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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549
   FORM 10-K FOR ANNUAL AND TRANSITION REPORTS
PURSUANT TO SECTIONS 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934 (Mark One) þ
    
    ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
 For the year ended December 31, 2004 or o
    
    TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
 For the transition period from         to
 Commission file number: 000-50651 Santarus, Inc. (Exact name of registrant as specified in its charter)
 Delaware
    
    33-0734433(State or other jurisdiction of
    
    (I.R.S. Employerincorporation or organization)
    
    Identification No.)10590 West Ocean Air Drive, Suite 200, San Diego, CA
    
    92130(Address of principal executive offices)
    
    (Zip Code)
 (858) 314-5700(Registrants telephone number, including area code) Securities registered pursuant to Section 12(b) of the Act: Title of Each Class
    
    Name of Each Exchange on Which RegisteredNone
    
    None
 Securities registered pursuant to Section 12(g) of the Act:
Common Stock, par value $0.0001 per share Indicate by check mark whether the registrant: (1) has filed all reports required to be filed
by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or
for such shorter period that the registrant was required to file such reports), and (2) has been
subject to such filing requirements for the past 90 days. Yes þ No o Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is
not contained herein, and will not be contained, to the best of the registrants knowledge, in
definitive proxy or information statements incorporated by reference in Part III of this Form 10-K
or any amendment to this Form 10-K. þ Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule
12b-2 of the Exchange Act). o þ
 As of June 30, 2004, the aggregate market value of the registrants common stock held by
non-affiliates of the registrant was approximately $280.7 million, based on the closing price of
the registrants common stock on the Nasdaq National Market on June 30, 2004 of $14.75 per share.* The number of outstanding shares of the registrants common stock, par value $0.0001 per
share, as of March 15, 2005 was 36,338,484. DOCUMENTS INCORPORATED BY REFERENCE Portions of the registrants definitive Proxy Statement to be filed with the Securities and
Exchange Commission within 120 days after registrants fiscal year end December 31, 2004 are
incorporated by reference into Part III of this report. *Excludes the common stock held by executive officers, directors and stockholders whose
ownership exceeded 10% of the common stock outstanding at June 30, 2004. This calculation does not
reflect a determination that such persons are affiliates for any other purposes.




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SANTARUS, INC. FORM 10-K  ANNUAL REPORT
For the Year Ended December 31, 2004 Table of Contents PagePART IItem 1
    
    Business
    
    
    2Item 2
    
    Properties
    
    
    34Item 3
    
    Legal Proceedings
    
    
    34Item 4
    
    Submission of Matters to a Vote of Security Holders
    
    
    34PART IIItem 5
    
    Market for Registrants Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
    
    
    35Item 6
    
    Selected Financial Data
    
    
    36Item 7
    
    Managements Discussion and Analysis of Financial Condition and Results of Operations
    
