**UNITED STATES**

**SECURITIESAND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

**Form 10-K**

**x**                              ANNUALREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACTOF 1934:

**Forthe fiscal year ended December 31, 2006**

**o**                                 TRANSITIONREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACTOF 1934:

**Forthe transition period from                      to                      **

**Commission file number 001-32966**

**Osiris Therapeutics, Inc.**

(Exact name of registrantas specified in its charter)

| **Delaware**                                                    |   | **71-0881115**                        |
|-----------------------------------------------------------------|--------|---------------------------------------|
| (State  or other jurisdiction of Incorporation or organization) |   | (I.R.S.  employer identification no.) |

 

| **2001 Aliceanna Street,  Baltimore, Maryland 21231-3043**    |   | **410-522-5005**                                           |
|---------------------------------------------------------------|--------|------------------------------------------------------------|
| (Address  of principal executive offices, including zip code) |   | (Registrant’s  telephone number, including area code) |

 

**Securitiesregistered pursuant to Section 12(b) of the Act:**

| **Title of Each Class**            |   | **Name of Each Exchange on with Registered** |
|------------------------------------|--------|----------------------------------------------|
| **Common Stock, $0.001 par value** |   | **NASDAQ Global Market**                     |

 

Indicate by check mark ifthe registrant is a well-known seasoned issuer, as defined in *Rule 405* of the Securities Act.  Yes o  No x

Indicate by check mark ifthe registrant is not required to file reports pursuant to Section 13 or Section 15(d) ofthe Act.  Yes o  No x

Indicate by check markwhether the registrant (1) has filed all reports required to be filed by Section 13or 15(d) of the Securities Exchange Act of 1934 during the preceding 12months (or for such shorter period that the registrant was required to filesuch reports), and (2) has been subject to such filing requirements forthe past 90 days.  Yes x  No o

Indicate by check mark ifdisclosure of delinquent filers pursuant to *Item 405* ofRegulation S-K is not contained herein, and will not be contained, to the bestof registrant’s knowledge, in definitive proxy or information statementsincorporated by reference in Part III of this Form 10-K or anyamendment to this Form 10-K. x

Indicateby check mark whether the registrant is a large accelerated filer, anaccelerated filer, or a non-accelerated filer. See definition of acceleratedfiler and large accelerated filer in Rule 12b-2 of the Exchange Act.(Check one):

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

 

Indicate by check mark whether the registrant is ashell company (as defined in Rule 12b-2 of the Exchange Act).  Yes o  No x

On June 30, 2006, thelast business day of the registrant’s most recently completed second fiscalquarter, the registrant’s common equity was not publicly traded. Our CommonStock began trading on the NASDAQ Global Market on August 4, 2006. Theaggregate market value of voting Common Stock held by non-affiliates ofregistrant, based upon the last sale price of the Common Stock reported on theNASDAQ Global Market as of the last business day of the registrant’s mostrecently completed third fiscal quarter ended September 30, 2006 wasapproximately $156,124,000.

The number of shares ofregistrant’s Common Stock outstanding as of March 9, 2007 is 27,429,341**.**

**DOCUMENTSINCORPORATED BY REFERENCE**

Portions of our definitiveProxy Statement for our 2007 Annual Meeting of Stockholders to be filed withthe Securities and Exchange Commission within 120 days after the end of our2006 fiscal year are incorporated by reference into Part III of thisAnnual Report on Form 10-K.

 

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**OSIRISTHERAPEUTICS, INC.**

**INDEX**

|                    | ** ** | ** **                                                                                                         | ** ** | **Page** | ** ** |
|--------------------|------------|--------------------------------------------------------------------------------------------------------------------|------------|----------|------------|
| **PART I**    |       |                                                                                                               |       |     |       |   |   |
| Item 1.            |       | BUSINESS                                                                                                           |       |     | 3          |   |   |
| Item 1A.      |       | RISK FACTORS                                                                                                       |       |     | 28         |   |   |
| Item 1B.           |       | UNRESOLVED STAFF COMMENTS                                                                                          |       |     | 46         |   |   |
| Item 2.            |       | PROPERTIES                                                                                                         |       |     | 46         |   |   |
| Item 3.            |       | LEGAL  PROCEEDINGS                                                                                                 |       |     | 46         |   |   |
| Item 4.            |       | SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS                                                                |       |     | 46         |   |   |
| **PART II**   |       |                                                                                                               |       |     |       |   |   |
| Item 5.            |       | MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED  STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES |       |     | 46         |   |   |
| Item  6.           |       | SELECTED  FINANCIAL DATA                                                                                           |       |     | 50         |   |   |
| Item 7.            |       | MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL  CONDITION AND RESULTS OF OPERATIONS                        |       |     | 51         |   |   |
| Item 7A.           |       | QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET  RISK                                                        |       |     | 60         |   |   |
| Item 8             |       | FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA                                                                        |       |     | 61         |   |   |
| Item 9             |       | CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON  ACCOUNTING AND FINANCIAL DISCLOSURES                             |       |     | 86         |   |   |
| Item 9A            |       | CONTROLS AND PROCEDURES                                                                                            |       |     | 86         |   |   |
| Item  9B           |       | OTHER  INFORMATION                                                                                                 |       |     | 86         |   |   |
| **PART III**  |       |                                                                                                               |       |     |       |   |   |
| Item 10            |       | DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE   GOVERNANCE                                                           |       |     | 87         |   |   |
| Item 11            |       | EXECUTIVE COMPENSATION                                                                                             |       |     | 87         |   |   |
| Item 12            |       | SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND  MANAGEMENT                                                    |       |     | 87         |   |   |
| Item 13.           |       | CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS AND  DIRECTOR INDEPENDENCE                                          |       |     | 87         |   |   |
| Item 14            |       | PRINCIPAL ACCOUNTANT FEES AND SERVICES                                                                             |       |     | 87         |   |   |
| **PART IV**   | ** ** | ** **                                                                                                         |       |     |       |   |   |
| Item 15            |       | EXHIBITS, FINANCIAL STATEMENT SCHEDULES                                                                            |       |     | 88         |   |   |
| SIGNATURES         |       |                                                                                                               | 91         |     |       |
| Exhibit Index |       |                                                                                                               |       |     |       |

 

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**PART I**

**Item 1.**                        BUSINESS

**Forward-LookingInformation**

ThisAnnual Report on Form 10-K includes “forward-looking statements”within the meaning of Section 21E of the Securities Exchange Act of 1934,or the Exchange Act. Forward-looking statements include statements concerningour plans, objectives, goals, strategies, future events, future revenues orperformance, capital expenditures, compensation arrangements, financing needs,plans or intentions relating to acquisitions, business trends and otherinformation that is not historical information and, in particular, may appearunder the headings “Risk Factors” in this Part I—Item 1A, “Part II—Item7. Management’s Discussion and Analysis of Financial Condition and Results ofOperations” and the other documents we file with the Securities and ExchangeCommission, or SEC, including, among others, our quarterly reports on Form 10-Qand amendments thereto. When used in this Annual Report, the words *estimates, expects, anticipates, projects, plans,intends, believes, forecasts* and variations of such words or similarexpressions are intended to identify forward-looking statements. Examples offorward-looking statements include, but are not limited to, statementsregarding the following: our product development efforts; our clinical trialsand anticipated regulatory requirements; the success of our product candidatesin development; status of the regulatory process for our biologic drugcandidates; implementation of our corporate strategy; our financialperformance; our product research and development activities and projectedexpenditures, including our anticipated timeline and clinical strategy for MSCsand biologic drug candidates; our cash needs; patents and proprietary rights;ability of our potential products to treat disease; our plans for sales andmarketing; our plans regarding facilities; types of regulatory frameworks weexpect will be applicable to our potential products; and results of ourscientific research. All forward-looking statements, including, without limitation,management’s examination of historical operating trends, are based upon ourcurrent expectations and various assumptions. Our expectations, beliefs andprojections are expressed in good faith and we believe there is a reasonablebasis for them. However, there can be no assurance that management’sexpectations, beliefs and projections will result or be achieved.

Thereare a number of risks and uncertainties that could cause our actual results todiffer materially from the forward-looking statements contained in this AnnualReport. Important factors that could cause our actual results to differmaterially from the forward-looking statements we make in this Annual Reportare set forth in this report, including “Risk Factors.”  There may be other factors that may cause ouractual results to differ materially from the forward-looking statements.

Allforward-looking statements attributable to us or persons acting on our behalfapply only as of the date of this Annual Report and are expressly qualified intheir entirety by the cautionary statements included herein. We undertake noobligation to publicly update or revise any forward-looking statements toreflect subsequent events or circumstances and do not intend to do so.

When we use the terms “Osiris,” “we,”  “us,” and “our” we mean Osiris Therapeutics, Inc.,a Delaware corporation.

**Company Overview**

Weare a leading stem cell therapeutic company headquartered in Baltimore,Maryland and focused on developing and marketing products to treat medicalconditions in the inflammatory, orthopedic and cardiovascular areas. We wereincorporated in Delaware in April 2002. Our predecessor company wasorganized in 1992. We currently market and sell Osteocel for regenerating bonein orthopedic indications. It is the only commercially available product in theU.S. containing viable stem cells. Our lead biologic drug candidate, Prochymal,for the treatment of inflammatory disease, is the only stem cell therapeuticfor which patients are being enrolled in Phase III clinical trials and is theonly stem cell therapeutic currently designated by the FDA as both an OrphanDrug and Fast Track product candidate. Our pipeline of internally developedbiologic drug candidates also includes Chondrogen, for regenerating cartilagein the 

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knee, and Provacel, for repairing heart tissuefollowing a heart attack. We are a fully integrated company, having developedstem cell capabilities in research and development, manufacturing, marketingand distribution. We have developed an extensive intellectual propertyportfolio to protect our technology in the United States and a number offoreign countries including 47 U.S. and 167 foreign patents owned or licensed.

Osteocel and our three biologic drug candidatesutilize human mesenchymal stem cells, or MSCs. MSCs are progenitor cells thatdifferentiate into various connective tissues when they receive appropriatebiochemical and biomechanical signals. In addition, MSCs have anti-inflammatoryproperties and can prevent fibrosis or scarring. These characteristics giveMSCs the potential to treat a wide variety of medical conditions. We believethat our biologic drug candidates have advantages over other stem celltherapeutics in development for the following reasons:

·       **Stem Cell Source.** Our stem cells are obtained from adult bonemarrow, a readily available source. The cells are drawn from the hips ofvolunteer donors between the ages of 18 and 30 years, using a simpleneedle and syringe aspiration. Because the cells are obtained from consentingadult donors, we are able to largely avoid the ethical controversy surroundingembryonic and fetal stem cell research.

·       **Ability to Mass Produce.** Through our proprietary manufacturingmethods, we can grow MSCs in a controlled fashion to produce up to 5,000treatments of our biologic drug candidates from a single bone marrow donation.Our ability to produce a large quantity of treatments from one donationprovides us with manufacturing efficiencies and product consistency that areessential to commercialization.

·       **Universal Compatibility.** Many stem cell therapies underdevelopment can elicit a rejection response in the recipient and thereforerequire donor-to-recipient matching or potentially harmful immunosuppression.This greatly reduces manufacturing efficiencies and creates a risk of mismatchwhich can result in an acute inflammatory response and, potentially, in death.Based on our clinical experience, we believe that our biologic drug candidatesare not rejected by the patient’s immune system and so, like type O negativeblood, do not require matching. This universal compatibility allows us toproduce a standardized product available to all patients in almost any medicalsetting.

·       **Treatment on Demand.** Our biologic drug candidates can bestored frozen at end-user medical facilities until they are needed. Weanticipate that medical facilities will be able to prescribe and dispense thisproduct in much the same way as conventional drugs. In contrast, other stemcell technologies under development require weeks to prepare after a patient’sneed is identified. This is a key feature of our technology, as many patientsin the critical care setting require prompt treatment.

The following tablesummarizes key information about Osteocel and our biologic drug candidates.

| Product/Candidate | ** ** | ** **              | ** ** | **Indication**                     | ** ** | **U.S. Commercialization Rights** | ** ** | **Status** |
|-------------------|------------|-------------------------|------------|------------------------------------|------------|-----------------------------------|------------|------------|
| **Osteocel**      |       | Spinal Procedures       |       | Osiris and Blackstone              |       | Marketing                         |
|                   |       | Orthopedics             |       | Osiris, AlloSource  and Blackstone |       | Marketing                         |
| **Prochymal**     |       | Steroid Refractory GvHD |       | Osiris                             |       | Phase III                         |
|              |       | Acute GvHD              |       | Osiris                             |       | Phase II                          |
|              |       | Crohn’s Disease    |       | Osiris                             |       | Phase III                         |
| **Chondrogen**    |       | Meniscus Regeneration   |       | Osiris                             |       | Phase I/II                        |
|                   |       | Cartilage Protection    |       |                               |       |                              |
| **Provacel**      |       | Heart Attack            |       | Boston Scientific                  |       | Phase I                           |

 

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*Osteocel*consists of a matrix of cancellous bone containingmesenchymal stem cells and is used in spinal fusion and other orthopedicsurgical procedures. Cancellous bone is the porous and spongy inner structureaccounting for approximately 20% of total bone mass. Osteocel is the onlycommercially available product containing viable stem cells in the UnitedStates. We launched Osteocel in July 2005 and to date it has been used inover 5,000 surgical procedures. We produce Osteocel from the marrow-rich boneof organ and tissue donors, and we believe that it is properly characterized,and regulated by the FDA, as a human cell, tissue, and cellular andtissue-based product, or HCT/P, under section 361 of the Public HealthService Act. Unlike our biologic drug candidates, our ability to supplyOsteocel is limited by the amount of marrow-rich bone that we are able toobtain from organ and tissue donors. Osteocel is currently distributed non-exclusivelyby us and by Blackstone Medical (recently acquired by Orthofix) for orthopedicindications, and jointly by us and Blackstone Medical for spinal procedures. In December 2006, weentered into a multi-year agreement with AlloSource, Inc., a non-profittissue procurement organization for the supply by AlloSource to us of  tissue for use in the manufacture ofOsteocel. Under the terms of the agreement, AlloSource commits to provide bonematrix to us for use in the production of Osteocel, and to ensure that thetechnology is made available to the communities from which it is sourced, theagreement enables AlloSource also to act as a non-exclusive distributor ofOsteocel in AlloSource’s local donor communities.

*Prochymal*is our biologic drug candidate for the treatment ofinflammatory disease. We are currently enrolling patients in a pivotal PhaseIII trial for the treatment of steroid refractory Graft versus Host Disease, orGvHD. GvHD is a life threatening immune system reaction that commonly affectsthe skin, gastrointestinal tract, and liver in patients who have received abone marrow transplant. Although in the U.S. there are no drugs approved fortreating GvHD, the disease is commonly treated off-label with steroids. GvHDthat does not respond to this treatment is known as steroid refractory GvHD. Alarge majority of steroid refractory GvHD patients die within six months. Inour Phase II trial for treatment refractory GvHD, we enrolled patients that didnot respond to treatment with steroids and at least one other therapy. Of thesepatients, 59% responded to Prochymal. We have also completed a Phase II trialevaluating Prochymal as an add-on therapy to steroids for the first-linetreatment of acute GvHD. The study found that patients were twice as likely tohave total clinical resolution of their disease when Prochymal was added tosteroid therapy, compared to reported results for steroid only treatment.Twenty-nine of 31 patients, or 94% responded after receiving two infusions ofProchymal, with 23 patients, or 74% achieving a complete response, meaning thepatients had experienced total clinical resolution of the disease. Sixpatients, or 19% had a partial response and 2 patients, or 6% did not respond.Furthermore, patients experiencing this complete response had a survival rateof 91% at Day 120.

Our Phase III trial to evaluate Prochymal as a treatment for steroid refractory GvHD is arandomized, double blind, placebo controlled study designed to enroll up to 240patients. The trial will investigate patient response to 2.0 million cellsper kilogram of body weight administered twice per week for four consecutiveweeks. The primary trial endpoint is complete resolution of GvHD for at least a28 day duration. Each patient will also be monitored for safety for up to180 days after their first treatment with Prochymal. Six-month survival isa key secondary endpoint

Based on our clinical observations of the effects ofProchymal on the gastrointestinal symptoms of patients with GvHD, we aredeveloping Prochymal for the treatment of Crohn’s Disease. Crohn’s Disease is achronic condition that results in inflammation of the gastrointestinal tract.We have completed Crohn’s disease patient enrollment in a Phase II trial undera separate Investigational New Drug application, and have clearance by the FDAto conduct a Phase III trial in biologic drug refractory Crohn’s patients. Wereceived Fast Track designation from the FDA, for the development of Prochymalfor moderate to severe Crohn’s Disease patients that are treatment refractoryto standard therapies, including biologics.

*Chondrogen*is our biologic drug candidate for regeneration ofmeniscus, a type of cartilage that cushions the knee joint. According to a 2005article in the *American Journal of SportsMedicine*, 

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approximately1.0 million people have surgery to remove damaged or torn meniscus in theUnited States each year. As noted in a 1999 article in the journal *Sports Medicine*, patients who have hadthis procedure are ten to 15 times more likely to develop osteoarthritis, ahighly debilitating orthopedic condition. There are currently no FDA approvedproducts available to regenerate meniscal tissue. In several preclinicalstudies, Chondrogen regenerated meniscal tissue and prevented osteoarthritis inanimal models. We recently completed enrollment in a Phase I/II clinical trialfor Chondrogen to evaluate its safety and efficacy in patients followingsurgery to remove torn meniscus.  A totalof 55 patients were treated in the Phase I/II, double-blind study evaluatingthe safety and exploratory effectiveness of Chondrogen, a preparation of adultstem cells formulated for direct injection into the knee. At the six month timepoint, Chondrogen met its primary endpoint, demonstrating product safety. Thetrial did not demonstrate that Chondrogen resulted in a statisticallysignificant increase in the volume of meniscus as compared to placebo; however,an improvement in baseline cartilage and joint condition was noted in patientstreated with the stem cell drug that was not seen in patients that receivedplacebo.

*Provacel*is our biologic drug candidate for the repair of heartmuscle in patients who have suffered a heart attack. Based on statisticspublished in 2005 by the American Stroke Association and the American Heart Association,approximately 700,000 individuals in the United States each year experiencetheir first heart attack. According to these same statistics, approximately 20%of these patients suffer extensive damage to their heart muscle leading toheart failure within six years. In preclinical studies in animal models,Provacel targeted the damaged area of the heart following a single treatment.These studies also indicate that Provacel prevents scar formation thattypically occurs after a heart attack and improves cardiac function eight toten weeks after its administration. 

We recently completed enrollment in a Phase I clinicaltrial for Provacel to evaluate its safety and efficacy to restore heartfunction in patients experiencing a first time heart attack. In March 2007, wereported six-month results in this trial. In a 53-patient, double-blind, placebo-controlled study evaluating thesafety and preliminary efficacy of the intravenous administration of Provacel,heart attack patients receiving the therapy had significantly lower rates ofadverse events, such as cardiac arrhythmias, as well as significantimprovements in heart, lung and global function. Administration of Provacel wasfound to be well tolerated at all dose levels. Patients in the Provacel  groupwere four times less likely to experience an arrhythmic event compared to thosereceiving placebo (9% vs. 37%, p=0.025). Fewer patients experienced clinically significant premature ventricularcontractions after receiving Provacel as compared to placebo at the one month(6% vs. 32%, p < 0.05) and two month (9% vs. 38%, p < 0.05) time points.Patients with anterior wall MIs had a statistically significant 7.0 point (24%)improvement in ejection fraction at three months and a 7.3 point (25%) improvementat six months over baseline (p<0.05). In comparison, placebo patients in this group did not have a significantincrease.   Patients receiving Provacelhad significantly improved pulmonary function as measured by improvement inFEV1% predicted values (17 point Provacel vs. 6 point placebo, p<0.05).  Significantly more patients who received Provacel experiencedimprovement in their overall condition at six months as compared to thosereceiving placebo (42% vs. 11%, p=0.027). 

We expended approximately$37.6 million in fiscal 2006, $16.9 million in fiscal 2005, and $11.9 millionin fiscal 2004, on research and development. For more detailed financialinformation, including information regarding our revenues, profit and loss, andtotal assets and research and development costs and expenses for the past threefiscal years, see our Financial Statements included in Item 8 to this AnnualReport on Form 10-K for fiscal year 2006.

**ScientificBackground**

Stem cells are a special class of cells that canself-replicate and differentiate into multiple tissue types. Differentpopulations of stem cells, also called progenitor or precursor cells, residewithin the body. These cells are generally classified according to theirdifferentiation potential, or ability to become distinct cell 

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types. Embryonic stemcells are recognized as being totipotent, or unlimited, in terms of the numberof different cell types they can become. Other stem cells are eithermultipotent, meaning capable of becoming two or more cell types, or unipotent,meaning preprogrammed for a single final cell type. Multipotent stem cellsinclude the hematopoietic stem cells responsible for generating cellsassociated with the circulatory and immune systems, mesenchymal stem cellsresponsible for the formation of connective tissue cells, and neuronal stemcells dedicated to producing the different nervous system cell types. Stemcells participate in embryological and fetal development and orchestrate tissuerepair following disease or injury in the adult. Though the precise mechanismof their activity has not yet been determined, experimental work has providedempirical evidence of the therapeutic benefit of various types of stem cellsadministered to animal and human subjects.

The embryonic stem cell, or ESC, has the greatestdifferentiation potential and is capable of developing into all cell typesfound within the human body. ESCs must be harvested from human embryos, givingrise to ethical controversies surrounding the procurement of ESCs, which havehindered progress in ESC research. The United States government hassignificantly restricted the funding of ESC research. Also, technicaldifficulties in purifying and growing ESCs have prevented widespreadexperimental work capable of withstanding academic or regulatory scrutiny.

In the adult, two major classes of stem cells exist inbone marrow, hematopoietic stem cells and mesenchymal stem cells. Throughoutlife, hematopoietic stem cells, or HSCs, located within the bone marrow giverise to most types of blood cells. HSC transplantation has served as the basisfor a number of aggressive treatments for various types of cancer. However,therapies based on HSCs are largely limited to hematological disorders becauseHSCs can only differentiate into blood cells.

In contrast toHSCs, mesenchymal stem cells, or MSCs, are progenitor cells that differentiateinto various connective tissues, such as bone, muscle, fat, tendon, ligament,cartilage and bone marrow stroma when they receive appropriate biochemical andbiomechanical signals. Other biochemical stimuli cause MSCs to mobilize toareas of injury or inflammatory disease. Once there, MSCs coordinate tissueregeneration at a local level by producing tissue growth factors and byinteracting with local cells to reduce inflammation and scarring. Importantly,MSCs do not express markers on the surface of cells, known as HLA class IIantigens, which are responsible for recognition of the cells by the immunesystem. Also, the cell surface markers, CD40, CD80 and CD86, which are essentialfor activation of immune cells, are not present on MSCs. These characteristicsallow MSCs to:

·       betransplanted into an unrelated patient without giving rise to an immuneresponse;

·       regenerateconnective tissues like bone and cartilage;

·       actas a potent anti-inflammatory agent; and

·       exhibitanti-fibrotic activity to limit tissue damage.

MSCs and HSCs are most readily isolated from bonemarrow. Because MSCs represent a small fraction of bone marrow cells, theyrequire amplification to be clinically useful. We have developed and optimizeda proprietary process for isolating and expanding these cells usingstandardized cell culture methodologies. We can grow MSCs in a controlledfashion to produce up to 5,000 treatments of our biologic drug candidates froma single bone marrow donation.

Stem cells can be derivedfrom either the patient, referred to as an autologous source, or from a donor,referred to as an allogeneic source. For many cell therapies, allogeneicsourcing is not possible due to the immune response that typically occursfollowing the injection of unrelated cells. The non-immunogenic nature of MSCspermits allogeneic cell sourcing and carries significant advantages overautologous sourcing. Allogeneic cell sourcing from a healthy donor populationallows for specific quality control measures to select therapeutically optimalstem cells. For example, if a patient’s cells are of poor 

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qualitydue to advanced age, disease or metabolic state, the product to be re-infusedwill likely be of similar poor quality. We believe that allogeneic sources usedin large scale production will enable us to utilize quality control practicesto ensure that product potency is reproducible from treatment to treatment. Wehave developed and continue to develop quality standards for our biologic drugcandidates, including potency assays directed to the specific indications foruse. To our knowledge, no patients participating in our clinical trials or whohave used Osteocel to date have experienced an immunogenic response.

**Strategy**

We are striving to be the first company to receive FDAmarketing approval and to commercialize a stem cell drug therapy.

*Successfullycommercialize our lead stem cell therapy, Prochymal.**  *We are currently enrolling patientsin a pivotal Phase III clinical trial for Prochymal. Assuming marketingapproval, we plan to develop a sales and marketing force to promote Prochymalinitially for the treatment of steroid refractory GvHD. Based on the smallnumber of bone marrow transplantation hospitals in the United States and thelack of effective treatments for this population, we believe we cansuccessfully market Prochymal with a specialized sales force.

*LeverageOsteocel’s orthopedic sales infrastructure for our biologic drug candidateChondrogen.**  *Inthe field of orthopedics, we intend to expand our network of salesprofessionals for the distribution of Osteocel. We plan to use our commercialexperience with Osteocel to build a specialized sales organization trained andexperienced in stem cell orthopedic sales. Given the overlap of potentialcustomers for Osteocel and Chondrogen, we believe our relationships withorthopedic surgeons established through sales of Osteocel will help drivecommercial adoption of Chondrogen and other orthopedic biologic drugcandidates.

*Expandour pipeline of biologic drug candidates where our stem cell technology has atherapeutic potential.**  *Weintend to continue investing in our biologic drug candidate pipeline bypursuing additional diseases and disorders where we believe MSCs have potentialtherapeutic benefit.

*Exploitour MSC technology, manufacturing ability and proprietary know-how to advanceour pipeline.**  *Weintend to leverage our preclinical research, safety data and manufacturingability to rapidly and efficiently grow our biologic drug candidate pipeline.Because we utilize MSCs as the active agent for all of our biologic drug candidates,we believe the accumulated safety data will reduce the time and cost associatedwith early stage clinical trials for new indications.

*Internally develop andcommercialize future biologic drug candidates.**  *We believe that we have therequisite experience to develop and commercialize our unpartnered biologic drugcandidates and any future biologic drug candidates without the help of astrategic partner. Due to our experience with Osteocel and our current pipelinecandidates, we believe we have gained the clinical, regulatory, manufacturingand commercial capabilities to successfully develop and commercialize biologicdrug candidates.

**Marketed Product**

*Osteocel*

Osteocel consists of a matrix of cancellous bonecontaining mesenchymal stem cells and is used in spinal fusion and otherorthopedic surgical procedures. It is the only commercially available productin the United States containing viable stem cells. We launched Osteocel inJuly 2005 and to date it has been used in over 5,000 surgical procedures.Osteocel is currently distributed non-exclusively by us, Blackstone and AlloSourcefor orthopedic indications, and by us jointly with Blackstone Medical forspinal procedures.

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According to data published by the Centers forMedicare and Medicaid Services, over 900,000 surgeries are performed in theUnited States each year that require the reconstruction or replacement of bone.The standard of care is a procedure known as autograft, in which bone isharvested from another site within the same patient and transferred to the siteof injury. The harvested bone contains stem cells and is often an effectiveagent for regenerating bone. However, this procedure has significant disadvantages.An additional surgery is required to obtain the autograft bone, resulting inincreased time under anesthesia, additional blood loss, and the costsassociated with an additional surgery. These patients also face an increasedrisk of infection and may experience chronic post-operative pain from theharvest procedure. As noted in an article published by the UCLA Department ofOrthopaedic Surgery, complications from the autograft harvest occur in up to35% of patients having the procedure. As such, we believe there is asignificant medical need for a product that can provide reliable bone formingcharacteristics and eliminate the need for autograft.

Spinal fusion isused to treat damage to the intervertebral disc, including herniated discs, andis one of the most common and expensive surgeries in orthopedics. Based on datapublished by the Centers for Medicare and Medicaid Services, there were 450,000spine fusion surgeries in 2003, associated with multi-billion dollar healthcare costs. All spinal fusion surgeries require autograft or other material tosupport bone formation. Non-viable bone sourced from cadavers, syntheticmaterials, and recombinant growth factors are used as alternatives toautograft. Each has significant limitations and none has the same regenerativecharacteristics of autograft. While Osteocel contains the same bone formingproperties as autograft, it has several distinct advantages:

·       Osteocelavoids the potential complications and expense of an additional surgicalprocedure.

·       Theavailability of Osteocel during surgery is limited only by the in-house supply,while autograft availability is limited to the amount harvested from thepatient in the prior surgical procedure.

·       Everylot of Osteocel is tested to ensure consistent quality, while the quality ofthe autograft is dependent upon the health of the patient.

·       Easeof use, storage characteristics, and shelf life allow Osteocel to be used invirtually any surgical setting where bone formation is needed.

Osteocel works in three ways. The cancellous bonematrix of Osteocel is osteoconductive, meaning it encourages new bone growth byproviding a scaffold to support bone formation. Osteocel is also inductive.Osteoinduction is the indirect promotion of bone formation by recruiting thepatient’s cells to the site through signaling mechanisms. Lastly, the stemcells contained in Osteocel make it osteogenic. Osteogenesis is the ability ofcertain cells to form bone directly. Only two current treatments contain allthree of these necessary components for new bone growth: autograft andOsteocel. Over the past 10 years our scientists have published over 20peer reviewed journal articles demonstrating the consistent osteogeniccapabilities of the MSCs in Osteocel.

We produce Osteocel from the marrow-rich bone of organand tissue donors. Since its introduction in July 2005, we have beenunable to produce quantities of Osteocel sufficient to meet surgeon demand.During 2006, we were constrained by our manufacturing facility and limitationson the supply of marrow-rich bone obtainable from adult organ and tissuedonors. To increase our ability to supply our customers, we are currentlyexpanding our manufacturing capacity and increasing the number of organ andtissue agencies that supply us with tissue. In December 2006, we enteredinto a multi-year agreement with AlloSource, Inc., a non-profit tissueprocurement organization, for the supply by AlloSource to us of tissue for usein the manufacture of Osteocel. Under the terms of the agreement, AlloSource commitsto provide bone matrix to us for use in the production of Osteocel, and toensure that the technology is made available to the communities from which itis sourced, the agreement enables AlloSource to act as a non-exclusivedistributor of Osteocel in AlloSource’s local donor communities.

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We believe that Osteocel is properly characterized,and regulated by the FDA, as a HCT/P under section 361 of the PublicHealth Service Act.

We are in the process of developing a secondgeneration MSC product for bone repair, Osteocel-XC, as a long-term strategy torelieve supply constraints. Unlike Osteocel, Osteocel-XC will utilizeculture-expanded MSCs like our other biologic drug candidates. Based on ourclinical and preclinical experience with Osteocel and MSCs, we are preparing tosubmit an Investigational New Drug application to FDA to study Osteocel-XC.

Revenues from sales ofOsteocel were $8.3 million in fiscal 2006 and $1.0 million in fiscal 2005. Therewere no Osteocel sales or revenues in fiscal 2004.

**Clinical Programs**

*Prochymal*

Prochymal is our biologic drug candidate for thetreatment of inflammatory disease. We are currently enrolling patients in apivotal Phase III trial for the treatment of steroid refractory GvHD. GvHD is alife threatening immune system reaction that commonly affects the skin,gastrointestinal tract, and liver in patients who have received a bone marrowtransplant. We estimate that there are approximately 3,000 instances of GvHD inthe United States each year. We are also evaluating Prochymal in a Phase IIItrial for Crohn’s Disease for patients refractory to biologics.

Bonemarrow transplantation is a treatment of last resort for patients with certaincancers and some genetic diseases. This procedure can result in a particularlyserious type of rejection referred to as Graft versus Host Disease. Thiscondition gets its name because the bone marrow transplant, or the graft,begins to attack the recipient, or the host. As noted in an article publishedin the journal *Biology of Blood and MarrowTransplantation* in 2005, acute GvHD is one of the most commoncomplications of allogeneic bone marrow or hematopoietic stem celltransplantation, affecting approximately 50% of transplant patients. Acute GvHDis graded for prognostic and treatment purposes on a four grade scale, withGrade I considered mild, Grade II moderate, and Grades III-IV considered severeand life-threatening. The onset of GvHD in patients who have received a bonemarrow transplant leads to a poor prognosis because of the already weakenedstate of such patients. According to a 2002 article published in *Biology of Blood and Marrow Transplantation*,the estimated one year survival rate for patients with acute GvHD decreasesdrastically with increasing disease severity, as illustrated below:

| **Acute GvHD** | ** ** | ** ** | ** ** | **Estimated One  Year Survival** | ** ** |
|---------------------|------------|------------|------------|--------------------------------------------|------------|
| Grade I             |       |       | 65         | %                                          |       |
| Grade II            |       |       | 60         | %                                          |       |
| Grade III           |       |       | 39         | %                                          |       |
| Grade IV            |       |       | 22         | %                                          |       |

 

Typically, patients are treated aggressively withsteroids when their GvHD reaches Grade II. A 2001 article published in the journal*Blood* noted that approximately50% of these patients will not respond to treatment with steroids andapproximately 50-80% of steroid refractory GvHD patients die of thedisease.

The current treatments available for acute GvHD areinadequate in several ways. First, mortality in patients with acute GvHD isunacceptably high. Second, most treatments for acute GvHD work by suppressingor destroying the immune system. This leads to a number of debilitating sideeffects, including severe and life threatening infection. Unlike steroids orother immunosuppressant drugs, which have a systemic effect, Prochymal’smechanism of action is designed to specifically target areas of inflammation.Therefore, we believe the use of Prochymal will result in a lower rate of lifethreatening infection.

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We completed a Phase II trial to evaluate Prochymal asa first-line treatment in combination with steroids, for patients diagnosedwith Grade II through Grade IV acute GvHD. Patients were treated with doses of2.0 or 8.0 million cells per kilogram of body weight administered in twoinfusions of Prochymal 72 hours apart. The treatment commenced within48 hours of GvHD diagnosis. In this study, we are evaluating safety, dose,and response to treatment by day 28. Patients will be followed for safety fortwo years after trial enrollment. A total of 32 patients have been treatedunder this protocol. The study found that patients were twice as likely to havetotal clinical resolution of their disease when Prochymal was added to steroidtherapy, compared to reported results for steroid only treatment. Twenty-nineof 31 patients, or 94% responded after receiving two infusions of Prochymal,with 23 patients, or 74% achieving a complete response, meaning the patientshad experienced total clinical resolution of the disease. Six patients, or 19%had a partial response and 2 patients, or 6% did not respond. Furthermore,patients experiencing this complete response had a survival rate of 91% at Day120.

