believes,” “seeks,”
“estimates,” variations of these words, and similar expressions are
intended to identify these forward-looking statements. As a result of many factors, such as
those set forth under the section entitled “Risk Factors” in Part II,
Item 1A and elsewhere in this report, our actual results may differ
materially from those anticipated in these forward-looking statements Readers
are cautioned that these forward-looking statements are only predictions based
upon assumptions made that we believed to be reasonable at the time, and are
subject to risks and uncertainties. Therefore, actual results may differ
materially and adversely from those expressed in any forward-looking statements.
Except as required by law, we undertake no obligation to revise or update
publicly any forward-looking statements.





Overview





We are a
clinical stage biotechnology company developing first-in-class anti-infectives
for the treatment and prevention of infections due to bacteria, fungus and
virus, including antibiotic-resistant infections.  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, fungal 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.





In August
2006, we 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 care. Under the terms of the agreement, Alcon paid 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. In
addition, NovaBay retains the rights to market, via a third-party co-marketing
partner, any products developed for ear or sinus indications in the major Asian
markets, including Japan, China, India and South Korea. NovaBay has also
retained such rights in other markets where Alcon is not committing reasonably
sufficient sales and marketing resources to the particular product. In each
instance, the appointment of the co-marketing partner would be subject to
certain conditions, including that the co-marketing partner be approved by
Alcon. The co-marketing partner, or NovaBay on its behalf, would be required to
pay Alcon a royalty based on net sales of the product in the applicable market
and would also be required to reimburse Alcon for part of its local development
costs or, in markets in which Alcon is not committing reasonably sufficient
sales and marketing resources, all of its local development costs. These
products may also be marketed in those markets by Alcon, its affiliates or
distributors.





Alcon is
responsible for all of the costs that it incurs in developing the products using
the Aganocide compounds.  We recently announced that Alcon has
increased its on-going financial support of the company’s research and
development efforts by more than $2.0 million per year. The additional funding
is expected to enhance NovaBay’s pre-clinical and clinical development programs
in the areas of eye, ear and sinus infections, as well as contact lens
solutions.  Alcon is conducting Phase II trials of NovaBay’s lead
compound, NVC-422, for the treatment of viral conjunctivitis, a type of “Pink
Eye”. The viral conjunctivitis trials are under way at over 30 medical centers
around the U.S. and internationally and Alcon expects to enroll approximately
250 patients.    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.





21


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.  We amended
this agreement in December 2009.  The agreement is exclusive and
worldwide in scope, with the exception of Asian markets and North American
healthcare institutions and hospitals.  In Asian markets we have
commercialization rights.  In North America we have an option to
exercise co-promotion rights in hospital and healthcare
institutions.





Galderma
will be responsible for the development costs of the acne and other indications
with two exceptions.  First, in Japan Galderma has the option to
request that we share such development costs.  Second, at this time we
are supporting the ongoing development program for impetigo; however, upon the
achievement of a specified milestone, Galderma will reimburse NovaBay for
associated expenses.  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.





Galderma
paid to NovaBay certain upfront fees at the inception of the contract and will
continue to pay 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. 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.





We
recently announced that we received $3.75 million in milestone payments from
Galderma; a $2.0 million milestone payment having been triggered by the
completion of formulation feasibility studies with our Aganocide compound for
topical use, and a $1.75 million milestone payment was for completing an
exploratory clinical study for the treatment of adult acne.  These
milestones were reached in 2009 and therefore the revenue was recorded in 2009
and the related receivable is included in our balance sheet as of December 31,
2009; we received payment on these receivables in January 2010.





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 fees received from Alcon and Galderma. We are a development stage
company and have incurred significant losses since commencement of our
operations in July 2002, as we have devoted substantially all of our resources
to research and development. As of March 31, 2010, we had an accumulated deficit
of $25.5 million. Our accumulated deficit resulted from research and development
expenses and general and administrative expenses. Although we were profitable in
2009, we expect 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.





Significant
Events in 2009 and 2010





In
January 2009, the FDA accepted the Investigational New Drug application (IND)
submitted by Alcon to permit the clinical development of our NVC-422 for
infections of the eye. The IND clearance triggered the immediate payment of the
first milestone of $1.0 million from Alcon.





On
January 9, 2009, we announced that the United States Patent and Trademark Office
has approved the issuance of a patent for novel Aganocide compounds, including
our current lead compound, NVC-422.





On March
7, 2009, we announced preclinical animal data showing that NVC-422, our lead
Aganocide compound, is effective in treating topical fungal
infections.





On March
25, 2009, we announced that we entered into an agreement with Galderma S.A.
to develop and commercialize our novel proprietary Aganocide compounds. We
amended this agreement in December 2009.  The exclusive agreement is
worldwide in scope, except in certain Asian markets, where we have
commercialization rights, and North America, where we have an option to exercise
co-promotion rights, and covers acne and impetigo and potentially other major
dermatological conditions, excluding onychomycosis (nail fungus) and orphan drug
indications.





22


On April
22, 2009 we announced an exclusive agreement with Professors Markus Nagl M.D.
and Waldemar Gottardi, Ph.D. of the Medical University of Innsbruck, Austria.
The agreement was entered into to advance the development of NovaBay’s Aganocide
compounds by integrating extensive and on-going clinical work at the university
with NovaBay’s development program.