    
    37Item 7A
    
    Quantitative and Qualitative Disclosures about Market Risk
    
    
    45Item 8
    
    Financial Statements and Supplementary Data
    
    
    45Item 9
    
    Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
    
    
    45Item 9A
    
    Controls and Procedures
    
    
    45Item 9B
    
    Other Information
    
    
    46PART IIIItem 10
    
    Directors and Executive Officers of the Registrant
    
    
    47Item 11
    
    Executive Compensation
    
    
    47Item 12
    
    Security Ownership of Certain Beneficial Owners and Management
    
    
    47Item 13
    
    Certain Relationships and Related Transactions
    
    
    47Item 14
    
    Principal Accounting Fees and Services
    
    
    47PART IVItem 15
    
    Exhibits and Financial Statement Schedules
    
    
    48Signatures
    
    
    51EXHIBIT 23.1EXHIBIT 31.1EXHIBIT 31.2EXHIBIT 32.1
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PART I Forward-Looking Statements Any statements in this report and the information incorporated herein by reference about our
expectations, beliefs, plans, objectives, assumptions or future events or performance that are not
historical facts are forward-looking statements. You can identify these forward-looking statements
by the use of words or phrases such as believe, may, could, will, estimate, continue,
anticipate, intend, seek, plan, expect, should, or would. Among the factors that
could cause actual results to differ materially from those indicated in the forward-looking
statements are risks and uncertainties inherent in our business including, without limitation,
statements about difficulties or delays in development, testing, obtaining regulatory approvals,
manufacturing and marketing our products; our ability to create market demand for and generate
revenues from our products; the progress and timing of our clinical trials; unexpected adverse side
effects or inadequate therapeutic efficacy of our products that could delay or prevent product
development or commercialization, or that could result in product recalls or product liability
claims; the scope and validity of patent protection for our products and our ability to
commercialize our products without infringing the patent rights of others; competition from other
pharmaceutical or biotechnology companies; our ability to obtain additional financing to support
our operations; and other risks detailed below under the caption Business  Risk Factors. Although we believe that the expectations reflected in our forward-looking statements are
reasonable, we cannot guarantee future results, events, levels of activity, performance or
achievement. We undertake no obligation to publicly update or revise any forward-looking
statements, whether as a result of new information, future events or otherwise, unless required by
law. Corporate Information Unless the context requires otherwise, in this report the terms Santarus, we, us and
our refer to Santarus, Inc., a Delaware corporation. We have received U.S. and European Union, or EU, trademark registration for our corporate
name, Santarus®. We also have received U.S. trademark registration and have applied for
EU trademark registration for our brand name, Zegerid®, and have applied for trademark
registration for various other names. All other trademarks, service marks or trade names appearing
in this report are the property of their respective owners. Use or display by us of other parties
trademarks, trade dress or products is not intended to and does not imply a relationship with, or
endorsements or sponsorship of, us by the trademark or trade dress owners. 1




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Item 1.
    Business Overview We are a specialty pharmaceutical company focused on acquiring, developing and commercializing
proprietary products to enhance the quality of life for patients with gastrointestinal diseases and
disorders. The primary focus of our current efforts is the development and commercialization of
next generation proton pump inhibitor, or PPI, products  the most frequently prescribed drugs for
the treatment of many upper gastrointestinal, or GI, diseases and disorders. Our Zegerid products are proprietary immediate-release formulations of the PPI omeprazole in
powder for oral suspension, capsule and chewable tablet formulations and are intended to treat or
reduce the risk of a variety of upper GI diseases and disorders. Immediate-ReleasePPI Products
    
    Dose
    
    Indications
    
    StatusApprovedZegerid
(omeprazole) Powder
for Oral Suspension
    
    20 mg
    
    Heartburn/GERD, Erosive
Esophagitis, Duodenal
Ulcers
    
    NDA approved in 2004;
currently being marketed40 mg
    
    Gastric Ulcers,
Reduction of
Risk of Upper GI
Bleeding in
Critically Ill Patients
    
    NDA approved in 2004;
currently being marketedUnder DevelopmentZegerid (omeprazole)
Capsules
    
    20 mg/40 mg
    
    Heartburn/GERD, Erosive
Esophagitis, Duodenal
Ulcers, Gastric Ulcers
    
    Pivotal PK/PD clinical
trials completed; NDA
submission planned for
third quarter of 2005Zegerid (omeprazole)
Chewable Tablets
    