Starting in 2004, several requests were made byphysicians to use Prochymal in a compassionate use setting for patients withacute severe treatment refractory GvHD and no remaining treatment options. Atotal of seven pediatric patients that had failed to respond to steroids andother immunosuppressive agents were treated on an emergency-use basis, andclinical improvements were seen in gastrointestinal and skin GvHD.

As a result of the compassionate use requests, weinitiated a second Phase II trial to investigate the use of Prochymal inpatients diagnosed with Grade III or Grade IV GvHD that did notrespond to treatment with steroids and at least one other therapy. This was anopen label study in which we evaluated safety, dose, and response to treatmentby day 28. Patients were treated with 8.0 million cells per kilogram every72 hours as needed for response, for a maximum of eight treatments.Fourteen patients were treated under this protocol. The subjects enrolled inthis trial had failed to respond to an average of 4.4 other drug therapies priorto enrollment. A 59% Prochymal response rate was observed in this treatmentrefractory population, defined as an improvement in at least one affected organby at least one full GvHD stage without disease progression in any other organ.Because the patients in this trial had previously not responded to multiplelines of therapy and their condition was immediately life threatening, forethical reasons the use of a placebo control was not possible. Therefore,further analysis of the statistical significance of our results was notperformed. We are following patients for safety for one year after trialenrollment.

In 2003 we completed a Phase I trial to determine thesafety of Prochymal in patients who received hematopoietic stem celltransplants. The trial investigated patient response to doses of 1.0, 2.5, and5.0 million cells per kilogram of body weight. No safety concerns relatedto the use of Prochymal were observed in the 46 subjects who were evaluated.

We obtained both Fast Track and Orphan Drug designationin 2005 for the use of Prochymal in GvHD patients. The FDA grants Fast Trackdesignation to investigational drugs that have the potential to treatlife-threatening diseases with unmet medical needs. Our Biologic LicenseApplication will be eligible for an expedited review process by the FDA as aresult of this designation. Orphan Drug designation offers several benefitsincluding eligibility for grants to fund studies, seven years of marketingexclusivity and a waiver of the Biologic License Application fee ofapproximately $900,000. Prochymal is the only stem cell therapeutic currentlydesignated by the FDA as both an Orphan Drug and Fast Track product candidate.

Based on our clinical observations of the effects ofProchymal on the gastrointestinal symptoms of patients with GvHD, we aredeveloping Prochymal for the treatment of Crohn’s Disease. Crohn’s Disease is achronic, life-long condition that features relapsing inflammation of thegastrointestinal tract. Severe Crohn’s Disease can cause intractable diarrheaand abdominal pain, undesirable changes in lifestyle, hospitalization, andunwanted side effects from required medications. Approximately 60% of Crohn’sDisease patients require at least one surgery to remove an affected portion oftheir intestine at some time 

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during their lifetime,according to a 2002 article in the journal *AlimentaryPharmacology & Therapeutics*. This article further notesthat there are over 500,000 cases of diagnosed Crohn’s Disease in the UnitedStates, and at any given time approximately 10% of these have a severeexacerbation or relapse that does not respond to traditional immunosuppressivetreatments. Standard treatments of steroids and other immune suppressants oftencause secondary health problems. According to a 2003 article in the *British Journal of Clinical Pharmacology*,with current medical therapies about 50% of patients with severe Crohn’sDisease will relapse within a year. Also, one year post-surgical recurrencerates of over 85% have been reported in such patients in a 1990 articlepublished by *The Medical Clinics of NorthAmerica*.

We completed a Phase II trial studying Prochymal as atreatment for moderate to severe Crohn’s Disease that is refractory to steroidsand other immune suppressants. We enrolled ten patients in this study andcommunicated the results during the October 2006 annual meeting of theAmerican College of Gastroenterology. The trial was a prospective, randomized,open label trial, conducted at 4 leading centers in the US. Patients withmoderate to severe Crohn’s disease, defined as having a CDAI (“Crohn’s DiseaseActivity Index”) of at least 220, who had previously failed treatment withsteroids and other immunosuppressive agents, were given two infusions ofProchymal seven days apart. A total of 10 patients were treated, with 9patients evaluated through the 28 day follow-up. One patient elected to exitthe trial prior to completion. Patients were divided into two groups andreceived either low dose (2 million cells per kilogram) or high dose (8 millioncells per kilogram) of Prochymal on an outpatient basis. In addition to safetyparameters, patients were evaluated for changes in CDAI and improvement in theInflammatory Bowel Disease Questionnaire or IBDQ. Prior to entering the trial,patients who had been treated with infliximab or other biological agents wererequired to complete a washout period of 90 days to preclude the possibilitythat response was the result of a previous treatment.

Entering the trial, the average CDAI score at baselinewas 341. Patients entering this study had suffered from Crohn’s Disease for anaverage of 14.2 years, and 80% of the patients required prior surgicalintervention to treat their Crohn’s Disease. In the study, one-third of thepatients had a reduction of CDAI of greater than 100 points within 14 days oftreatment. Each of these responders had failed previous treatment withinfliximab (Remicade(R)). Mean IBDQ scores improved significantly from baselineto day 28 (113 to 146, p=0.008). One-third of the patients reported IBDQ scoresof at least 170, indicating they had achieved clinical remission of theirdisease. Although not reaching statistical significance, there appeared to becorrelation between dose and response. Patients receiving the high dose had a72 point greater reduction in CDAI than those receiving low dose (CDAIreduction of 137 vs. 65). There were no infusional toxicities, nor were thereany treatment related severe adverse event.

As the result of theencouraging data, we initiated a Phase III program for moderate to severe Crohn’sDisease patients who are refractory to standard therapy, including biologics. Wehave received Fast Track designation from the FDA, which makes us eligible forexpedited FDA review of Prochymal for this indication. We have also receivedclearance from the FDA to conduct a Phase III clinical trial using Prochymal totreat this resistant form of Crohn’s Disease.

*Chondrogen*

Chondrogen is our biologic drug candidate forregeneration of meniscus, a type of cartilage that cushions the knee joint.There are currently no FDA approved products available to regenerate meniscaltissue. In several preclinical studies, Chondrogen, a preparation of adult stemcells formulated for direct injection into the knee, regenerated meniscus andprevented osteoarthritis in animal models. As described further below, at theend of the first quarter of 2006 we completed enrollment in a Phase I/IIclinical trial for Chondrogen, designed to evaluate the safety and preliminaryefficacy in patients following surgery to remove torn meniscus.

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Themeniscus is a crescent-shaped cushion in the knee joint that protects cartilageand enables the knee to move smoothly. Injury and tears to the meniscus arecommon and can be traumatic, arising from sports injury for example, ordegenerative, due to daily wear and tear. An injured or torn meniscus ispainful and typically requires surgical intervention. The current standard ofcare for significant injuries is partial meniscectomy surgery, in which thedamaged portion of the meniscus is permanently removed. According to a 2005article in the *American Journal of SportsMedicine*, approximately 1.0 million people have surgery toremove damaged or torn meniscus in the United States each year. As noted in a1999 article in the journal *Sports Medicine*,patients who have had this procedure are ten to 15 times more likely to developosteoarthritis, a highly debilitating orthopedic condition. As a result, asignificant medical need exists for a product that can regenerate the meniscaltissue removed during surgery and prevent cartilage degeneration.

At the end of the first quarter of 2006, we completedenrolling patients in a randomized double-blind, placebo controlledPhase I/II clinical trial evaluating Chondrogen for safety and preliminaryefficacy based upon regeneration of meniscus at six-months. We plan onevaluating each patient for safety two years after the patient enrolled in thetrial. Participants in the trial received doses of either 50 millioncells, 150 million cells, or placebo and a total of 55 patients weretreated. At the six month time point, Chondrogen met its primary endpoint,demonstrating product safety. An initial review of the data showed thatChondrogen was well tolerated, was not associated with serious adverse events,did not result in any adverse hematological events, and did not result in theformation of any unwanted or ectopic tissue. There was no significant change inthe volume of meniscus on MRI at six-months in patients that receivedChondrogen compared to those patients receiving placebo. However, about 30% ofpatients treated with Chondrogen demonstrated an improvement in their baselinecartilage or joint condition, while no patients in the placebo groupdemonstrated similar improvement. Patients will be followed for safety andadditional preliminary efficacy, such as cartilage damage and changes in themeniscus for two years under the current study protocol.

*Provacel*

Provacelis our biologic drug candidate for the repair of heart muscle in patients whohave suffered a heart attack. Preclinical studies indicate that Provacelprevents scar formation that typically occurs after a heart attack and improvescardiac function eight to ten weeks after its administration. As discussedfurther below, in March 2006 we completed enrollment in a Phase I clinicaltrial for Provacel. This trial is designed to evaluate the safety and efficacyof Provacel to restore heart function in patients experiencing a first timeheart attack.

Aheart attack, or acute myocardial infarction (AMI), occurs when coronaryarteries become blocked with fatty deposits, depriving the heart muscle ofoxygen and nutrients. Based on statistics published in 2005 by the AmericanStroke Association and the American Heart Association, in the United Statesapproximately 700,000 individuals each year experience their first heartattack. According to these same statistics, approximately 20% of patientsexperiencing their first heart attack suffer extensive damage to their heartmuscle, leading to heart failure within six years. Furthermore, we believe thestatistics indicate that despite improvements in the standard of care, thisprogression from myocardial infarction to heart failure remains largelyunavoidable in patients with AMIs.

Provacelis being developed for the treatment of heart muscle damage following AMI. Itsprimary indication is to treat post-AMI complications and prevent the formationof scar tissue and associated cardiac dysfunction. Our preclinical studiesindicate that the mechanism by which Provacel improves myocardial functionincludes preventing pathological scarring of the heart muscle and growing newblood vessels. We are developing Provacel as a therapy to be delivered througha standard intravenous line up to 10 days post-myocardial infarction.

Inpreclinical studies, Provacel selectively targeted the damaged area of theheart when a single infusion was administered. These studies also indicatedthat Provacel has the effect of retarding or 

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stopping the progress of further cardiac tissuedeterioration and limiting the damage caused by an AMI. Significantimprovements in cardiac function as demonstrated by increased ejectionfraction, reduced end diastolic pressures, and reduced wall stress wereobserved eight to ten weeks after administration of Provacel. A preclinicalstudy was performed to determine if an intravenous infusion of MSCs followingmyocardial infarction would result in an improvement in cardiac function.Significant improvement in cardiac function as indicated by left ventricularejection fraction was observed three months after infarct in those animalsreceiving intravenous delivery of MSCs compared to control animals. MSCs weredetected in the damaged area of the heart muscle of Provacel treated animals,but not in the remote, undamaged regions.

InMarch 2006, we completed enrollment of a 53 patient Phase I randomized, doubleblind, placebo controlled clinical study to evaluate Provacel in patientsfollowing AMI. The trial is designed to investigate patient response to dosesof 0.5, 1.6, and 5.0 million cells per kilogram of body weight or placebo.Exploratory efficacy endpoints include overall improvement in the function andremodeling of the heart muscle six months after treatment. A safety evaluationfor each subject will be conducted two years after the subject is enrolled inthe trial.

InMarch 2007, we reported six-month results in this trial.  Heart attack patients receiving Provacel hadsignificantly lower rates of adverse events, such as cardiac arrhythmias, aswell as significant improvements in heart, lung and global function.Administration of Provacel was found to be well tolerated at all doselevels.  Patients in the Provacel  group were four times less likely to experiencean arrhythmic event compared to those receiving placebo (9% vs. 37%,p=0.025).  Fewer patients experiencedclinically significant premature ventricular contractions after receivingProvacel as compared to placebo at the one month (6% vs. 32%, p < 0.05) andtwo month (9% vs. 38%, p < 0.05) time points. Patients with anterior wallMIs had a statistically significant 7.0 point (24%) improvement in ejectionfraction at three months and a 7.3 point (25%) improvement at six months overbaseline (p<0.05).  In comparison,placebo patients in this group did not have a significant increase.   Patients receiving Provacel hadsignificantly improved pulmonary function as measured by improvement in FEV1 %predicted values (17 point Provacel  vs.6 point placebo, p<0.05).  Significantly more patients who received Provacel experiencedimprovement in their overall condition at six months as compared to thosereceiving placebo (42% vs. 11%, p=0.027). 

We entered into a collaboration with Boston ScientificCorporation in 2003, and assuming successful completion of our clinical trialsand regulatory approval, it will market and distribute Provacel.

*Other*

In addition to the indications described above, weintend to investigate alternative uses for MSCs and our biologic drugcandidates. We may also evaluate the use of Provacel for additionalcardiovascular indications and Chondrogen for the regeneration of cartilage inother areas of the body.

**Collaborations**

*Boston ScientificCorporation—Research, Development and Commercialization Collaboration*

In March 2003,we entered into a collaboration agreement with Boston Scientific Corporation,or Boston Scientific, to develop applications of our MSC technology to treatacute myocardial infarction and chronic ischemia. Our biologic drug candidateunder development pursuant to this collaboration is Provacel.

Underthe terms of the collaboration, we are responsible for the preclinicaldevelopment of an MSC biologic drug candidate having application in the coveredfield, and for associated regulatory filings, and Boston Scientific isresponsible for the research and development activities performed followingcompletion of preclinical development of a biologic drug candidate, including,without limitation, development of the clinical protocols, clinical trialmanagement and Phase II efficacy research testing. The collaboration providesfor us to manufacture the MSC clinical trial materials, and provides that, upon

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regulatory approval for commercial sale, we willmanufacture and Boston Scientific will have exclusive rights to distribute andsell the product globally. Boston Scientific may also assume the manufacturingrights and responsibilities from us and if it does so the royalty rate payableto us is subject to increase. This collaboration may be terminated at any timeupon mutual agreement of the parties. Also, Boston Scientific can terminate thecollaboration prior to obtaining FDA approval of a product, provided that itgives us at least 120 days notice of such termination.

Inconnection with this collaboration, we granted to Boston Scientific aworldwide, exclusive license to develop, market and distribute MSC products inthe covered field. Unless earlier terminated, the license terminates on theexpiration of the last to expire licensed patent covering the product, and withregard to member states of the European Economic Area, or EEA, on the later ofthe tenth anniversary of the commercial launch of a product in the EEA or theexpiration of the last to expire patent. This license automatically terminatesupon termination of the collaboration prior to FDA approval of a product asdescribed above.

BostonScientific paid a $5.0 million licensing fee to us upon the effectivenessof the license. Boston Scientific is also required to pay to us up to$25.0 million in pre-commercialization milestones per product, as well asroyalty payments for MSC products acquired or manufactured by Boston Scientificoutside of the terms of the contract manufacturing agreement. In addition, anyand all MSC products sold by us to parties other than Boston Scientific must besold with a limited label license that states that the product may only be usedin a specified field or application which does not fall within the exclusivefield granted to Boston Scientific.

Wehave a $50.0 million line of credit with Boston Scientific, of which wehave drawn $5.0 million to date. Borrowings can only be used by us inconnection with Provacel development efforts. Advances under the loan agreementare secured by an interest granted to Boston Scientific in the licenseagreement, including the right to develop, market and distribute MSC productsin the covered field and our right to receive payments under the license; allequipment, books and records relating to the manufacture of Provacel; and allfuture proceeds or payments received in connection with such collateral. Wemust commence quarterly repayment of the advance during the first fiscalquarter following commercialization of Provacel up to a maximum of 2.5% ofsales of Provacel per quarter. If commercialization has not occurred prior to December 31,2008, we must issue shares of our common stock in repayment of the loan at arate of 20% per year up to a maximum repayment term of five years.Alternatively, upon any termination of the collaboration with Boston Scientificor any default under the loan agreement, Boston Scientific may require us tosatisfy the full balance of the outstanding loan through an issuance of sharesof our common stock. We can elect to repay the amounts borrowed from BostonScientific at any time.

In conjunction with this collaboration, BostonScientific made a $10.0 million investment in our preferred stock, whichwas converted into 500,000 shares of our common stock. Upon the enrollment ofthe first patient in a Phase III clinical trial for Provacel, Boston Scientificis obligated to purchase from us and we are obligated to sell, 166,667 sharesof common stock for an aggregate purchase price of $10.0 million, or$60.00 per share. Upon FDA approval of Provacel, Boston Scientific is obligatedto purchase from us and we are obligated to sell, 89,286 shares of common stockfor an aggregate purchase price of $10.0 million, or $112.00 per share.Boston Scientific was granted registration rights in respect of the shares ofour common stock received by it, which rights have been waived to the extentthat they related to our initial public offering. Boston Scientific was alsogranted a preemptive right to purchase its pro rata share of securities issuedand sold by us, which right has been permanently waived.

*JCR PharmaceuticalsCo., Ltd.—License Agreement*

In August 2003,we entered into a license agreement with JCR Pharmaceuticals Co., Ltd., orJCR, pursuant to which we granted to JCR an exclusive right in Japan to our MSCtechnology for use in connection with the use of hematopoietic stem cellsderived from peripheral blood, cord blood or bone marrow in the treatment ofhematological malignancies including the treatment of GvHD with Prochymal.

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Thelicense agreement provided for a payment by JCR to us of an up-front licensefee of $3.0 million and payment of an additional $500,000 upon certaintechnology transfer. In addition, if and when marketing approval is obtained inJapan, JCR is required to pay up to $7.0 million in pre-commercializationmilestones per product and certain amounts for pre-determined thresholds ofcumulative net sales. Lastly, JCR has an obligation to pay royalties to us,with such amount dependent upon the cumulative net sales.

Underthe terms of the collaborative arrangement, JCR is obligated to use itsreasonable best efforts to develop and commercialize in Japan products coveredunder the terms of the license, including conducting clinical trials andprocuring regulatory and other approvals. The license expires with respect tospecific products on the later of 15 years from the date of the first saleof the product in Japan or the date on which our last patent in Japan coveringthat product expires. Also, the license and the collaboration can be terminatedunilaterally by JCR upon 180 days notice to us or by mutual agreementbetween us and JCR.

In conjunction with this collaboration, JCR made a$3.0 million investment in our preferred stock, which converted at theclosing of our initial public offering into 136,363 shares of our common stock.JCR was granted registration rights in respect of the shares of our capitalstock received by it, which rights have been waived to the extent that theyrelated to our initial public offering. JCR was also granted a preemptive rightto purchase its pro rata share of securities issued and sold by us, which righthas been permanently waived.

*Blackstone Medical, Inc.—DistributionAgreement*

In November 2005,we entered into a distribution and supply arrangement for Osteocel withBlackstone Medical, Inc., or Blackstone. Blackstone has since beenacquired and now operates as a division of Orthofix International, N.V. Blackstonehas the right to distribute Osteocel in the United States for the treatment ofspinal injuries or diseases. In addition, we granted Blackstone an exclusivedistribution right with regard to spinal implant manufacturers provided that itcommits to purchase at least 80% of the quarterly production forecast ofOsteocel at a stipulated price per unit.

Blackstonemarkets Osteocel under the “Trinity” name. We have also retained the right todirectly market and distribute Osteocel under the Osteocel brand.

Blackstoneis required to use its best efforts to distribute Osteocel. Unless earlierterminated, the agreement terminates on December 31, 2008; however, it canbe renewed for one-year periods so long as Blackstone achieves certainpredetermined performance objectives.

Either party may terminate the agreement immediatelyupon written notice to the other party of the occurrence of certain bankruptcyevents or failure to remedy a material breach that continues for more than30 days.

**Intellectual Property**

Wehave established a considerable patent position in adult stem cell technology.We currently own or have exclusive licenses to 47 issued U.S. patents. Foreigncounterparts to these patents, including composition of matter claims, havebeen filed, and we own or hold licenses to 167 issued patents in Europe,Canada, Australia and other countries. The patents and patent licenses includedin our portfolio address the composition and therapeutic use of mesenchymalstem cells. We are committed to protecting our intellectual property positionand to aggressively pursue our patent portfolio, and have 13 additionalU.S. patent applications pending and 59 foreign patent applications onfile but not yet allowed.

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For most of our biologicdrug candidates, we rely on multiple patents in combination. The followingprovides a description of our key patents and pending applications and is notintended to represent an assessment of claims limitations or scope.

| **Patent**                | ** ** | **Subject Matter**                                           | ** ** | **Related Product(s)**                     | ** ** | **Expiry** | ** ** |
|---------------------------|------------|-------------------------------------------------------------------|------------|-------------------------------------------------|------------|------------|------------|
| US5,486,359               |       | Composition of Matter  for mesenchymal stem cells.                |       | Chondrogen,  Prochymal,  Osteocel XC,  Provacel |       |       | 2013       |   |   |
| US5,811,094               |       | Therapeutic use of MSCs  for the repair of connective tissue.     |       | Chondrogen,  Osteocel XC                        |       |       | 2015       |   |   |
| US6,355,239               |       | Basis for universal use  of MSCs without recipient matching.      |       | Chondrogen,  Osteocel XC                        |       |       | 2018       |   |   |
| US6,387,369               |       | Use of MSCs for cardiac  muscle repair.                           |       | Provacel                                        |       |       | 2020       |   |   |
| US6,328,960               |       | Use of MSCs in  transplantation, e.g. marrow, tissues and organs. |       | Prochymal,e.g.  GvHD                            |       |       | 2019       |   |   |
| **Pending  Applications** |       |                                                              |       |                                            |       |       |       |   |   |
|                      |       | Use of MSC for  inflammation.                                     |       | Prochymal, e.g.  Crohn’s Disease           |       |       |       |   |   |
|                      |       | Use of matrix-associated MSCs for bone repair.                    |       | Osteocel                                        |       |       |       |   |   |

 

Throughour experience with MSCs and MSC-based product development, we have developedexpertise and know-how in this field. We manufacture clinical grade MSCsin-house and contract for the production through contract manufacturers. Toprotect this non-patentable know-how, our policies require confidentialityagreements with our employees, consultants, contractors, manufacturers, outsidecollaborators, sponsored researchers, and advisors. These agreements generallyprovide for protection of confidential information, restrictions on the use ofmaterials and assignment of inventions conceived during the course of performancefor us. These agreements might not effectively prevent disclosure of ourconfidential information.

Wewere founded on the basis of MSC technology obtained from Case Western ReserveUniversity, or CWRU. In January 1993, we entered into a Technology Transferand License Agreement with CWRU, which was subsequently amended in October 1999and twice in October 2003. Pursuant to this license agreement certainpatents were assigned to us and others were exclusively licensed to us, withthe right to grant sublicenses.

Theexclusive license is subject to any rights of a governmental agency based onresearch funding by such an agency, and to CWRU’s retained rights under thepatents for non-clinical research, testing or educational purposes of CWRU.

Withrespect to the patents licensed to us, we are obligated to pay royalties toCWRU based on sales of products covered by granted licensed patents, and suchroyalties commence with respect to each such product on the third anniversaryof the initial sale thereof. We are also obligated to pay minimum royaltiesunder the agreement with CWRU. We are responsible for patent costs and alongwith CWRU have the right to enforce licensed patents. The license is terminableby CWRU in the event that there is a material breach by us. Otherwise thelicense is for the life of the patents. Under certain circumstances, we areobligated to negotiate in good faith with a third party a sublicense underpatents licensed from CWRU and under patents and know-how owned by us that arereasonably required by the third party to exercise the granted sublicense. Weare not obligated to grant such a sublicense where it would have a potentialadverse effect on a product being researched, developed or commercialized by usor by a licensee or sublicensee of ours.

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Underterms of a Marketing, Collaboration and License Agreement with BioWhittaker, Inc.,(recently acquired by Lonza), we have licensed our MSC technology toBioWhittaker to sell MSCs, MSC descendants, cells produced from MSCs and materialsused with MSCs for commercial and non-commercial research purposes. Under theterms of this agreement, BioWhittaker is specifically precluded from sellingthe licensed products for use in humans. We receive royalties on any salesunder this agreement.

Patent life determination depends on the date offiling of the application or the date of patent issuance and other factors aspromulgated under patent law. The United States Drug Price Competition andPatent Term Restoration Act of 1984, known as the Hatch-Waxman Act, permits apatent extension of up to five years as compensation for patent term lostduring the FDA regulatory review process. The patent term restoration period isgenerally one-half the time between the effective date of an InvestigationalNew Drug Application or IND and the submission date of a New Drug Applicationor NDA, plus the time between the submission date of an NDA and the approval ofthe drug. Only the earliest patent applicable to an approved drug is eligiblefor the extension. The United States Patent and Trademark Office, inconsultation with the FDA, reviews and approves applications for patent termextension. We expect to apply for patent term extensions for eligible patentsto add patent life beyond the expiration date, depending on the expected lengthof clinical trials and other factors involved in the filing of a new drugapplication.

**Manufacturing**

*Production of BiologicDrug Candidates*

Webelieve that we have differentiated ourselves from other stem cell companiesthrough proprietary manufacturing methods that allow for the controlled growthof MSCs to produce up to 5,000 treatments of our biologic drug candidates froma single bone marrow donation. This is in contrast to most other stem celltechnologies that are able to make only a single treatment from each donation.

Wehave been manufacturing mesenchymal stem cells for over eight years. The firstmaterial manufactured in-house was released in 1999. Since that timemanufacturing has continued to improve in support of clinical trials. Thecurrent manufacturing process utilizes cell factories, a closed system ofsurfaces on which the cells adhere, for stem cell expansion. We have developedthis technology into a reproducible process that we believe can be scaled up atadditional sites. A second manufacturing site was successfully qualified in2003. In addition, JCR Pharmaceuticals, our partner in Japan, has successfullyimplemented our manufacturing technology in Japan. We believe that we performall of our manufacturing activities in compliance with FDA current GoodManufacturing Practice requirements.

Ourmanufacturing process begins with the collection of bone marrow aspirate fromqualified volunteer donors, 18-30 years of age. Prior to donation,these individuals are screened and tested for a battery of diseases includingHIV and hepatitis according to FDA donor suitability guidance. We purchase bonemarrow aspirate from commercial sources. Since the mesenchymal stem cell isextremely rare, accounting for only one in every 100,000 cells in bone marrow,an initial purification process is required. Upon arrival at our facilities,MSCs are isolated and selectively removed from the bone marrow by an adherentculture process. Our stem cells adhere to the surface of the cell factory andthe other remaining cell populations do not adhere and are washed awaythroughout the process. Our stem cells are then expanded over the course of amonth. Once expanded, the cells are harvested, packaged and cryopreserved as anin-process intermediate, and we conduct a second battery of quality testing.Each packaged intermediate is further expanded and formulated to produce thefinal product. Sterility and quality testing completes the process. Thiswell-defined process has allowed for the development of a supply chain wherematerial specifications have been established and vendors have been qualified.

The final product will be configured to allow for easeof storage, distribution and use in the clinic. We expect the product will beprovided in ready to use patient dose quantities, shipped from the distributioncenter on dry ice, and stored in the freezer at the pharmacy.

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*Production of Osteocel*

Osteocelis a matrix of viable cancellous bone containing primary or unexpanded MSCs.Unlike our biologic drug candidates, the stem cells and cancellous bone used inOsteocel are obtained from organ and tissue donors. Additionally, theproduction of Osteocel is different from our biologic drug candidates in thatit does not feature the expansion of MSCs.

Sinceits introduction into the marketplace in July 2005, we have been unable toproduce Osteocel in quantities sufficient to meet our customer demand due toconstraints in our manufacturing facility and the lack of sufficient quantitiesof marrow-rich bone. We contract with tissue recovery agencies for Osteocelsource tissue. We currently have eight agencies under contract, includingAllosource as discussed above. These agencies in turn have contracts withfederally designated Organ Procurement Organizations who notify the agencies ofdonor candidates in their areas. Once an initial qualification of the donor isperformed, a surgical team is deployed to remove the tissue and send it to ourprocessing center via overnight delivery. The agencies also compile the donor’smedical records, perform a medical and social history evaluation, collect serumsamples for serological testing and perform other donor screening services.These agencies operate on a fee for service basis, which varies depending uponthe tissue type and transplant suitability. We intend to enter into contractswith additional tissue recovery agencies in the future in order to fulfillproduct demand. We expect to continue to increase manufacturing capacities inline with tissue supply, and believe we will eventually be limited by availabledonor material regardless of manufacturing capacity.

The processing of Osteocel is in many ways more likethe process of organ donation than standard tissue processing. This is becauseit is essential that the stem cells contained within Osteocel are kept in aliving, healthy state. We overcome this challenge through a proprietary processthat is designed to preserve the material, particularly the stem cells.Sterility cultures are performed on the final product from every lot accordingto United States Pharmacopeia standards. Following completion of qualitycontrol testing and quality assurance review, the product is released fordistribution.

**Sales, Marketing andDistribution**

Ourcurrent sales network consists of approximately 45 independent salesrepresentatives and a distribution agreement with BlackstoneMedical, Inc., and its affiliates, for the distribution of Osteocel. Inaddition, to ensure that Osteocel is made available to the communities fromwhich it is sourced, our agreement with AlloSource enables AlloSource to act asa non-exclusive distributor of Osteocel in AlloSource’s local donorcommunities.

Toincrease Osteocel’s market penetration, we intend to further expand our networkof sales professionals in the United States. Except for Provacel, we intend toself commercialize all of our biologic drug candidates in the United Statesupon FDA approval through the creation of additional sales and marketingcapabilities in existing and new indications and the leverage of Osteocel’ssales and marketing infrastructure for orthopedic indications. We have enteredinto a collaborative arrangement with Boston Scientific Corporation tocommercialize Provacel upon marketing approval. We also have a collaborative arrangementwith JCR Pharmaceuticals Co. Ltd. for the distribution of Prochymal forGvHD in Japan following marketing approval.

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Both our Osteocel productand our biologic drug candidates have long-term storage requirements withinspecific frozen temperature ranges, -80 degrees Centigrade and -140degrees Centigrade, respectively. Generally, we do not believe this will pose asignificant problem for end-users as most hospitals and medical centers havefreezers with these storage capabilities readily available. However, somefacilities may not have this type of storage available and this may limitproduct and biologic drug candidate distribution. In an effort to mitigatepotential issues with product and biologic drug candidate storage, we areperforming studies to develop less restrictive storage temperatures. Forexample, we have implemented temporary -50 degree Centigrade storage ofOsteocel for up to two weeks, which opens distribution to a wider hospitalbase.

*Osteocel*

Our marketing of Osteocelis targeted to orthopedic surgeons and neurosurgeons practicing in the UnitedStates. The most rapid adoption rates to date have been for spinal fusionprocedures. Osteocel is currently distributed by our corporate partner,Blackstone Medical, Inc., and its affiliates, and is also distributed byAlloSource and for us by an independent network of approximately 45 salesrepresentatives. Blackstone is a designer and manufacturer of spinalinstruments and implants located in Massachusetts. In the field of orthopedics,we intend to continue to develop a network of sales professionals for thedistribution of Osteocel.

*Prochymal*

Upon FDA approval of Prochymal,we expect to focus our sales and marketing efforts on the approximately 210transplantation hospitals in the United States that are registered with theInternational Bone Marrow Transplantation Registry. We expect to employ anumber of sales representatives, initially targeting the most activetransplantation centers in a region. An important component of the salesstrategy will be to gain the support of key opinion leaders, facilitating theadoption of Prochymal as the treatment strategy for GvHD. We have entered intoa license agreement with JCR Pharmaceuticals that grants it the exclusive rightto distribute Prochymal for the treatment of GvHD in Japan when it has beenapproved for marketing in that country.

*Chondrogen*

According to a 2005 articlein the *American Journal of Sports Medicine*,approximately 1.0 million people have surgery to remove damaged or tornmeniscus in the United States each year. Given the similarity in call pointsbetween Osteocel and our biologic drug candidate Chondrogen, we intend toutilize our Osteocel sales force to penetrate this market if we successfullydevelop and obtain marketing approval for Chondrogen. Current Osteocel salestraining includes modules on basic stem cell biology, immunology, and thepreclinical and clinical data pertaining to Chondrogen. This cross-trainingwill help the existing sales force in marketing Chondrogen to orthopedicsurgeons.

*Provacel*

We entered into acollaboration with Boston Scientific Corporation in 2003. Boston Scientificwill market and distribute Provacel if we successfully complete our clinicaltrials and obtain marketing approval.

**Competition**

Our industry is subject to rapid and intensetechnological change. We face, and will continue to face, intense competitionfrom pharmaceutical, biopharmaceutical and biotechnology companies, as well asnumerous academic and research institutions and governmental agencies engagedin drug discovery 

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activities or funding,both in the U.S. and abroad. Some of these competitors are pursuing the developmentof drugs and other therapies that target the same diseases and conditions thatwe target in our commercial, clinical and preclinical programs.

Many of the companies competing against us havefinancial and other resources substantially greater than our own. In addition,many of our competitors have significantly greater experience in testingpharmaceutical and other therapeutic products, obtaining FDA and otherregulatory approvals of products, and marketing and selling those products.Accordingly, our competitors may succeed more rapidly than we will in obtainingFDA approval for products and achieving widespread market acceptance. If weobtain necessary regulatory approval and commence significant commercial salesof our products, we will also be competing with respect to manufacturingefficiency and marketing capabilities, areas in which we have limited or nocommercial-scale experience.

Our commercializedproduct, Osteocel, currently competes with established treatment options suchas autograft bone and Medtronic’s InFuse and potentially may compete with otherproducts currently in development for the same indications. Our three biologicdrug candidates, if approved, would compete with several marketed products andother future biologic drug candidates. For our existing product and each of ourclinical-stage biologic drug candidates, the primary competitors include:

·       *Osteocel.* Our commercialized bone regeneration productcompetes with autograft bone, synthetic biomaterials, growth factors and allograftbone. Competing products include Medtronic’s InFuse, Stryker’s OP-1,numerous bone void filler products such as Zimmer’s CopiOsTM and autologous bonemarrow products such as DePuy Spine’s CELLECTTM.

·       *Prochymal.* If approved, Prochymal willcompete with approved products such as Novartis’ Neoral® for the prevention oforgan rejection in kidney, liver, and heart allogeneic transplant patients,Johnson & Johnson’s Remicade® and Abbott’s Humira for Crohn’s Diseaseand if approved DOR BioPharma’s orBec® for gastrointestinal GvHD.

·       *Chondrogen.* If approved, Chondrogen willcompete with products such as allograft menisci from cadavers, Conmed Linvatec’smeniscal fixation system of screws and arrows and if approved, Regen Biologics’Collagen Meniscus Implant.

·       *Provacel.* If approved, Provacel willcompete with pharmaceutical therapies, mechanical therapies and cellular basedtherapies. Pharmaceutical therapies include anti-thrombotics, calcium channelblockers such as Pfizer’s Norvasc® and ACE inhibitors such as Sanofi’s Delix®.Mechanical therapies such as biventricular pacing, ventricular restraintdevices and mitral valve therapies have been developed by companies such asMedtronic, Acorn Cardiovascular and Edwards Lifesciences. Cellular basedtherapies such as skeletal myoblasts and embryonic stem cells are being pursuedby companies such as Bioheart, MG Biotherapeutics, a joint venture created byMedtronic and Genzyme, and Geron.