On August
26, 2009, we closed a registered direct offering of 1,225,000 units, with each
unit consisting of (i) one share of the NovaBay common stock, par value $0.01
per share, and (ii) one warrant to purchase one share of NovaBay common stock.
The purchase price for each unit was $2.00. Each warrant has an exercise price
of $2.75 and will expire five years from the date of issuance. Neither the units
nor warrants trade on any exchange or are listed for quotation on any
market.





In
July 2009, we announced that Alcon has begun treating patients in a Phase II
clinical trial of NovaBay’s patented lead Aganocide compound, NVC-422, for viral
conjunctivitis, a type of “pink eye.”





In
September 2009, we announced that we initiated our Phase IIa proof-of-concept
study for the treatment of impetigo.





In
October 2009, we announced that our Aganocide compounds show penetration and
efficacy in a pre-clinical infected human nail model of Onychomycosis. This data
was presented at the 47th Annual Meeting of the Infectious Diseases Society of
America (IDSA) in Philadelphia.





In
December 2009, we announced that Alcon has increased its on-going financial
support of the company’s research and development efforts by more than $2.0
million per year. The additional funding is expected to enhance NovaBay’s
pre-clinical development programs and to support Alcon’s clinical development
programs in the areas of eye, ear and sinus infections, as well as contact lens
solutions.





In
January 2010, we announced that we received $3.75 million in milestone payments
from Galderma, a $2.0 million milestone payment having been triggered by the
completion of formulation feasibility studies with our Aganocide compounds for
topical use and a $1.75 million milestone payment for completing an exploratory
clinical study for the treatment of adult acne.  Both of these studies
were concluded in 2009 and the resulting revenues were recorded in our 2009
results.





In April
2010, we reported positive results of an open-label Phase 2a trial of NVC-422 in
chronically catheterized patients with significant bacteriuria, or bacteria in
the urine. The study showed that NVC-422 was well tolerated and reduced or
eliminated certain pathogens in the urine.





Critical
Accounting Policies and Estimates





Our
consolidated financial statements have been prepared in accordance with
generally accepted accounting principles in the United States for interim
reporting. The preparation of these consolidated financial statements requires
us to make estimates, assumptions and judgments 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
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, research and development costs, patent
costs, stock-based compensation, income taxes 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  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, 2009.  We have not
materially changed these policies from those reported in our Annual Report on
Form 10-K for the year ended December 31, 2009.





23





Results
of Operations





Comparison
of the Three Months Ended March 31, 2010 and March 31,
2009





License
and Collaboration Revenue





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.





Total
license and collaboration revenue was $2.1 million for the three months ended
March 31, 2010, compared to $2.6 million for the three months ended March 31,
2009.  During 2010 we have begun receiving increased reimbursements
from Alcon.  However, revenue decreased compared to the first quarter
of 2009 due to the receipt of a $1.0 million milestone from Alcon in the three
months ended March 31, 2009.





To the
extent we earn milestone payments under the Alcon and Galderma collaborations,
we would expect revenues to increase.  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 increased by 64% to $2.2 million for the three
months ended March 31, 2010 from $1.4 million for the three months ended March
31, 2009. The increase was due to increased research and development in
connection with our agreements with Galderma and Alcon in addition to activities
related to our catheter-associated urinary tract infections
programs.  We did not enter into our agreement with Galderma until the
last week of the quarter ended March 31, 2009.





We expect
to incur increased research and development expenses in 2010 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 2010 in connection with the dermatology, and catheter associated urinary
tract infections programs.





General
and Administrative





Total
general and administrative expenses decreased by 7% to $1.5 million for the
three months ended March 31, 2010 compared to $1.6 million for the three months
ended March 31, 2009.  Professional services costs decreased primarily
as a result of Sarbanes-Oxley implementation costs in 2009, which were not
repeated in 2010.





We expect
that general and administrative expenses will increase during 2010 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 was an expense of $11,000 for the three months ended March
31, 2010 compared to an income of $11,000 for the three months ended March
31, 2009. This change was primarily attributable to interest expense on our
capital lease and equipment loan offset by lower interest rates on our
investments.  Interest income relates primarily to interest earned on
cash, cash equivalents and investments in marketable securities.





We expect
that other income, 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.





24


Liquidity
and Capital Resources





In August
2006, we entered into a collaboration and license agreement with
Alcon.  Under the terms of this agreement, we received an up-front
technology access fee of $10.0 million in September
2006.  Additionally, we are entitled to receive semi-annual payments
each January and July over the four year term of the agreement to support
on-going research and development efforts.  In both January and July
2007, we received a payment of $1.4 million to support the performance of
research and development activities throughout 2007.  The Alcon
agreement also provides for milestone payments upon the achievement of specified
milestones in each field of use and royalty payments upon the sale of
commercialized products.  The aggregate milestone payments payable in
connection with the ophthalmic, otic and sinus fields are $19.0 million, $12.0
million and $39.0 million, respectively.  In January 2009, we received
$1.0 million for the non-rejection of an IND application related to its optic
indication.  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, 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 March 31, 2010 we had an outstanding equipment
loan balance of $372,000 carrying a weighted-average interest rate of 11.02%.
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, which we amended in
December 2009.  Under the terms of the agreement, we have received an
initial upfront payment of $1.0 million and milestones of $3.75 million to
date.  In addition, Galderma will pay to NovaBay certain upfront fees,
ongoing fees, reimbursements, and additional milestone payments related to
achieving development and commercialization of its Aganocide
compounds.