    20 mg/40 mg
    
    Heartburn/GERD, Erosive
Esophagitis, Duodenal
Ulcers, Gastric Ulcers
    
    Pivotal PK/PD clinical
trials completed; NDA
submission planned for
second half of 2005
 Our Zegerid products are the first immediate-release oral PPIs to be developed for the U.S.
market. The formulations are based on patented technology and utilize antacids to protect the
omeprazole from acid degradation in the stomach, allowing the omeprazole to be quickly absorbed
into the blood stream. Although other marketed oral PPIs enjoy widespread use due to their potent
acid suppression, favorable safety profile and once-a-day dosing, they are available only in
delayed-release, enteric-coated formulations. While the enteric coating protects the PPI from acid
degradation, it also delays absorption until the PPI reaches the less acidic small intestine. Our
immediate-release Zegerid products do not have enteric coatings and are designed to be absorbed
rapidly, while providing a duration of effect similar to delayed-release PPIs. We received approval from the U.S. Food and Drug Administration, or FDA, to market Zegerid
Powder for Oral Suspension 20 mg in June 2004 for the treatment of heartburn and other symptoms
associated with gastroesophageal reflux disease, or GERD, treatment and maintenance of healing of
erosive esophagitis and treatment of duodenal ulcers. We received FDA approval to market the 40 mg
dose in December 2004 for the treatment of gastric ulcers and the reduction of risk of upper GI
bleeding in critically ill patients. There is currently no other PPI product approved for the
reduction of risk of upper GI bleeding indication. Zegerid Powder for Oral Suspension is currently being marketed through a field sales force of
approximately 400 representatives, which includes approximately 230 of our sales representatives in
addition to approximately 170 sales representatives from our co-promotion partner, Otsuka America
Pharmaceutical, Inc., or Otsuka America. Our sales representatives have an average of five years
of pharmaceutical sales experience, with many also having prior PPI selling experience. The
combined commercial sales organizations are targeting the highest PPI-prescribing physicians in the
U.S., with a focus on approximately 10,000 gastroenterologists and 26,000 primary care physicians,
who we estimate were responsible for writing approximately $5.6 billion of 2




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PPI prescriptions in 2004. We believe this concentration of high-volume PPI prescribers will
enable us to effectively promote our products with a relatively small and focused sales and
marketing organization. We are also developing immediate-release capsule and chewable tablet formulations of our
Zegerid product. We believe these products will provide many of the same features as our powder for
oral suspension product, with the convenience of a capsule or chewable tablet. We completed pivotal
pharmacokinetic/pharmacodynamic, or PK/PD, clinical trials evaluating these products in 20 mg and
40 mg doses in late 2004 and early 2005. These trials measured blood levels of omeprazole, as well
as acid control. We intend to submit new drug applications, or NDAs, for these products to the FDA
during the second half of 2005, seeking approval for the treatment of GERD, erosive esophagitis and
gastric and duodenal ulcers. Our business strategy is to develop and market proprietary pharmaceutical products for the
prevention and treatment of GI diseases and disorders with new formulations, enhanced drug delivery
systems or expanded indications that are based on currently marketed or late stage products or