We may face competition in the future from othercompanies that are researching and developing stem cell therapies. We are awareof many companies working in this area, including: Aastrom Biosciences,Advanced Cell Technology, Athersys, Cellerant Therapeutics, CognateTherapeutics, Cytori Therapeutics, Gamida Cell, Geron, Mesoblast, MultiCellTechnologies, Neuronyx, Theradigm, ViaCell and StemCells.

We expect to compete basedupon, among other things, our intellectual property portfolio and the efficacyof our products. Our ability to compete successfully will depend on ourcontinued ability to attract and retain skilled and experienced scientific,clinical development and executive personnel, to identify and develop viablebiologic drug candidates and to exploit these products and compoundscommercially before others are able to develop competitive products.

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**GovernmentRegulation**

Regulation by governmentalauthorities in the United States and other countries is a significant factor inthe development, manufacture, commercialization and reimbursement of ourproducts and services. Virtually all of the products we develop will requiremarketing approval, or licensure, by governmental agencies prior tocommercialization. In particular, human therapeutic products are subject torigorous preclinical and clinical testing and other approval procedures of theU.S. Food and Drug Administration, or FDA, and similar regulatory authoritiesin other countries. Various governmental statutes and regulations also governor influence testing, manufacturing, safety, labeling, storage and recordkeeping related to such products and their marketing. State, local and otherauthorities may also regulate pharmaceutical manufacturing facilities. Theprocess of obtaining these approvals and the subsequent compliance withappropriate statutes and regulations require the expenditure of substantialtime and money, and there can be no guarantee that approvals will be granted.

*FDA ApprovalProcess*

We believe thatOsteocel is appropriately characterized as a product regulated by the FDA as a “humancells, tissues and cellular and tissue-based product,” for which the FDA doesnot require premarket approval. See the discussion below under the caption “—HumanCellular and Tissue-Based Product.” Our biologic drug candidates will requireapproval from the FDA and corresponding agencies in other countries before theycan be marketed. The FDA regulates human therapeutic products in one of threebroad categories: biologics, drugs, or medical devices. Our biologic drugcandidates will be regulated as biological products. The FDA generally requiresthe following steps for premarket approval or licensure of a new biologicalproduct or new drug product:

·       preclinicallaboratory and animal tests conducted in compliance with FDA’s Good LaboratoryPractice, or GLP, requirements to assess a drug’s biological activity and toidentify potential safety problems, and to characterize and document theproduct’s chemistry, manufacturing controls, formulation, and stability;

·       submissionto the FDA of an investigational new drug or IND application, which must becomeeffective before clinical testing in humans can begin;

·       obtainingapproval of Institutional Review Boards, or IRBs, of research institutions orother clinical sites to introduce the biologic drug candidate into humans inclinical trials;

·       adequateand well-controlled human clinical trials to establish the safety and efficacyof the product for its intended indication conducted in compliance with FDA’sGood Clinical Practice, or GCP, requirements;

·       compliancewith current Good Manufacturing Practices, or cGMP regulations and standards;

·       submissionto the FDA of a biologics license application, or BLA, or new drug application,or NDA, for marketing that includes adequate results of preclinical testing andclinical trials;

·       FDAreview of the marketing application in order to determine, among other things,whether the product is safe, effective and potent for its intended uses; and

·       obtainingFDA approval of the BLA or NDA, including inspection and approval of theproduct manufacturing facility as compliant with cGMP requirements, prior toany commercial sale or shipment of the pharmaceutical agent.

Typically, clinical testing involves a three-phaseprocess although the phases may overlap. In Phase I, clinical trials areconducted with a small number of healthy volunteers or patients and aredesigned to provide information about product safety and to evaluate thepattern of drug distribution and metabolism 

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within the body. In PhaseII, clinical trials are conducted with groups of patients afflicted with aspecific disease in order to determine preliminary efficacy, optimal dosagesand expanded evidence of safety. In some cases, an initial trial is conductedin diseased patients to assess both preliminary efficacy and preliminary safetyand patterns of drug metabolism and distribution, in which case it is referredto as a Phase I/II trial. Phase III clinical trials are generally large-scale,multi-center, comparative trials conducted with patients afflicted with atarget disease in order to provide statistically valid proof of efficacy, aswell as safety and potency. In some circumstances, the FDA may require Phase IVor post-marketing trials if it feels that additional information needs to becollected about the drug after it is on the market. During all phases ofclinical development, regulatory agencies require extensive monitoring andauditing of all clinical activities, clinical data and clinical trialinvestigators. An agency may, at its discretion, re-evaluate, alter, suspend,or terminate the testing based upon the data which have been accumulated tothat point and its assessment of the risk/benefit ratio to the patient.Monitoring all aspects of the study to minimize risks is a continuing process.All adverse events must be reported to the FDA.

The results of the preclinical and clinical testing ona non-biologic drug and certain diagnostic drugs are submitted to the FDA inthe NDA or BLA. In the case of vaccines or gene and cell therapies, the resultsof clinical trials are submitted as a BLA. In responding to the submission of aBLA or NDA, the FDA may grant marketing authority, request additional clinicaldata or deny approval if the FDA determines that the application does notsatisfy its regulatory approval criteria. FDA review of a BLA or NDA typicallytakes one to three years, but may last longer, especially if the FDA asks formore information or clarification of information already provided. Furtherclinical trials may be required to gain approval to promote the use of theproduct for any additional indications. Such additional indications areobtained through the approval of a supplemental BLA or NDA.

The process of obtaining regulatory approval islengthy, uncertain, and requires the expenditure of substantial resources. EachNDA or BLA must be accompanied by a user fee, pursuant to the requirements ofthe Prescription Drug User Fee Act, or PDUFA, and its amendments. The FDAadjusts the PDUFA user fees on an annual basis. According to the FDA’s feeschedule, effective through September 30, 2007, the user fee for anapplication requiring clinical data, such as an NDA or BLA, is $896,200. PDUFAalso imposes an annual product fee for prescription drugs and biologics($49,750), and an annual establishment fee ($313,100) on facilities used tomanufacture prescription drugs and biologics. Fee waivers or reductions areavailable in certain circumstances, including a waiver of the application feefor the first application filed by a small business. Additionally, no user feesare assessed on NDAs or BLAs for products designated as orphan drugs, unlessthe drug also includes a non-orphan indication, and if a contract manufactureris used, the contract manufacturer is responsible for the establishment fee.

Before approving an NDA or BLA, all facilities andmanufacturing techniques used for the manufacture of products must comply withapplicable FDA regulations governing cGMP. A local field division of the FDA isresponsible for completing this inspection and providing recommendation for oragainst approval. This effort is intended to assure appropriate facility andprocess design to avoid potentially lengthy delays in product approvals due toinspection deficiencies. Similarly, before approving a new drug or biologicsapplication, the FDA may also conduct pre-licensing inspections of a company,its contract research organizations and/or its clinical trial sites to ensurethat clinical, safety, quality control and other regulated activities arecompliant with GCP. To assure such cGMP and GCP compliance, the applicants mustincur significant time, money and effort in the area of training, recordkeeping, production, and quality control. Following approval, the manufacture,holding, and distribution of a product must continue to devote significant resourcesto maintain full compliance in these areas.

After FDA approval has been obtained, the FDA willrequire post-marketing reporting to monitor the side effects of the drug.Further studies may be required to provide additional data on the product’srisks, benefits, and optimal use, and will be required to gain approval for theuse of the product as a treatment for clinical indications other than those forwhich the product was initially tested. Results of post-

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marketing programs maylimit or expand the further marketing of the product. Further, if there are anymodifications to the drug, including changes in indication, labeling, or achange in the manufacturing process or manufacturing facility, an NDA or BLAsupplement may be required to be submitted to the FDA.

Additionally, after the FDA has authorized a drugproduct to enter commercial distribution, numerous regulatory requirementsapply. These include, among others, the cGMPs, which require manufacturers tofollow extensive design, testing, control, documentation and other qualityassurance procedures during the manufacturing process; labeling regulations;the FDA’s general prohibition against promoting drug products for unapproved oroff-label uses; and adverse event reporting regulations, which require thatmanufacturers report to the FDA if their drug may have caused or contributed toa death or serious injury. The FDA has broad post-market and regulatory andenforcement powers. Failure to comply with the applicable U.S. drug regulatoryrequirements could result in, among other things, warning letters, fines,injunctions, consent decrees, civil penalties, refunds, recalls or seizures ofproducts (which would result in the cessation or reduction of productionvolume), total or partial suspension of production, withdrawals or suspensionsof current product applications, and criminal prosecution. Adverse eventsrelated to a drug product in any existing or future markets could causeregulatory authorities to withdraw market approval for such product.

*Fast Track andOrphan Drug Designations*

Congress enacted the Food and Drug AdministrationModernization Act of 1997 in part to ensure the availability of safe andeffective drugs, biologics, and medical devices by expediting the FDA reviewprocess for new products. The Modernization Act establishes a statutory programfor the approval of Fast Track products, including biologics. A Fast Trackproduct is defined as a new drug or biologic intended for the treatment of aserious or life-threatening condition that demonstrates the potential toaddress unmet medical needs for this condition. Under the Fast Track program,the sponsor of a new drug or biologic may request the FDA to designate the drugor biologic as a Fast Track product at any time during the clinical developmentof the product. This designation assures access to FDA personnel forconsultation throughout the development process and provides an opportunity torequest priority review of a marketing application providing a six-month reviewtimeline for the designated product. If a preliminary review of the clinicaldata suggests that a Fast Track product may be effective, the FDA may initiatereview of sections of a marketing application for a Fast Track product beforethe sponsor completes the application. This rolling review is available if theapplicant provides a schedule for submission of remaining information and paysapplicable user fees. However, the time periods specified under PDUFAconcerning timing goals to which the FDA has committed in reviewing anapplication do not begin until the sponsor submits the complete application.During the first quarter of 2005 the FDA designated Prochymal as a Fast Trackproduct for the treatment of GvHD. Prochymal also received Fast Trackdesignation from the FDA in January 2007 for treatment refractory Crohn’sDisease. We cannot predict whether this designation will impact the timing orlikelihood of FDA approval of Prochymal.

The Orphan Drug Act provides incentives tomanufacturers to develop and market drugs for rare diseases and conditionsaffecting fewer than 200,000 persons in the United States at the time ofapplication for Orphan Drug designation. The first developer to receive FDAmarketing approval for an Orphan Drug is entitled to a seven year exclusive marketingperiod in the United States for that product as well as a waiver of the BLAuser fee. However, a drug that the FDA considers to be clinically superior to,or different from, another approved orphan drug, even though for the sameindication, may also obtain approval in the United States during the seven yearexclusive marketing period. The FDA granted Orphan Drug designation forProchymal during the last quarter of 2005.

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Legislation similar to theOrphan Drug Act has been enacted in countries other than the United States,including the European Union. The orphan legislation in the European Union isavailable for therapies addressing conditions that affect five or fewer out of10,000 persons. The marketing exclusivity period is for ten years, althoughthat period can be reduced to six years if, at the end of the fifth year,available evidence establishes that the product is sufficiently profitable notto justify maintenance of market exclusivity.

*Human Cellular andTissue-Based Product*

Human cells or tissue intended for implantation,transplantation, infusion, or transfer into a human recipient is regulated bythe FDA as human cells, tissues, and cellular and tissue-based product, orHCT/Ps. We believe that Osteocel is appropriately characterized as an HCT/P andnot as a biologic or drug. HCT/Ps are regulated differently from drug orbiologic products due to the fact they are minimally manipulated tissuesintended for homologous use in the patient’s body, are not combined with adrug, device or biologic, and do not have systemic or metabolic effects on thebody. The FDA does not require premarket approval for HCT/Ps, however, it doesrequire strict adherence to federally mandated current Good Tissue Practice, orcGTP, regulations. These regulations are analogous to the GMP regulationsdescribed above in terms of manufacturing standards. In addition, FDA’sregulations include other requirements to prevent the introduction, transmissionand spread of communicable disease. Specifically, FDA’s regulations requiretissue establishments to register and list their HCT/Ps with the FDA and toevaluate donors through screening and testing.

We maintain statelicensure as a human tissue bank in Maryland, California, Florida, Illinois andNew York. These are the only states in which such licensure is required for us.

*Privacy Law*

Federal and state laws govern our ability to obtainand, in some cases, to use and disclose data we need to conduct researchactivities. Through the Health Insurance Portability and Accountability Act of1996, or HIPAA, Congress required the Department of Health and Human Servicesto issue a series of regulations establishing standards for the electronictransmission of certain health information. Among these regulations werestandards for the privacy of individually identifiable health information. Mosthealth care providers were required to comply with the Privacy Rule as of April 14,2003.

HIPAA does not preempt, oroverride, state privacy laws that provide even more protection for individuals’health information. These laws’ requirements could further complicate ourability to obtain necessary research data from our collaborators. In addition,certain state privacy and genetic testing laws may directly regulate ourresearch activities, affecting the manner in which we use and discloseindividuals’ health information, potentially increasing our cost of doingbusiness, and exposing us to liability claims. In addition, patients andresearch collaborators may have contractual rights that further limit ourability to use and disclose individually identifiable health information.Claims that we have violated individuals’ privacy rights or breached ourcontractual obligations, even if we are not found liable, could be expensiveand time-consuming to defend and could result in adverse publicity that couldharm our business.

*Other Regulations*

In addition to privacy lawrequirements and regulations enforced by the FDA, we also are subject tovarious local, state and federal laws and regulations relating to safe workingconditions, laboratory and manufacturing practices, the experimental use ofanimals and the use and disposal of hazardous or potentially hazardoussubstances, including chemicals, micro-organisms and various radioactivecompounds used in connection with our research and development activities.These laws include, but are not limited to, the Occupational Safety and HealthAct, the Toxic Test Substances Control Act and the 

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ResourceConservation and Recovery Act. Although we believe that our safety proceduresfor handling and disposing of these materials comply with the standardsprescribed by state and federal regulations, we cannot assure you thataccidental contamination or injury to employees and third parties from thesematerials will not occur. We may not have adequate insurance to cover claimsarising from our use and disposal of these hazardous substances.

*Foreign Regulation*

We will most likely haveto obtain approval for the manufacturing and marketing of each of our productsfrom regulatory authorities in foreign countries prior to the commencement ofmarketing of the product in those countries. The approval procedure variesamong countries, may involve additional preclinical testing and clinicaltrials, and the time required may differ from that required for FDA approval orlicensure. Although there is now a centralized European Union approvalmechanism in place, this applies only to certain specific medicinal productcategories. In respect of all other medicinal products each European countrymay impose certain of its own procedures and requirements in addition to thoserequirements set out in the appropriate legislation, many of which could betime-consuming and expensive. Although data requirements presently exist forgene therapy and somatic cell therapy medicinal products, additional Europeanapproval standards for cellular therapy are still under development, andconsequently approval of cell therapy products in Europe may require additionaldata that we may not be able to satisfy.

**Employees**

As of December 31,2006, our headcount was 113 individuals, comprising 73 full-time employees and40 full-time contract employees. Of this total, 68 were engaged in manufacturingand operations, 32 were engaged in research and development and clinical trialsand 13 were engaged in administration, facilities and finance. All of ouremployees have entered into non-disclosure agreements with us regarding ourintellectual property, trade secrets and other confidential information. Noneof our employees are represented by a labor union or covered under a collectivebargaining agreement, nor have we experienced any work stoppages.

**Executive Officers of the Registrant**

Executive officers areappointed annually by the Board of Directors and, subject to the terms of anyapplicable employment agreement, serve at the discretion of the Board ofDirectors. Information regarding our executive officers is as follows:
| Name                   | ** ** | ** ** | ** ** | **Age**                                                       | ** ** | **Position**                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  | ** ** | **Other Offices or Positions Held  During the Past Five Years** |
|------------------------|------------|------------|------------|---------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------------------------------------------------------------------|
| C. Randal Mills, Ph.D. |       | 35         |       | President and Chief  Executive Officer (since July 2004) |       | Dr. Mills is also a  member of the Board of Directors. Prior to joining Osiris, Dr. Mills was  an executive officer of Regeneration Technologies, Inc. (NASDAQ—RTIX).  Dr. Mills served in several leadership positions at RTI from its  formation in 1998 until 2004, including Vice President of Business  Development and Vice President of Operation and R&D and is credited with  several key initiatives including the development and commercialization of  RTI’s core technology, BioCleanse®. |

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| Name                    | ** ** | ** ** | ** ** | **Age**                                                                           | ** ** | **Position**                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            | ** ** | **Other Offices or Positions Held  During the Past Five Years** |
|-------------------------|------------|------------|------------|-----------------------------------------------------------------------------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------------------------------------------------------------------|
| Cary J. Claiborne       |       | 46         |       | Chief  Financial Officer and Corporate Secretary (since December 2004)       |       | Mr. Claiborne  previously was Vice President, Financial Planning and Analysis at  Constellation Energy, a diversified energy company from December 2001 to  June 2004. At Constellation, he oversaw a budget consisting of $12  billion in revenue and over $500 million in net income. Prior to  Constellation Energy, he served as Vice President, Financial Planning and  Analysis for Home Depot from April 2000 to July 2001. Mr. Claiborne  spent the first 15 years at GE Capital Business Services and served as  President of New Enterprise Wholesale Services. |
| Harry  E. Carmitchel    |       | 56         |       | Chief Operating Officer (since September 2004)                               |       | Mr. Carmitchel has over 20 years of general management and  operations experience in the medical field. Prior to joining Osiris,  Mr. Carmitchel was a Principal with the Pacific Consulting Group for  four years, where he specialized in corporate turnarounds. Prior to this  time, Mr. Carmitchel was a General Manager with McQuay International,  running a $410 million group, and spent eight years as President of the  Medical Division for Stryker Corporation.                                                                                                         |
| Earl  R. Fender         |       | 59         |       | Vice President and General Manager of Orthopedics (since  June 2006)         |       | Prior to joining Osiris, Mr Fender served for over ten years with  DePuy Spine, a Johnson & Johnson company, holding positions as Vice  President, Sales, U.S. President, and finally as Worldwide President. Under  his direction, DePuy Spine became the second largest spinal implant manufacturer  in the world.                                                                                                                                                                                                                                                                      |
| Lode Debrabandere Ph.D. |       | 42         |       | Vice  President and General Manager, Inflammatory Diseases (since July 2006) |       | Prior  to joining Osiris, Dr. Debrabandere served for over four years with  Bristol-Myers Squibb as Vice President for Strategic Marketing for  Neuroscience and Infectious Diseases. He led the Neuroscience Unit and was  the Global Brand Leader for AbilifyTM. Previously, Dr. Debrabandere led  the Marketing department of UCB Pharma Inc., focusing in the areas of  allergy/respiratory (ZyrtecTM) and neurology (KeppraTM).                                                                                                                                              |

 

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**Item 1A.**                RISKFACTORS

**Risks Related ToOur Business**

**We have a historyof operating losses and may not achieve or sustain profitability.**

We have incurred losses in each year since ourinception and expect to experience losses over the next several years. As of December  31,2006, we had an accumulated deficit of $188 million. These losses resultedprincipally from costs incurred in our research and development programs andfrom our general and administrative expenses. These losses, among other things,have had and will continue to have an adverse effect on our stockholders’equity, total assets and working capital.

We expect tocontinue to incur significant operating expenses and anticipate that ourexpenses and losses will increase in the foreseeable future as we seek to:

·       completeour Phase II and III clinical trials for Prochymal;

·       completeour Phase I/II clinical trial for Chondrogen and, if supported by the PhaseI/II clinical trial, initiate additional clinical trials;

·       completeour Phase I clinical trial for Provacel and, if supported by the Phase Iclinical trial, initiate Phase II clinical trials;

·       maintainand expand our network of sales professionals for the distribution of Osteocel,and further expand and train our sales network in anticipation of the approvalof our biologic drug candidates for commercial sale;

·       expandour manufacturing capacity, which will require that we obtain additionaladministrative and manufacturing space and build-out a portion of that space asa Food and Drug Administration, or FDA, compliant and validated productmanufacturing facility;

·       continuethe relocation of  some or all of ourbusiness operations to a newly leased facility;

·       maintain,expand and protect our intellectual property portfolio;

·       hireadditional clinical, quality control, scientific and management personnel; and

·       addoperational, financial, accounting, facilities engineering and informationsystems personnel, consistent with expanding our operations and our status as apublic company.

In addition, Osteocel is our only commerciallyavailable product. While revenue from Osteocel has increased since itscommercial introduction in July 2005, our ability to scale up ourproduction capabilities for commercial quantities of this product are limited,and our costs in marketing and distributing this product will also increase asproduction increases.

The extent of our futureoperating losses or profits is highly uncertain, and we may not achieve orsustain profitability. If we are unable to achieve and then maintainprofitability, the market value of our common stock will decline and you couldlose part or all of your investment.

**If we are not ableto recruit and retain qualified management and scientific personnel, we mayfail in developing our technologies and biologic drug candidates.**

Our future success dependsto a significant extent on the skills, experience and efforts of the principalmembers of our scientific, management and sales personnel. These membersinclude C. Randal Mills, Ph.D., Harry E. Carmitchel, Cary J. Claiborne,Earl R. Fender and Lode Debrabandere Ph.D. The loss of any or all of theseindividuals could harm our business and might significantly delay or preventthe achievement of research, development or business objectives. We haveentered into employment agreements with Dr. Mills, Messrs. Carmitchel,Claiborne, Fender and Dr. Debrabandere for an initial 

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term ofthree years. The existence of an employment agreement does not, however,guarantee retention of these employees, and we may not be able to retain thoseindividuals for the duration of or beyond the end of their respective terms.Except for Dr. Mills, Messrs. Claiborne, Carmitchel, Fender and Dr. Debrabandere,none of our employees is employed for a specified term. Competition forpersonnel is intense. We may be unable to retain our current personnel orattract or integrate other qualified management and scientific personnel in thefuture.

**We may not be ableto raise additional capital necessary to fund our operations.**

Our future capitalrequirements will depend on many factors, including:

·       thelevel of cash flows from Osteocel sales;

·       thescope and results of our research and preclinical development programs;

·       thescope and results of our clinical trials, particularly regarding the number ofpatients required for our Phase III trial for Prochymal;

·       thetiming of and the costs involved in obtaining regulatory approvals for ourbiologic drug candidates, which could be more lengthy or complex than obtainingapproval for a new conventional drug, given the FDA’s limited experience withlate-stage clinical trials and marketing approval for stem cell therapeutics;

·       thecosts of building and operating our manufacturing facilities, both in the nearterm to support Osteocel sales and our clinical activities and also inanticipation of expanding our commercialization activities;

·       thecosts of maintaining, expanding and protecting our intellectual propertyportfolio, including potential litigation costs and liabilities;

·       ourdebt repayment obligations; and

·       thecosts of enlarging our work force consistent with expanding our business andoperations and status as a public company, and as necessary to enhance andtrain our sales network in anticipation of the approval of our biologic drugcandidates for commercial sale.

As a result of these factors, we may need or choose toseek additional funding prior to our becoming cash flow positive on anoperational basis. We would likely seek such funding through public or privatefinancings or some combination of them. Although not our current focus, wemight also seek funding through collaborative arrangements if determined to benecessary or appropriate. Additional funding may not be available to us onacceptable terms, or at all. If we obtain capital through collaborativearrangements, these arrangements could require us to relinquish rights to ourtechnologies or biologic drug candidates. If we raise capital through the saleof equity, or securities convertible into equity, dilution to our then existingstockholders would result. In October 2006, we issued approximately $20.0 millionin convertible promissory notes that are convertible under certaincircumstances into shares of our common stock at $18.00 per share. The holdersof these notes also are afforded registration rights in respect to the sharesof common stock issuable upon conversion. If we raise additional capitalthrough the incurrence of debt, we would likely become subject to covenantsrestricting our business activities, and holders of debt instruments would haverights and privileges senior to those of our equity investors. In addition,servicing the interest and repayment obligations under these borrowings woulddivert funds that would otherwise be available to support research and development,clinical or commercialization activities.

If we are unable to obtainadequate financing on a timely basis, we may be required to delay, reduce thescope of or eliminate one or more of our programs, any of which could have amaterial adverse effect on our business, financial condition and results ofoperations.

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**If the potential ofour stem cell therapies to treat diseases is not realized, the value of ourtechnology and our development programs could be significantly reduced.**

The potential of our stemcell therapies to treat diseases is currently being explored by us. We have notproven in clinical trials that our stem cell therapy will be a safe andeffective treatment for any disease. Our stem cell therapies are susceptible tovarious risks, including undesirable and unintended side effects, unintendedimmune system responses, inadequate therapeutic efficacy or othercharacteristics that may prevent or limit their marketing approval orcommercial use. We have not treated a sufficient number of patients to allow usto make a determination that serious unintended consequences will not occur. Ifthe potential of our stem cell therapies to treat disease is not realized, thevalue of our technology and our development programs could be significantly reduced.Because our biologic drug candidates are based on MSCs, any negativedevelopments regarding the therapeutic potential or side effects of MSCs couldhave a material adverse effect on our business, financial condition and resultsof operations. At the six month time point of our randomized, double blind,placebo controlled Phase I/II clinical trial evaluating Chondrogen’s ability toregenerate meniscus in patients who have had a significant portion of theirmeniscus surgically removed, the trial did not demonstrate that Chondrogenresulted in a statistically significant increase in the volume of meniscus ascompared to placebo; however, Chondrogen met its primary endpoint,demonstrating product safety, and an improvement in baseline cartilage and jointcondition was noted in patients treated with the stem cell drug but was notseen in patients that received placebo.

**Our productdevelopment programs are based on novel technologies and are inherently risky.**

We are subject to therisks of failure inherent in the development of products based on newtechnologies. The novel nature of our therapeutics creates significantchallenges in regards to product development and optimization, manufacturing,government regulation, third-party reimbursement and market acceptance. Forexample, the FDA has relatively limited experience with stem cell therapies.None has been approved by the FDA for commercial sale, and the pathway toregulatory approval for our biologic drug candidates may accordingly be morecomplex and lengthy. Additionally, stem cells are subject to donor-to-donorvariability, which can make standardization more difficult. As a result, thedevelopment and commercialization pathway for our therapies may be subject toincreased uncertainty, as compared to the pathway for new conventional drugs.

**There are no FDAapproved treatments for some of the disease indications we are pursuing. Thiscould complicate and delay FDA approval of our biologic drug candidates.**

There are no drugs or therapies currently approvedwith stated indications for the first-line treatment of acute GvHD or thetreatment of steroid refractory GvHD. As a result, the clinical efficacyendpoints, or the criteria to measure the intended results of treatment, forour biologic drug candidate Prochymal for the treatment of GvHD may bedifficult to determine. In addition, patients battling GvHD and who, therefore,are candidates for treatment with Prochymal, are typically very ill as a resultof an underlying genetic or oncologic condition. Due to the graveness of theirunderlying disease and the very serious complications and disorders that oftenaccompany acute GvHD, many of these patients will die from causes other thanGvHD prior to the completion of the study even if their GvHD responds favorablyto treatment with Prochymal. The resulting reduction in the number of patientsavailable for evaluation at the end of the study may make it more difficult forus to demonstrate efficacy, as necessary to obtain FDA approval to marketProchymal for commercial sale.

There are also no drugs ortherapies currently approved with stated indications for the regeneration ofmeniscal tissue or the repair of heart muscle following heart attack. As aresult, the clinical endpoints for our biologic drug candidates Chondrogen andProvacel may be difficult to determine. In the case of Prochymal for thetreatment of Crohn’s Disease, there are other products approved for thetreatment of this disease, so it is expected that the clinical efficacyendpoints for Prochymal for this indication will be 

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establishedby comparison with these already approved treatments. In order to obtain FDAapproval for this indication, we will have to demonstrate, among other things,that our biologic drug candidate is safe and effective. The results of ourclinical trials must be statistically significant, meaning that there must besufficient data to indicate that it is unlikely the outcome occurred by chance.These challenges may prevent us from developing and commercializing products ona timely or profitable basis, or at all.

**Our biologic drugcandidates represent new classes of therapy that the marketplace may notunderstand or accept.**

Even if wesuccessfully develop and obtain regulatory approval for our biologic drugcandidates, the market may not understand or accept them. We are developingbiologic drug candidates that represent novel treatments and will compete witha number of more conventional products and therapies manufactured and marketedby others, including major pharmaceutical companies. The degree of marketacceptance of any of our developed and potential products will depend on anumber of factors, including:

·       theclinical safety and effectiveness of Osteocel and our biologic drug candidatesand their perceived advantage over alternative treatment methods;

·       ourability to demonstrate that Prochymal can have a clinically significant effecton steroid refractory GvHD;

·       ourability to separate ourselves from the ethical controversies associated withstem cell drug candidates derived from human embryonic or fetal tissue;

·       ethicalcontroversies that may arise regarding the use of stem cells or human tissue ofany kind, including adult stem cells, adult bone marrow and other adult tissuesderived from donors, in the manufacture and sale for profit of Osteocel and ourbiologic drug candidates;

·       adverseevents involving our biologic drug candidates or the products or productcandidates of others that are stem cell based;

·       ourability to supply a sufficient amount of our product to meet regular andrepeated demand in order to develop a core group of medical professionalsfamiliar with and committed to the use of our products; and

·       thecost of our products and the reimbursement policies of government andthird-party payors.

If the health carecommunity does not accept Osteocel or our potential products for any of theforegoing reasons, or for any other reason, it could affect our sales, having amaterial adverse effect on our business, financial condition and results ofoperations.

**The successfulcommercialization of our biologic drug candidates, or any of our otherpotential stem cell therapeutics, will depend on obtaining reimbursement fromthird-party payors.**

If we successfully develop and obtain necessaryregulatory approvals, we intend to sell our biologic drug candidates initiallyin the United States and Europe. In the United States, the market for anypharmaceutical product is affected by the availability of reimbursement fromthird-party payors, such as government health administration authorities,private health insurers, health maintenance organizations and pharmacy benefitmanagement companies. Stem cell therapies like Prochymal, Chondrogen andProvacel may be expensive compared with standard pharmaceuticals, due to thehigher cost and complexity associated with the research, development andproduction of stem cell therapies, the small size and large geographicdiversity of the target patient population for some indications, and thecomplexity associated with distribution of stem cell therapies which requirespecial handling and shipment procedures and protocols. This, in turn, may makeit more difficult for us to obtain adequate reimbursement from third-partypayors, particularly if we cannot demonstrate a favorable cost-benefitrelationship. Third-party 

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payors may also denycoverage or offer inadequate levels of reimbursement for our potential productsif they determine that the product has not received appropriate clearances fromthe FDA or other government regulators or is experimental, unnecessary orinappropriate. For example, patients battling GvHD and who, therefore, arecandidates for treatment with Prochymal, are typically very ill as a result ofan underlying genetic or oncologic condition. Because these patients have a lowprobability of survival (whether or not their GvHD is successfully treated),third-party payors may resist reimbursing the cost of treatment.

In the countries of Europe and in some othercountries, the pricing of prescription pharmaceutical products and services andthe level of government reimbursement are subject to governmental control. Inthese countries, pricing negotiations with governmental authorities can takesix to twelve months or longer after the receipt of marketing approval fora product. To obtain reimbursement or pricing approval in some countries, wemay be required to conduct one or more clinical trials that compares the costeffectiveness of our biologic drug candidates or products to other availabletherapies. Conducting one or more clinical trials would be expensive and resultin delays in commercialization of our products.

Managing and reducinghealth care costs has been a general concern of federal and state governmentsin the United States and of foreign governments. Although we do not believethat any recently enacted or presently proposed legislation should impact ourbusiness, we might be subject to future regulations or other cost-controlinitiatives that materially restrict the price we receive for our products. Inaddition, third-party payors are increasingly challenging the price andcost-effectiveness of medical products and services, and many limitreimbursement for newly approved health care products. In particular,third-party payors may limit the indications for which they will reimbursepatients who use any products that we may develop. Cost control initiativescould decrease the price for products that we may develop, which would resultin lower product revenues to us.

**Our dependence upona limited supply of adult marrow-rich bone necessary to produce Osteocel mayimpact our ability to produce Osteocel on a large scale.**

The production of Osteoceldoes not involve an expansion of MSCs and is therefore limited by the amount ofadult human marrow-rich bone donations that are available to us. Since theintroduction of Osteocel into the marketplace in July 2005, we have beenunable to obtain quantities of adult human marrow-rich bone sufficient to meetthe demand for Osteocel. Osteocel consists of primary, or unexpanded, MSCs in amatrix of viable cancellous bone. Cancellous bone is the porous and spongyinner structure of bones accounting for approximately 20% of total bone mass.The bone and cells are derived from human organ and tissue donors. We rely onthe efforts of not-for-profit donor procurement agencies to educate the publicand foster an increased willingness to donate bone tissue. These organizationsmay not be able to provide us with sufficient amounts of viable cancellous boneto meet present or future demand for Osteocel. Our inability to secure enoughviable cancellous bone to meet our Osteocel demands could limit our ability tosuccessfully market and drive market acceptance of Osteocel and may limit ourpotential revenues from Osteocel.

**Our dependence upona limited supply of bone marrow donors may impact our ability to producesufficient quantities of our biologic drug candidates as necessary to completeour clinical trials, and if our trials are successful, to meet product demand.**

The population ofacceptable bone marrow donors is limited to volunteers between the ages of 18and 30. In addition, potential donors are prescreened for a variety of healthconditions and are only allowed to donate bone marrow a total of six times intheir lifetime, further limiting the total number of potential donors. Theamount of bone marrow donated may be insufficient for us to mass produce ourbiologic drug candidates. Future government regulation or health concerns mayalso reduce the number of donors or otherwise limit the amount of bone marrowavailable to us. If we cannot secure quantities of bone marrow 

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sufficientto meet the manufacturing demands for our clinical trials, we might not be ableto complete our clinical trials and obtain marketing approval for our biologicdrug candidates. Moreover, even if our clinical trials are successful and weobtain marketing approval for our biologic drug candidates, our inability tosecure enough bone marrow to meet product demand would limit our potentialrevenues.

**Osteocel and ourbiologic drug candidates are derived from human tissue and bone marrow sourcesand therefore have the potential for disease transmission.**

The utilization ofdonated adult human cancellous bone and bone marrow creates the potential fortransmission of communicable disease, including but not limited to humanimmunodeficiency virus, or HIV, viral hepatitis, syphilis, Creutzfeldt-Jakobdisease, or the human form of “mad cow” disease, and other viral, fungal orbacterial pathogens. Although we are required to comply with federal and stateregulations intended to prevent communicable disease transmission, and oursuppliers of adult human bone and bone marrow are also required to comply withsuch regulations in connection with their collection, storage and supply to us:

·       weor our suppliers may fail to comply with such regulations;

·       evenwith compliance, our products might nevertheless be viewed by the public asbeing associated with transmission of disease; and

·       apatient that contracts an infectious disease might assert that the use of ourproducts resulted in disease transmission, even if the patient became infectedthrough another source.