Cash,
Cash Equivalents and Short-Term Investments





As of
March 31, 2010, we had cash, cash equivalents, and short-term investments of
$13.7 million compared to $11.3 million at December 31, 2009.




Cash
Provided by Operating Activities





For the
three months ended March 31, 2010 cash provided by operating activities of
$2.6 million was primarily attributable to receipt of a $3.75 million milestone
payment from Galderma that was included in outstanding receivables as of
December 31, 2009.  This was partially offset by our research and
development and general administrative expenses. For the three months ended
March 31, 2009, cash provided by operating activities of $862,000, resulted
primarily from the receipt of milestone and other cash payments from
collaborative agreements, which more than offset our operating expenses.




Cash
Used in Investing Activities





For the
three months ended March 31, 2010, cash used in investing activities of
$592,000 was attributable to purchases of short-term investments (net of
maturities or sales) of $562,000 and purchases of property and equipment of
$30,000.





For the
three months ended March 31, 2009, cash used in investing activities of
$2.7 million was attributable to purchases of short-term investments (net of
maturities or sales) of $2.6 million and purchases of property and equipment of
$27,000.





Cash  Used
in Financing Activities





Net cash
used in financing activities of $68,000 for the three months ended
March 31, 2010 was primarily attributable to the payments on the equipment
loan, offset by proceeds from the exercise of stock options.





25


Net cash
used in financing activities of $51,000 for the three months ended
March 31, 2009 was primarily attributable to the payments on the equipment
loan and capital lease, offset by proceeds from the exercise of stock
options.





We have
incurred cumulative net losses of $25.5 million since inception through March
31, 2010.  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,
our initial public offering, and the recently concluded registered direct
offering of our common stock.   We raised total net proceeds of
$12.6 million from sales of our preferred stock in 2002 through
2006.  In October 2007, we completed our IPO in which we raised a
total of $20.0 million, or approximately $17.1 million in net cash proceeds
after deducting underwriting discounts and commissions of $1.4 million and other
offering costs of $1.5 million.  In August 2009, we completed a
registered direct offering from which we received net proceeds of $1.9
million.





Net
Operating Losses and Tax Credit Carryforwards





As of
March 31, 2010 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 2016 and 2029.





Current
federal and California tax laws include substantial restrictions on the
utilization of net operating loss carryforwards in the event of an ownership
change of a corporation. Accordingly, our ability to utilize net operating loss
carryforwards may be limited as a result of such ownership changes. Such a
limitation could result in the expiration of carryforwards before they are
utilized





Inflation





We do not
believe that inflation has had a material impact on our business and operating
results during the periods presented, and we do not expect it to have a material
impact in the near future. There can be no assurances, however, that our
business will not be affected by inflation.





Off-Balance
Sheet Arrangements





We have
no off-balance sheet arrangements.





Contractual
Obligations





Our
commitments consist of an operating 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 and the total commitment as of March 31,
2010 is $5.2 million due over the lease term.  Our commitment for the
equipment loan consists of the total payments due under the loan facility of
$395,000. This amount includes $23,000 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. However, we will need to
raise additional capital or incur indebtedness to continue to fund our
operations in the future. Our future capital requirements will depend on many
factors, including:





·
            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.





26


We do not
anticipate that we will generate significant product revenue for a number of
years. Until we can generate a sufficient amount of product revenue, if ever, we
expect to finance future cash needs through public or private equity offerings,
debt financings or corporate collaboration and licensing arrangements, as well
as through interest income earned on cash balances and short-term investments.
To the extent that we raise additional funds by issuing equity securities, our
shareholders may experience dilution. In addition, debt financing, if available,
may involve restrictive covenants. To the extent that we raise additional funds
through collaboration and licensing arrangements, it may be necessary to
relinquish some rights to our technologies or product candidates, or grant
licenses on terms that are not favorable to us. If adequate funds are not
available, we may be required to delay, reduce the scope of or eliminate one or
more of our research or development programs or to obtain funds through
collaborations for some of our technologies or product candidates that we would
otherwise seek to develop on our own. Such collaborations may not be on
favorable terms or they may require us to relinquish rights to our technologies
or product candidates.





ITEM 3.
            QUANTITATIVE
      AND QUALITATIVE DISCLOSURES ABOUT MARKET
RISK





Our
market risk consists principally of interest rate risk on our cash, cash
equivalents, and short-term investments. Our exposure to market risk is limited
primarily to interest income sensitivity, which is affected by changes in
interest rates, particularly because the majority of our investments are in
short-term debt securities.





Our
investment policy restricts our investments to high-quality investments and
limits the amounts invested with any one issuer, industry, or geographic area.
The goals of our investment policy are as follows: preservation of capital;
assurance of liquidity needs; best available return on invested capital; and
minimization of capital taxation. Some of the securities in which we invest may
be subject to market risk. This means that a change in prevailing interest rates
may cause the principal amount of the investment to fluctuate. For example, if
we hold a security that was issued with an interest rate fixed at the
then-prevailing rate and the prevailing interest rate later rises, the principal
amount of our investment will probably decline. To minimize this risk, in
accordance with our investment policy, we maintain our cash and cash equivalents
in short-term marketable securities, including money market mutual funds,
Treasury bills, Treasury notes, commercial paper, and corporate and municipal
bonds. The risk associated with fluctuating interest rates is limited to our
investment portfolio. Due to the short term nature of our investment portfolio,
we believe we have minimal interest rate risk arising from our investments. As
of March 31, 2010 and December 31, 2009, a 10% change in interest rates would
have had an immaterial affect on the value of our short-term marketable
securities.  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 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.