compounds that have clinically demonstrated safety and efficacy. We believe this business strategy
will potentially reduce development and regulatory risks and enhance market acceptance of our
products. In order to continue to execute our business strategy, we plan to:  
    explore additional strategic arrangements with one or more pharmaceutical companies
to expand the promotion of our Zegerid family of products in the U.S.;
    out-license development, distribution and marketing rights for our Zegerid family of
products to one or more pharmaceutical companies outside the U.S.; and
    enhance our product portfolio through internal development, in-licensing or
co-promotion arrangements. To date, in addition to developing our immediate-release omeprazole products, we have
sublicensed our proprietary immediate-release PPI technology to TAP Pharmaceutical Products Inc.,
or TAP. Under the terms of the sublicense, TAP has the North American rights to develop,
manufacture and sell products resulting from the use of our technology with lansoprazole and
derivatives of lansoprazole. We have also entered into a co-promotion agreement with Otsuka
America in October 2004, under which Otsuka America is co-promoting Zegerid Powder for Oral
Suspension and has options to co-promote our capsule and chewable tablet products in the future. Targeted Upper Gastrointestinal Diseases and Disorders and Limitations of Current Treatments Gastrointestinal diseases and disorders affect the digestive tract with varying degrees of
severity. Upper GI diseases and disorders, such as heartburn, GERD, erosive esophagitis and upper
GI bleeding, are generally caused by or aggravated by acid in the stomach or gastric acid that
refluxes into the esophagus. Prolonged exposure to excess acid may result in ulcers or other
serious damage to the tissue of the esophagus, stomach or small intestine. Heartburn and Gastroesophageal Reflux Disease (GERD).Heartburn is pain or a burning sensation
in the throat or chest area resulting from the reflux of acid from the stomach into the swallowing
tube, or esophagus. An individual consistently experiencing heartburn at least twice per week is
generally diagnosed as having GERD. According to the American Gastroenterological Association, an
estimated 25 million American adults suffer from GERD. A significant number of children also
suffer from GERD, and studies have indicated that as many as 2% to 8% of infants and older children
experience symptoms related to GERD. In addition, GERD symptoms frequently occur during the
nighttime hours, and a recent independent survey estimates that as many as 79% of GERD patients
experience nighttime heartburn. Physicians have many choices in treating GERD. A physician will usually first attempt to have
patients alter their diet in order to reduce the frequency of heartburn symptoms. However, most
patients with GERD will eventually require treatment with drugs or surgery. Antacids were
introduced in the early 1900s and are still a frequent over-the-counter treatment option. Although
antacids work quickly, they only neutralize acid in the esophagus and stomach for approximately 30
minutes to one hour after dosing and so provide only short-term relief. Introduced in the 1970s, H2-receptor antagonists are compounds that reduce the production of
stomach acid resulting from stimulation of histamine receptors. In 2000, antacids were combined
with H2-receptor antagonists for over-the-counter treatment of heartburn. However, because the
histamine receptors are only one of three potential sources of acid stimulation, H2-receptor
antagonists generally provide only a partial reduction of acid production. In addition, H2-receptor
antagonists generally work for a 3