Any actual or allegedtransmission of communicable disease could result in patient claims,litigation, distraction of management’s attention and potentially increasedexpenses. Further, any failure in screening, whether by us or othermanufacturers of similar products, could adversely affect our reputation, thesupport we receive from the medical community and overall demand for ourproducts. As a result, such actions or claims, whether or not directed at us,could have a material adverse effect on our reputation with our customers andour ability to market our products, which could have a material adverse effecton our business, financial condition and results of operations.

**We have onlylimited experience manufacturing Osteocel and our biologic drug candidates. Wemay not be able to manufacture Osteocel in quantities sufficient to expand ourmarket for the product and may not be able to manufacture our biologic drugcandidates in quantities sufficient for later stage clinical studies or forcommercial sale.**

We may encounter difficulties in the production ofOsteocel and our biologic drug candidates due to our manufacturing capabilities.We have not built commercial-scale manufacturing facilities, and we havelimited manufacturing experience with Osteocel and our biologic drugcandidates. These difficulties could reduce sales of our products, increase ourcosts or cause production delays, any of which could damage our reputation andhurt our profitability. Even if we were to obtain access to quantities of adultmarrow-rich bone sufficient to allow us otherwise to expand our Osteocelmanufacturing capabilities, we may not be able to produce sufficient quantitiesof the product at an acceptable cost, or at all.

If we successfully obtain marketing approval for oneof our biologic drug candidates, we may not be able to produce sufficientquantities of the product at an acceptable cost. Commercial-scale production oftherapies made from live human mesenchymal stem cells involves production insmall batches and strict adherence to complex manufacturing and storageprotocols and procedures. Our biologic drug candidates are inherently more difficultto manufacture at commercial-scale than chemical pharmaceuticals, which aremanufactured using precise chemical formulations and operational methods.

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**We use third-partycollaborators to help us develop and commercialize our products, and ourability to commercialize such products may be impaired or delayed ifcollaborations are unsuccessful.**

We havearrangements in place with third-party collaborators as a means to help us withresearch and development efforts or marketing and distribution. For example:

·       wecurrently sell a large majority of our Osteocel product through a distributionarrangement with Blackstone Medical, Inc., which sells this product underthe Blackstone brand “Trinity”;

·       wehave a collaboration with Boston Scientific Corporation for cardiovascularapplications of our MSC technology; and

·       wehave a collaboration with JCR Pharmaceuticals Co., Ltd. granting to JCR anexclusive right to Prochymal for the treatment of GvHD in Japan.

Although we have nocurrent intention to do so, we may enter into additional collaborations in thefuture. We are dependent upon the success of our current and any futurecollaborators in performing their responsibilities and their continuedcooperation. Our collaborators may not cooperate with us or perform theirobligations under our agreements with them. We cannot control the amount andtiming of our collaborators’ resources that will be devoted to performing theirresponsibilities under our agreements with them. Our collaborators may chooseto pursue alternative technologies in preference to those being developed incollaboration with us. The development and commercialization of our potentialproducts will be delayed if collaborators fail to conduct theirresponsibilities in a timely manner or if they breach or terminate theircollaboration agreements with us. Disputes with our collaborators could resultin product development delays, decreased revenues and litigation expenses. Inaddition, because our products may be marketed under a different brand name byour collaborators, as is the case in our relationship with Blackstone, shouldthe relationship be terminated for any reason, our product recognition could beadversely impacted, affecting our product and potentially causing brandconfusion in the market.

**We are dependentupon third-party suppliers for services and raw materials needed for themanufacture, and we are dependent upon third parties for the distribution, ofOsteocel and our biologic drug candidates. If any of these third parties failor are unable to perform in a timely manner, our ability to manufacture anddeliver will be compromised.**

In order to produce our biologic drug candidates foruse in clinical studies, and to produce Osteocel and any other of our biologicdrug candidates that may be approved for commercial sale, we require biologicalmedia, reagents and other highly specialized materials. This is in addition tothe adult marrow-rich bone donations used in the manufacture of Osteocel, andthe bone marrow aspirate used in the manufacture of our biologic drugcandidates. These items must be manufactured and supplied to us in sufficientquantities and in compliance with current Good Manufacturing Practices, orcGMP. To meet these requirements, we have entered into supply agreements withfirms that manufacture these components to cGMP standards. Our requirements forthese items are expected to increase if and when we transition to the manufactureof commercial quantities of our biologic drug candidates.

In addition, as we proceed with our clinical trialefforts, we must be able to demonstrate to the FDA that we can manufacture ourbiologic drug candidates with consistent characteristics. Accordingly, we arematerially dependent on these suppliers for supply of cGMP-grade components ofconsistent quality. Our ability to complete ongoing clinical trials may benegatively affected in the event that we are forced to seek and validate areplacement source for any of these critical components. If we are not able toobtain adequate supplies of these items of consistent quality from ourthird-party suppliers, it will also be more difficult to manufacture commercialquantities of Osteocel or any of our current biologic drug candidates that maysubsequently be approved for commercial sale.

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In addition, we rely onthird parties to distribute Osteocel and, if approved, our biologic drugcandidates. Proper shipping and distribution requires compliance with specificstorage and shipment procedures. For example, our products must be placed in afreezer within 72 hours of shipment. Failure to comply with theseprocedures or the occurrence of inadvertent damage to the shipping containerwill necessitate return and replacement, potentially resulting in additionalcost and causing us to fail to meet supply requirements.

**Use of third-partymanufacturers may increase the risk that we will not have adequate quantitiesof our biologic drug candidates.**

We have usedthird-party manufacturers to supply our biologic drug candidates for clinicaltrials. Reliance on third-party manufacturers entails risks to which we wouldnot be subject if we manufactured such components ourselves, including:

·       relianceon the third party for regulatory compliance and quality assurance;

·       thepossible breach of the manufacturing agreement by the third party; and

·       thepossible termination or nonrenewal of the agreement by the third party, basedon its own business priorities, at a time that is costly or inconvenient forus.

Our contract manufacturers are subject to all of therisks and uncertainties that we have when we manufacture on our own. Similar tous, they are subject to ongoing, periodic, unannounced inspection by the FDAand corresponding state and foreign agencies or their designees to ensurestrict compliance with cGMP regulations and other governmental regulations andcorresponding foreign standards. However, we do not control compliance by ourcontract manufacturers with these regulations and standards. Our present orfuture manufacturers might not be able to comply with these regulatoryrequirements. If our third-party manufacturers fail to comply with applicableregulations, the FDA or other regulatory authorities could impose sanctions onus, including fines, injunctions, civil penalties, denial of marketing approvalof our biologic drug candidates, delays, suspension or withdrawal of approvals,license revocation, seizures or recalls of biologic drug candidates or ourother products, operating restrictions and criminal prosecutions. Any of theseactions could significantly and adversely affect supplies of our biologic drugcandidates or other products and could have a material adverse effect on ourbusiness, financial condition and results of operations.

We have contracted withBioWhittaker (recently acquired by Lonza) to manufacture quantities of our stemcell drug candidates for our clinical trials. In addition, we are negotiatingwith a second contract manufacturing company, to supply us with biologic drugproduct. If we are unable to successfully negotiate this agreement or if thesecontract manufacturers are unable to supply sufficient product in a timelymanner, we could experience shortages of clinical trial materials which wouldnegatively impact our ability to complete our clinical trials and obtainmarketing approval for the commercial sale of our biologic drug candidates. Ifone or both of these contract manufacturers is unable to ramp up productionsufficiently, we may also not be able to meet anticipated market demand in thefuture.

**If our processingand storage facility or our clinical manufacturing facilities are damaged ordestroyed, our business and prospects would be negatively affected.**

If our processing and storage facility or theequipment in the facility were to be significantly damaged or destroyed, wecould suffer a loss of some or all of the stored units of our biologic drug candidatesand it would force us to halt our clinical trial processes.

We have a manufacturing facility located in Baltimore,Maryland at which we produce and store stem cells for our clinical trials andOsteocel prior to sale. If this facility or the equipment in it issignificantly damaged or destroyed, we may not be able to quickly orinexpensively replace our manufacturing capacity. 

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This facility is locatedon the Baltimore harbor, and in September 2003 it was flooded by HurricaneIsabel. This event resulted in a temporary suspension of our manufacturingoperations. In the event of another temporary or protracted loss of thisfacility or equipment, we may be able to transfer manufacturing to a thirdparty, but the shift would likely be expensive, and the timing would depend onavailability of third-party resources and the speed with which we could have anew facility comply with the necessary regulatory requirements. Such an eventcould halt our clinical trials and distribution of Osteocel due to a lack of availableproduct.

We entered into an agreement to sublease approximately61,203 square feet of space in Columbia, Maryland beginning August 2006,and plan to begin manufacturing our biologic drug candidates in this facilityin the fourth quarter of 2007.

Currently, we maintaininsurance coverage totaling $12.3 million against damage to our propertyand equipment, an additional $4.0 million to cover business interruptionand extra expenses, and $5.6 million to cover R&D restoration expenses.If we have underestimated our insurance needs, we will not have sufficientinsurance to cover losses above and beyond the limits on our policies.

**Ethical and otherconcerns surrounding the use of stem cell therapy or human tissue maynegatively affect public perception of us or our products or biologic drugcandidates, or may negatively affect regulatory approval of our products orbiologic drug candidates, thereby reducing demand for our products andadversely affecting the market price for our common stock.**

The commercial success of Osteocel and our biologicdrug candidates will depend in part on general public acceptance of the use ofstem cell therapy and donated human tissue for the prevention or treatment ofhuman diseases. The use of embryonic stem cells and fetal tissue for researchand stem cell therapy has been the subject of substantial national andinternational debate regarding related ethical, legal and social issues. In theU.S., for example, federal government funding of embryonic stem cell researchhas been limited to specifically identified cell lines and is not otherwiseavailable. We do not use embryonic stem cells or fetal tissue, but the publicmay not be able to, or may fail to, differentiate our use of adult stem cellsfrom the use by others of embryonic stem cells or fetal tissue. This couldresult in a negative perception of our company or our products or biologic drugcandidates.

We obtain our stem cells from volunteer adult bonemarrow donors and we obtain cancellous human bone for the production ofOsteocel from non-profit organizations that collect and process human organ andtissue donations. Bone marrow donors receive payment, but payment is notreceived by either human organ and tissue donors or their surviving familymembers. Ethical concerns have been raised by some about the use of donatedhuman tissue in a for-profit setting, as we are doing.

Future adverse events inthe field of stem cell therapy or changes in public policy could also result ingreater governmental regulation of our products and biologic drug candidatesand potential regulatory delays relating to the testing or approval of ourbiologic drug candidates.

**We compete withother companies for funding and product sales. Many of our competitors havegreater resources or capabilities than we have, or may already have or succeedin developing better products or in developing products more quickly than wedo, and we may not compete successfully with them.**

The pharmaceutical and biotechnology industries arehighly competitive. We compete for funding and, if our products becomeavailable for commercial sale, we will compete in the market place. Forfunding, we compete primarily with other companies which, like us, are focusedon developing novel products or therapies for the treatment of human diseasebased on stem cells or other novel scientific principles. These include AastromBiosciences, Advanced Cell Technology, Athersys, Cellerant Therapeutics,Cognate Therapeutics, Cytori Therapeutics, Gamida Cell, Geron, Mesoblast,MultiCell Technologies, Neuronyx, Theradigm, ViaCell, and StemCells.

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In the marketplace, we compete or may eventuallycompete with other companies and organizations that are marketing or developingtherapies for our targeted disease indications, based on traditional pharmaceutical,medical device or other, non-cellular therapy and technologies. These include:Johnson & Johnson, the manufacturer of CELLECTTM for the repair ofbone, which competes with Osteocel; Medtronic and Stryker, the manufacturers ofInFuse and OP-1, respectively, which compete with Osteocel; Novartis, themanufacturer of Neoral® for the prevention of organ rejection in transplantpatients, which would compete with Prochymal for the treatment of GvHD; andJohnson & Johnson, the manufacturer of Remicade®, and Abbott, themanufacturer of Humira, which would compete with Prochymal for the treatment ofCrohn’s Disease. In addition to those listed above, we have other potentialcompetitors developing a variety of therapeutics.

We also face competition in the cell therapy fieldfrom academic institutions and governmental agencies. Many of our current andpotential competitors have greater financial and human resources than we have,including more experience in research and development and more established sales,marketing and distribution capabilities.

We anticipate thatcompetition in our industry will increase. In addition, the health careindustry is characterized by rapid technological change, resulting in newproduct introductions and other technological advancements. Our competitors maydevelop and market products that render our current product or any futureproduct non-competitive or otherwise obsolete.

**The use of our stemcell therapies in human subjects may expose us to product liability claims, andwe may not be able to obtain adequate insurance.**

We face an inherentrisk of product liability claims. Neither Osteocel nor any of our biologic drugcandidates has been widely used over an extended period of time, and thereforeour safety data are limited. We derive the raw materials for manufacturingOsteocel and our biologic drug candidates from human donor sources, themanufacturing process is complex, and the handling requirements are specific,all of which increase the likelihood of quality failures and subsequent productliability claims. We will need to increase our insurance coverage if and whenwe begin commercializing our biologic drug candidates. We may not be able toobtain or maintain product liability insurance on acceptable terms withadequate coverage or at all. If we are unable to obtain insurance, or if claimsagainst us substantially exceed our coverage, then our business could beadversely impacted. Whether or not we are ultimately successful in any productliability litigation, such litigation could consume substantial amounts of ourfinancial and managerial resources and could result in:

·       significantawards against us;

·       substantiallitigation costs;

·       recallof the product;

·       injuryto our reputation;

·       withdrawalof clinical trial participants; and

·       adverseregulatory action.

Any of these results couldhave a material adverse effect on our business, financial condition and resultsof operations.

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**Risks Related toIntellectual Property**

**If our patentposition does not adequately protect Osteocel, our biologic drug candidates orany future products, others could compete against us more directly, which wouldharm our business and have a material adverse effect on our financial conditionand results of operations.**

Our success depends, in large part, on our ability toobtain and maintain intellectual property protection for our biologic drugcandidates. The patent position of biotechnology companies is generally highlyuncertain, involves complex legal and factual questions and has been the subjectof much litigation. Neither the U.S. Patent and Trademark Office nor the courtshas a consistent policy regarding the breadth of claims allowed or the degreeof protection afforded under many biotechnology patents.

The claims of our existing U.S. patents and those thatmay issue in the future, or those licensed to us, may not confer on ussignificant commercial protection against competing products. Third parties maychallenge, narrow, invalidate or circumvent any patents we own or may obtain inthe future. Our patents on MSC technology, in particular, are quite broad inthat they cover mesenchymal stem cells and the therapeutic use thereof. Patentswith broad claims tend to be more vulnerable to challenge by other parties thanpatents with more narrowly written claims. Also, our pending patentapplications may not issue, and we may not receive any additional patents.Further, the laws of foreign countries may not protect our intellectualproperty rights to the same extent as do laws of the United States. Our patentsmight not contain claims that are sufficiently broad to prevent others fromutilizing our technologies. Consequently, our competitors may independentlydevelop competing products that do not infringe our patents or otherintellectual property. We have filed a patent application covering thecomposition of matter and methods of manufacture of our commercially availableproduct, Osteocel. This patent has not yet issued and there can be noassurances that it will ever issue. Osteocel is different from our otherbiologic drug candidates in that it contains primary, or unexpanded, MSCs in amatrix of cancellous bone. Because we do not have a granted patent specificallydirected to Osteocel, and because FDA approval is generally not required fortissue based products like Osteocel, competitors might choose to enter thismarket and produce a substantially similar product that is not covered by agranted patent, whereby we may not be able to prevent the marketing and sale ofany such similar products by others. Should others produce a substantiallysimilar product, we will be subject to increased competition and our potentialrevenues from Osteocel sales may be limited.

Because of the extensivetime required for development, testing and regulatory review of a potentialproduct, it is possible that, before any of our products can be commercialized,any related patent may expire or remain in force for only a short periodfollowing commercialization, thereby reducing any advantages of the patent. Forinstance, one of our base patents on MSC technology will expire in 2013. To theextent our biologic drug candidates based on that technology are notcommercialized significantly ahead of this date, or to the extent we have noother patent protection on such products, those products would not be protectedby patents beyond 2013. The background technologies used in the development ofour biologic drug candidates are known in the scientific community, and it ispossible to duplicate the methods we use to create our biologic drugcandidates.

**If we are unable toprotect the confidentiality of our proprietary information and know-how, ourcompetitive position would be impaired and our business, financial conditionand results of operations could be adversely affected.**

A significant amount of our technology, especiallyregarding manufacturing processes, is unpatented and is maintained by us astrade secrets. In an effort to protect these trade secrets, we require ouremployees, consultants, collaborators and advisors to execute confidentialityagreements upon the commencement of their relationships with us. Theseagreements require that all confidential information developed by theindividual or made known to the individual by us during the course of  the individual’s 

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relationship with us bekept confidential and not disclosed to third parties. These agreements,however, may not provide us with adequate protection against improper use ordisclosure of confidential information, and these agreements may be breached.For example, a portion of the manufacture of Osteocel is protected by tradesecrets. A breach of confidentiality could affect our competitive position. Inaddition, in some situations, these agreements may conflict with, or be subjectto, the rights of third parties with whom our employees, consultants,collaborators or advisors have previous employment or consulting relationships.Also, others may independently develop substantially equivalent proprietaryinformation and techniques or otherwise gain access to our trade secrets.

Adequate remedies may notexist in the event of unauthorized use or disclosure of our confidentialinformation. The disclosure of our trade secrets would impair our competitiveposition and could have a material adverse effect on our business, financialcondition and results of operations.

**If we infringe orare alleged to infringe intellectual property rights of third parties, it willadversely affect our business, financial condition and results of operations.**

Our research, development and commercializationactivities, including any biologic drug candidates or products resulting fromthese activities, may infringe or be claimed to infringe patents owned by thirdparties and to which we do not hold licenses or other rights. There may beapplications that have been filed but not published that, when issued, could beasserted against us. These third parties could bring claims against us thatwould cause us to incur substantial expenses and, if successful against us,could cause us to pay substantial damages. Further, if a patent infringementsuit were brought against us, we could be forced to stop or delay research,development, manufacturing or sales of the product or biologic drug candidatethat is the subject of the suit.

For example, we are aware of patents owned by thirdparties that are directed toward mesenchymal stem cells and the use thereof.Our preliminary research suggests that our biologic drug candidates, uponcommercialization, would not infringe a valid claim of these patents. However, ourreview of these patents is still at an early stage, and our views are subjectto change.

As a result of patent infringement claims, or in orderto avoid potential claims, we may choose or be required to seek a license fromthe third party. These licenses may not be available on acceptable terms, or atall. Even if we are able to obtain a license, the license would likely obligateus to pay license fees or royalties or both, and the rights granted to us mightbe nonexclusive, which could result in our competitors gaining access to thesame intellectual property. Ultimately, we could be prevented fromcommercializing a product, or be forced to cease some aspect of our businessoperations, if, as a result of actual or threatened patent infringement claims,we are unable to enter into licenses on acceptable terms. All of the issuesdescribed above could also impact our collaborators, which would also impactthe success of the collaboration and therefore us.

There has been substantiallitigation and other proceedings regarding patent and other intellectualproperty rights in the pharmaceutical and biotechnology industries. In additionto infringement claims against us, we may become a party to other patentlitigation and other proceedings, including interference proceedings declaredby the United States Patent and Trademark Office and opposition proceedings inthe European Patent Office, regarding intellectual property rights with respectto our products and technology. For example, the patent that was granted to usin Europe for human mesenchymal stem cells has been opposed in the EuropeanPatent Office by two different companies. A hearing date for the opposition hasnot been set, and the losing party has the right to appeal the initialdecision. If we do not prevail in the opposition proceedings, we will not havebroad patent protection with respect to mesenchymal stem cells in Europe. Theoutcome of the proceedings is uncertain at this time. The cost to us of anypatent litigation or other proceeding, even if resolved in our favor, could besubstantial. Some of our competitors may be able to sustain the costs of suchlitigation or proceedings more effectively than we can because of their 

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substantiallygreater financial resources. Patent litigation and other proceedings may alsoabsorb significant management time. Uncertainties resulting from the initiationand continuation of patent litigation or other proceedings could have amaterial adverse effect on our ability to compete in the marketplace and, as aresult, on our business, financial condition and results of operations.

**We may becomeinvolved in lawsuits to protect or enforce our patents or the patents of ourcollaborators or licensors, which could be expensive and time consuming.**

Competitors may infringe our patents or the patents ofour collaborators or licensors. As a result, we may be required to fileinfringement claims to counter infringement or unauthorized use. This can beexpensive, particularly for a company of our size, and time-consuming. In addition,in an infringement proceeding, a court may decide that a patent of ours is notvalid or is unenforceable, or may refuse to stop the other party from using thetechnology at issue on the grounds that our patents do not cover itstechnology. An adverse determination of any litigation or defense proceedingscould put one or more of our patents at risk of being invalidated orinterpreted narrowly and could put our patent applications at risk of notissuing. We are aware of several companies that are employing mesenchymal stemcell technology in their research and product development efforts. If suchcompanies commercialize such products, there is no assurance that we would havea basis for initiating patent infringement proceedings or that if initiated wewould prevail in such proceedings.

Interference proceedings brought by the U.S. Patentand Trademark Office may be necessary to determine the priority of inventionswith respect to our patent applications or those of our collaborators orlicensors. Litigation or interference proceedings may fail and, even ifsuccessful, may result in substantial costs and distraction to our management.We may not be able, alone or with our collaborators and licensors, to preventmisappropriation of our proprietary rights, particularly in countries where thelaws may not protect such rights as fully as in the United States.

Furthermore, because of the substantial amount ofdiscovery required in connection with intellectual property litigation, thereis a risk that some of our confidential information could be compromised bydisclosure during this type of litigation. In addition, during the course ofthis kind of litigation, there could be public announcements of the results ofhearings, motions or other interim proceedings or developments. If investorsperceive these results to be negative, the market price for our common stockcould be significantly harmed.

**Risks Related toRegulatory Approval and Other Government Regulations**

**If we are not ableto successfully develop and commercialize our biologic drug candidates andobtain the necessary regulatory approvals, we may not generate sufficientrevenues to continue our business operations.**

In order to generate sales revenue from our biologicdrug candidates, we must conduct extensive preclinical studies and clinicaltrials to demonstrate that our biologic drug candidates are safe and effectiveand obtain required regulatory approvals. Our early stage biologic drugcandidates may fail to perform as we expect. Moreover, our biologic drugcandidates in later stages of development may fail to show the desired safetyand efficacy traits despite having progressed successfully through preclinicalor initial clinical testing. We will need to devote significant additionalresearch and development, financial resources and personnel to developcommercially viable products and obtain the necessary regulatory approvals.

If our biologic drug candidates do not prove to besafe and efficacious in clinical trials, we will not obtain the requiredregulatory approvals. If we fail to obtain such approvals, we may not generatesufficient revenues to continue our business operations.

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Even if we obtainregulatory approval of a product, that approval may be subject to limitationson the indicated uses for which it may be marketed. Even after grantingregulatory approval, the FDA and regulatory agencies in other countriescontinue to review and inspect marketed products, manufacturers andmanufacturing facilities, which may create additional regulatory burdens. Laterdiscovery of previously unknown problems with a product, manufacturer orfacility, may result in restrictions on the product or manufacturer, includinga withdrawal of the product from the market. Further, regulatory agencies mayestablish additional regulations that could prevent or delay regulatoryapproval of our products.

**We cannot marketand sell our biologic drug candidates in the United States or in othercountries if we fail to obtain the necessary regulatory approvals or licensure.**

We cannot sell our biologic drug candidates untilregulatory agencies grant marketing approval, or licensure. The process ofobtaining regulatory approval is lengthy, expensive and uncertain. It is likelyto take two to three years or more to obtain the required regulatory approvalsfor our lead stem cell biologic drug candidate, Prochymal, or we may never gainthe necessary approvals. Any difficulties that we encounter in obtainingregulatory approval may have a substantial adverse impact on our operations andcause our stock price to decline significantly. Moreover, because our biologicdrug candidates are all based on a single platform technology, MSCs, anyadverse events in our clinical trials for one of our biologic drug candidatescould negatively impact the clinical trials and approval process for our otherbiologic drug candidates.

To obtain marketing approvals in the United States forMSC products, for instance, we must, among other requirements, completecarefully controlled and well-designed clinical trials sufficient todemonstrate to the FDA that the biologic drug candidate is safe and effectivefor each disease for which we seek approval. Several factors could preventcompletion or cause significant delay of these trials, including an inabilityto enroll the required number of patients or failure to demonstrate adequatelythat MSCs are safe, effective and potent for use in humans. Negative orinconclusive results from or adverse medical events during a clinical trialcould cause the clinical trial to be repeated or a program to be terminated,even if other studies or trials relating to the program are successful. The FDAcan place a clinical trial on hold if, among other reasons, it finds thatpatients enrolled in the trial are or would be exposed to an unreasonable andsignificant risk of illness or injury. If safety concerns develop, we or theFDA could stop our trials before completion. Some participants in our MSCclinical trial have experienced serious adverse events, four of which have beendetermined to be possibly related to MSCs and one of which has been determinedto be probably related. A serious adverse event is an event that results insignificant medical consequences, such as hospitalization, disability or death,and must be reported to the FDA. We cannot assure you that safety concernsregarding MSCs will not develop.

The pathway to regulatoryapproval for MSCs may be more complex and lengthy than for approval of a newconventional drug. Similarly, to obtain approval to market our stem cellproducts outside of the United States, we will need to submit clinical dataconcerning our products and receive regulatory approval from governmentalagencies, which in certain countries includes approval of the price we intendto charge for our product. We may encounter delays or rejections if changesoccur in regulatory agency policies during the period in which we develop abiologic drug candidate or during the period required for review of anyapplication for regulatory agency approval. If we are not able to obtainregulatory approvals for use of our biologic drug candidates under development,we will not be able to commercialize such products, and therefore may not beable to generate sufficient revenues to support our business.

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**If we are not ableto conduct our clinical trials properly and on schedule, marketing approval byFDA and other regulatory authorities may be delayed or denied.**

The completion ofour clinical trials may be delayed or terminated for many reasons, including,but not limited to, if:

·       theFDA does not grant permission to proceed and places the trial on clinical hold;

·       subjectsdo not enroll in our trials at the rate we expect;

·       subjectsexperience an unacceptable rate or severity of adverse side effects;

·       third-partyclinical investigators do not perform our clinical trials on our anticipatedschedule or consistent with the clinical trial protocol, Good Clinical Practiceand regulatory requirements, or other third parties do not perform datacollection and analysis in a timely or accurate manner;

·       inspectionsof clinical trial sites by the FDA or Institutional Review Boards (IRBs) ofresearch institutions participating in our clinical trials, find regulatoryviolations that require us to undertake corrective action, suspend or terminateone or more sites, or prohibit us from using some or all of the data in supportof our marketing applications; or

·       oneor more IRBs suspends or terminates the trial at an investigational site,precludes enrollment of additional subjects, or withdraws its approval of thetrial.

Our development costs willincrease if we have material delays in our clinical trials, or if we are requiredto modify, suspend, terminate or repeat a clinical trial. If we are unable toconduct our clinical trials properly and on schedule, marketing approval may bedelayed or denied by FDA.

**We may not be ableto secure and maintain research institutions to conduct our clinical trials.**

We rely on researchinstitutions to conduct our clinical trials. Specifically, the limited numberof bone marrow transplant centers further heightens our dependence on suchresearch institutions for the Phase III Prochymal trial. Our reliance uponresearch institutions, including hospitals and clinics, provides us with lesscontrol over the timing and cost of clinical trials and the ability to recruitsubjects. If we are unable to reach agreement with suitable research institutionson acceptable terms, or if any resulting agreement is terminated, we may beunable to quickly replace the research institution with another qualifiedinstitution on acceptable terms. We may not be able to secure and maintainsuitable research institutions to conduct our clinical trials.

**Final marketingapproval of our biologic drug candidates by the FDA or other regulatoryauthorities for commercial use may be delayed, limited, or denied, any of whichwould adversely affect our ability to generate operating revenues.**

Any of thefollowing factors may cause final marketing approval for our biologic drugcandidates to be delayed, limited or denied:

·       ourbiologic drug candidates require significant clinical testing to demonstratesafety and effectiveness before applications for marketing approval can befiled with the FDA;

·       dataobtained from preclinical and nonclinical animal testing and clinical trialscan be interpreted in different ways, and the FDA may not agree with ourinterpretations;

·       itmay take many years to complete the testing of our biologic drug candidates,and failure can occur at any stage of the process;

·       negativeor inconclusive results or adverse side effects during a clinical trial couldcause us to delay or terminate development efforts for a biologic drugcandidate; and

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·       commercializationmay be delayed if the FDA requires us to expand the size and scope of theclinical trials.

If marketing approval forour biologic drug candidates is delayed, limited or denied, our ability tomarket products, and our ability to generate product sales, would be adverselyaffected.

**Should the FDAdecide that Osteocel does not meet the appropriate regulatory requirements, wewill be required to stop production, which will have a material adverse effecton our business, financial condition and results of operations.**

The FDA has developed atiered, risk-based regulatory framework, which includes criteria for facilitymanagement, quality assurance, donor selection, and processing of human cells,tissues, and cellular and tissue based products. We believe that commercialsale of Osteocel does not require pre-market approval by the FDA because webelieve that it meets the regulatory definition of human cells, tissue, andcellular and tissue-based products, or HCT/Ps. However, should the FDA decidethat Osteocel does not meet the regulatory definition of HCT/Ps, we will not beable to produce and sell Osteocel until we obtain FDA approval, which couldtake years to obtain and which could have a material adverse effect on ourbusiness, financial condition and results of operations.

**Producing andmarketing an approved drug or other medical product is subject to significantand costly post-approval regulation.**

It is likely thatProchymal, if approved based on our currently contemplated Phase IIItrial, will receive conditional approval by the FDA, and we will be required toconduct Phase IV clinical trials to obtain full approval. Even if we obtainfull approval of a product, that approval is subject to limitations on theindicated uses for which we can market it. After granting marketing approval,the FDA and regulatory agencies in other countries continue to review andinspect marketed products, manufacturers and manufacturing facilities, creatingadditional regulatory burdens. Later discovery of previously unknown problemswith a product, manufacturer or facility may result in restrictions on theproduct or manufacturer, including a withdrawal of the product from the market.Further, regulatory agencies may establish additional regulations that couldprevent or delay marketing approval of our products.

**Our businessinvolves the use of hazardous materials that could expose us to environmentaland other liability.**

We have facilities inMaryland that are subject to various local, state and federal laws andregulations relating to safe working conditions, laboratory and manufacturingpractices, the experimental use of animals and the use and disposal ofhazardous or potentially hazardous substances, including chemicals, micro-organismsand various radioactive compounds used in connection with our research anddevelopment activities. In the United States, these laws include theOccupational Safety and Health Act, the Toxic Test Substances Control Act andthe Resource Conservation and Recovery Act. We cannot assure you thataccidental contamination or injury to our employees and third parties fromhazardous materials will not occur. We do not have insurance to cover claimsarising from our use and disposal of these hazardous substances other thanlimited clean-up expense coverage for environmental contamination due to anotherwise insured peril, such as fire.

**We may not be ableto obtain or maintain Orphan Drug designation for our biologic drug candidates.**

Some jurisdictions, includingEurope and the United States, may designate drugs for relatively small patientpopulations as orphan drugs. Although the FDA and it’s European counterpart,EMFA have designated Prochymal for the treatment of steroid refractory GvHD asan orphan drug, none of our other biologic drug candidates have received suchdesignation. Orphan Drug designation does not convey any 

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advantagein, or shorten the duration of, the regulatory review and approval process, butdoes make the product eligible for orphan drug exclusivity, reduced filing feesand specific tax credits. Generally, if a company receives the first marketingapproval for a product with an Orphan Drug designation in the clinicalindication for which it has such designation, the product is entitled to orphandrug exclusivity. Orphan drug exclusivity means that the health authoritieswill not approve another application to market the same drug for the sameindication, except in limited circumstances, for a period of seven years in theUnited States and ten years in Europe. This exclusivity, however, could blockthe approval of our biologic drug candidates if a competitor obtains marketingapproval before us. Even if we obtain orphan drug exclusivity for any of ourbiologic drug candidates, we may not be able to maintain it. For example, if acompetitive product is shown to be clinically superior to our product, anyorphan drug exclusivity we have will not block the approval of such competitiveproduct.

**The Fast Trackdesignation for development of any of our products may not lead to a fasterdevelopment or regulatory review or approval process, and it does not increasethe likelihood the biologic drug candidate will receive marketing approval.**

If a drug is intended forthe treatment of a serious or life-threatening condition and the drugdemonstrates the potential to address unmet medical needs for this condition,the drug sponsor may apply for FDA Fast Track designation for a particularindication. Marketing applications filed by sponsors of products in Fast Trackdevelopment may qualify for priority review under the policies and proceduresoffered by the FDA, but the Fast Track designation does not assure any suchqualification. Although we have obtained a Fast Track designation from the FDAfor Prochymal for the treatment of GvHD and treatment refractory Crohn’sDisease, receipt of Fast Track designation may not result in a fasterdevelopment process, review or approval compared to drugs considered forapproval under conventional FDA procedures. In addition, the FDA may withdrawour Fast Track designation at any time. If we lose our Fast Track designation,the approval process may be delayed. In addition, our Fast Track designationdoes not guarantee that we will qualify for or be able to take advantage of theexpedited review procedures and does not increase the likelihood that Prochymalwill receive regulatory approval for the treatments of steroid refractory GvHDor Crohn’s Disease.

**Risks Related toOur Common Stock**

**The trading priceof the shares of our common stock could be highly volatile, and purchasers ofour common stock could incur substantial losses.**

Our stock price isvolatile. The stock market in general and the market for biotechnologycompanies in particular have experienced extreme volatility that has often beenunrelated to the operating performance of particular companies. As a result ofthis volatility, investors may not be able to sell their common stock at orabove the price they paid for it. The market price for our common stock may be influencedby many factors, including:

·       resultsof clinical trials of our biologic drug candidates or those of our competitors;

·       regulatorydevelopments in the United States and foreign countries;

·       variationsin our financial results or those of companies that are perceived to be similarto us;

·       changesin the structure of healthcare payment systems;

·       announcementsby us of significant acquisitions, strategic partnerships, joint ventures orcapital commitments;

·       marketconditions in the pharmaceutical and biotechnology sectors and issuance ofsecurities analysts’ reports or recommendations;

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·       salesof substantial amounts of our stock by existing stockholders;

·       salesof our stock by insiders and 5% stockholders;

·       generaleconomic, industry and market conditions;

·       additionsor departures of key personnel;

·       intellectualproperty, product liability or other litigation against us;

·       expirationor termination of our relationships with our collaborators; and

·       theother factors described in this “Risk Factors” section.