ITEM
4. CONTROLS AND PROCEDURES





Not
applicable.  See Item 4T.





ITEM
4T. 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.





27


A control
system, no matter how well conceived and operated, can provide only reasonable,
not absolute, assurance that the objectives of the control system are met.
Further, the design of a control system must reflect the fact that there are
resource constraints, and the benefits of controls must be considered relative
to their costs. Assessing the costs and benefits of such controls and procedures
necessarily involves the exercise of judgment by management. Because of the
inherent limitations in all control systems, no evaluation of controls can
provide absolute assurance that all control issues and instances of fraud, if
any, have been detected.





Changes
in Internal Control Over Financial Reporting





Our
management, including our Chief Executive Officer and Chief Financial Officer,
has evaluated any changes in our internal control over financial reporting that
occurred during the quarter ended March 31, 2010, and has concluded that there
was no change in our internal control over financial reporting during the
quarter that has materially affected, or is reasonably likely to materially
affect, our internal control over financial reporting.








PART
II. OTHER INFORMATION





ITEM
1A. RISK FACTORS





The
risk factors facing our company have not changed materially from those set forth
in Part I, Item 1A of our Annual Report on Form 10-K for the year ended December
31, 2009, as filed with the SEC on March 30, 2010, which risk factors are set
forth below.





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, before deciding to buy, sell or hold our common stock. The risks and
uncertainties described below are not the only ones facing our company.
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, the value of our
common stock could decline and you may lose all or part of your
investment.





Risks
Relating to Our Business





Current
worldwide economic conditions may limit our access to capital, adversely affect
our business and financial condition, as well as further decrease our stock
price.





General
worldwide economic conditions have experienced a downturn due to the effects of
the subprime lending crisis, general credit market crisis, collateral effects on
the finance and banking industries, concerns about inflation, slower economic
activity, decreased consumer confidence, reduced corporate profits and capital
spending, adverse business conditions and liquidity concerns. Although the
impact of the downturn on our business is uncertain at this time, downturn may
adversely affect our business and operations in a number of ways, including
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.





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.





28


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.





We
are an early stage company with a history of losses. Although we were profitable
in 2009, we do not have any commercial products, and expect that we will incur
net losses in the future, and that we may never achieve or maintain sustained
profitability.





We have
incurred net losses since our inception through 2008. For the years ended
December 31, 2007 and 2008 we had net losses of approximately $5.4 million
and $8.1 million, respectively, and for the year ended December 31, 2009, we had
net income of $2.7 million.  We were able to record a profit in 2009
due to our receipt of a $3.75 million milestone payment under our agreement with
Galderma; however, there is no assurance that we will receive any additional
large milestone payments under this agreement and, as a result, we may not be
able to continue to be profitable.  For example, we had a net loss of
$1.6 million for the three months ended March 31, 2010. Through March 31, 2010,
we had an accumulated deficit of approximately $25.5 million. We have been, and
expect to remain for the foreseeable future, mostly in a research and
development stage. We have incurred substantial research and development
expenses, which were approximately $7.4 million, $9.6 million and $7.3 million
for the years ended December 31, 2007, 2008 and 2009, respectively, and
approximately $2.2 million for the three months ended March 31,
2010.  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 incur substantial losses for the foreseeable future, and we may never
achieve or maintain sustained profitability. 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;


·
            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.





29


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 additional
Phase I, II and III human clinical trials to confirm such results in larger
patient populations 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.





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.





30


The
process of developing new products takes several years. Our product development
efforts may fail for many reasons, including:





·
            the
      failure of our product candidates to demonstrate safety and
      efficacy;


·
            the
      high cost of clinical trials and our lack of financial and other
      resources; and


·
            our
      inability to partner with firms with sufficient resources to assist us in
      conducting clinical trials.





Success
in early clinical trials often is not replicated in later studies, and few
research and development projects result in commercial products. At any point,
we may abandon development of a product candidate or we may be required to
expend considerable resources repeating clinical trials, which would eliminate
or adversely impact the timing for revenues from those product candidates. If a
clinical study fails to demonstrate the safety and effectiveness of our product
candidates, we may abandon the development of the product or product feature
that was the subject of the clinical trial, which could harm our
business.





Even if
we develop products for commercial use, these products may not be accepted by
the medical and pharmaceutical marketplaces or be capable of being offered at
prices that will enable us to become profitable. We cannot assure you that our
products will be approved by regulatory authorities or ultimately prove to be
useful for commercial markets, meet applicable regulatory standards, or be
successfully marketed.





We
must maintain and expand expensive finance and accounting systems, procedures
and controls in order to grow our business and organization, which will increase
our costs and require additional management resources.