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shorter period of time than PPIs. PPIs were introduced in the late 1980s and are currently the most common prescription
treatment option for upper GI diseases including GERD. PPIs are compounds which reduce the
production of stomach acid. Once a PPI is absorbed into the bloodstream, it irreversibly binds to
the active acid-producing pumps in parietal cells located in the stomach walls and inhibits acid
production. Once a PPI irreversibly binds to a pump, that pump will no longer produce acid. As a
result, PPIs are more effective in reducing acid production as compared with H2-receptor
antagonists and generally need only to be taken once a day. Because new pumps and parietal cells
are generated continuously, however, dosing with PPIs generally needs to be repeated once daily if
continuous acid suppression is desired. Since PPIs rapidly degrade in the presence of stomach acid, current oral PPI products, other
than Zegerid, have an enteric coating to protect the drug from acid degradation. The enteric
coating is designed to remain intact in the highly acidic stomach. Once the stomach empties its
contents into the less acidic small intestine, the enteric coating begins to dissolve, allowing the
PPI to be absorbed into the bloodstream. This results in a delay in the absorption of the PPI,
resulting in average peak absorption time of up to two to six hours after the initial dose for
enteric coated PPIs. Erosive Esophagitis.Erosive esophagitis is characterized by erosions and ulcers from the
repeated exposure of the esophagus to acid and develops in as many as 10 million patients in the
U.S. Erosive esophagitis may or may not be accompanied by heartburn, and is typically diagnosed by
a gastroenterologist through a procedure known as endoscopy. An eight-week course of therapy with
PPIs will generally be effective in healing erosions associated with erosive esophagitis. Surgery
may be required if the esophagus becomes extremely damaged. Gastric and Duodenal Ulcers.Gastric and duodenal ulcers are ulcers or erosions in the
stomach or duodenum, respectively. These ulcers may be caused by a combination of gastric acid and
bacterial infection or may result from the use of other medications such as nonsteroidal
anti-inflammatory drugs. There are approximately 5 million patients who suffer from gastric and
duodenal ulcers in the U.S. Most patients with these ulcers are referred to a gastroenterologist
who will perform an endoscopy to determine the extent and severity of the ulcers. Based on the
assessment, the gastroenterologist will prescribe a course of treatment, usually a PPI, to be taken
daily for up to eight weeks and an antibiotic, if appropriate. Upper GI Bleeding.Critically ill ventilated patients are at high risk for developing
erosions and upper GI bleeding that occur when the gastric mucosa, already compromised by stress,
is continuously exposed to significant amounts of acid. Many hospitals treat these patients
prophylactically to reduce acid and the risk of upper GI bleeding. Patients who develop upper GI
bleeding may require blood transfusions or in some cases may require surgery with a high mortality
rate. It is estimated that as many as 4 million critically ill patients are treated annually in the
U.S., with approximately 1.5 million mechanically ventilated patients at highest risk for upper GI
bleeding. Our Products Zegerid Product Differentiation Our Zegerid approved product and products under development are proprietary immediate-release
formulations of the PPI omeprazole in powder for oral suspension, capsule and chewable tablet
formulations. These products are intended to treat or reduce the risk of a variety of upper GI
diseases and disorders, including heartburn and other symptoms associated with GERD, erosive
esophagitis, upper GI bleeding and gastric and duodenal ulcers. PPIs enjoy widespread use due to their potent acid suppression, favorable safety profile and
once-a-day dosing. However, all currently marketed PPIs, other than Zegerid, are available for oral
use only in delayed-release, enteric-coated formulations. While the enteric coating protects the
PPI from acid degradation, it also delays absorption until the PPI reaches the less acidic small
intestine. Our immediate-release Zegerid products do not have enteric coatings and are designed to
be absorbed rapidly, while providing a duration of effect similar to delayed-release PPIs. We have developed our Zegerid family of products to provide the following distinct features:  
    Immediate Release Our Zegerid products utilize one or more antacids instead of
delayed-release, enteric coatings to protect the omeprazole from acid degradation,
providing for more rapid absorption of the omeprazole into the bloodstream. The antacids
neutralize gastric acid, protect the omeprazole from acid degradation and enable rapid
absorption of the omeprazole, 4