In addition, in the past,stockholders have initiated class action lawsuits against biotechnology andpharmaceutical companies following periods of volatility in the market pricesof these companies’ stock. Such litigation, if instituted against us, couldcause us to incur substantial costs and divert management’s attention andresources, which could have a material adverse effect on our business,financial condition and results of operations.

**Concentration ofownership of our common stock among our existing executive officers, directorsand principal stockholders may prevent new investors from influencingsignificant corporate decisions.**

Our executive officers, directors and beneficialowners of 5% or more of our common stock and their affiliates, in aggregate,beneficially own approximately 50% of our outstanding common stock as of December 31,2006. These persons, acting together, will be able to significantly influenceall matters requiring stockholder approval, including the election and removalof directors and any merger or other significant corporate transactions. Theinterests of this group of stockholders may not coincide with our interests orthe interests of other stockholders.

In addition, PeterFriedli, our Chairman of the Board of Directors, and certain entities withwhich he is affiliated, beneficially own approximately 47% of our outstandingcommon stock as of December 31, 2006. Accordingly, Mr. Friedlicurrently has, and will continue to have, a significant influence over the outcomeof all corporate actions requiring stockholder approval.

**Certain provisionsof Delaware law and of our charter documents contain provisions that coulddelay and discourage takeover attempts and any attempts to replace our currentmanagement by stockholders.**

Certain provisionsof our certificate of incorporation and bylaws, and applicable provisions ofDelaware corporate law, may make it more difficult for or prevent a third partyfrom acquiring control of us or changing our Board of Directors and management.These provisions include:

·       theability of our Board of Directors to issue preferred stock with voting or otherrights or preferences;

·       theinability of stockholders to act by written consent;

·       aclassified Board of Directors with staggered three-year terms;

·       requirementsthat special meetings of our stockholders may only be called by the chairman ofour Board of Directors, upon request of stockholders holding at least 20% ofour capital stock issued and outstanding, or upon a resolution adopted by, oran affirmative vote of, a majority of our Board of Directors; and

·       requirementsthat our stockholders comply with advance notice procedures in order tonominate candidates for election to our Board of Directors or to placestockholders’ proposals on the agenda for consideration at meetings ofstockholders.

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We will also be afforded the protections of Section 203of the Delaware General Corporation Law, which will prevent us from engaging ina business combination with a person who acquires at least 15% of our commonstock for a period of three years from the date such person acquired suchcommon stock, unless advance board or stockholder approval was obtained.

Any delay or prevention ofa change of control transaction or changes in our Board of Directors ormanagement could deter potential acquirors or prevent the completion of atransaction in which our stockholders could receive a substantial premium overthe then current market price for their shares.

**Item 1B.**               UNRESOLVEDSTAFF COMMENTS

**Not Applicable**

**Item 2.**                        PROPERTIES

Our corporate headquartersare currently located in Baltimore, Maryland, where we lease approximately118,000 square feet, currently at a rent of approximately $1.1 million perannum. This lease expires in September 2008. We have an option to renewthis lease through 2023 and have not made a decision regarding the exercise ofour renewal options. Since August 2006, we have subleased approximately61,000 square feet of space in Columbia, Maryland at a rent of approximately$0.8 million per annum. This sublease expires in May 2009. We havealso entered into a direct lease with the owner of the facility that willbecome effective upon expiration of the sublease. This direct lease terminatesin July 2016 and includes options to extend the term of the lease for twoadditional five-year periods. We moved our administrative offices to theColumbia facility in March 2007, and during the fourth quarter of 2007 weexpect to move our manufacturing facilities for our biologic drug candidates tothe Columbia building. Our tissue manufacturing facilities will remain inBaltimore.

**Item 3.**                        LEGALPROCEEDINGS

Lawsuits and claims arefiled against us from time to time in the ordinary course of our business,including without limitation, challenges to our intellectual property positions.We do not believe that any lawsuits or claims, or proceedings, currentlypending against us, individually or in the aggregate, are material, or willhave a material adverse effect on our financial condition or business.

**Item 4.**                        SUBMISSIONOF MATTERS TO A VOTE OF SECURITY HOLDERS

No matters were submittedto a vote of our security holders during the fourth quarter of the year ended December 31,2006.

**Item 5.**                        MARKETFOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUERPURCHASES OF EQUITY SECURITIES

**Market Information**

Our Common Stock begantrading on the NASDAQ Global Market on August 4, 2006 under the symbol “OSIR”.The following table sets forth, the high and low sales prices for the CommonStock, as reported by the NASDAQ Global Market, during the periods indicated.

| ** **                                | ** ** | **High** | ** ** | **Low** | ** ** |
|-------------------------------------------|------------|----------|------------|---------|------------|
| Fiscal Year Ended  December 31, 2006 |       |     |       |    |       |
| Fourth Quarter                            |       | $        | 27.93      |    | $          | 10.00 |   |
|                                           |            |          |            |         |            |  |  |

 

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**Stockholders**

As of March 7, 2007,there were approximately 1,023 stockholders of record or our Common Stock and,according to our estimates, approximately 1,726 beneficial owners of the CommonStock.

**Dividends**

We have not paid dividendsto our stockholders since our inception and we do not plan to pay cashdividends in the foreseeable future. We currently intend to retain earnings, ifany, to finance our growth.

**Unregistered Salesof Securities**

On October 30, 2006, the Company issued anaggregate of $20 million in convertible promissory notes, placed byFriedli Corporate Finance, Inc., as further described in Item 2.03 of ourCurrent Report on Form 8-K filed with the United States Securitiesand Exchange Commission on October 30, 2006, which is incorporated hereinby reference.

From January 1,2006 through December 31, 2006, we sold and issued the followingunregistered securities without the involvement of underwriters or placementagents:

(a)    In April 2006, we issued 6,250 restricted shares ofour common stock to our non-employee medical director as compensation. Twenty-fivepercent of these shares vest immediately and the balance vest ratably over thefollowing three years.

(b)   In January 2006,we issued 12,500 shares of our common stock to a non-management director inconnection with his successful fundraising activities during 2005.

(c)    In April 2006,we issued 10,000 shares of our common stock to non-management directors ascompensation.

(d)   In June 2006,we issued 307 shares of our common stock to a former non-management director ascompensation.

(e)    In May 2006,we issued warrants to purchase 1,000,000 shares of our common stock, with anexercise price equal to the initial public offering price of $11.00 per share,to a non-management director. These warrants expire five years after grant.

(f)    In September 2006, options to purchase an aggregateof 95,000 shares of our common stock were exercised by two of our executiveofficers under our Amended and Restated 1994 Stock Incentive Plan.

The sale and issuance of the securities described inparagraphs (a) through (e) above were issued in reliance upon theexemption from the registration requirements of the Securities Act as set forthin Section 4(2) under the Securities Act and Rule 506 ofRegistration D promulgated there under relating to sales by an issuer notinvolving any public offering, to the extent an exemption from suchregistration was required. The purchasers of our securities described aboverepresented to us in connection with their purchase that they were accreditedinvestors and were acquiring the shares for investment and not distribution,that they could bear the risks of the investment and could hold the securitiesfor an indefinite period of time. The purchasers received written disclosuresthat the securities had not been registered under the Securities Act and thatany resale must be made pursuant to a registration or an available exemptionfrom such registration. The sales of these securities were made without generalsolicitation or advertising.

The sale and issuance ofthe securities described in paragraph (f) above were issued were issued inreliance upon the exemption from the registration requirements of theSecurities Act as set forth in 

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Section 4(2) underthe Securities Act, and as set forth in Rule 701 promulgated thereunder inthat they were offered and sold pursuant to a written compensatory benefitplan, as provided in Rule 701.

**Issuer Purchase ofEquity Securities and Use of Proceeds**

There were no repurchases by us of our securitiesduring fiscal 2006.

On August 4, 2006, we sold 3,500,000 shares ofour common stock in our initial public offering at the price to the public of$11.00 per share. The offer and sale of all of the shares in the offering wereregistered under the Securities Act of 1933, as amended, pursuant to aregistration statement on Form S-1 (File No. 333-13407),which was declared effective by the Securities and Exchange Commission on August 3,2006. The underwriters of the offering were Jefferies & Company, Inc.,Lazard Capital Markets, LLC and Leerink Swann & Co., Inc. Therewere no selling stockholders in the offering.

We registered 3,500,000 shares of our common stock inconnection with the initial public offering and the aggregate offering amountwas $38.5 million. We paid approximately $2.7 million in underwriting discountsand commissions to the underwriter. We also incurred other expenses inconnection with the offering of approximately $1.4 million, includingregistration fees, accounting and legal, printing and engraving and otherexpenses.

None of the underwriting discounts and commissions oroffering expenses were incurred or paid to directors or officers of ours or theirassociates, to persons owning 10 percent or more of our common stock or to anyaffiliates or ours.

After deducting the underwriting discounts andcommissions and these other estimated offering expenses, our net proceeds fromthe offering were approximately $34.4 million. We deposited the net proceeds intwo highly rated financial institutions in the United States.

There has been no materialchange in our planned use of proceeds from our initial public offering asdescribed in our final prospectus filed with the Securities and ExchangeCommission pursuant to Rule 424(b). Between August 3, 2006 and December 31,2006, we used approximately $10.5 million of the net proceeds to fund ouroperating activities, including activities relating to the development of ourbiologic drug candidates and for working capital, capital expenditures,repayment of debt and other general corporate purposes. During this period, ourresearch and development expenses comprised approximately 94% of our operatingexpenses. The remaining approximately $23.9 million in net proceeds remains ondeposit in two highly rated financial institutions in the United States. At December 31,2006, we had $39.2 million in cash and short-term investments.

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**Stock PerformanceGraph**

The following graph shows the cumulative total return,assuming the investment of $100 on August 4, 2006 (based upon the closingprice of our common stock on August 4, 2006, the first day of trading onthe NASDAQ Global Market), on an investment in each of the Company’s commonstock, the NASDAQ Composite Index (U.S. and Foreign) and the NASDAQBiotechnology Index. The comparisons in the table are required by the SEC andare not intended to forecast or be indicative of possible future performance ofthe Company’s common stock.

****

**SecuritiesAuthorized for Issuance under Equity Compensation Plans**

The information required by Item 201(d) ofRegulation S-K, pursuant to paragraph (a) of this Item 5, is incorporatedby reference to the information set forth under the caption “EquityCompensation Plan Information” in the Company’s Proxy Statement for the 2007Annual Meeting of Stockholders, which is anticipated to be filed pursuant toRegulation 14A no later than one hundred twenty (120) days following the end ofthe fiscal year reported on.

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**Item 6.**                        SELECTEDFINANCIAL DATA

Wederived the selected financial data presented below for the periods or datesindicated from our financial statements. Our financial statements for theseperiods were audited by Stegman & Company, an independent registeredpublic accounting firm. You should read the data below in conjunction with ourfinancial statements, related notes and other financial information appearingin “Item 7. Management’s Discussion and Analysis of Financial Condition andResults of Operations.”
|                                                                                                 | ** ** | **Year Ended December 31,**                         | ** ** |
|-------------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------|------------|
| ** **                                                                                      | ** ** | **2002**                                                           | ** ** | **2003** | ** ** | **2004** | ** ** | **2005** | ** ** | **2006** | ** ** |
| ** **                                                                                      | ** ** | **(in thousands, except per share data)** | ** ** |
| **Statement of Operations Data:**                                                               |       |                                                               |       |   |   |   |   |   |   |   |   |
| Product sales                                                                                   |       | $                                                                  | —     |   | $ | — |   | $ |   |   | $ | 957 |   | $ | 8,291 |   |
| Cost of goods  sold                                                                             |       | —                                                             |       | — |   | — |   | 444 |   | 3,697 |   |
| Gross profit                                                                                    |       | —                                                             |       | — |   | — |   | 513 |   | 4.594 |   |
| Revenue from  collaborative research licenses and grants                    |       | 1,217                                                              |       | 3,981 |   | 3,911 |   | 3,013 |   | 1,181 |   |
| Operating  expenses:                                                                            |       |                                                               |       |   |   |   |   |   |   |   |   |
| Research and development                                                                        |       | 11,206                                                             |       | 18,639 |   | 11,888 |   | 16,927 |   | 37,590 |   |
| General and administrative and other   expenses                                                 |       | 4,096                                                              |       | 4,467 |   | 1,704 |   | 2,294 |   | 8,459 |   |
| Total operating expenses                                                                        |       | 15,302                                                             |       | 23,106 |   | 13,592 |   | 19,221 |   | 46,049 |   |
| Loss from operations                                                                            |       | (14,085                                                            | )          | (19,125 | ) | (9,681 | ) | (15,695 | ) | (40,274 | ) |
| Interest expense,  net                                                                          |       | (5,033                                                             | )          | (605 | ) | (847 | ) | (4,300 | ) | (4,685 | ) |
| Net loss                                                                                        |       | $                                                                  | (19,118    | ) | $ | (19,730 | ) | $ | (10,528 | ) | $ | (19,995 | ) | $ | (44,959 | ) |
| Basic and diluted net loss per share                                                            |       | $                                                                  | (8.69      | ) | $ | (3.60 | ) | $ | (1.19 | ) | $ | (2.23 | ) | $ | (2.70 | ) |
| Weighted average shares of common stock used in  computing basic and diluted net loss per share |       | 2,201                                                              |       | 5,475 |   | 8,814 |   | 8,959 |   | 16,663 |   |

 

| ** **                                          | ** ** | **At December 31,** | ** ** |
|-----------------------------------------------------|------------|--------------------------|------------|
| ** **                                          | ** ** | **2002**                 | ** ** | **2003** | ** ** | **2004** | ** ** | **2005** | ** ** | **2006** | ** ** |
| **Balance Sheet Data:**                             |       |                     |       |   |   |   |   |   |   |   |   |
| Cash and  short-term investments                    |       | $                        | 394        |   | $ | 1,339 |   | $ | 488 |   | $ | 43,371 |   | $ | 39,181 |   |
| Working capital                                     |       | (34,495                  | )          | (5,314 | ) | (7,893 | ) | 38,103 |   | 33,166 |   |
| Total assets                                        |       | 8,525                    |       | 9,748 |   | 5,972 |   | 51,014 |   | 49,168 |   |
| Notes payable,  less current portion                |       | 245                      |       | 179 |   | 7,519 |   | 47,411 |   | 25,000 |   |
| Mandatorily  redeemable convertible preferred stock |       | —                   |       | — |   | — |   | 64,267 |   | — |   |
| Convertible  preferred stock                        |       | —                   |       | 13,000 |   | 15,243 |   | 32,746 |   | — |   |
| Accumulated  deficit                                |       | (92,291                  | )          | (112,021 | ) | (122,549 | ) | (142,544 | ) | (187,503 | ) |
| Total stockholders’  equity (deficit)          |       | (26,476                  | )          | (5,563 | ) | (13,004 | ) | (73,662 | ) | 11,287 |   |
|                                                     |            |                          |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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**Quarterly Financial Data (Unaudited)**
|                                                | ** ** | **First**                                                          | ** ** | **Second**  | ** ** | **Third**   | ** ** | **Fourth**  | ** ** |
|------------------------------------------------|------------|--------------------------------------------------------------------|------------|-------------|------------|-------------|------------|-------------|------------|
| ** **                                     | ** ** | **Quarter**                                                        | ** ** | **Quarter** | ** ** | **Quarter** | ** ** | **Quarter** | ** ** |
| ** **                                     | ** ** | **(in thousands, except per share data)** | ** ** |
| **2006**                                       | ** ** | ** **                                                         | ** ** | ** **  | ** ** | ** **  | ** ** | ** **  | ** ** |
| Total revenues                                 |       | $                                                                  | 1,400      |        | $          | 1,987       |       | $           | 2,841      |   | $ | 3,244 |   |
| Product sales                                  |       | 1,105                                                              |       | 1,689       |       | 2,539       |       | 2,958       |       |
| Cost of goods sold                             |       | 489                                                                |       | 762         |       | 1,113       |       | 1,333       |       |
| Research and development expenses              |       | 4,368                                                              |       | 10,922      |       | 9,242       |       | 13,058      |       |
| General and administrative expenses and fees   |       | 1,138                                                              |       | 1,209       |       | 5,300       |       | 812         |       |
| Net loss                                       |       | (5,121                                                             | )          | (11,605     | )          | (15,565     | )          | (12,668     | )          |
| **Net loss per common share, basic and diluted |       | (0.56                                                              | )          | (1.27       | )          | (0.75       | )          | (0.46       | )          |
| **2005**                                       | ** ** | ** **                                                         | ** ** | ** **  | ** ** | ** **  |       |        |       |
| Total revenues                                 |       | $                                                                  | 385        |        | $          | 1,339       |       | $           | 1,285      |   | $ | 961 |   |
| Product sales                                  |       | —                                                             |       | —      |       | 284         |       | 673         |       |
| Cost of goods sold                             |       | —                                                             |       | —      |       | 220         |       | 224         |       |
| Research and development expenses              |       | 2,657                                                              |       | 3,592       |       | 3,464       |       | 7,214       |       |
| General and administrative expenses and fees   |       | 752                                                                |       | 487         |       | 554         |       | 501         |       |
| Net loss                                       |       | (3,868                                                             | )          | (2,740      | )          | (4,678      | )          | (8,055      | )          |
| **Net loss per  common share, basicand diluted |       | (0.43                                                              | )          | (0.38       | )          | (0.52       | )          | (0.88       | )          |

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**             Earning per share arecalculated on a quarterly basis and may not be additive to year-to-dateamounts.

**Item 7.**                        MANAGEMENT’SDISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

**Overview**

We are a leading stem cell therapeutic company focusedon developing and marketing products to treat medical conditions in theinflammatory, orthopedic and cardiovascular areas. Our marketed product,Osteocel, and our biologic drug candidates utilize mesenchymal stem cells, orMSCs. In July 2005, we launched Osteocel for regenerating bone inorthopedic indications. We currently have five clinical trials ongoing. We arecurrently enrolling patients in a Phase III clinical trial for Prochymal, ourlead biologic drug candidate, for the treatment of steroid refractory Graftversus Host Disease, or GvHD. We were recently given clearance to conduct aPhase III trial using Prochymal to treat Crohn’s Disease. In addition, we havetwo other clinical stage biologic drug candidates, Chondrogen for regeneratingcartilage in the knee, and Provacel for repairing heart tissue following a heartattack. We have developed stem cell capabilities in research and development,manufacturing, marketing and distribution. We manufacture Osteocel and clinicalbatches of our biologic drug candidates. We, together with AlloSource,distribute Osteocel in orthopedic indications and jointly distribute Osteocelwith Blackstone Medical, Inc., a division of Orthofix International, N.V.,for spinal procedures.

We have incurred annualoperating losses since inception and expect to incur substantial operatinglosses in the future in connection with the development of our core products.As of December 31, 2006, we had an accumulated deficit of $187.5 million.

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**FinancialOperations Overview**

*Revenue*

Osteocel is our only commercial product. Sales ofOsteocel generated revenue of approximately $8.3 million for the yearended December 31, 2006. In prior years, we have entered into strategicagreements with other companies for the development and commercialization ofselect stem cell biologic drug candidates for specific indications andgeographic markets. In 2003, we entered into an agreement with a majorpharmaceutical company relating to the development of our cardiac biologic drugcandidate, and we received a $5.0 million fee for licensing the use of ourtechnology. This fee is being recognized as revenue over a 63-month period,$1.0 million of which was recognized in 2006 and 2005. Also in 2003, weentered into an agreement with a foreign pharmaceutical company granting itexclusive rights to Prochymal for the treatment of GvHD in Japan. We recognized$0.5 million of revenue during 2005 related to this agreement.

Historically, we have also recognized revenue fromgovernmental grants for research and in 2005, we recorded $1.4 million in grantrevenues from three separate grants. Revenue from research grants is recognizedas the related research expenditures are incurred. During 2006, we did not haveany active government grants and we presently do not expect to solicitgovernmental grants in the future.

Other than Osteocel, wehave no commercial products for sale. A substantial portion of our revenue inthe future will be dependent on the approval and sale of our biologic drugcandidates. Our revenue may vary substantially from quarter to quarter and fromyear to year. We believe that period-to-period comparisons of our results ofoperations are not meaningful and should not be relied upon as indicative ofour future performance.

*Cost of Goods Sold*

Our cost of goods soldrelate to direct costs of producing Osteocel, which we launched inJuly 2005. Cost of goods sold consist primarily of the costs of obtainingtissue and other chemicals and supplies, direct labor and allocated costs ofour facilities and overhead.

*Research andDevelopment Costs*

Our research and development costs consist of expensesincurred in identifying, developing and testing biologic drug candidates. Theseexpenses consist primarily of salaries and related expenses for personnel, feespaid to professional service providers for independent monitoring and analysisof our clinical trials, costs of contract research and manufacturing, costs offacilities, and the costs of manufacturing clinical batches of biologic drugcandidates, quality control supplies and material to expand biologic drugcandidates.

Consistent with our focus on the development ofbiologic drug candidates with potential uses in multiple indications, many ofour costs are not attributable to a specifically identified product. We use ouremployee and infrastructure resources across several projects. Accordingly, wedo not account for internal research and development costs on aproject-by-project basis. As a result, we cannot state precisely the totalcosts incurred for each of our clinical and preclinical projects on aproject-by-project basis. From inception through December 31, 2006, weincurred aggregate research and development costs of approximately $183million.

We expect ourresearch and development expenses to increase substantially in the future, aswe expand our clinical trial activity, as our biologic drug candidates advancethrough the development cycle and as we invest in additional productopportunities and research programs. Clinical trials and preclinical studiesare time-consuming and expensive. Our expenditures on current and futurepreclinical and clinical development programs are subject to many uncertainties.We test our products in several preclinical 

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studies,and we then conduct clinical trials for those biologic drug candidates that wedetermine to be the most promising. As we obtain results from clinical trials,we may elect to discontinue or delay trials for some biologic drug candidatesin order to focus our resources on more promising biologic drug candidates.Completion of clinical trials may take several years or more, but the length oftime generally varies substantially according to the type, size of trial andintended use of a biologic drug candidate. The cost of clinical trials may varysignificantly over the life of a project as a result of a variety of factors,including:

·       the number of patients whoparticipate in the trials;

·       the number of sitesincluded in the trials;

·       the length of time requiredto enroll trial participants;

·       the duration of patienttreatment and follow-up;

·       the costs of producingsupplies of the biologic drug candidates needed for clinical trials andregulatory submissions;

·       the efficacy and safetyprofile of the biologic drug candidate; and

·       the costs and timing of,and the ability to secure, regulatory approvals.

As a result of theuncertainties discussed above, we are unable to determine with any significantdegree of certainty the duration and completion costs of our research anddevelopment projects or when and to what extent we will generate revenues fromthe commercialization and sale of any of our biologic drug candidates.

*General andAdministrative Expenses*

General and administrative expenses consist primarilyof the costs associated with our general management, including salaries,allocations of facilities and related costs, and professional fees such aslegal and accounting expenses. In anticipation of and since the closing of ourinitial public offering in August 2006, we began to incur increases in ourgeneral and administrative expense for legal and accounting compliance costs,investor relations and other activities associated with operating as a publiclytraded company. Continued increases will also likely result from additional thehirings of operational, financial, accounting, facilities engineering andinformation systems personnel.

*Interest and OtherIncome (Expense), Net*

Interest income consistsof interest earned on our cash and short-term investments. Interest expenseconsists of interest incurred on capital leases and other debt financings. Wepay interest on our bank loan, capital leases and our convertible long-termdebt.

*Income Taxes*

We have not recognized anydeferred tax assets or liabilities in our financial statements since we cannotassure their future realization. Because realization of deferred tax assets isdependent upon future earnings, a full valuation allowance has been recorded onthe net deferred tax assets, which relate primarily to net operating loss andresearch and development carry-forwards. In the event that we become profitablewithin the next several years, we have net deferred tax assets of approximately$70 million that may be utilized prior to us having to recognize any income taxexpense or make payments to the taxing authorities. Utilization of our netoperating loss carry-forwards in any one year may be limited however, and wecould be subject to the alternative minimum tax.

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**Critical AccountingPolicies**

*General*

Our discussion and analysis of our financial conditionand results of operations are based on our financial statements, which we haveprepared in accordance with accounting principles generally accepted in the UnitedStates. The preparation of these financial statements requires us to makeestimates and judgments that affect the reported amounts of assets,liabilities, revenues and expenses, and related disclosure of contingent assetsand liabilities. On an ongoing basis, we evaluate our estimates, includingthose related to revenue recognition, deferred tax assets, stock-basedcompensation, and contingencies. We base our estimates on historical experienceand on various other assumptions that we believe are reasonable. These resultsform the basis for making judgments about the carrying value of assets andliabilities that are not readily apparent from other sources. Actual resultsmay differ from these estimates under different assumptions or conditions.

We believe that thefollowing critical accounting policies reflect our more significant judgmentsand estimates used in the preparation of our financial statements.

*Revenue Recognition*

Our revenue recognition policies are governed by theSecurities and Exchange Commission’s, or SEC, Staff Accounting Bulletin No. 101, *Revenue Recognition in Financial Statements*, as amended bySEC Staff Accounting Bulletin No. 104, *RevenueRecognition*.

We have one commercial product on the market. Werecognize revenue on sales when legal title to the product has passed to thecustomer, which is usually when the product is shipped from our Baltimore,Maryland facilities. We have agreements with our customers that specify theterms of sale, including price.

Revenues from collaborative agreements and grants arerecognized as earned upon either the incurring of reimbursable expensesdirectly related to the particular research plan or the completion of certaindevelopment milestones as defined within the terms of the collaborativeagreement. Payments received in advance of research performed are designated asdeferred revenue. We recognize non-refundable upfront license fees and certainother related fees on a straight-line basis over the development period. Feesassociated with substantive at risk, performance based milestones arerecognized as revenue upon their completion, as defined in the respectiveagreements. Incidental assignment of technology rights is recognized as revenueat the time of receipt.

Milestone payments that are based on designatedachievement points and that are considered at risk and substantive at theinception of the collaboration are recognized as earned when the correspondingpayment is considered reasonably assured. We evaluate whether milestonepayments are at risk and substantive based on the contingent nature of themilestone, specifically reviewing factors such as the technological andcommercial risk that must be overcome and the level of the investment required.Milestone payments that are not considered at risk and substantive arerecognized, when achieved, in proportion to the percentage of the collaborationcompleted through the date of achievement. The remainder of the milestonepayment is recognized as services are performed over the remaining term of thecollaboration.

Royalties for the use of our MSCs for clinicalresearch purposes are recognized when earned, however, such amounts have notbeen material and are not expected to be material in the future. Additionally,we may receive royalty payments under our collaborative arrangements upon salesof product.

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We evaluate allcollaborative agreements on a quarterly basis to determine the appropriaterevenue recognition for that period. The evaluation includes all of thepotential revenue components from each specific collaborative agreement.

*Accounts Receivable*

Our accounts receivableare reported at their net realizable value. As of December 31, 2006 and2005, there was no allowance for doubtful accounts as we believe the reportedamounts are fully collectible. During the year ended December 31, 2006, werecognized $3 of bad debt expense. We did not recognize any bad debt expensefor the years ended December 31, 2005 and 2004. Accounts receivablebalances are not collateralized.

*Stock-BasedCompensation*

Prior to January 1, 2006, as permitted by theprovisions of Statement of Financial Accounting Standards, SFAS, No. 148, *“Accounting for Stock-Based Compensation—Transitionand Disclosure,”*and SFAS No. 123, *“Accounting for Stock-Based Compensation,”*our employee stockoption plan was accounted for under Accounting Principles Board Opinion No. 25,APB 25, *“Accounting for Stock Issued toEmployees.”*We grant qualified stock options for a fixed number ofshares to employees and directors with an exercise price equal to the fairmarket value of the shares at the date of grant. Prior to January 1, 2006,in these circumstances and in accordance with APB 25, we recognized nocompensation expense for qualified stock option grants. We have issued somenon-qualified stock options for a fixed number of shares to employees anddirectors with an exercise price less than the fair market value of the sharesat the date of grant. As such options vest, we will recognize the differencebetween the exercise price and fair market value at date of grant ascompensation expense in accordance with APB 25. For share-grants of commonstock to directors, we record the intrinsic value of the shares granted basedupon the estimated fair value on the date of grant.

In December 2004,FASB issued SFAS No. 123(R) (revised 2004), *“Share-Based Payment.”*This Statement is arevision of SFAS No. 123, *“Accountingfor Stock-Based Compensation.”*This Statement supersedes APB 25 andits related implementation guidance. We adopted SFAS No. 123(R) on January 1,2006, and now expense stock options using a fair-value method in our statementof operations. Adoption of the expensing requirements has increased our netloss. See “Stock-Based Compensation” in Note 6 of our financial statementsfor disclosures regarding the effect on net earnings and earnings per share ifwe had applied the fair value recognition provisions of SFAS No. 123(R) priorto January 1, 2006. We use the modified prospective method. Under thismethod, compensation cost is recognized beginning with the effective date ofadoption (a) based on the requirements of SFAS 123(R) for allshare-based payments granted after the effective date of adoption and (b) basedon the requirements of SFAS 123(R) for all awards granted toemployees prior to the effective date of adoption that remain unvested on thedate of adoption. We currently utilize the Black-Scholes option pricing modelto estimate the fair value. The Black-Scholes model meets the requirements ofSFAS 123(R), but the fair values generated by the model may not beindicative of the actual fair values of our stock-based awards.

**Significant NewAccounting Pronouncements**

In May 2005, the Financial Accounting StandardsBoard (“FASB”) issued SFAS No. 154, “Accounting Changes and ErrorCorrections,” a replacement of APB Opinion No. 20 and FASB Statement No. 3.SFAS No. 154 requires retrospective application to prior periods’financial statements for changes in accounting principle, unless it isimpracticable to determine either the period-specific effects or the cumulativeeffect of the change. SFAS No. 154 also requires that a change indepreciation, amortization, or depletion method for long-lived, non-financialassets be accounted for as a change in accounting estimate affected by a changein accounting principle. SFAS No. 154 is effective for accounting 

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changes and corrections oferrors made in fiscal years beginning after December 15, 2005. Theimplementation of SFAS No. 154 on January 1, 2006 did not have amaterial impact on the results of operations, financial position or cash flows.

In November 2005, FASB issued, FASB StaffPosition (“FSP”) FAS 115-1 and FAS 124-1, “The meaning ofOther-than-Temporary Impairment and Its Application to Certain Investments” (“FSP115-1”) which provides guidance on determining when investments incertain debt and equity securities are considered impaired, whether thatimpairment is other-than-temporary, and on measuring such impairment loss. FSP115-1 also includes accounting considerations subsequent to therecognition of an other-than—temporary impairment and requires certaindisclosures about unrealized losses that have not been recognized asother-than-temporary impairments. FSP 115-1 is effective for reportingperiods beginning after December 15, 2005. Our adoption of FSP 115-1on January 1, 2006 did not have a material impact on our results ofoperations, financial position or cash flows.

In July 2006, FASB issued FASB Interpretation No. 48“Accounting for Uncertainty in Income Taxes,” an interpretation of FASB No. 109(“FIN 48”) that clarifies the accounting for uncertainty in income taxesrecognized in accordance with SFAF 109, “Accounting for Income Taxes. FIN 48prescribes a recognition threshold and measurement attribute for the financialstatement effects of a tax position when it is more likely than not of beingsustained on examination, based on the technical merits of the position. Inaddition, FIN 48 indicates that the measurement of a tax position that meetsthe more likely than not threshold shall consider the amounts and probabilitiesof the outcomes that could be realized upon ultimate settlement. Thisinterpretation is effective for fiscal years beginning after December 15,2006. We expect the impact of adopting FIN 48 to be immaterial.

In September 2006,the SEC issued Staff Accounting Bulletin (SAB) No. 108, “Considering theEffects of Prior Year Misstatements when Quantifying Misstatements in CurrentYear Financial Statements” (“SAB 108”). SAB 108 provides guidance on theconsideration of the effects of prior year misstatements in quantifying currentyear misstatements for the purpose of determining whether the current year’sfinancial statements are materially misstated. SAB 108 is effective for fiscalyears ending after November 15, 2006. The implementation of SAB 108 didnot have a material impact on the results of operations, financial position orcash flows.

**Results OfOperations**

*Comparison of Yearsended December 31, 2006 and 2005*

*Revenue*

Total revenues increased138% to $9.5 million for the twelve months ended December 31, 2006,compared to $4.0 million in the corresponding period in 2005. Our revenuesin 2006 resulted primarily from $8.3 million generated from the sale ofOsteocel and the recognition of $1.2 million in licensing fees androyalties. In the twelve months ended December 31, 2005, we recognized$1.0 million from the sale of Osteocel and $3.0 million in license feesand grants.

*Cost of Goods Sold*

Cost of goods sold were$3.7 million for the twelve months ended December 31, 2006 comparedto $0.4 million in the prior year. The cost of goods sold associated with salesof Osteocel was comprised of payments to tissue banks, direct labor costs andthe costs of processing, testing and preserving Osteocel, plus allocated costsof our facilities and overhead. The gross margin on Osteocel sales for thetwelve months ended December 31, 2006 was 56%, compared with 54% for 2005.

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*Research andDevelopment Expenses*

Research and developmentexpenses were approximately $37.5 million for the twelve months ended December 31,2006 compared to $16.9 million in the prior year. The increase in researchand development expenses in 2006 reflects the increased number of clinicaltrials in process versus the prior year. In 2006, we incurred costs associatedwith the enrollment of a Phase II trial for Prochymal as an add-on therapy tosteroids for the first-line treatment of acute GvHD, a Phase II trial forProchymal for treatment of steroid refractory GvHD, a Phase II trial forProchymal for treatment of Crohn’s Disease, a Phase I/II clinical trial forChondrogen, and a Phase I clinical trial for Provacel.

*General andAdministrative Expenses*

General and administrativeexpenses were $4.4 million for the twelve months ended December 31,2006 compared to $2.2 million in the prior year. The increase in 2006includes $0.9 million of non-cash charges associated with the completion of ourinitial public offering. Exclusive of these charges, general and administrativeexpenses in 2006 were $3.5 million and the increase over the prior year wasattributable to additional personnel and related costs to support the company’sgrowth and costs incurred in connection with being a public company.

*Related partyexpenses*

Fees paid to relatedparties were $0.6 million for the twelve months ended December 31, 2006compared to $0.1 million in the prior year. In 2006, we recorded $3.5 millionin non-cash charges related to warrants issued to our chairman that were pricedand vested upon completion of our initial public offering and $0.2 million inshare-based compensation for stock awards for services of our board ofdirectors

*Interest Expense,Net*

Interest expense, net was$4.7 million for the twelve months ended December 31, 2006 comparedto $4.3 million in the prior year. The 2006 costs include $2.7 million ofpreviously deferred debt financing costs and premiums associated with debt thatwas converted into common stock upon the completion of our initial publicoffering. Exclusive of these charges, net interest expense during 2006 was $2.0million, a decrease of $2.3 million compared to 2005. This decrease is theresult of higher interest income related to the investment of the proceeds ofthe initial public offering and the $21.8 million decrease in debt, which wasconverted into common stock upon the completion of the initial public offeringin early August 2006.