We
completed our initial public offering, or IPO, in October 2007. As a public
reporting company, we are required to comply with the Sarbanes-Oxley Act of 2002
and the related rules and regulations of the SEC and Canadian securities
regulatory authorities, including expanded disclosure and accelerated reporting
requirements and more complex accounting rules. We are also required to comply
with marketplace rules and the heightened corporate governance standards of the
NYSE Amex. Compliance with these rules has been expensive, and there are
additional rules with which we have not yet needed to comply but which we will
need to comply with in the future.  For example, to date we have not
been required to have our independent auditors audit our internal control over
financial reporting, but next year we expect to be required to do so. If our
independent registered public accounting firm is unable to provide us with an
unqualified report as to the effectiveness of our internal control over
financial reporting as of the date of our Annual Report on Form 10-K for 2010,
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.





Our
current research collaborations with Alcon and Galderma may fail, and entering
into additional collaborations may not happen, resulting in a decrease in
funding and inhibition of our ability to continue developing
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 have also
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.





31


Our
long-term success depends upon the successful development and commercialization
of other products from our research and development activities.





Our
long-term viability and growth will depend upon the successful development and
commercialization of other products from our research and development
activities. Product development and commercialization is very expensive and
involves a high degree of risk. Only a small number of research and development
programs result in the commercialization of a product. Success in early stage
clinical trials or preclinical work does not ensure that later stage or larger
scale clinical trials will be successful. Even if later stage clinical trials
are successful, the risk remains that unexpected concerns may arise from
additional data or analysis or that obstacles may arise or issues may be
identified in connection with review of clinical data with regulatory
authorities or that regulatory authorities may disagree with our view of the
data or require additional data or information or additional
studies.





Conducting
clinical trials is a complex, time-consuming and expensive process. Our ability
to complete our clinical trials in a timely fashion depends in large part on a
number of key factors including protocol design, regulatory and institutional
review board approval, the rate of patient enrollment in clinical trials, and
compliance with extensive current good clinical practice requirements. We are in
many cases using the services of third-party contract clinical trial providers.
If we fail to adequately manage the design, execution and regulatory aspects of
our clinical trials, our studies and ultimately our regulatory approvals may be
delayed or we may fail to gain approval for our product candidates
altogether.





If
we do not successfully execute our growth initiatives through the acquisition,
partnering and in-licensing of products, technologies or companies, our future
performance could be adversely affected.





In
addition to the expansion of our pipeline through spending on internal
development projects, we anticipate growing through external growth
opportunities, which include the acquisition, partnering and in-licensing of
products, technologies and companies or the entry into strategic alliances and
collaborations. If we are unable to complete or manage these external growth
opportunities successfully, we may not be able to grow our business in the way
that we currently expect. The availability of high quality opportunities is
limited and we are not certain that we will be able to identify suitable
candidates or complete transactions on terms that are acceptable to us. In order
to pursue such opportunities, we may require significant additional financing,
which may not be available to us on favorable terms, if at all. The availability
of such financing is limited by the recent tightening of the global credit
markets.





We
may acquire other businesses or form joint ventures or in-license compounds that
could disrupt our business, harm our operating results, dilute your ownership
interest in us, or cause us to incur debt or significant expense.





As part
of our business strategy, we may pursue acquisitions of complementary businesses
and assets, and enter into technology or pharmaceutical compound licensing
arrangements. We also may pursue strategic alliances that leverage our core
technology and industry experience to enhance our ability to commercialize our
product candidates and expand our product offerings or distribution. We have no
experience with respect to acquiring other companies and limited experience with
respect to the formation of commercial partnering agreements, strategic
alliances, joint ventures or in-licensing of compounds. If we make any
acquisitions, we may not be able to integrate these acquisitions successfully
into our existing business, and we could assume unknown or contingent
liabilities. If we in-license any additional compounds, we may fail to develop
the product candidates, and spend significant resources before determining
whether a compound we have in-licensed will produce revenues. Any future
acquisitions or in-licensing by us also could result in significant write-offs
or the incurrence of debt and contingent liabilities, any of which could harm
our operating results. Integration of an acquired company also may require
management resources that otherwise would be available for ongoing development
of our existing business. We may not identify or complete these transactions in
a timely manner, on a cost-effective basis, or at all, and we may not realize
the anticipated benefits of any acquisition, technology license, strategic
alliance or joint venture.





To
finance any acquisitions, we may choose to issue shares of our common stock as
consideration, which would dilute your interest in us. If the price of our
common stock is low or volatile, we may not be able to acquire other companies
for stock. Alternatively, it may be necessary for us to raise additional funds
for acquisitions by incurring indebtedness. Additional funds may not be
available on terms that are favorable to us, or at all.





32





We
do not have our own manufacturing capacity, and we plan to rely on partnering
arrangements or third-party manufacturers for the manufacture of our potential
products.





We do not
currently operate manufacturing facilities for clinical or commercial production
of our product NeutroPhase and other product candidates. We have no experience
in drug formulation or manufacturing, and we lack the resources and the
capabilities to manufacture NeutroPhase or any of our product candidates on a
clinical or commercial scale. As a result, we have partnered and expect to
partner with third parties to manufacture our products or rely on contract
manufacturers to supply, store and distribute product supplies for our clinical
trials. Any performance failure on the part of our commercial partners or
future manufacturers could delay clinical development or regulatory approval of
our product candidates or commercialization of our products, producing
additional losses and reducing the potential for product revenues.





Our
products, if developed and commercialized, will require precise, high quality
manufacturing. The failure to achieve and maintain high manufacturing standards,
including the incidence of manufacturing errors, could result in patient injury
or death, product recalls or withdrawals, delays or failures in product testing
or delivery, cost overruns or other problems that could seriously harm our
business. Contract manufacturers and partners often encounter difficulties
involving production yields, quality control and quality assurance, as well as
shortages of qualified personnel. These manufacturers and partners are subject
to ongoing periodic unannounced inspection by the FDA and corresponding state
agencies to ensure strict compliance with current Good Manufacturing Practice
and other applicable government regulations and corresponding foreign standards;
however, we do not have control over third-party compliance with these
regulations and standards. If any of our manufacturers or partners fails to
maintain compliance, the production of our products could be interrupted,
resulting in delays, additional costs and potentially lost
revenues.





In
addition, if the FDA or other regulatory agencies approve any of our product
candidates for commercial sale, we will need to manufacture them in larger
quantities. Significant scale-up of manufacturing will require validation
studies, which the FDA must review and approve. If we are unable to successfully
increase the manufacturing capacity for a product, the regulatory approval or
commercial launch of any drugs may be delayed or there may be a shortage in
supply and our business may be harmed as a result.





We
depend on skilled and experienced personnel to operate our business effectively.
If we are unable to recruit, hire and retain these employees, our ability to
manage and expand our business will be harmed, which would impair our future
revenue and profitability.





Our
success largely depends on the skills, experience and efforts of our officers,
especially our Chief Executive Officer, Chief Financial Officer, Chief
Scientific Officer, Chief Alliance Officer and Vice President of Product
Development, Vice President of Medical Affairs, Vice President of Business and
Corporate Development 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.





33


If
our facilities become inoperable, we will be unable to perform our research and
development activities, fulfill the requirements under our collaboration
agreement and continue developing products and, as a result, our business will
be harmed.





We do not
have redundant laboratory facilities. We perform substantially all of our
research, development and testing in our laboratory located in Emeryville,
California. Emeryville is situated on or near active earthquake fault lines. Our
facility and the equipment we use to perform our research, development and
testing would be costly to replace and could require substantial lead time to
repair or replace. The facility may be harmed or rendered inoperable by natural
or man-made disasters, including earthquakes, flooding and power outages, which
may render it difficult or impossible for us to perform our research,
development and testing for some period of time. The inability to perform our
research and development activities may result in the loss of partners or harm
our reputation, and we may be unable to regain those partnerships in the future.
Our insurance coverage for damage to our property and the disruption of our
business may not be sufficient to cover all of our potential losses, including
the loss of time as well as the costs of lost opportunities, and may not
continue to be available to us on acceptable terms, or  at
all.





Obtaining regulatory approval in the
United States does not ensure we will obtain regulatory approval in other
countries.





We will
aim to obtain regulatory approval in the United States as well as in other
countries. To obtain regulatory approval to market our proposed products outside
of the United States, we and any collaborator must comply with numerous and
varying regulatory requirements in other countries regarding safety and
efficacy. Approval procedures vary among countries and can involve additional
product testing and additional administrative review periods. The time required
to obtain approval in other countries might differ significantly from that
required to obtain FDA approval. The regulatory approval process in other
countries include all of the risk associated with FDA approval as well as
additional, presently unanticipated risks. Regulatory approval in one country
does not ensure regulatory approval in another, but a failure or delay in
obtaining regulatory approval in one country may negatively impact the
regulatory process in others. Failure to obtain regulatory approval in other
countries or any delay or setback in obtaining such approval could have the same
adverse effects associated with regulatory approval in the United States,
including the risk that our product candidates may not be approved for all
indications requested and that such approval may be subject to limitations on
the indicated uses for which the product may be marketed. In addition, failure
to comply with applicable regulatory requirements in other countries can result
in, among other things, warning letters, fines, injunctions, civil penalties,
recall or seizure of products, total or partial suspension of production,
refusal of the government to renew marketing applications and criminal
prosecution.





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.   Further, because our product candidates are
all in the same class of compounds, failure in one clinical trial may cause us
or our partners to have to suspend or terminate other clinical trials. For
example, if toxicity issues were to arise in one clinical trial, it could
indicate that all of our product candidates have toxicity issues.





34





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.








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 or 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 or 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.





35


We
and our collaborators are and will be subject to ongoing FDA obligations and
continued regulatory review, such as continued safety reporting requirements,
and we and our collaborators may also be subject to additional FDA
post-marketing obligations or new regulations, all of which may result in
significant expense and which may limit our ability to commercialize our medical
device and drug products candidates.





Any
regulatory approvals that we receive may also be subject to limitations on the
indicated uses for which the product may be marketed or contain requirements for
potentially costly post-marketing follow-up studies. The FDA may require us to
commit to perform lengthy Phase IV post-approval studies (as further described
below), for which we would have to expend additional resources, which could have
an adverse effect on our operating results and financial condition. In addition,
if the FDA approves any of our drug product candidates, the labeling, packaging,
adverse event reporting, storage, advertising, promotion and record keeping for
the drug will be subject to extensive regulatory requirements. The subsequent
discovery of previously unknown problems with the drugs, including adverse
events of unanticipated severity or frequency, may result in restrictions on the
marketing of the drugs or the withdrawal of the drugs from the market. If we are
not able to maintain regulatory compliance, we may be subject to fines,
suspension or withdrawal of regulatory approvals, product recalls, seizure of
products, operating restrictions and criminal prosecution. Any of these events
could prevent us from marketing any products we may develop and our business
could suffer.