*Comparison of Yearsended December 31, 2005 and 2004*

*Revenue*

Total revenues were $4.0 million for the yearended December 31, 2005, compared to $3.9 million in the prior year.Our revenues in 2005 resulted primarily from $1.0 million generated fromthe sale of Osteocel which launched in July 2005, the recognition of$1.0 million in licensing fees resulting from our agreement with BostonScientific for our cardiac technology, royalty fees of $0.5 millionrecognized upon completion of the transfer of technology to JCRPharmaceuticals, and $1.4 million in revenues recognized upon completionof work in furtherance of governmental grants. In 2004, we recognized$2.0 million in license fees from JCR Pharmaceuticals for the futuredistribution of our products in Japan, $0.9 million in licensing fees fromBoston Scientific, and $0.8 million relating to completion of work infurtherance of our grants from the U.S. government. These grants were completedduring the second quarter of 2005. We do not expect that future grant revenuewill be significant.

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*Cost of Goods Sold*

Cost of goods sold were$0.4 million for the year ended December 31, 2005 compared to none inthe prior year. We launched Osteocel in July 2005. The cost of goods soldassociated with sales of Osteocel was comprised of payments to tissue banks andthe costs of processing, testing and preserving Osteocel.

*Research andDevelopment Expenses*

Research and developmentcosts were approximately $16.9 million for the year ended December 31,2005 compared to $11.9 million in the prior year. The increase in researchand development expenses in 2005 reflects the costs we incurred in theinitiation of a Phase II trial for Prochymal as an add-on therapy to steroidsfor the first-line treatment of acute GvHD, a Phase II trial for Prochymal fortreatment of steroid refractory GvHD, a Phase I/II clinical trial forChondrogen, and a Phase I clinical trial for Provacel during the year. Of the$16.9 million in 2005 research and development costs, approximately$7.4 million is attributable to external research and clinical trials,$3.9 million to the cost of science supplies including research materialsfor cell manufacture, media and testing supplies, $3.4 million to payrolland related expenses for personnel, and $2.2 million to facilities andequipment costs.

*General andAdministrative Expenses*

General and administrativeexpenses were $2.3 million for the year ended December 31, 2005compared to $1.7 million in the prior year. The increase in general andadministrative expenses in 2005 compared to 2004 primarily reflects the costsof our new management team. In the third quarter of 2004, our Chief ExecutiveOfficer and Chief Operating Officer joined us and, in the fourth quarter of2004, our Chief Financial Officer was hired. These three positions werepreviously vacant.

*Interest Expense,Net*

Interest expense, net was$4.3 million for the year ended December 31, 2005 compared to$0.8 million in the prior year. The increase was attributable to a higheraverage level of debt in 2005 than in the prior year. The non-cash portion ofour interest expense was $3.5 million in 2005 compared to$0.5 million in 2004.

**Liquidity andCapital Resources**

***Liquidity***

At December 31, 2006, we had $0.7 million in cashand $38.5 million in short-term investments. In addition to the cash andshort-term investments, at December 31, 2006, we had drawn only$5.0 million of the $50.0 million line of credit available for thedevelopment of Provacel under a loan agreement with a  large pharmaceutical company. This $5.0million draw occurred in March 2004. In connection with this line ofcredit, we have granted the pharmaceutical company a security interest in theintellectual property, equipment and books and records involved in thedevelopment, manufacture and distribution of Provacel. The pharmaceuticalcompany is also obligated to make additional investments in our Company and paylicensing fees up to $45.0 million to us upon completion of certainmilestones.

In addition to the$5.0 million balance on the line of credit, at December 31, 2006 ourdebt included approximately $20.0 million of convertible promissory notesdue in 2009.

***Cash Flows***

Net cash used in operating activities was$35.3 million for the twelve months ended December 31, 2006 primarilyreflecting our net loss of $45.0 million, partially offset by$5.7 million in non-cash interest $5.5 million in non-cash stock-basedcompensation expense and $1.5 million in depreciation and 

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amortization. Otherlong-term liabilities decreased by $1.9 million, reflecting the reclassificationof the accrued interest and principal on the $20.6 million convertible notepayable that was redeemed in October 2006. Net cash used for operatingactivities was $14.6 million for the twelve months ended December 31,2005. Net cash used in operating activities for 2005 primarily reflects our netloss of $20.0 million, partially offset by $3.5 million in non-cashinterest expense.

Net cash provided by investing activities was $2.6million for the twelve months ended December 31, 2006. Net cash used ininvesting activity for the twelve months ended December 31, 2005 was $43.1million. Net cash provided by investing activities in 2006 includes cash flowsfrom the sale of $40.1 million of short-term investment, largely offset by thepurchase of $35.8 million of short-term investments. In 2005, we purchased$45.0 million of short-term investments during the year. Purchases of propertyand equipment during 2006 were $1.7 million, including $0.5 million to buildout our new Columbia, Maryland facility.

Net cash provided by financing activities was $32.8million for the twelve months ended December 31, 2006. Net cash providedby financing activities was $57.8 million for the twelve months ended December 31,2005 and consisted principally of $40.0 million in net proceeds from theissuance of convertible notes and $21.4 million in net proceeds from theissuance of common and preferred stock. The cash provided by financingactivities in 2006 was primarily from the proceeds of our initial publicoffering in August 2006 and the issuance of $20.0 million of convertiblepromissory notes in October 2006, which was offset by the redemption ofthe $20.6 million convertible note, also in October 2006.

***Capital Resources.***

Our future capitalrequirements will depend on many factors, including:

·       the level of cash flowsfrom Osteocel sales;

·       the scope and results ofour research and preclinical development programs;

·       the scope and results ofour clinical trials, particularly regarding the number of patients required forour Phase III trial for Prochymal;

·       the timing of and the costsinvolved in obtaining regulatory approvals for our biologic drug candidates,which could be more lengthy or complex than obtaining approval for a newconventional drug, given the FDA’s limited experience with late-stage clinicaltrials and marketing approval for stem cell therapeutics;

·       the costs of building andoperating our manufacturing facilities, both in the near term to supportOsteocel sales and our clinical activities and also in anticipation ofexpanding our commercialization activities;

·       the costs of maintaining,expanding and protecting our intellectual property portfolio, includinglitigation costs and liabilities;

·       the costs of repaying ourdebt; and

·       the costs of enlarging ourwork force consistent with expanding our business and operations and status asa public company, and as necessary to enhance and train our sales network inanticipation of the approval of our biologic drug candidates for commercialsale.

As a result of these factors, we may need or choose toseek additional funding prior to our becoming cash flow positive on anoperational basis. We would likely seek such funding through public or privatefinancings or some combination of them. Although not our current focus, wemight also seek funding through collaborative arrangements if determined to benecessary or appropriate. Additional funding may not be available to us onacceptable terms, or at all. If we obtain capital through collaborativearrangements, these arrangements could require us to relinquish rights to ourtechnologies or biologic 

59

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drug candidates. If weraise capital through the sale of equity, or securities convertible intoequity, dilution to our then existing stockholders would result. If we raiseadditional capital through the incurrence of debt, we would likely becomesubject to covenants restricting our business activities, and holders ofdebt  instruments would have rights and privileges senior to those of ourequity investors. In addition, servicing the interest and repayment obligationsunder these borrowings would divert funds that would otherwise be available tosupport research and development, clinical or commercialization activities.

If we are unable to obtain adequate financing on atimely basis, we may be required to delay, reduce the scope of or eliminate oneor more of our programs, any of which could have a material adverse effect onour business, financial condition and results of operations.

We expect that our available cash and interest income,including the availability under our line-of-credit, will be sufficient tofinance currently planned activities through early 2008. These estimates arebased on certain assumptions, which could be negatively impacted by the mattersdiscussed under “Risk Factors.”

If adequate funds are notavailable, we may be required to delay, reduce the scope of, or eliminate oneor more of our research and development programs, which may have a materialadverse affect on our business. See “Risk Factors.”

**Off-Balance SheetArrangements.**

We have no off-balancesheet financing arrangements and we have not entered into any transactionsinvolving unconsolidated subsidiaries or special purpose entities.

**Summary Disclosuresabout Contractual Obligations and Commercial Commitments.**

Thefollowing table reflects a summary of our contractual cash obligations andother commercial commitments as of December 31, 2006:
|                                     | ** ** | **Payment Due by Fiscal Year** | ** ** |
|-------------------------------------|------------|----------------------------------------------------|------------|
| ** **                          | ** ** | ** **                                         | ** ** | **Less Than** | ** ** | ** ** | ** ** | ** ** | ** ** | **More Than** | ** ** |
| ** **                          | ** ** | **Total**                                          | ** ** | **1–Year** | ** ** | **Years 1–3** | ** ** | **Years 4–5** | ** ** | **5–Years** | ** ** |
| Long-term debt                      |       | $                                                  | 25,049     |   |   | $ | 49 |   |   |   | $ | 20,000 |   |   |   | $ | — |   |   |   | $ | 5,000 |   |   |
| Operating  lease—facilities    |       | 9,952                                              |       |   | 852 |   |   |   | 2,910 |   |   |   | 2,191 |   |   |   | 3,999 |   |   |
| Capital  leases—facilities     |       | 2,004                                              |       |   | 1,124 |   |   |   | 880 |   |   |   | — |   |   |   | — |   |   |
| Capital leases—equipment       |       | 20                                                 |       |   | 5 |   |   |   | 15 |   |   |   | — |   |   |   | — |   |   |
| Interest payments                   |       | 9,340                                              |       |   | 2,117 |   |   |   | 4,002 |   |   |   | — |   |   |   | 3,221 |   |   |
| Total contractual cash  obligations |       | $                                                  | 46,365     |   |   | $ | 4,147 |   |   |   | $ | 27,807 |   |   |   | $ | 2,191 |   |   |   | $ | 12,220 |   |   |

 

**Item 7A.**                Quantitativeand Qualitative Disclosures About Market Risk

Due to the short duration of our investment portfolioand the high quality of our investments, an immediate 10% change in interestrates would not have a material effect on the fair market value of ourportfolio. Therefore, we would not expect our operating results or cash flowsto be affected to any significant degree by the effect of a sudden change inmarket interest rates on our securities portfolio.

We believe that the interest rate risk related to ouraccounts receivable is not significant. We manage the risk associated withthese accounts through periodic reviews of the carrying value fornon-collectability and establishment of appropriate allowances in connectionwith our internal controls and policies.

We do not enter into hedging or derivative instrumentarrangements.

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**Item 8.**                        FinancialStatements and Supplementary Data

**Osiris Therapeutics, Inc.**

**FinancialStatements**

**INDEX**

|                                                                                                                | ** ** | **Page** | ** ** |
|----------------------------------------------------------------------------------------------------------------|------------|----------|------------|
| Report of Independent Registered Public Accounting  Firm                                                       |       | 62       |       |
| Balance Sheets at December 31, 2006 and 2005                                                              |       | 63       |       |
| Statements of Operations for the fiscal years ended  December 31, 2006, 2005 and 2004                     |       | 64       |       |
| Statements of Stockholders’ Equity (Deficit) for the  years ended December 31, 2006, 2005   and 2004 |       | 65       |       |
| Statements of Cash Flows for the years ended  December 31, 2006, 2005 and 2004                            |       | 67       |       |
| Notes  to Financial Statements                                                                                 |       | 69       |       |

 

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**REPORT OFINDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**

Board of Directors and StockholdersOsiris Therapeutics, Inc.Baltimore, Maryland

We have audited the accompanying balance sheets ofOsiris Therapeutics, Inc. as of December 31, 2006 and 2005, and therelated statements of operations, stockholders’ equity (deficit) and cash flowsfor each of the three years in the period ended December 31, 2006. Thesefinancial statements are the responsibility of the Company’s management. Ourresponsibility is to express an opinion on these financial statements based onour audits.

We conducted our audits in accordance with thestandards of the Public Company Accounting Oversight Board (United States). Thosestandards require that we plan and perform the audit to obtain reasonableassurance about whether the financial statements are free of materialmisstatement. An audit includes examining, on a test basis, evidence supportingthe amounts and disclosures in the financial statements. An audit also includesassessing the accounting principles used and significant estimates made bymanagement, as well as evaluating the overall financial statement presentation.We believe that our audits provide a reasonable basis for our opinion.

In our opinion, thefinancial statements referred to above present fairly, in all materialrespects, the financial position of Osiris Therapeutics, Inc. as of December 31,2006 and 2005, and its results of its operations and its cash flows for each ofthe three years in the period ended December 31, 2006, in conformity withaccounting principles generally accepted in the United States of America.

/s/ STEGMAN &COMPANY

Baltimore, MarylandMarch 14, 2007

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**OSIRISTHERAPEUTICS, INC.BALANCE SHEETS(amounts in thousands)**

| ** **                                                                                                                                                    | ** ** | **December 31,** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                    | ** ** | **2006**              | ** ** | **2005** | ** ** |
| **ASSETS**                                                                                                                                                    |       |                  |       |   |   |
| Current assets:                                                                                                                                               |       |                  |       |   |   |
| Cash                                                                                                                                                          |       | $                     | 714        |   | $ | 597 |   |
| Short-term investments                                                                                                                                        |       | 38,467                |       | 42,774 |   |
| Accounts receivable                                                                                                                                           |       | 1,596                 |       | 974 |   |
| Inventory                                                                                                                                                     |       | 1,892                 |       | 101 |   |
| Other current assets                                                                                                                                          |       | 966                   |       | 266 |   |
| Total current assets                                                                                                                                          |       | 43,635                |       | 44,712 |   |
| Property and equipment, net                                                                                                                                   |       | 3,942                 |       | 3,792 |   |
| Restricted cash                                                                                                                                               |       | 297                   |       | 190 |   |
| Deferred  financing costs, net                                                                                                                                |       | 567                   |       | 2,050 |   |
| Other assets                                                                                                                                                  |       | 727                   |       | 270 |   |
| Total assets                                                                                                                                                  |       | $                     | 49,168     |   | $ | 51,014 |   |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY (DEFICIT)**                                                                                                      |       |                  |       |   |   |
| Current liabilities:                                                                                                                                          |       |                  |       |   |   |
| Accounts payable and accrued expenses                                                                                                                         |       | $                     | 8,339      |   | $ | 4,565 |   |
| Note payable, current portion                                                                                                                                 |       | 49                    |       | 65 |   |
| Capital lease obligations, current portion                                                                                                                    |       | 1,129                 |       | 1,027 |   |
| Deferred revenue, current portion                                                                                                                             |       | 952                   |       | 952 |   |
| Total current liabilities                                                                                                                                     |       | 10,469                |       | 6,609 |   |
| Notes payable and long-term line-of-credit, net of  current portion                                                                                           |       | 25,000                |       | 47,411 |   |
| Capital lease  obligations, net of current portion                                                                                                            |       | 895                   |       | 2,024 |   |
| Deferred revenue,  net of current portion                                                                                                                     |       | 397                   |       | 1,349 |   |
| Long-term  interest payable and other liabilities                                                                                                             |       | 1,120                 |       | 3,016 |   |
| Mandatorily  redeemable convertible preferred stock Series D 3,750 shares designated,  3,213 shares issued and outstanding in 2005                       |       | —                |       | 64,267 |   |
| Total liabilities                                                                                                                                             |       | 37,881                |       | 124, 676 |   |
| Stockholders’  equity (deficit):                                                                                                                         |       |                  |       |   |   |
| Convertible Preferred Stock, issuable in series,  $0.001 par value, 16,250 shares authorized, 12,250 shares designated and  10,651 shares outstanding in 2005 |       | —                |       | 32,746 |   |
| Common stock, $.001 par value, 90,000 shares  authorized 27,321 and 9,098 shares outstanding in 2006 and 2005                                                 |       | 27                    |       | 9 |   |
| Additional paid-in-capital                                                                                                                                    |       | 198,763               |       | 36,127 |   |
| Accumulated deficit                                                                                                                                           |       | (187,503              | )          | (142,544 | ) |
| Total stockholders’ equity (deficit)                                                                                                                     |       | 11,287                |       | (73,662 | ) |
| Total liabilities  and stockholders’ equity (deficit)                                                                                                    |       | $                     | 49,168     |   | $ | 51,014 |   |

 

The accompanying notes are an integral part of thesefinancial statements.

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**OSIRISTHERAPEUTICS, INC.STATEMENTS OF OPERATIONS(amounts in thousands, except per share data)**

| ** **                                                                     | ** ** | **Years Ended December 31,** | ** ** |
|--------------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                                     | ** ** | **2006**                                    | ** ** | **2005** | ** ** | **2004** | ** ** |
| Product Sales                                                                  |       | $                                           | 8,291      |   | $ | 957 |   | $ | — |   |
| Cost of goods sold                                                             |       | 3,697                                       |       | 444 |   | — |   |
| Gross profit                                                                   |       | 4,594                                       |       | 513 |   | — |   |
| Revenue from collaborative research licenses and  grants                       |       | 1,181                                       |       | 3,013 |   | 3,911 |   |
| Operating  expenses:                                                           |       |                                        |       |   |   |   |   |
| Research and development                                                       |       | 37,590                                      |       | 16,927 |   | 11,888 |   |
| General and administrative                                                     |       | 4,340                                       |       | 2,229 |   | 1,641 |   |
| Fees paid to  related parties                                                  |       | 451                                         |       | 65 |   | 63 |   |
| Share-based  payment to related party                                          |       | 3,668                                       |       | — |   | — |   |
| Total operating expenses                                                       |       | 46,049                                      |       | 19,221 |   | 13,592 |   |
| Loss from operations                                                           |       | (40,274                                     | )          | (15,695 | ) | (9,681 | ) |
| Interest income  (expense):                                                    |       |                                        |       |   |   |   |   |
| Interest income                                                                |       | 2,069                                       |       | 504 |   | 25 |   |
| Interest expense                                                               |       | (6,754                                      | )          | (4,804 | ) | (872 | ) |
| Total interest expense, net                                                    |       | (4,685                                      | )          | (4,300 | ) | (847 | ) |
| Net loss                                                                       |       | $                                           | (44,959    | ) | $ | (19,995 | ) | $ | (10,528 | ) |
| Basic and diluted net loss per share                                           |       | $                                           | (2.70      | ) | $ | (2.23 | ) | $ | (1.19 | ) |
| Weighted average  common shares outstanding, in thousands  (basic and diluted) |       | 16,663                                      |       | 8,959 |   | 8,814 |   |

 

The accompanying notes are an integral part of thesefinancial statements.

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**OSIRIS THERAPEUTICS, INC. STATEMENTS OF STOCKHOLDERS’ EQUITY (DEFICIT) (amounts in thousands, except for share data)**

| ** **                                                                                                               | ** ** | **Convertible   Preferred Stock** | ** ** | **Common Stock** | ** ** | **Additional   Paid-in** | ** ** | **Deferred** | ** ** | **Accumulated** | ** ** | **Total   Stockholders’   Equity** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------------|------------|-----------------------|------------|--------------------------|------------|--------------|------------|-----------------|------------|-----------------------------------------|------------|
| ** **                                                                                                               | ** ** | **Shares**                             | ** ** | **Amount**            | ** ** | **Shares**               | ** ** | **Amount**   | ** ** | **Capital**     | ** ** | **Compensation**                        | ** ** | **Deficit** | ** ** | **(Deficit)** | ** ** |
| **Balance at January 1, 2004**                                                                                      |       | 2,545,454                              |       | $                     | 13,000     |                     | 8,748,703  |         |       | $               | 9          |                                    |       |   | $ | 93,708 |   |   |   | $ | (259 | ) |   |   | $ | (112,021 | ) |   |   | $ | (5,563 | ) |   |
| Exercise of options to purchase common stock ($0.40  to $0.80 per share)                                                 |       | —                                 |       | —                |       | 36,405                   |       |         | —     |            |       |                                    | 16         |   |   |   | — |   |   |   | — |   |   |   | 16 |   |   |
| Share based payment—director services ($0.40 per  share)                                                            |       | —                                 |       | —                |       | 12,500                   |       |         | —     |            |       |                                    | 5          |   |   |   | — |   |   |   | — |   |   |   | 5 |   |   |
| Issuance of common stock to settle lawsuit ($0.40 per  share)                                                            |       | —                                 |       | —                |       | 93,750                   |       |         | —     |            |       |                                    | 38         |   |   |   | — |   |   |   | — |   |   |   | 38 |   |   |
| Issuance of common stock to settle debt ($18.00 per   share)                                                             |       | —                                 |       | —                |       | 9.000                    |       |         | —     |            |       |                                    | 162        |   |   |   | — |   |   |   | — |   |   |   | 162 |   |   |
| Issuance of convertible preferred stock,  Series C ($4.50 per share)                                                |       | 548,090                                |       | 2,243                 |       | —                   |       |         | —     |            |       |                                    | —     |   |   |   | — |   |   |   | — |   |   |   | 2,243 |   |   |
| Fair value of warrants issued in connection with  financing arrangements                                                 |       | —                                 |       | —                |       | —                   |       |         | —     |            |       |                                    | 400        |   |   |   | — |   |   |   | — |   |   |   | 400 |   |   |
| Forfeiture of stock options                                                                                              |       | —                                 |       | —                |       | —                   |       |         | —     |            |       |                                    | (10        | ) |   |   | 10 |   |   |   | — |   |   |   | — |   |   |
| Amortization of deferred compensation from stock  option grants                                                          |       | —                                 |       | —                |       | —                   |       |         | —     |            |       |                                    | 67         |   |   |   | 37 |   |   |   | — |   |   |   | 104 |   |   |
| Write-off of stockholder loans receivable                                                                                |       | —                                 |       | —                |       | —                   |       |         | —     |            |       |                                    | —     |   |   |   | 119 |   |   |   | — |   |   |   | 119 |   |   |
| Net loss                                                                                                                 |       | —                                 |       | —                |       | —                   |       |         | —     |            |       |                                    | —     |   |   |   | — |   |   |   | (10,528 | ) |   |   | (10,528 | ) |   |
| **Balance at December 31,   2004**                                                                                  |       | 3,093,544                              |       | 15,243                |       | 8,900,358                |       |         | 9          |            |       |                                    | 94,386     |   |   |   | (93 | ) |   |   | (122,549 | ) |   |   | (13,004 | ) |   |
| Exercise of options to purchase common stock ($0.40  to $0.80 per share)                                                 |       | —                                 |       | —                |       | 27,148                   |       |         | —     |            |       |                                    | 12         |   |   |   | — |   |   |   | — |   |   |   | 12 |   |   |
| Share-based payment—director services ($0.40 per  share)                                                            |       | —                                 |       | —                |       | 45,000                   |       |         | —     |            |       |                                    | 18         |   |   |   | — |   |   |   | — |   |   |   | 18 |   |   |
| Conversion of restricted stock units to management  ($0.40 per share)                                                    |       | —                                 |       | —                |       | 125,000                  |       |         | —     |            |       |                                    | 50         |   |   |   | — |   |   |   | — |   |   |   | 50 |   |   |
| Issuance of convertible preferred stock,  Series E ($2.50 per share)                                                |       | 7,557,000                              |       | 17,503                |       | —                   |       |         | —     |            |       |                                    | —     |   |   |   | — |   |   |   | — |   |   |   | 17,503 |   |   |
| Redemption premium on mandatorily redeemable  convertible preferred stock, Series D, redeemable at $20.00 per share |       | —                                 |       | —                |       | —                   |       |         | —     |            |       |                                    | (58,305    | ) |   |   | — |   |   |   | — |   |   |   | (58,305 | ) |   |
| Deferred compensation from stock option grants                                                                           |       | —                                 |       | —                |       | —                   |       |         | —     |            |       |                                    | 247        |   |   |   | (247 | ) |   |   | — |   |   |   | — |   |   |
| Forfeiture of stock options                                                                                              |       | —                                 |       | —                |       | —                   |       |         | —     |            |       |                                    | (17        | ) |   |   | 17 |   |   |   | — |   |   |   | — |   |   |
| Amortization of deferred compensation from stock  option grants                                                          |       | —                                 |       | —                |       | —                   |       |         | —     |            |       |                                    | 13         |   |   |   | 46 |   |   |   | — |   |   |   | 59 |   |   |
| Net loss                                                                                                                 |       | —                                 |       | —                |       | —                   |       |         | —     |            |       |                                    | —     |   |   |   | — |   |   |   | (19,995 | ) |   |   | (19,995 | ) |   |
|                                                                                                                          |            |                                        |            |                       |            |                          |            |              |            |                 |            |                                         |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

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**OSIRIS THERAPEUTICS, INC. STATEMENTS OF STOCKHOLDERS’ EQUITY (DEFICIT)  (Continued) (amounts in thousands, except for share data)**

 

| **Balance at December 31,   2005**                                 |   | 10,650,544  |   | 32,746  |   | 9,097,506 |       |   | 9      |   |   |   | 36,404 |   |   |    | (277   | )      |   |   | (142,544 | )      |   |   | (73,662 | )        |   |
|-------------------------------------------------------------------------|--------|-------------|--------|---------|--------|-----------|------------|--------|--------|--------|--------|--------|--------|--------|--------|---------|--------|--------|--------|--------|----------|--------|--------|--------|---------|----------|--------|
| Exercise of options to purchase common stock ($0.40-$0.80  per share)   |   | —      |   | —  |   | 178,378   |       |   | — |   |   |   | 73     |   |   |    | — |   |   |   | —   |   |   |   | 73      |     |   |
| Exercise of warrants to purchase common stock ($0.40  per share)        |   | —      |   | —  |   | 875,000   |       |   | 1      |   |   |   | 349    |   |   |    | — |   |   |   | —   |   |   |   | 350     |     |   |
| Share-based payment—director services ($6.84 - $11.00  per share)  |   | —      |   | —  |   | 22,807    |       |   | — |   |   |   | 198    |   |   |    | — |   |   |   | —   |   |   |   | 198     |     |   |
| Share-based payment—consulting services ($6.84 per  share)         |   | —      |   | —  |   | 6,250     |       |   | — |   |   |   | 43     |   |   |    | — |   |   |   | —   |   |   |   | 43      |     |   |
| Reclassification due to adoption of new accounting  standard            |   | —      |   | —  |   | —    |       |   | — |   |   |   | (277   | )      |   |    | 277    |   |   |   | —   |   |   |   | —  |     |   |
| Initial public offering of common stock, net of  offering costs         |   | —      |   | —  |   | 3,500,000 |       |   | 3      |   |   |   | 34,399 |   |   |    | — |   |   |   | —   |   |   |   | 34,402  |     |   |
| Conversion of convertible preferred stock into common  stock            |   | (10,650,544 | )      | (32,746 | )      | 2,833,914 |       |   | 3      |   |   |   | 32,743 |   |   |    | — |   |   |   | —   |   |   |   | —  |     |   |
| Conversion of mandatorily redeemable preferred stock  into common stock |   | —      |   | —  |   | 8,033,388 |       |   | 8      |   |   |   | 64,259 |   |   |    | — |   |   |   | —   |   |   |   | 64,267  |     |   |
| Conversion of convertible notes payable into common   stock             |   | —      |   | —  |   | 2,774,076 |       |   | 3      |   |   |   | 25,320 |   |   |    | — |   |   |   | —   |   |   |   | 25,323  |     |   |
| Share-based payment—employee compensation                          |   | —      |   | —  |   | —    |       |   | — |   |   |   | 1,725  |   |   |    | — |   |   |   | —   |   |   |   | 1,725   |     |   |
| Share-based payment—related party                                  |   | —      |   | —  |   | —    |       |   | — |   |   |   | 3,527  |   |   |    | — |   |   |   | —   |   |   |   | 3,527   |     |   |
| Net loss                                                                |   | —      |   | —  |   | —    |       |   | — |   |   |   | — |   |   |    | — |   |   |   | (44,959  | )      |   |   | (44,959 | )        |   |
| **Balance  at December 31,   2006**                                |   | —      |   | $       | — |      | 27,321,319 |   |   | $      | 27     |   |   |   | $      | 198,763 |   |   |   | $      | —   |   |   |   | $       | (187,503 | )      |   |   | $ | 11,287 |   |   |
|                                                                         |        |             |        |         |        |           |            |        |        |        |        |        |        |        |        |         |        |        |        |        |          |        |        |        |         |          |        |  |  |  |  |  |  |

 

The accompanying notes are an integral part of thesefinancial statements.

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**OSIRIS THERAPEUTICS, INC. STATEMENTS OF CASH FLOWS (amounts in thousands)**

| ** **                                                                       | ** ** | **Years Ended December 31,** | ** ** |
|----------------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                                       | ** ** | **2006**                                    | ** ** | **2005** | ** ** | **2004** | ** ** |
| **Cash flows from operating  activities:**                                       | ** ** | ** **                                  | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net loss                                                                         |       | $                                           | (44,959    | ) | $ | (19,995 | ) | $ | (10,528 | ) |
| **Adjustments  to reconcile net loss to net cash used in operating activities:** | ** ** | ** **                                  | ** ** | ** ** | ** ** | ** ** | ** ** |
| Depreciation and amortization                                                    |       | 1,546                                       |       | 1,515 |   | 1,790 |   |
| Non cash share-based payments                                                    |       | 5,494                                       |       | 109 |   | 104 |   |
| Stockholder loan write-off                                                       |       | —                                      |       | — |   | 119 |   |
| Non cash interest expense                                                        |       | 5,653                                       |       | 3,497 |   | 523 |   |
| **Changes  in operating assets and liabilities:**                                | ** ** | ** **                                  | ** ** | ** ** | ** ** | ** ** | ** ** |
| Accounts receivable                                                              |       | (622                                        | )          | (913 | ) | (1,102 | ) |
| Inventory and other current assets                                               |       | (2,491                                      | )          | (276 | ) | 14 |   |
| Other assets                                                                     |       | (457                                        | )          | (120 | ) | 47 |   |
| Accounts payable and accrued expenses                                            |       | 3,374                                       |       | 1,875 |   | (1,789 | ) |
| Deferred revenue                                                                 |       | (952                                        | )          | (952 | ) | (2,952 | ) |
| Long-term interest and other liabilities                                         |       | (1,896                                      | )          | 640 |   | (562 | ) |
| Net cash used in operating activities:                                           |       | (35,310                                     | )          | (14,620 | ) | (12,132 | ) |
| **Cash  flows from investing activities:**                                       | ** ** | ** **                                  | ** ** | ** ** | ** ** | ** ** | ** ** |
| Purchases of property and equipment                                              |       | (1,696                                      | )          | (338 | ) | (50 | ) |
| Proceeds from sale of short-term investments                                     |       | 40,112                                      |       | 2,200 |   | — |   |
| Purchase of short-term investments                                               |       | (35,805                                     | )          | (44,974 | ) | — |   |
| Net cash provide by (used in) investing activities                               |       | 2,611                                       |       | (43,112 | ) | (50 | ) |
| **Cash  flows from financing activities:**                                       | ** ** | ** **                                  | ** ** | ** ** | ** ** | ** ** | ** ** |
| Principal payments on capital lease obligations and  notes payable               |       | (21,692                                     | )          | (1,000 | ) | (845 | ) |
| Restricted cash                                                                  |       | (107                                        | )          | 23 |   | 22 |   |
| Proceeds from convertible notes payable                                          |       | 20,000                                      |       | 39,957 |   | 9,690 |   |
| Proceeds from the issuance of common and preferred  stock, net of offering costs |       | 34,824                                      |       | 21,360 |   | 2,464 |   |
| Payment of debt financing costs                                                  |       | (209                                        | )          | (2,499 | ) | — |   |
| Net cash provided by financing activities                                        |       | 32,816                                      |       | 57,841 |   | 11,331 |   |
| Net increase in cash                                                             |       | 117                                         |       | 109 |   | (851 | ) |
| Cash at beginning  of year                                                       |       | 597                                         |       | 488 |   | 1,339 |   |
| **Cash at  end of year**                                                         |       | $                                           | 714        |   | $ | 597 |   | $ | 488 |   |

 

The accompanying notes arean integral part of these financial statements.

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**OSIRIS THERAPEUTICS, INC. STATEMENTS OF CASH FLOWS (Continued) (amounts in thousands)**

 

| ** **                                                                                                                                                  | ** ** | **Years Ended December 31,** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                                                                                                                  | ** ** | **2006**                                    | ** ** | **2005** | ** ** | **2004** | ** ** |
| **Supplemental disclosure of cash  flows information:**                                                                                                     | ** ** | ** **                                  | ** ** | ** ** | ** ** | ** ** | ** ** |
| Cash paid for interest                                                                                                                                      |       | $                                           | 1,260      |   | $ | 448 |   | $ | 349 |   |
| Cash paid for taxes                                                                                                                                         |       | —                                      |       | — |   | — |   |
| **Supplemental  schedule of non cash investing and financing activities:**                                                                                  | ** ** | ** **                                  | ** ** | ** ** | ** ** | ** ** | ** ** |
| Conversion of notes payable to common stock                                                                                                                 |       | 21,762                                      |       | — |   | — |   |
| Conversion of related parties notes payable to  Series D Mandatorily Redeemable Convertible Preferred Stock                                                 |       | —                                      |       | 2,350 |   | — |   |
| Conversion of accrued interest into common stock                                                                                                            |       | 3,558                                       |       | — |   | — |   |
| Conversion of related party convertible notes  payable accrued interest and premium into Series D Mandatorily  Redeemable Convertible  Preferred Stock |       | —                                      |       | 355 |   | — |   |
| Common stock issued to settle lawsuit                                                                                                                       |       | —                                      |       | — |   | 38 |   |
| Common stock issued to settle debt                                                                                                                          |       | —                                      |       | — |   | 162 |   |
| Share-based payment—related party for financing  services                                                                                              |       | 3,527                                       |       | — |   | — |   |
| Redemption  premium on Series D Mandatorily Redeemable Convertible Preferred Stock                                                                     |       | —                                      |       | 58,305 |   | — |   |
|                                                                                                                                                             |            |                                             |            |  |  |  |  |  |  |  |

 

The accompanying notes are an integral part of thesefinancial statements.

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**OSIRIS THERAPEUTICS, INC.NOTES TO FINANCIAL STATEMENTSYEARS ENDED DECEMBER 31, 2007 AND 2006(amounts in thousands, except for share and per share data)**

**1.   InitialPublic Offering, Non-Cash Charges and Reverse Stock Split**

On August 9, 2006, we consummated our initialpublic offering, consisting of 3,500,000 shares of common stock at a publicoffering price of $11.00, resulting in net proceeds to us of approximately$34.4 million (after deducting payment of underwriters discounts andcommissions, as well as offering expenses). Our common stock began trading onthe NASDAQ Global Market on August 4, 2006.