Conducting
clinical trials of our product candidates may expose us to expensive liability
claims, and we may not be able to maintain liability insurance on reasonable
terms or at all.





The risk
of clinical trial liability is inherent in the testing of pharmaceutical and
medical device products. If we cannot successfully defend ourselves against any
clinical trial claims, we may incur substantial liabilities or be required to
limit or terminate testing of one or more of our product candidates. Our
inability to obtain sufficient clinical trial insurance at an acceptable cost to
protect us against potential clinical trial claims could prevent or inhibit the
commercialization of our product candidates. Our current clinical trial
insurance covers individual and aggregate claims up to $3.0 million. This
insurance may not cover all claims and we may not be able to obtain additional
insurance coverage at a reasonable cost, if at all, in the future. In addition,
if our agreements with any future corporate collaborators entitle us to
indemnification against product liability losses and clinical trial liability,
such indemnification may not be available or adequate should any claim
arise.








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.





36


Intellectual
property litigation, regardless of outcome, is expensive and time-consuming,
could divert management’s attention from our business and have a material
negative effect on our business, operating results or financial condition. If
such a dispute were to be resolved against us, we may be required to pay
substantial damages, including treble damages and attorneys fees if we were to
be found to have willfully infringed a third party’s patent, to the party
claiming infringement, develop non-infringing technology, stop selling any
products we develop, cease using technology that contains the allegedly
infringing intellectual property or enter into royalty or license agreements
that may not be available on acceptable or commercially practical terms, if at
all. Our failure to develop non-infringing technologies or license the
proprietary rights on a timely basis could harm our business. Modification of
any products we develop or development of new products thereafter could require
us to conduct additional clinical trials and to revise our filings with the FDA
and other regulatory bodies, which would be time-consuming and expensive. In
addition, parties making infringement claims may be able to obtain an injunction
that would prevent us from selling any products we develop, which could harm our
business.





We
may be subject to damages resulting from claims that we or our employees have
wrongfully used or disclosed alleged trade secrets of their former
employers.





Some of
our employees may have been previously employed at universities or other
biotechnology or pharmaceutical companies, including our competitors or
potential competitors. Although no claims against us are currently pending, we
may be subject to claims that these employees or we have inadvertently or
otherwise used or disclosed trade secrets or other proprietary information of
their former employers. Litigation may be necessary to defend against these
claims. Even if we are successful in defending against these claims, litigation
could result in substantial costs and be a distraction to management. If we fail
in defending such claims, in addition to paying money damages, we may lose
valuable intellectual property rights or personnel. A loss of key research
personnel or their work product could hamper or prevent our ability to
commercialize product candidates, which could severely harm our
business.





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.





37


Because
our clinical development activities rely heavily on sensitive and personal
information, an area which is highly regulated by privacy laws, we may not be
able to generate, maintain or access essential patient samples or data to
continue our research and development efforts in the future on reasonable terms
and conditions, which may adversely affect our business.





As a
result of our clinical development, we will have access to very sensitive data
regarding the patients enrolled in our clinical trials. This data will contain
information that is personal in nature. The maintenance of this data is subject
to certain privacy-related laws, which impose upon us administrative and
financial burdens, and litigation risks. For instance, the rules promulgated by
the Department of Health and Human Services under the Health Insurance
Portability and Accountability Act, or HIPAA, creates national standards to
protect patients’ medical records and other personal information in the United
States. These rules require that healthcare providers and other covered entities
obtain written authorizations from patients prior to disclosing protected health
care information of the patient to companies like NovaBay. If the patient fails
to execute an authorization or the authorization fails to contain all required
provisions, then we will not be allowed access to the patient’s information and
our research efforts can be substantially delayed. Furthermore, use of protected
health information that is provided to us pursuant to a valid patient
authorization is subject to the limits set forth in the authorization (i.e., for
use in research and in submissions to regulatory authorities for product
approvals). As such, we are required to implement policies, procedures and
reasonable and appropriate security measures to protect individually
identifiable health information we receive from covered entities, and to ensure
such information is used only as authorized by the patient. Any violations of
these rules by us could subject us to civil and criminal penalties and adverse
publicity, and could harm our ability to initiate and complete clinical studies
required to support regulatory applications for our proposed products. In
addition, HIPAA does not replace federal, state, or other laws that may grant
individuals even greater privacy protections. We can provide no assurance that
future legislation will not prevent us from generating or maintaining personal
data or that patients will consent to the use of their personal information,
either of which may prevent us from undertaking or publishing essential
research. These burdens or risks may prove too great for us to reasonably bear,
and may adversely affect our ability to function profitably in the
future.





We
may be subject to fines, penalties, injunctions and other sanctions if we are
deemed to be promoting the use of our products for non-FDA-approved, or
off-label, uses.





Our
business and future growth depend on the development, use and ultimate sale of
products that are subject to FDA regulation, clearance and approval. Under the
U.S. Federal Food, Drug, and Cosmetic Act and other laws, we are prohibited from
promoting our products for off-label uses. This means that we may not make
claims about the safety or effectiveness of our products and may not proactively
discuss or provide information on the use of our products, except as allowed by
the FDA.





There is
a risk that the FDA or other federal or state law enforcement authorities could
determine that the nature and scope of our sales and marketing activities may
constitute the promotion of our products for a non-FDA-approved use in violation
of applicable law. We also face the risk that the FDA or other regulatory
authorities might pursue enforcement based on past activities that we have
discontinued or changed, including sales activities, arrangements with
institutions and doctors, educational and training programs and other
activities.





Government
investigations concerning the promotion of off-label uses and related issues are
typically expensive, disruptive and burdensome and generate negative publicity.
If our promotional activities are found to be in violation of applicable law or
if we agree to a settlement in connection with an enforcement action, we would
likely face significant fines and penalties and would likely be required to
substantially change our sales, promotion, grant and educational activities. In
addition, were any enforcement actions against us or our senior officers to
arise, we could be excluded from participation in U.S. government healthcare
programs such as Medicare and Medicaid.





If
we are unable to protect our intellectual property, our competitors could
develop and market products similar to ours that may reduce demand for our
products.





Our
success, competitive position and potential future revenues will depend in
significant part on our ability to protect our intellectual property. We rely on
the patent, trademark, copyright and trade secret laws of the United States and
other countries, as well as confidentiality and nondisclosure agreements, to
protect our intellectual property rights. We apply for patents covering our
technologies as we deem appropriate.





38


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.





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.





39


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.





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.





40


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.





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.




Health
care reform measures could limit the prices we or our collaborative partners can
obtain for our potential products, or impose additional costs on
us.
 
 In
March 2010, the U.S. Congress adopted and President Obama signed into law
comprehensive health care reform legislation through the passage of the Patient
Protection and Affordable Health Care Act (H.R. 3590) and the Health Care and
Education Reconciliation Act (H.R. 4872).  While we anticipate that this
legislation may, over time, increase the number of patients who have insurance
coverage for pharmaceutical products, it also imposes cost containment measures
that may adversely affect the amount of reimbursement for pharmaceutical
products. In addition, such legislation contains a number of provisions designed
to generate the revenues necessary to fund the coverage expansion, including new
fees or taxes on certain health-related industries.
 
 Many of
the details of the new law will be included in new and revised regulations,
which have not yet been promulgated, and require additional guidance and
specificity to be provided by the Department of Health and Human Services,
Department of Labor and Department of the Treasury. Accordingly, while it is too
early to understand and predict the ultimate impact of the new legislation on
our business, the legislation could have a material adverse effect on our
business.
  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.





41


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
December 31, 2009, our officers and directors collectively controlled
approximately 4,158,640 shares of our outstanding common stock (and
approximately 5,445,570 shares of our common stock when including options held
by them which were exercisable as of or within 60 days of December 31, 2009).
Furthermore, as of December 31, 2009, our largest shareholder, a family trust
established and controlled by Dr. Ramin Najafi, our Chairman and Chief
Executive Officer, beneficially owned 3,128,700 shares or 13.4 % of our
outstanding common stock. As a result, Dr. Najafi can significantly
influence the management and affairs of our company and most matters requiring
shareholder approval, including the election of directors and approval of
significant corporate transactions. This concentration of ownership may have the
effect of delaying or preventing a change in control and might adversely affect
the market price of our common stock. This concentration of ownership may not be
in the best interests of our other shareholders.





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.





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.





42


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.





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.





43


SIGNATURES







Pursuant
to the requirements of the Securities Exchange Act of 1934, the registrant has
duly caused this report to be signed on its behalf by the undersigned thereunto
duly authorized.





Date:
      May 12, 2010
            NOVABAY
      PHARMACEUTICALS, INC./s/
      Ramin NajafiRamin
      (“Ron”) NajafiPresident
      and Chief Executive Officer
              (duly
      authorized officer)Date:
      May 12, 2010
            /s/
      Thomas J. PaulsonThomas
      J. PaulsonChief
      Financial Officer
              (principal
      financial officer)





44




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. (SEC File No. 001-33678).)3.2
            Amended
      and Restated Bylaws of registrant (Incorporated by reference to the
      exhibit of the same number from the Company’s current report on
      Form 8-K as filed with the SEC on January 26, 2010 (SEC File No.
      001-33678).)4.1
            Specimen
      common stock certificate (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.)4.2
            Form
      of Warrant issued in the August 2009 offering.  (Incorporated by
      reference to the exhibit with the same description from the Company’s
      current report on Form 8-K, as filed with the SEC on August 21, 2009
      (SEC File No. 001-33678).)10.1
            NovaBay
      Pharmaceuticals, Inc. Employee Incentive Cash Compensation Plan
      (Incorporated by reference to exhibit 10.7 of the Company’s annual report
      on Form 10-K for the year ended December 31, 2009, as filed with the
      SEC on March 30, 2010 (SEC File No. 001-33678).)10.2
            Named
      Executive Officer Cash Compensation Arrangements (Incorporated by
      reference to exhibit 10.19 of the Company’s annual report on
      Form 10-K for the year ended December 31, 2009, as filed with the SEC
      on March 30, 2010 (SEC File No. 001-33678).)31.1
            Certification
      of the principal executive officer pursuant to Section 302 of the
      Sarbanes-Oxley Act of 2002.31.2
            Certification
      of the principal financial officer pursuant to Section 302 of the
      Sarbanes-Oxley Act of 2002.32.1
            Certification
      of the chief executive officer pursuant to Section 906 of the
      Sarbanes-Oxley Act of 2002.32.2
            Certification
      of the chief financial officer pursuant to Section 906 of the
      Sarbanes-Oxley Act of 2002.