In connection with the initial public offering, theCompany effected a 1-for-4 reverse stock split of the issued andoutstanding common stock. Information relating to common stock and commonstock-equivalents set forth in this report (including the share numbers in thepreceding paragraph) have been restated to reflect this split for all periodspresented. Upon consummation of the initial public offering, all outstandingshares of the Class I, Series 2003, Series B, Series C, Series Eand the Mandatorily Redeemable Series D convertible preferred stock wereconverted into an aggregate of 10,867,302 shares of our common stock. Inaddition, approximately $21.8 million of our convertible notes payable,together with accrued interest, were converted into an aggregate of 2,774,076shares of our common stock.

Immediately following the initial public offering, wehad 27,198,307 shares of common stock outstanding.

We incurred $7.0 million in non-cash charges relatingto the completion of the initial public offering. Included in General andAdministrative expenses is a charge of $0.8 million for stock-basedcompensation related to the accelerated vesting of certain employee stockoptions pursuant to employment agreements. We also recognized a $3.5 millionshare-based payment to related party related to warrants that were priced uponthe completion of the initial public offering and $0.2 million in share-basedcompensation for stock awarded to our directors for service on our board.Interest expense includes $2.7 million in previously deferred financing costsand premiums that were expensed as a result of debt that was converted intocommon stock at the completion of the initial public offering.

In the fourth quarter of2006, we incurred $0.7 million in non-cash interest expense as a result of theearly redemption of debt, as discussed more fully in Note 4.

**2.   Descriptionof Business and Significant Accounting Policies**

***Description of business***

Osiris Therapeutics, Inc. (the “Company”) is aDelaware corporation headquartered in Baltimore, Maryland. We began operationson December 23, 1992. The Company is a clinical stage biotechnologycompany founded to commercialize stem cell products from adult bone marrow. Welaunched our first commercial product in July 2005. Our operations consistprimarily of research, development and clinical activities to bring ourbiologic drug candidates to the marketplace and efforts to secure adequatecapital for anticipated growth and operations. Prior to 2005, we presented ourfinancial statements as a development stage company.

We are dependent upon the registration of our coreproducts for sale before we can expand our commercial operations. We expect tosubmit product applications for approval with the United States Food and DrugAdministration (“FDA”) in the future and plan to continue to seek additionalequity and debt financing as the need arises. We believe our long-term cash positionis inadequate to fund all of the 

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costs associated with thefull range of testing and clinical trials required by the FDA for our coreproducts. We expect that our available cash and interest income, including theavailability under our line-of-credit, will be sufficient to finance currentlyplanned activities through early 2008.. We have several research collaborationagreements that provide funding.

No assurance can be giventhat (i) we will be able to expand our operations prior to FDA approval ofour biologic drug candidates, or (ii) that FDA approval will ever begranted for our biologic drug candidates.

***Use of estimates***

The preparation offinancial statements in conformity with accounting principles generallyaccepted in the United States requires management to make estimates andassumptions that affect the amounts reported in the financial statements andaccompanying notes. Due to the inherent uncertainty involved in making thoseassumptions, actual results could differ from those estimates. We believe thatthe most significant estimates that affect our financial statements are thosethat relate to revenue recognition, deferred tax assets, and stock-basedcompensation.

***Short-term investments***

Short-term investmentsconsist primarily of investment grade auction rate certificates with maturitiesof less than three months. Short-term investments are valued at cost, whichapproximates their fair value.

***Accounts Receivable***

Our accounts receivableare reported at their net realizable value. As of December 31, 2006 and2005, there was no allowance for doubtful accounts as we believe the reportedamounts are fully collectible. During the year ended December 31, 2006, werecognized $3 of bad debt expense. We did not recognize any bad debts expensein 2005. Accounts receivable balances are not collateralized.

***Inventory***

We commenced sales of ourfirst commercial product in July 2005 and began carrying inventory on ourbalance sheet thereafter. Inventory consists of tissue products in process andavailable for distribution. We determine our inventory values using thefirst-in, first-out method. Inventory of supplies purchased to manufacture ofbiologic drug candidates and manufactured biologic drug candidate doses arepresently used exclusively for research and development activities, includingclinical trials. These items are expensed as incurred, consistent with ouraccounting for all other research and development costs.

***Property and equipment***

We record property andequipment, including improvements that extend useful lives, at cost, whilemaintenance and repairs are charged to operations as incurred. We calculatedepreciation using the straight-line method based on estimated useful livesranging from three to seven years for furniture, equipment and internal usesoftware. We amortize leasehold improvements and assets under capital leasesover the shorter of the estimated useful life of the asset or the lease term.

***Valuation of long-lived assets***

We review long-lived assets for impairment wheneverevents or changes in circumstances indicate that the carrying amount of anasset or group of assets may not be fully recoverable. These events or changesin circumstances may include a significant deterioration of operating results,changes in business plans, or changes in anticipated future cash flows. If animpairment indicator is present, we evaluate recoverability 

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by a comparison of thecarrying amount of the assets to future undiscounted net cash flows we expectthe assets to generate. We group assets at the lowest level for which there isidentifiable cash flows that are largely independent of the cash flowsgenerated by other asset groups. If the total of the expected undiscountedfuture cash flows is less than the carrying amount of the asset, an impairmentloss is recognized for the difference between the fair value and carrying valueof assets. Fair value is generally determined by estimates of discounted cashflows. The discount rate used in any estimate of discounted cash flows would bethe rate required for a similar investment of like risk. There were noimpairment losses recognized during the years 2006, 2005 or 2004.

Assets to be disposed ofare reported at the lower of carrying values or fair values, less estimatedcosts of disposal.

***Deferred financing costs***

We amortize the costs weincur to obtain debt financing over the terms of the underlying obligationsusing the effective interest method. The amortization of debt financing costsis included in interest expense. In 2006, we refinanced a $20.6 million convertiblepromissory note to a foreign investor, and we converted $21.8 million ofconvertible debt into common stock concurrent with our initial public offering.In connection with these transactions, in 2006, we recognized $2.1 million ininterest expense for the deferred costs associated with these instruments,which were paid off. In 2005, we recognized $476 in interest expense from theamortization of these costs.

***Revenue recognition***

Our revenue recognition policies are in accordancewith the Securities and Exchange Commission’s (SEC) Staff Accounting Bulletin No. 101,*Revenue Recognition in Financial Statements*,as amended by SEC Staff Accounting Bulletin No. 104, *Revenue Recognition*.

In July 2005, we launched our first commercialproduct, Osteocel. We recognize revenue on Osteocel sales when legal title tothe product has passed to the customer, which is generally when the product isshipped from our Baltimore, MD facilities. We have agreements with ourcustomers that specify the terms of sale, including price. During 2006 and2005, sales of our Osteocel product were primarily to two customers. We haveentered into several strategic agreements with other pharmaceutical companiesfocusing on the development and commercialization of our stem cell drug products.In 2003, we entered into such an agreement with Boston Scientific Corporationpertaining to our cardiac drug development and we received a $5 millionfee for licensing the use of our technology. This fee is being recognized asrevenue over a 63-month period, $952 of which was recognized in each of2006, 2005 and 2004. Also in 2003, we entered into a similar agreement with JCRPharmaceuticals Co., Ltd. (“JCR”) pertaining to our hematologicmalignancies drugs for distribution in Japan. We recognized $500 of revenue in2005 and $2 million in 2004 from the JCR agreement.

Revenues from collaborative research licenses andgrants are recognized as earned upon either the incurring of reimbursableexpenses directly related to the particular research plan or the completion ofcertain development milestones as defined within the terms of the collaborativeagreement. Payments received in advance of research performed are designated asdeferred revenue. We recognize non-refundable upfront license fees and certainother related fees on a straight-line basis over the development period. Feesassociated with substantive at risk, performance based milestones arerecognized as revenue upon their completion, as defined in the respectiveagreements. Incidental assignment of technology rights is recognized as revenueas earned and was received from an unrelated third party.

Historically, we have alsorecognized revenue from governmental grants for research products and in 2005we recorded $1.4 million in grant revenue as we completed work on threeseparate grants. In 2004, we earned $844 from governmental research grants.Revenue from research grants is recognized as the related 

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researchexpenditures are incurred. The Company no longer solicits governmental grants,and did not recognize any revenue from grants during 2006.

***Cost of Goods Sold***

In July 2005, welaunched Osteocel. Costs of goods sold consist primarily of the costs to obtainthe tissue and other chemicals and supplies, plus labor and allocated overheadcosts and the costs of operating the clean-room facilities.

***Research and development costs***

Research and developmentcosts are expensed as incurred.

***Income taxes***

Deferred tax liabilitiesand assets are recognized for the estimated future tax consequences oftemporary differences, income tax credits and net operating losscarry-forwards. Temporary differences are primarily the result of thedifferences between the tax bases of assets and liabilities and their financialreporting values. Deferred tax liabilities and assets are measured by applyingthe enacted statutory tax rates applicable to the future years in whichdeferred tax liabilities or assets are expected to be settled or realized.Valuation allowances are established when necessary to reduce deferred taxassets to the amount expected to be realized. Income tax expense, if any,consists of the taxes payable for the current period and the change during theperiod in deferred tax assets and liabilities. For all periods presented,valuation allowances have been provided for the full amount of net deferred taxassets and no income tax expense or benefit has been recognized.

***Business Segments***

Statement of FinancialAccounting Standards No. 131 *Disclosuresabout Segments of an Enterprise and Related Information* (“SFAS No. 131”)established standards for reporting information about operating segments inannual financial statements of public enterprises and in interim financialreports issued to stockholders. It also established standards for relateddisclosures about products and services, geographic areas and major customers.The Company currently operates as one business segment that producescommercialized stem cell products.

***Comprehensive income***

In 2006, 2005 and 2004,except for our net loss, we did not have any components of comprehensive incomeas defined in the accounting literature.

***Loss per Common Share***

Basic loss per commonshare is calculated by dividing net loss by the weighted average number ofcommon shares outstanding during the period. Diluted loss per common shareadjusts basic loss per share for the potentially dilutive effects of sharesissuable under our stock option plan, and the conversion of our preferred stockand convertible debt, using the treasury stock method. Common equivalent sharesfrom the conversion of preferred stock and convertible debt and the exercise ofstock options and warrants are excluded from the computation of diluted lossper share as their effect is anti-dilutive. Since our initial public offeringin August 2006, the market value of our common stock is determined basedupon the closing price on the NASDAQ Global Market. Prior to August 2006when our common stock started publicly trading, our Board of Directorsdetermined the fair value of our common stock.

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***Stock-Based Compensation***

Prior to January 1, 2006, we accounted forshare-based compensation in accordance with Accounting Principles Board OpinionNo. 25, (“ABP 25”) “Accounting for Stock Issued to Employees,” and relatedinterpretations. We also followed the disclosure requirements of SFAS No. 123,“Accounting for Stock-Based Compensation,” as amended by SFAS No. 148, “Accountingfor Stock-Based Compensation—Transition and Disclosure.” As a result, noexpense was recognized for options to purchase our common stock that weregranted with an exercise price equal to fair market value at the day of thegrant. Effective January 1, 2006, we adopted the provisions of SFAS No. 123R,“Share-Based Payment,” which establishes accounting for equity instrumentsexchanged for services. Under the provisions of SFAS No. 123R, share-basedcompensation cost is measured at the grant date, based on the fair value of theaward, and is recognized as expense over the employee’s requisite serviceperiod (generally the vesting period of the equity grant). We elected themodified prospective transition method as provided by SFAS No. 123R and,accordingly, financial statement amounts for the prior periods presented inthis Form 10-K have not been restated to reflect the fair valuemethod of expensing share-based compensation.

As a result of adopting SFAS No. 123R on January 1,2006, our net income for the year ended December 31, 2006 was $5.5 millionlower than had we continued to account for stock-based compensation under ABP No. 25.Net loss per common share for the year ended December 31, 2006, wasincreased by $0.33 by the adoption of SFAS No. 123R.

Thefollowing table illustrates the effect on net loss and net loss per share ifthe Company had applied the fair value recognition provisions of SFAS No. 123,“Accounting for Stock-Based Compensation” for periods prior to January 1,2006.

| ** **                                                                                              | ** ** | **Years ended December 31,**                                      | ** ** |
|---------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------------|------------|
| ** **                                                                                              | ** ** | **      2005      ** | ** ** | **      2004      ** | ** ** |
| Net loss, as  reported                                                                                  |       |                                                                             | $          | (19,995 | ) |   |   | $ | (10,528 | ) |   |
| Add stock-based employee compensation included in  reported net loss                                    |       |                                                                             | 109        |   |   |   | 104 |   |   |
| Deduct total stock-based employee compensation determined  under fair-value-based method for all awards |       |                                                                             | (8         | ) |   |   | (46 | ) |   |
| Pro forma net  loss                                                                                     |       |                                                                             | $          | (19,894 | ) |   |   | $ | (10,470 | ) |   |
| Basic and diluted  loss per share, as reported                                                          |       |                                                                             | $          | (2.23 | ) |   |   | $ | (1.19 | ) |   |
| Basic and diluted loss  per share, pro forma                                                            |       |                                                                             | $          | (2.23 | ) |   |   | $ | (1.19 | ) |   |

 

Certain employee options outstanding at the beginningof 2003 were repriced to below their initial exercise price and hence aresubject instead to the variable method of accounting. These options give riseto compensation expense in accordance with APB No. 25.

The pro forma impact of applying the fair value methodprescribed by SFAS No. 123 to historical financial results is notrepresentative of the impact that may be expected in the future due to changesresulting from additional grants in future years and changes in assumptionssuch as volatility, interest rates and expected life used to estimate fairvalue of the grants in future years.

Share-basedcompensation expense included in the accompanying statements of operations was:

| ** **                  | ** ** | **Year ended December 31,** | ** ** |
|-----------------------------|------------|--------------------------------------------|------------|
| ** **                  | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
| Cost of goods  sold         |       | $                                          | —     |   | $ | — |   | $ | — |   |
| Research and  development   |       | 755                                        |       | — |   | — |   |
| General and  administrative |       | 4,738                                      |       | 109 |   | 104 |   |
| Share-based compensation    |       | $                                          | 5,493      |   | $ | 109 |   | $ | 104 |   |

 

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***Concentration of credit risk***

We maintain cash and short-term investment balances inaccounts that exceed federally insured limits, although we have not experiencedany losses on such accounts. We invest our excess cash in investment gradesecurities, generally with maturities of three months or less. We providecredit, in the normal course of business, to the distributors of our product.Our receivables at December 31, 2006 consist primarily of amounts due fromtwo commercial customers, and we expect these receivables to be collected.

***Significant New Accounting Pronouncements***

In May 2005, the Financial Accounting StandardsBoard (“FASB”) issued SFAS No. 154, “Accounting Changes and ErrorCorrections,” a replacement of APB Opinion No. 20 and FASB Statement No. 3.SFAS No. 154 requires retrospective application to prior periods’financial statements for changes in accounting principle, unless it isimpracticable to determine either the period-specific effects or the cumulativeeffect of the change. SFAS No. 154 also requires that a change indepreciation, amortization, or depletion method for long-lived, non-financialassets be accounted for as a change in accounting estimate affected by a changein accounting principle. SFAS No. 154 is effective for accounting changesand corrections of errors made in fiscal years beginning after December 15,2005. The implementation of SFAS No. 154 on January 1, 2006 did nothave a material impact on the results of operations, financial position or cashflows.

In November 2005, FASB issued, FASB StaffPosition (“FSP”) FAS 115-1 and FAS 124-1, “The Meaning ofOther-than-Temporary Impairment and Its Application to Certain Investments” (“FSP115-1”) which provides guidance on determining when investments incertain debt and equity securities are considered impaired, whether thatimpairment is other-than-temporary, and on measuring such impairment loss. FSP115-1 also includes accounting considerations subsequent to therecognition of an other-than—temporary impairment and requires certaindisclosures about unrealized losses that have not been recognized asother-than-temporary impairments. FSP 115-1 is effective for reportingperiods beginning after December 15, 2005. Our adoption of FSP 115-1on January 1, 2006 did not have a material impact on our results ofoperations, financial position or cash flows.

In July 2006, FASB issued FASB Interpretation No. 48“Accounting for Uncertainty in Income Taxes,” an interpretation of FASB No. 109(“FIN 48”) that clarifies the accounting for uncertainty in income taxesrecognized in accordance with SFAF 109, “Accounting for Income Taxes. “ FIN 48prescribes a recognition threshold and measurement attribute for the financialstatement effects of a tax position when it is more likely than not of beingsustained on examination, based on the technical merits of the position. Inaddition, FIN 48 indicates that the measurement of a tax position that meetsthe more likely than not threshold shall consider the amounts and probabilitiesof the outcomes that could be realized upon ultimate settlement. Thisinterpretation is effective for fiscal years beginning after December 15,2006. We expect the impact of adopting FIN 48 to be immaterial.

In September 2006, the FASB issued SFAS No. 157,“Fair Value Measurements.” SFAS No. 157 defines fair value, establishes aframework for measuring fair value and expands disclosure requirementsregarding fair value measurements. SFAS No. 157 does not require any newfair value measurements. We are required to adopt the provisions of SFAS No. 157effective January 1, 2008 although earlier adoption is permitted. We donot believe the adoption of this standard will have a material effect on ourfinancial position, results of operations or cash flows.

In September 2006,the SEC issued Staff Accounting Bulletin (SAB) No. 108, “Considering theEffects of Prior Year Misstatements when Quantifying Misstatements n CurrentYear Financial Statements” (“SAB 108”). SAB 108 provides guidance on theconsideration of the effects of prior year misstatements in quantifying currentyear misstatements for the purpose of determining whether the current year’sfinancial statements are materially misstated. SAB 108 is effective for fiscalyears ending 

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after November 15,2006. The implementation of SAB 108 did not have a material impact on theresults of operations, financial position or cash flows.

***Reclassifications***

Certain amounts in theprior years’ financial statements have been reclassified to conform to the 2006presentation.

**3.   Propertyand equipment**

Propertyand equipment consist of the following at December 31,:

| ** **                                 | ** ** | **2006** | ** ** | **2005** | ** ** |
|--------------------------------------------|------------|----------|------------|----------|------------|
| Laboratory and  manufacturing equipment    |       | $        | 4,720      |     | $          | 3,758 |   |
| Computer  hardware, furniture and fixtures |       | 1,213    |       | 1,103    |       |
| Leased assets                              |       | 11,725   |       | 11,725   |       |
| Leasehold  improvements                    |       | 4,517    |       | 4,437    |       |
| Construction in  process                   |       | 545      |       | —   |       |
|                                       |       | 22,720   |       | 21,023   |       |
| Accumulated  depreciation and amortization |       | (18,778  | )          | (17,231  | )          |
| Property and equipment,  net               |       | $        | 3,942      |     | $          | 3,792 |   |

 

**4.   Notes Payable and Capital Lease Obligations**

| ** **                                                                                                                                                  | ** ** | **December 31,** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                  | ** ** | **2006**              | ** ** | **2005** | ** ** |
| Bank Loan,  payable in quarterly installments and bearing interest at LIBOR plus applicable  margins, 7.33%—7.83% in 2006                         |       | $                     | 49         |   | $ | 114 |   |
| Boston Scientific  Corporation. Line of credit, 8%, to be repaid from future product sales, up  to $50 million may be borrowed for product development |       | 5,000                 |       | 5,000 |   |
| Term Note, 5%,  convertible into common stock at $6.00/share                                                                                                |       | —                |       | 2,000 |   |
| Term Note, 6%,  convertible at the sole option of the Holder, due in 2008                                                                              |       | —                |       | 20,600 |   |
| Term Notes, 6%,  convertible into common stock at initial public offering at Specified prices                                                               |       | —                |       | 19,762 |   |
| Term Notes, 10%,  convertible into common stock at $18 per share and under Specified conditions                                                             |       | 20,000                |       | — |   |
|                                                                                                                                                        |       | 25,049                |       | 47,476 |   |
| Less current portion                                                                                                                                        |       | (49                   | )          | (65 | ) |
| Notes  payable—long-term                                                                                                                               |       | $                     | 25,000     |   | $ | 47,411 |   |
| Total capital lease obligations                                                                                                                             |       | $                     | 2,024      |   | $ | 3,051 |   |
| Less current portion                                                                                                                                        |       | (1,129                | )          | (1,027 | ) |
| Capital lease  obligations, long-term                                                                                                                       |       | $                     | 895        |   | $ | 2,024 |   |

 

During June 1995, we borrowed $750 from acommercial bank in connection with the acquisition and renovation of ourBaltimore, Maryland facilities. This loan is partially guaranteed by an agencyof the State of Maryland and matures in September 2007. This loan bearsinterest at LIBOR plus 2.0% to 2.5% (7.33% to 7.83% at December 31, 2006).Compensating balance arrangements with Wachovia Bank require us to maintain acash balance of 105% of the non-guaranteed portion of this loan, which is shownas a component of restricted cash in the accompanying balance sheet. At December 31,2006 and 2005, this compensating balance requirement was $17 and $34,respectively.

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In September 2004, we issued a convertiblepromissory note to a foreign investor for $2.0 million. This note bore interestat 5% and the principal and accrued interest was converted into 397,853 sharesof our common stock upon the completion of our initial public offering on August 9,2006.

During 2005, we had issued convertible promissorynotes outstanding to twenty-six shareholders for a total of $19.8 million. Thesenotes accrue interest at 6% per annum, and provide for redemption premiumsstarting at 9% of the principal amount and escalating up to 27% of theprincipal amount, depending upon the date of redemption or conversion to CommonStock. All twenty-six convertible promissory notes, together with accruedinterest were subsequently converted into 2,376,223 shares of our common stockupon the completion of our initial public offering on August 9, 2006.

In November 2005, we issued a $20.6 millionpromissory note to a foreign investor. This note bore interest at 6% and hadredemption premiums that started at 9% and increase over time up to 27%. Interestpayments were due in November 2006, 2007 and upon maturity in November 2008.This note was convertible into our common stock only if the initial publicoffering took place after December 2006. In October 2006, we issued$20.0 million in convertible promissory notes in a private placement to Swissinvestors and used the proceeds from these notes, plus an additional $3.6million in cash to redeem the $20.6 million promissory note.

In October 2006, weissued $20.0 million in convertible promissory notes in a private placement toseveral Swiss investors. The notes bear interest at a rate of 10%, withsemi-annual payments of accrued interest becoming due and payable on April 30and October 30 of each calendar year, until maturity on April 30,2009. The notes are convertible at the option of the respective holders at anytime after February 9, 2007, into shares of common stock at the conversionprice of $18.00 per share. The notes automatically convert into common stock atthe same conversion price, if at any time after February 9, 2007, theclosing price of the Company’s common stock for ten consecutive trading daysequals $25.00 per share or greater. The notes provide for redemption at anytime at the option of the Company, with 30-day written notice.

***Future maturities of Notes Payable and Capital LeaseObligations***

Foryears subsequent to 2006, scheduled annual maturities of notes payable andcapital lease obligations outstanding as of December 31, 2006, are asfollows:

| ** ** | ** ** | **Notes  Payable** | ** ** | **Capital  Lease  Obligations** | ** ** | **Total** | ** ** |
|------------|------------|--------------------|------------|---------------------------------|------------|-----------|------------|
| 2007       |       | $                  | 49         |                            |       | $         | 1,129      |   |   | $ | 1,178 |   |
| 2008       |       | —             |       |                            | 885        |      |       | 885 |   |
| 2009       |       | 20,000             |       |                            | 7          |      |       | 20,007 |   |
| 2010       |       | —             |       |                            | 3          |      |       | 3 |   |
| 2011       |       | —             |       |                            | —     |      |       | — |   |
| Thereafter |       | 5,000              |       |                            | —     |      |       | 5,000 |   |
|       |       | $                  | 25,049     |                            |       | $         | 2,024      |   |   | $ | 27,073 |   |

 

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**5.   PreferredStock Conversion**

Allour convertible preferred stock was converted into common stock upon thecompletion of our initial public offering in August 2006, as follows:

| ** **                                                                                                                                   | ** ** | **December 31,** | ** ** | **No. Shares of  Common Stock  Issued Upon  Conversion at IPO  (Aggregate  Liquidation  Preference /  Conversion Price)** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|
| ** **                                                                                                                                   | ** ** | **2006**              | ** ** | **2005**                                                                                                                                                          | ** ** | **Per Share** | ** ** |
| Convertible  preferred stock, Class I, Series 2003, $0.001 par value, 2,000,000  shares designated, issued and outstanding in 2005 |       |                  | $          | —                                                                                                                                                            |       |   | $ | 10,000 |   |   | 500,000 |   |   |
| Convertible  preferred stock, Series B, $0.001 par value, 750,000 shares designated,  545,454 shares issued and outstanding in 2005     |       |                  | —     |                                                                                                                                                              |       | 3,000 |   |   | 136,364 |   |   |
| Convertible  preferred stock, Series C, $0.001 par value, 3,500,000 shares  designated, 548,090 shares issued and outstanding in 2005   |       |                  | —     |                                                                                                                                                              |       | 2,243 |   |   | 308,300 |   |   |
| Convertible  preferred stock, Series E, $0.001 par value, 8,000,000 shares  designated, 7,557,000 shares issued and outstanding in 2005 |       |                  | —     |                                                                                                                                                              |       | 17,503 |   |   | 1,889,250 |   |   |
|                                                                                                                                         |       |                  | $          | —                                                                                                                                                            |       |   | $ | 32,746 |   |   | 2,833,914 |   |   |

 

We issued 2,000,000 shares of our Class I, Series 2003convertible preferred stock to a collaborative partner as part of an agreementrelated to product development, clinical trials and FDA approval. These shareswere converted into 500,000 shares of our common stock at the conversion priceof $20.00 per share.

We issued 545,454 shares of our Series Bconvertible preferred stock in 2003, as part of a collaborative agreement. Theseshares were converted into 136,364 shares of our common stock at the conversionprice of $22.00 per share.

We issued 548,090 shares of our Series Cconvertible preferred stock in 2004 at the price of $4.50 per share. Theseshares were converted into 308,300 shares of our common stock at the conversionprice of $8.00 per share.

We issued 7,557,000 shares of our Series Econvertible preferred stock in 2005 at a price of $2.50 per share. These shareswere converted into 1,889,250 shares of our common stock at the conversionprice of $10.00 per share.

Also in 2005, we issued 3,213,335 shares of Series DMandatorily Redeemable Convertible Preferred Stock at a price of $2.00 pershare. These shares were converted into 8,033,388 shares of our common stock atthe conversion price of $0.80 per share.

These Series D shares included a mandatoryredemption feature whereby if the Company did not complete an initial publicoffering prior to June 1, 2007 and the shares were not previouslyconverted into common stock, the Company must then redeem the shares at a priceof $20.00 per share. The Series D Mandatorily Redeemable ConvertiblePreferred Stock is recorded as a liability in the balance sheet at December 31,2005, in accordance with SFAS No. 150 “Accounting for Certain FinancialInstruments with Characteristics of Both Liabilities and Equity.” In additionto the initial net proceeds of $6.0 million from the Series D offering, aredemption premium of $58.3 million was recorded as a liability.

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**6.   Share-BasedCompensation**

In April 2006, we adopted our 2006 Omnibus Plan,in addition to our Amended and Restated 1994 Stock Incentive Plan. The Plansauthorize the issuance of various forms of stock-based awards, includingincentive and non-qualified stock options, stock purchase rights, stockappreciation rights and restricted and unrestricted stock awards. A total of850,000 shares of our common stock have been reserved for issuance under the2006 Omnibus Plan and 736,378 shares were reserved under our Amended andRestated 1994 Stock Incentive Plan. We ceased all grants under the Amended andRestated 1994 Stock Incentive Plan concurrent with our initial public offeringin August 2006. At December 31, 2006, there were 785,010 sharesavailable for future awards under the 2006 Omnibus Plan.

We generally issue stock option awards that vest overfour years and have a ten-year life. We estimate the fair value of stockoptions using the Black-Scholes option-pricing model. Our common stock startedtrading on the public market in August 2006, and the historical data todetermine volatility does not presently exist. We determine volatility by usingthe historical stock volatility of other companies with similar characteristics.Estimates of fair value are not intended to predict actual future events or thevalue ultimately realized by persons who receive equity awards.

Thefair value of stock options granted during each of the periods was estimatedusing the following assumptions:

| ** **                       | ** ** | **Years ended December 31,** | ** ** |
|----------------------------------|------------|---------------------------------------------|------------|
| ** **                       | ** ** | **2006**                                    | ** ** | **2005** | ** ** | **2004** | ** ** |
| Assumptions                      |       |                                        |       |   |   |   |   |
| Risk-free  interest rate         |       | 4.75                                        | %          | 4.21 | % | 3.93 | % |
| Dividend yield                   |       | 0.0                                         | %          | 0.0 | % | 0.0 | % |
| Expected life of  option grants  |       | 5-years                                     |       | 5-years |   | 5-years |   |
| Expected stock price  volatility |       | 74.11                                       | %          | 85.64 | % | 100 | % |

 

Asummary of stock option activity for the years ended December 31, 2006,2005 and 2004 is as follows:

| ** **                             | ** ** | ** **         | ** ** | ** **              | ** ** | **Weighted**              | ** ** | ** **               | ** ** |
|----------------------------------------|------------|--------------------|------------|-------------------------|------------|---------------------------|------------|--------------------------|------------|
| ** **                             | ** ** | ** **         | ** ** | **Weighted**            | ** ** | **Average**               | ** ** | **Aggregate**            | ** ** |
| ** **                             | ** ** | **Number of** | ** ** | **Average**             | ** ** | **Remaining**             | ** ** | **Intrinsic Value** | ** ** |
| ** **                             | ** ** | **Shares**         | ** ** | **Exercise Price** | ** ** | **Contractual Life** | ** ** | **(in thousands)**  | ** ** |
| Outstanding at  January 1, 2004   |       |               | 389,043    |                    |       |                      | $          | 0.94                     |       |   |   |   |   |   |   |   |   |   |
| Granted                                |       |               | 435,000    |                    |       |                      | $          | 0.40                     |       |   |   |   |   |   |   |   |   |   |
| Exercised                              |       |               | (36,405    | )                       |       |                      | $          | (0.46                    | )          |   |   |   |   |   |   | $ | — |   |   |
| Forfeited or canceled                  |       |               | (243,986   | )                       |       |                      | $          | (0.51                    | )          |   |   |   |   |   |   |   |   |   |
| Outstanding at  December 31, 2004 |       |               | 543,652    |                    |       |                      | $          | 0.70                     |       |   |   | 7.9-years |   |   |   |   |   |   |
| Granted                                |       |               | 106,000    |                    |       |                      | $          | 0.40                     |       |   |   |   |   |   |   |   |   |   |
| Exercised                              |       |               | (27,148    | )                       |       |                      | $          | (0.41                    | )          |   |   |   |   |   |   | $ | 7 |   |   |
| Forfeited or canceled                  |       |               | (56,024    | )                       |       |                      | $          | (3.45                    | )          |   |   |   |   |   |   |   |   |   |
| Balance,  December 31, 2005       |       |               | 566,480    |                    |       |                      | $          | 0.40                     |       |   |   | 8.4-years |   |   |   |   |   |   |
| Granted                                |       |               | 314,500    |                    |       |                      | $          | 4.06                     |       |   |   |   |   |   |   |   |   |   |
| Exercised                              |       |               | (178,378   | )                       |       |                      | $          | (0.41                    | )          |   |   |   |   |   |   | $ | 1,827 |   |   |
| Forfeited or canceled                  |       |               | (6,687     | )                       |       |                      | $          | (1.36                    | )          |   |   |   |   |   |   |   |   |   |
| Balance,  December 31, 2006       |       |               | 695,915    |                    |       |                      | $          | 2.05                     |       |   |   | 8.3-years |   |   |   | $ | 16,149 |   |   |
| Exercisable at  December 31, 2006 |       |               | 417,336    |                    |       |                      | $          | 0.40                     |       |   |   | 7.7-years |   |   |   | $ | 10,400 |   |   |

 

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Asummary of stock options outstanding at December 31, 2006, by price rangeis as follows:

| ** **                                                    | ** ** | **Options Outstanding** | ** ** | **Options Exercisable** | ** ** |
|---------------------------------------------------------------|------------|------------------------------|------------|------------------------------|------------|
| ** **                                                    | ** ** | ** **                   | ** ** | **Weighted-Average**         | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                                    | ** ** | ** **                   | ** ** | **Remaining**                | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                                    | ** ** | **Number**                   | ** ** | **Contractual Life**    | ** ** | **Weighted-Average** | ** ** | **Number** | ** ** | **Weighted-Average** | ** ** |
| **Range of Exercise Prices**                   | ** ** | ** **                   | ** ** | **Outstanding**              | ** ** | **(in years)** | ** ** | **Exercise Price** | ** ** | **Outstanding** | ** ** | **Exercise Price** | ** ** |
| $  0.40  to $  0.79                       |       |                         | 525,602    |                         |       |   | 7.9 |   |   |   | $ | 0.40 |   |   |   | 417,055 |   |   |   | $ | 0.40 |   |   |
|     0.80  to     2.00 |       |                         | 1,563      |                         |       |   | 6.6 |   |   |   | 0.80 |   |   |   | 281 |   |   |   | 0.80 |   |   |
|     2.01  to   10.99            |       |                         | 157,250    |                         |       |   | 9.5 |   |   |   | 6.88 |   |   |   | — |   |   |   | — |   |   |
| $11.00 to $16.00                                              |       |                         | 11,500     |                         |       |   | 9.6 |   |   |   | 11.45 |   |   |   | — |   |   |   | — |   |   |
|                                                          |       |                         | 695,915    |                         |       |   | 8.3 |   |   |   | $ | 2.05 |   |   |   | 417,336 |   |   |   | $ | 0.40 |   |   |
|                                                               |            |                              |            |                              |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The weighted fair value of options granted during theyears ended December 31, 2006, 2005 and 2004 were $7.11, $2.84 and $0.32,respectively.

Both contemporaneous and retrospective valuations wereperformed by the Board of Directors for options granted from January 2005through the date of our initial public offering. As a result of thesevaluations, the Company, for financial reporting purposes, retrospectivelyadjusted the fair market value of the equity instruments granted during certainperiods.

During 2003, we cancelled and reissued 126,366 stockoptions that had previously been granted at amounts equal to the estimated fairvalue of the underlying stock. The exercise price of the reissued stock optionswas reduced to $0.40 per share at a time when the estimated fair value of thecommon stock was $6.00 per share. We are accounting for these options as ifthey were simply repriced. As such, we accounted for these repriced optionsusing variable accounting under FASB Interpretation No. 44. “Accountingfor Certain Transactions Involving Stock Compensation (an Interpretation of APBNo. 25)” Consequently, during each reporting period we record compensationexpense relating to the vested portion of the repriced options to the extentthat the fair market value of our common stock exceeds the exercise price ofsuch options. Compensation expense of $530, $35 and $67 was recognized duringthe years ended December 31, 2006, 2005 and 2004, respectively.

In connection with thestock options exercised during the year ended December 31, 2006, wereceived cash proceeds of $72. At December 31, 2006, there was $1.3million of total unrecognized compensation costs related to non-vested stockoptions, which is expected to be recognized over a weighted average period ofthree years.

**7.   RelatedParty Transactions**

***General.******  ***Peter Friedli,the Chairman of our Board of Directors, has been responsible for procuringsince 1993, either directly or through affiliated entities, an aggregate ofapproximately $200 million in debt and equity financing for us and ourpredecessor company. Mr. Friedli is the beneficial owner of greater than47% of our common stock as of December 31, 2006. Of the sharesbeneficially owned by Mr. Friedli, 20,000 shares were received by him asBoard compensation since 1996, 12,500 shares were granted in recognition of hisfundraising efforts, as discussed below, and the remaining shares were acquiredthrough investment or purchase from third parties.

***ConsultingAgreement.******  ***Since 1995, we and our predecessorcompany have been party to a Consulting Agreement, originally with FriedliCorporate Finance AG, and now Friedli Corporate Finance, Inc., or FCF, forthe provision of business and advisory services to us. Mr. Friedli is thesole owner of FCF. Under this agreement, FCF has provided general business,financial and investment advice to us, and has served as a liaison between usand FCF clients who have invested in us, many of which are located inSwitzerland. This Consulting Agreement had also granted to FCF a right of firstrefusal with respect to any debt or equity financings by us, and contains aprovision requiring us to allocate ten percent of the shares in this 

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offering to FCF. TheConsulting Agreement between us and FCF was terminated upon the closing of ourinitial public offering. The base compensation paid by us under this agreementwas $47 in 2006, $65 in 2005, and $63 in 2004. In addition, pursuant to thisConsulting Agreement, we paid $50 as expense reimbursements in 2005 and $350 in2006, to or as directed by FCF.

***Referral Fees and Costs.******  ***Separate fromthe Consulting Agreement, FCF served as our agent in Europe in connection with:

·       theissuance and sale in 2004 of 400,000 shares of our Series C ConvertiblePreferred Stock at a purchase price of $4.50 per share, representing aggregategross proceeds of $1.8 million;

·       theissuance and sale in 2004 of $4.8 million of our Convertible PreferredNotes;

·       theissuance and sale in 2005 of 3,187,056 shares of our Series D MandatorilyRedeemable Convertible Preferred Stock at a purchase price of $2.00 per share,representing aggregate gross proceeds of $6.4 million;

·       theissuance and sale in 2005 of $19.4 million of our Convertible PreferredNotes;

·       theissuance and sale in 2005 of 7,557,000 shares of our Series E ConvertiblePreferred Stock at a purchase price of $2.50 per share, representing aggregategross proceeds of $18.9 million; and

·       theissuance and sale in 2006 of $20 million of our Convertible Notes.

Mr. Friedli also arranged the placement through aEuropean investment bank of a $20.6 million convertible promissory note inlate fall 2005. In connection with all of these transactions, an aggregate of$71.9 million in gross proceeds was raised for us. We paid referral feesand costs of $3.4 million to accounts designated by Mr. Friedli,including accounts of third parties unrelated to Mr. Friedli. We also paidexpense reimbursement of $350 to Mr. Friedli and issued 12,500 shares ofour common stock to him in recognition of his fundraising efforts on our behalfin 2004 and 2005. In addition, specific to the placement of the$20.6 million convertible promissory note, we paid placement agency feesto the European investment bank.

In addition, the Company will pay an amount for costsup to three percent (3%) of the aggregate amount of the Notes issued in 2006,of which one-third was paid to Friedli Corporate Finance, Inc., and up totwo thirds will be paid to others or Friedli Corporate Finance, as directed byFriedli Corporate Finance, Inc. Included among the purchasers of the Notesis Peter Friedli, individually, who purchased $4,500,000, and New Venturetec, Inc.,a Swiss publicly traded company approximately 3% owned by Mr. Friedli whoserves as its President, which purchased an additional $4,000,000 of the Notes.The Board of Directors of the Company, including all of the Company’sindependent directors, but with Mr. Friedli abstaining, unanimouslyapproved the offering and sale of the Notes, including the sale of a portion ofthe Notes to Mr. Friedli and New Venturetec, Inc. and the arrangementswith Friedli Corporate Finance, Inc.

***New Venturetec/PineLoans.******  ***In 2004, we obtained$2.35 million in debt financing through two entities affiliated with Mr. Friedli.The first of these entities was a wholly owned subsidiary of New Venturetec, Inc..The other entity is Pine, Inc., a company which at the time of the financingwas majority owned and managed by Mr. Friedli. These convertible demandnotes accrued interest at 10% and included a 10% premium due upon redemption.

In this financing, the New Venturetec subsidiary lentus $1.35 million, and Pine lent us $1.0 million. In consideration ofthese loans, we issued to the lenders promissory notes in the principal amountof the sums lent to us. To facilitate these borrowings and other financings,and for commitments of consideration in respect of yet additional financing ifneeded, we issued warrants for an aggregate of 1,250,000 shares at an exerciseprice of $0.40 per share. Mr. Friedli subsequently arranged for theacquisition of those warrants and they have since been cancelled. Inrecognition of his efforts in procuring the cancellation of all of these 

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warrants, we issued anadditional warrant to Mr. Friedli, exercisable for up to 1,000,000 sharesof our common stock at $11.00 per share, the price for which shares were soldin the initial public offering. This warrant expires in May 2011.

The loans made by the New Venturetec subsidiary andPine, plus premium and accrued interest totaling $355, were converted into1,352,325 shares of our Series D Mandatorily Redeemable ConvertiblePreferred Stock in early 2005, representing an effective price of $2.00 pershare at the same price as was paid by other purchasers. Each share of our Series DMandatorily Redeemable Convertible Preferred Stock will convert into 2.5 sharesof our common stock upon completion of this offering.

***Other Financings.******  ***We haveengaged in the following additional financings that involved Mr. Friedli,either directly or indirectly:

·       TheNew Venturetec subsidiary described above purchased in 2005 an additional47,244 shares of our Series D Mandatorily Redeemable Convertible PreferredStock at $2.00 per share, representing aggregate gross proceeds of $94. It alsopurchased in 2005 400,000 shares of our Series E Preferred Stock at $2.50per share, representing aggregate gross proceeds of $1.6 million.

·       USVenture 05, Inc., a venture fund for which Mr. Friedli is presidentand investment manager, purchased in 2005 4,000,000 shares of our Series EPreferred Stock at $2.50 per share, representing aggregate gross proceeds of$10.0 million. Mr. Friedli has no ownership interest in thisinvestor.

·       WorldCommunication Development AG, a Swiss corporation of which Mr. Friedli isa member of the board of directors, purchased in 2005 66,666 shares of our Series DMandatorily Redeemable Convertible Preferred Stock at $2.00 per share,representing aggregate gross proceeds of $133. Mr. Friedli has noownership interest in this investor.

·       JoyceLtd., an entity which at the time was majority owned by Mr. Friedli,purchased 340,495 shares of our Series D Mandatorily RedeemableConvertible Preferred Stock in 2005 at $2.00 per share, representing aggregategross proceeds of $681.

·       Mr. Friedli purchased488,118 shares of our Series D Mandatorily Redeemable ConvertiblePreferred Stock in 2005 at $2.00 per share, representing aggregate grossproceeds of $976.

***Lockup Agreement.***

On October 30, 2006, we entered into a LockupAgreement with Mr. Friedli and certain entities with which he isaffiliated, Venturetec, Inc. and U.S. Venture 05, Inc. Pursuant tothe Lockup Agreement, Mr. Friedli and such entities have agreed with theCompany, subject to limited exceptions, not to transfer Company securities heldby them without approval of the Company, until January 30, 2008.

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**8.**   Warrants

At December 31,2006, we had warrants to purchase our common and preferred stock outstanding asshown in the following table.

| ** **                                    | ** ** | **Common Stock** | ** ** | **Preferred Stock**         | ** ** |
|-----------------------------------------------|------------|-----------------------|------------|----------------------------------|------------|
| ** **                                    | ** ** | **# of  Shares** | ** ** | **Weighted Average  Price** | ** ** | **# of  Shares** | ** ** | **Weighted Average  Price** | ** ** |
| Warrants  outstanding, January 1, 2005   |       | 2,175,625             |       |                             | 1.16       |   |   | 17,928 |   |   | 12.00 |   |   |
| Warrants granted                              |       | —                |       |                             | —     |   |   | — |   |   | — |   |   |
| Warrants  exercised                           |       | —                |       |                             | —     |   |   | — |   |   | — |   |   |
| Warrants expired                              |       | (50,625               | )          |                             | 39.00      |   |   | (17,928 | ) |   | 12.00 |   |   |
| Warrants outstanding, December 31, 2005  |       | 2,125,000             |       |                             | $          | 0.40 |   |   | — |   |   | $ | — |   |   |
| Warrants granted                              |       | 1,000,000             |       |                             | 11.00      |   |   | — |   |   | — |   |   |
| Warrants  cancelled                           |       | (1,250,000            | )          |                             | 0.40       |   |   | — |   |   | — |   |   |
| Warrants  exercised                           |       | (875,000              | )          |                             | 0.40       |   |   | — |   |   | — |   |   |
| Warrants  outstanding, December 31, 2006 |       | 1,000,000             |       |                             | $          | 11.00 |   |   | — |   |   | $ | — |   |   |

 

Followingis the summary of the status of outstanding warrants to purchase our commonstock at December 31, 2006.

| **Warrant** Price | ** ** | **Common** Shares | ** ** | **Weighted Average  Remaining** Contractual Life | ** ** | **Intrinsic** Value | ** ** |
|-------------------|------------|-------------------|------------|------------------------------------------------------------|------------|---------------------|------------|
| $11.00            |       |              | 1,000,000  |                                                       |       |                | 4.5 years  |   |   |   | $ | 14,320 |   |   |
|                   |            |                   |            |                                                            |            |                     |            |  |  |  |  |  |  |  |

 

In August 2006, when the price of the 2006warrant was determined, we computed its value using the Black-Scholes optionpricing method, using a risk free interest rate of 4.80%, the expected life of2.5-years and a stock volatility factor of 44.66%. Since the Company justrecently completed its initial public offering and previously its stock did nottrade, we determined the volatility by selecting a comparable public company inthe biotech industry and tracking its stock prices over the past 2.5-years.The value of this warrant was determined to be $3.5 million which as beenrecorded in the accompanying statement of operations as General andAdministrative expenses.

The 875,000 warrants thatwere exercisable at $0.40 per share as of January 1, 2006 were allexercised concurrent with the closing of our initial public offering in August 2006.

**9.   IncomeTaxes**

Thecomponents of the Company’s net deferred tax assets at December 31 are asfollows:

| ** **                                         | ** ** | **2006** | ** ** | **2005** | ** ** |
|----------------------------------------------------|------------|----------|------------|----------|------------|
| Deferred Tax  Assets:                              |       |     |       |     |       |
| Net operating loss carry-forwards                  |       | $        | 63,157     |     | $          | 50,818 |   |
| Research and experimentation credit carry-forwards |       | 5,142    |       | 4,803    |       |
| Property and equipment                             |       | 1,546    |       | 1,662    |       |
| Other                                              |       | 51       |       | 51       |       |
|                                               |       | 69,896   |       | 57,334   |       |
| Valuation  allowance                               |       | (69,896  | )          | (57,334  | )          |
| Net deferred tax  assets                           |       | $        | —     |     | $          | — |   |

 

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Our deferred tax assetshave been fully reserved in both 2006 and 2005 since their ultimate futurerealization cannot be assured. The valuation allowance increased by$12.6 million for the year ended December 31, 2006. We presently haveavailable for federal income tax purposes, approximately $164 million ofnet operating loss carry-forwards and $5.1 million of research andexperimentation credit carry-forwards, which expire beginning in 2009 through2026. However, as a result of changes in our ownership since inception, theamount of these carry-forwards available to offset future taxable income andincome taxes could be subject to annual limitations under IRC Section 382.

**10.   ResearchCollaboration Agreements and Deferred Revenue**

***Boston ScientificAgreement.******  ***In 2003, we entered into a long-termcollaboration agreement with Boston Scientific Corporation (“BSC”) focusingupon the development and commercialization of the use of Mesenchymal Stem Cellstechnology to treat cardiovascular disease. The BSC agreement, which entitlesus to a licensing fee and to royalties on resulting revenue includes both a BSCequity investment and significant BSC debt financing for the cardiovascular project.

We received a $5 million licensing fee for theuse of its technology by BSC. This revenue is being recognized as revenue overa 63-month period, $952 of which was recognized in 2006, 2005 and 2004.As provided for in the agreement, BSC purchased 2 million shares of theour Class 1, Series 2003 Convertible Preferred Stock for$10 million. These shares were converted into 500,000 shares of commonstock concurrent with our initial public offering in August 2006. If weachieve certain milestones, BSC will purchase up to an additional$20 million of common stock, at prices ranging from $60 to $112 per shareand pay license fees of up to $25.0 million.

We have a $50.0 million line of credit with BostonScientific. In March 2004, the Company drew $5 million under thisline of credit, which is recorded as long-term debt and accrues interest at 8%.We can only use borrowings in connection with Provacel development efforts. Advancesunder the loan agreement are secured by an interest granted to Boston Scientificin the license agreement, including the right to develop, market and distributeMSC products in the covered field and our right to receive payments under thelicense. At December 31, 2006, the Company estimates that it was entitledto draw approximately $9 million more on this line of credit.

***JCR Pharmaceuticals Agreement.******  ***Also in 2003,we entered into a strategic alliance with JCR Pharmaceuticals Co., Ltd. (“JCR”).Under the JCR agreement, we have granted to JCR the exclusive right in Japan touse our technology in conjunction with the treatment of hematologicmalignancies using hematopoietic stem cell transplants. The JCR agreemententitles us to a licensing fee and to royalties on any resulting revenue. Uponcommencement of the agreement, JCR purchased 545,454 shares of our Series BConvertible Preferred Stock for $3.0 million. These shares were convertedinto 136,363 shares of our common stock concurrent with our initial publicoffering in August 2006. They also paid us a $3.0 million licensingfee, which was recognized as revenue over twelve months, including$2.0 million in 2004. In 2005, upon the completion of certain milestones,we received $500 in additional licensing fees, which was recognized as revenue.

**11.   DefinedContribution Plan**

We have a 401(k) planthat is available to all employees. Employee contributions are voluntary andare determined on an individual basis up to the amount allowable under federalregulations. Employer contributions to the plan are at the discretion of theBoard of Directors and vest over a seven year period beginning after the thirdyear of eligibility. No employer contributions have been made to date.

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**12.**   Commitmentsand Contingencies

We lease approximately 118,000 square feet oflaboratory, production, warehouse and office space under an amended leaseagreement that expires in 2008. We have an option to renew this lease through2023 and have not made a decision regarding the exercise of our renewal option.This lease was originally arranged by the Maryland Economic DevelopmentCorporation and the City of Baltimore who arranged the financing of thebuilding improvements. We have an outstanding letter of credit of$150 that is used as security for this lease. The letter of credit isfully collateralized by restricted cash. We sublease a portion of the officeand warehouse space to a third party on a month-to-month basis and record the$10 monthly rent as a reduction of our facilities expense.

During 2006, we entered into a sublease agreement forapproximately 61,000 square feet of laboratory, production, warehouse andoffice space in Columbia, Maryland. We have also entered into a direct leasewith the owner of this facility that is effective upon the expiration of thesublease and expires in July 2016. This lease has two five-year renewaloptions. We have an outstanding letter of credit of $130 that is used in lieuof a security deposit for this lease. The letter of credit is fullycollateralized by restricted cash.

Wealso have entered into various financing arrangements to lease laboratory andother equipment. The terms of these facilities and equipment leases areconsidered capitalized leases, and the following amounts are included in ourbalance sheets at December 31, 2006 and 2005:

| ** **                          | ** ** | **2006** | ** ** | **2005** | ** ** |
|-------------------------------------|------------|----------|------------|----------|------------|
| Facilities leases                   |       | $        | 8,568      |     | $          | 8,568 |   |
| Equipment leases                    |       | 3,157    |       | 3,157    |       |
|                                |       | 11,725   |       | 11,725   |       |
| Less—accumulated  amortization |       | (10,351  | )          | (9,635   | )          |
| Leased property  and equipment, net |       | $        | 1,374      |     | $          | 2,090 |   |

 

Futureminimum lease payments under these capitalized facilities and equipmentarrangements are as follows:

| ** **                                         | ** ** | **Facilities** | ** ** | **Equipment** | ** ** | **Total** | ** ** |
|----------------------------------------------------|------------|----------------|------------|---------------|------------|-----------|------------|
| 2007                                               |       |           | $          | 1,236         |       |      |       | $ | 8 |   |   | $ | 1,224 |   |
| 2008                                               |       |           | 906        |          |       |      | 8          |   |   | 914 |   |
| 2009                                               |       |           | —     |          |       |      | 8          |   |   | 8 |   |
| 2010                                               |       |           | —     |          |       |      | 3          |   |   | 3 |   |
| 2011                                               |       |           | —     |          |       |      | —     |   |   |   |   |
|                                               |       |           | 2,142      |          |       |      | 27         |   |   | 2,169 |   |
| Less interest                                      |       |           | (138       | )             |       |      | (7         | ) |   | (145 | ) |
| Present value of  minimum lease payments           |       |           | 2,004      |          |       |      | 20         |   |   | 2,024 |   |
| Less current  portion                              |       |           | (1,124     | )             |       |      | (5         | ) |   | (1,129 | ) |
| Capital lease  obligations, net of current portion |       |           | $          | 880           |       |      |       | $ | 15 |   |   | $ | 895 |   |

 

84

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Thefuture minimum lease payments due under the operating lease for our Columbia,Maryland facility are as follows:

| ** **       | ** ** | **Columbia** | ** ** |
|------------------|------------|--------------|------------|
| ** **       | ** ** | **Facility** | ** ** |
| 2007             |       |         | $          | 852 |   |   |
| 2008             |       |         | 876        |   |   |
| 2009             |       |         | 978        |   |   |
| 2010             |       |         | 1,056      |   |   |
| 2011             |       |         | 1,082      |   |   |
| 2012 – 2016 |       |         | 5,108      |   |   |
|             |       |         | $          | 9,952 |   |   |

 

***Agreement.******  ***In 1994, weentered into a Technology Transfer and License Agreement with Case WesternReserve University (“CWRU”) under which we purchased rights to certainmesenchymal stem cell and related technology and patents. We are required topay royalties on revenues related to CWRU developed technology, with minimumroyalties of $50 per year. We paid CWRU $50 in 2006, 2005 and 2004.

**13.   QuarterlyFinancial Data (Unaudited)**

Followingis a summary of our Unaudited quarterly results for the years ended December 31,2006 and 2005:

| ** **                                      | ** ** | **First**   | ** ** | **Second**  | ** ** | **Third**   | ** ** | **Fourth**  | ** ** |
|-------------------------------------------------|------------|-------------|------------|-------------|------------|-------------|------------|-------------|------------|
| ** **                                      | ** ** | **Quarter** | ** ** | **Quarter** | ** ** | **Quarter** | ** ** | **Quarter** | ** ** |
| **2006**                                        |       |        |       |        |       |        |       |        |       |
| Total revenues                                  |       | $           | 1,400      |        | $          | 1,987       |       | $           | 2,841      |   | $ | 3,244 |   |
| Product sales                                   |       | 1,105       |       | 1,689       |       | 2,539       |       | 2,958       |       |
| Cost of goods sold                              |       | 489         |       | 762         |       | 1,113       |       | 1,333       |       |
| Research and development expenses               |       | 4,368       |       | 10,922      |       | 9,242       |       | 13,058      |       |
| General and administrative expenses and fees    |       | 1,138       |       | 1,209       |       | 5,300       |       | 812         |       |
| Net loss                                        |       | (5,121      | )          | (11,605     | )          | (15,565     | )          | (12,668     | )          |
| **Net loss per common share, basic and diluted  |       | (0.56       | )          | (1.27       | )          | (0.75       | )          | (0.46       | )          |
| **2006**                                        |       |        |       |        |       |        |       |        |       |
| Total revenues                                  |       | $           | 385        |        | $          | 1,339       |       | $           | 1,285      |   | $ | 961 |   |
| Product sales                                   |       | —      |       | —      |       | 284         |       | 673         |       |
| Cost of goods sold                              |       | —      |       | —      |       | 220         |       | 224         |       |
| Research and development expenses               |       | 2,657       |       | 3,592       |       | 3,464       |       | 7,214       |       |
| General and administrative expenses and fees    |       | 752         |       | 487         |       | 554         |       | 501         |       |
| Net loss                                        |       | (3,868      | )          | (2,740      | )          | (4,678      | )          | (8,055      | )          |
| **Net loss per  common share, basic and diluted |       | (0.43       | )          | (0.38       | )          | (0.52       | )          | (0.88       | )          |

----

**             Loss per share iscalculated on a quarterly basis and may not be additive to year-to-dateamounts.

85

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**Item 9.**                        Changesin and Disagreements with Accountants on Accounting and Financial Disclosures.

None.

**Item 9A.**                Controlsand Procedures

***Evaluation ofDisclosure Controls and Procedures.***   Anevaluation of the effectiveness of the design and operation of our “disclosurecontrols and procedures” (as defined in Rule 13a-15(e) underthe Securities Exchange Act of 1934, as amended), as of the end of the periodcovered by this Annual Report on Form 10-K was made under thesupervision and with the participation of our management, including our ChiefExecutive Officer and Chief Financial Officer. Based upon this evaluation, ourChief Executive Officer and Chief Financial Officer have concluded that ourdisclosure controls and procedures (a) are effective to ensure that informationrequired to be disclosed by us in reports filed or submitted under theSecurities Exchange Act of 1934 is timely recorded, processed, summarized andreported and (b) include, without limitation, controls and proceduresdesigned to ensure that information required to be disclosed by us in reportsfiled or submitted under the Securities Exchange Act of 1934 is accumulated andcommunicated to our management, including our Chief Executive Officer and ChiefFinancial Officer, as appropriate to allow timely decisions regarding requireddisclosure.

***Changes in Internal Control over Financial Reporting.******  ***This AnnualReport on Form 10-K does not include a report on management’sassessment regarding internal control over financial reporting or anattestation report of the company’s registered public accounting firm due to atransition period established by rules of the Securities and ExchangeCommission for newly public companies. There have not been any changes in ourinternal control over financial reporting that occurred during the year ended December 31,2006 that have materially affected, or are reasonably likely to materiallyaffect, our internal control over financial reporting.

**Item 9B.**               OtherInformation

None.

86

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**Part III**

**Item 10.**                 Directors,Executive Officers and Corporate Governance.

The information withrespect to the identity, business experience and directorships of the directorsof the Company and their remuneration is incorporated by reference to theinformation set forth in the section captioned “Election of Directors” in theCompany’s Proxy Statement for the 2007 Annual Meeting of Stockholders, which isanticipated to be filed pursuant to Regulation 14A no later than one hundredtwenty (120) days following the end of the fiscal year reported upon (the “ProxyStatement”). The information with respect to the identity and businessexperience of executive officers of the Company is set forth in the Section captioned“Executive Officers of the Registrant” in Part I of this Annual Report on Form 10-K.The information with respect to the Company’s Audit Committee is incorporatedby reference to the information set forth in the section captioned “Meetingsand Committees of the Board of Directors” in the Proxy Statement. Theinformation with respect to material changes in the nominating process for theBoard of Directors, if any is, incorporated by reference to the information setforth in the appropriate subsection of the section captioned “Election ofDirectors” in the Proxy Statement. The information with respect to compliancewith Section 16(a) of the Exchange Act is incorporated by referenceto the section captioned “Section 16(a) Beneficial OwnershipReporting Compliance” in the Proxy Statement. The information with respect tothe Company’s Code of Ethics is incorporated by reference to the sectioncaptioned “Code of Ethics” in the Proxy Statement.

**Item 11.**                 ExecutiveCompensation.

The information requiredby this item is incorporated by reference to the information set forth underthe caption “Executive Compensation and Other Information” in the Company’sProxy Statement for the 2007 Annual Meeting of Stockholders which isanticipated to be filed pursuant to Regulation 14A no later than onehundred twenty (120) days following the end of the fiscal year reported upon.

**Item 12.**                 SecurityOwnership of Certain Beneficial Owners and Management and Related StockholderMatters.

The information requiredby this item is incorporated by reference to the information set forth underthe caption “Security Ownership of Management and Principal Stockholders” inthe Company’s Proxy Statement for the 2007 Annual Meeting of Stockholders whichis anticipated to be filed pursuant to Regulation 14A no later than onehundred twenty (120) days following the end of the fiscal year reported upon.

**Item 13.**                 CertainRelationships and Related Transactions and Director Independence.

The information requiredby this item, if any, is incorporated by reference to the information set forthunder the caption “Certain Relationships and Related Transactions” in theCompany’s Proxy Statement for the 2007 Annual Meeting of Stockholders which isanticipated to be filed pursuant to Regulation 14A no later than one hundredtwenty (120) days following the end of the fiscal year reported upon.

**Item 14.**                 PrincipalAccountant Fees and Services.

The information required by this item is incorporatedby reference to the information set forth under the caption “PrincipalAccountant Fees and Services” in the Company’s Proxy Statement for the 2007Annual Meeting of Stockholders which is anticipated to be filed pursuant toRegulation 14A no later than one hundred twenty (120) days following theend of the fiscal year reported upon.

87

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**Part IV**

**Item 15.**                 Exhibits,Financial Statement Schedules.

(a)           The following documentsare filed as part of this report:

1.                Thefollowing financial statements are included in Item 8 of this Annual Report:

|        |   | Report of Independent Registered Public Accounting  Firm                                                     |
|--------|--------|--------------------------------------------------------------------------------------------------------------|
|   |   | Balance Sheets as of December 31, 2006 and 2005                                                         |
|   |   | Statements of Operations for the years ended  December 31, 2006, 2005 and 2004                          |
|   |   | Statements of Stockholders’ Equity (Deficit) for the  years ended December 31, 2006, 2005 and 2004 |
|   |   | Statements of Cash Flows for the years ended  December 31, 2006, 2005 and 2004                          |
|   |   | Notes to Financial Statements                                                                                |

 

Schedules not listed above have been omitted becausethe information required to be set forth therein is not applicable.

2.                Exhibits

| Exhibit  Number | ** ** | **Description of Exhibit**                                                                                                                     |
|-----------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.1†       |       | Articles of Amendment and Restatement of the Registrant                                                                                        |
| 3.2†       |       | Bylaws of the Registrant                                                                                                                       |
| 4.1†       |       | Form of Common Stock Certificate.                                                                                                         |
| 10.1†      |       | Amended and Restated 1994 Stock Incentive Plan, as  amended.                                                                                   |
| 10.2†      |       | 2006 Omnibus Plan.                                                                                                                             |
| 10.3†      |       | Director Compensation Policy.                                                                                                                  |
| 10.4†      |       | Employment Agreement by and between the Registrant  and C. Randal Mills, Ph.D., dated as of May 15, 2004.                       |
| 10.5†      |       | Employment Agreement by and between the Registrant  and Cary J. Claiborne, dated as of December 3, 2004.                             |
| 10.6†      |       | Employment Agreement by and between the Registrant  and Harry Carmitchel, dated as of September 1, 2004.                                  |
| 10.7†      |       | Employment Agreement by and between the Registrant  and Earl R. Fender, dated as of June 12, 2006.                                        |
| 10.8†      |       | Loan Agreement by and between the Registrant and  Boston Scientific Corporation, dated as of March 5, 2003, as amended.                   |
| 10.9†      |       | Amendment No. 1 to the Loan Agreement by and  between the Registrant and Boston Scientific Corporation, dated as of  March 12, 2004. |
| 10.10†     |       | Security Agreement from the Registrant to Boston  Scientific Corporation, dated as of March 12, 2004.                                     |
| 10.11†     | *          | Contract Manufacturing Agreement by and between the  Registrant and Boston Scientific Corporation, dated as of March 5, 2003.             |
| 10.12†     | *          | Development Agreement by and between the Registrant  and Boston Scientific Corporation, dated as of March 5, 2003.                        |
| 10.13†     |       | Investment Agreement by and between the Registrant  and Boston Scientific Corporation, dated as of March 5, 2003.                         |
| 10.14†     |       | Investor Rights Agreement by and between the  Registrant and Boston Scientific Corporation, dated as of March 5, 2003.                    |

88

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| 10.15†       | *      | License Agreement by and between the Registrant and  Boston Scientific Corporation, dated as of March 5, 2003.                                                       |
|-------------------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.16†       |   | Investor Rights Agreement by and between the  Registrant and JCR Pharmaceuticals, Inc. dated August 26, 2003.                                                   |
| 10.17†       | *      | License Agreement by and between the Registrant and  JCR Pharmaceuticals, Inc. dated August 26, 2003.                                                           |
| 10.18†       | *      | Distribution and Supply Agreement by and between the  Registrant and Blackstone Medical, Inc., dated as of November 10,  2005.                                  |
| 10.19†       |   | Technology Transfer and License Agreement by and  between the Registrant and Case Western University, dated as of  January 1, 1993, as amended.                      |
| 10.20†       | *      | Marketing Collaboration and License Agreement by and  between the Registrant and BioWhittaker, Inc., dated as of August 11,  1999.                              |
| 10.21†       |   | Registration Rights Agreement by and between the  Registrant and Cambrex Corporation, dated November 28, 2005.                                                       |
| 10.22†† |   | Form of Convertible Promissory Note, dated  October 30, 2006                                                                                                    |
| 10.23†       |   | Lease Agreement by and between the Registrant and  SAGA Limited Partnership, dated as of January 18, 1995, as amended.                                               |
| 10.24†       |   | Second Amended and Restated Sublease Agreement by  and between the Registrant and Maryland Economic Development Corporation,  dated as of June 30, 1998, as amended. |
| 10.25†       |   | Lease Agreement by and between Gateway S-8,  LLLP and Nova Telecommunications, Inc., dated August 11, 1998, as  amended.                                        |
| 10.26†       |   | Sublease Agreement by and between the Registrant and  Broadwing Corporation, dated as of June 2, 2006.                                                               |
| 10.27†       |   | Agreement of Lease by and between the Registrant and  Columbia Gateway S-28, L.L.C., dated June 6, 2006.                                                             |
| 10.28†       |   | Consulting Agreement by and between the Registrant  and Friedli Corporate Finance, Inc., f/k/a Friedli Corporate Finance AG,  dated November 1995, as amended.  |
| 10.29†       |   | Termination Letter from Friedli Corporate  Finance, Inc., f/k/a Friedli Corporate Finance AG, to the Registrant,  dated May 10, 2006.                           |
| 10.30†       |   | Indemnification Letter from Friedli Corporate  Finance, Inc., f/k/a Friedli Corporate Finance AG, and Peter Friedli to  the Registrant, dated May 19, 2006.     |
| 10.31†       |   | Warrant to Purchase up to 4,000,000 shares of Common  Stock granted by Registrant to Peter Friedli, dated May 24, 2006.                                              |
| 10.32†† |   | Lock-up Agreement dated as of October 30, 2006  by and among the Registrant, Peter Friedli, Friedli Corporate  Finance, Inc. and US Venture 05, Inc.       |
| 10.33†† |   | Letter Agreement dated October 30, 2006 by and  between the Registrant and Friedli Corporate Finance, Inc.                                                      |
| 10.36†       |   | Employment Agreement by and between the Registrant  and Lode Debrabandere, dated as of July 31, 2006.                                                                |
| 11.1.1            |   | Statement re: Computation of Per Share Loss  (included in Note 2 to Financial Statements included in Part II Item 8  herein).                                        |
| 23.1.1            |   | Consent of Independent Registered Public Accounting  Firm (filed herewith).                                                                                               |
| 31.1.1            |   | Rule 15d-14(a) Certification of C.  Randal Mills, Chief Executive Officer (filed herewith).                                                                     |

89

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| 31.2.1 |   | Rule 15d-14(a) Certification of Cary  J. Claiborne, Chief Financial Officer (filed herewith).                                         |
|--------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------|
| 32.1.1 |   | Section 1350 Certification of C. Randal Mills,  Chief Executive Officer, and Cary J. Claiborne, Chief Financial Officer  (filed herewith). |

----

†                    Previouslyfiled as an Exhibit to the Registrant’s Registration Statement onForm S-1, which was declared effective by the United StatesSecurities and Exchange Commission on August 3, 2006.   

††             Previously filed asan Exhibit to the Registrant’s Current Report on Form 8-K, asfiled with the United States Securities and Exchange Commission onNovember 2, 2006.

*                    Confidentialtreatment has been granted for certain portions thereof pursuant to an order ofthe United States Securities and Exchange Commission issued in connection withour Registration Statement on Form S-1, declared effective onAugust 3, 2006.

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**Signatures**

Pursuantto the requirements of Section 13 or 15(d) of the Securities ExchangeAct of 1934, the registrant has duly caused this report to be signed on itsbehalf by the undersigned, thereunto duly authorized.

|                     |   | Osiris Therapeutics, Inc |
|---------------------|--------|--------------------------|
| March 26, 2007 |   | By:                      |   | /s/ C. RANDAL MILLS |
|                |   |                     |   | C. Randal Mills, President |
|                |   |                     |   |   |

 

Pursuantto the requirements of the Securities Exchange Act of 1934, this report hasbeen signed below by the following persons on behalf of the registrant and inthe capacities and on the dates indicated.

| /s/ C. RANDAL MILLS             |   | President and Chief Executive Officer         |   | March 26, 2007 |
|---------------------------------|--------|-----------------------------------------------|--------|---------------------|
| C. Randal Mills                 |   | (principal executive officer)                 |   |                |
| /s/  CARY J. CLAIBORNE          |   | Chief Financial Officer,  and Corporate       |   | March 26, 2007 |
| Cary J. Claiborne               |   | Secretary (principal financial officer)       |   |                |
| /s/  PHILIP R. JACOBY, JR. |   | Corporate Controller and  Assistant Corporate |   | March 26, 2007 |
| Philip R.  Jacoby, Jr.     |   | Secretary (principal accounting officer)      |   |                |
| /s/  GREGORY H. BARNHILL        |   | Director                                      |   | March 26, 2007 |
| Gregory H.  Barnhill            |   |                                          |   |                |
| /s/  PETER FRIEDLI              |   | Director                                      |   | March 26, 2007 |
| Peter Friedli                   |   |                                          |   |                |
| /s/  FELIX GUTZWILLER           |   | Director                                      |   | March 26, 2007 |
| Felix Gutzwiller                |   |                                          |   |                |
| /s/  JAY M. MOYES               |   | Director                                      |   | March 26, 2007 |
| Jay M. Moyes                    |   |                                          |   |                |

 

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