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which, in turn, allows the omeprazole to begin to inhibit acid production. For example,
Zegerid Powder for Oral Suspension reaches peak plasma levels in approximately 30 minutes
after dosing. This compares to average peak absorption time of up to two to six hours after
the initial dose for enteric-coated PPIs.
    Duration of Acid Control Our Zegerid products are designed to provide a duration of
acid control similar to delayed-release PPIs and, thus, allow for once-a-day dosing. For
example, data from our pivotal PK/PD clinical trial evaluating Zegerid Powder for Oral
Suspension 40 mg demonstrated that the product maintained a median gastric pH above 4.0 for
18.6 hours per day with repeated once-daily dosing. This duration of
acid control is competitive with the data available for the delayed-release PPIs.
    Variety of Formulations Our Zegerid products are currently available in a powder for
oral suspension formulation and are being developed in capsule and chewable tablet
formulations. In addition to providing alternative formulations for use in the general
adult population, one or more of our formulations may address the needs of specific patient
populations such as pediatric, elderly and hospitalized patients.
    Potential for Expanded Indications We plan to pursue expanded indications and uses for
our products based on their specific features and benefits. For example, we completed a
pivotal Phase III clinical trial evaluating Zegerid Powder for Oral Suspension 40 mg in
critically ill patients and recently received approval to market the 40 mg dose for
reduction of risk of upper GI bleeding in those patients. There is currently no other PPI
product approved for this indication. Zegerid Product Family  Approved Product Zegerid (omeprazole) Powder for Oral Suspension Our first product, Zegerid (omeprazole) Powder for Oral Suspension, is immediate-release
omeprazole in a powder for oral suspension formulation and is available in 20 mg and 40 mg dose
strengths. We received approval from the FDA to market the 20 mg dose in June 2004 for the
treatment of heartburn and other symptoms associated with GERD, treatment and maintenance of
healing of erosive esophagitis, and treatment of duodenal ulcers. In December 2004, we received
approval from the FDA to market the 40 mg dose for the treatment of gastric ulcers and the
reduction of risk of upper GI bleeding in critically ill patients. In addition, in connection with
the approval of our NDAs for Zegerid Powder for Oral Suspension, we have committed to evaluate the
product in pediatric populations, including in PK/PD and safety studies which we plan to initiate
during the second half of 2005. Zegerid Powder for Oral Suspension utilizes sodium bicarbonate, an antacid, instead of an
enteric coating to protect the omeprazole from acid degradation and enable rapid absorption of the
omeprazole into the bloodstream. When constituted with water to form a uniform suspension and then
administered, the antacid neutralizes acid in the stomach, protects the omeprazole from degradation
and allows for rapid absorption of the omeprazole into the bloodstream, with peak plasma levels in
approximately 30 minutes after dosing. In addition to use in the general adult population, our
suspension formulation, which is administered in a liquid, titratable dosage form, is designed to
be easily administered to critically ill patients via a nasogastric tube and may also be
appropriate for patients who have difficulty swallowing a capsule or a tablet, such as pediatric or
elderly patients. To support our NDA submissions, we completed two pivotal PK/PD clinical trials in 2002
comparing the 20 mg and 40 mg doses of our powder for oral suspension product to 20 mg and 40 mg
delayed-release omeprazole capsules given prior to a meal for seven days. The PK portion of these
studies measured various aspects of blood levels of omeprazole. The PD portion of these studies
measured acid control over a 24-hour period. Each study was conducted by a third party in at least
24 subjects. The results indicated that both the 20 mg and 40 mg doses of Zegerid Powder for Oral
Suspension produced peak blood levels of omeprazole in approximately 30 minutes after dosing, as
compared with peak blood levels of omeprazole in approximately one and one-half to two hours for
the delayed-release omeprazole, due to the immediate-release profile of our formulations. While
achieving more rapid absorption of omeprazole, the immediate-release Zegerid products also
maintained a similar duration of effect on acid concentration in the stomach as compared to
delayed-release omeprazole. For example, the 40 mg dose maintained a median gastric pH above 4.0
for 18.6 hours per day with repeated once-daily dosing. The amount of time that pH is greater than
4.0 is a parameter that is frequently used to evaluate the clinical effects of treatment with PPIs
in patients with acid-related diseases. Studies suggest that healing rates and relief of symptoms
associated with acid-related diseases can be correlated with the duration for which pH is
maintained above 4.0. In addition, in June 2003, we completed a multi-center Phase III clinical trial evaluating the
40 mg dose of Zegerid Powder for Oral Suspension for the reduction of risk of upper GI bleeding in
critically ill patients. Critically ill patients who have experienced trauma are generally at
higher risk for developing significant bleeding from ulcers or erosions, and many physicians choose
to 5




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prophylactically treat these patients with an acid reducing medication. Given the serious condition
of the patient population, the blinded clinical trial compared Zegerid Powder for Oral Suspension,
administered through a nasogastric tube, with intravenous, or IV, cimetidine, a H2-receptor
antagonist, rather than a placebo. At the time of the trial, IV cimetidine was the only drug
approved by the FDA for the studied indication. A total of 359 mechanically-ventilated, critically ill patients at approximately 50 clinical
sites participated in this trial. The primary endpoint of the study, the occurrence of clinically
significant bleeding, was the same as that used in the IV cimetidine trial which led to its
approval. In the trial, 10 patients treated with IV cimetidine experienced clinically significant
bleeding, compared to 7 patients treated with Zegerid Powder for Oral Suspension 40 mg,
demonstrating that our powder for oral suspension product was not inferior to IV cimetidine in
reducing the risk of upper GI bleeding in critically ill patients. In addition, in the trial,
Zegerid Powder for Oral Suspension 40 mg achieved a median gastric pH of greater than 4.0 within 1
to 2.5 hours after the first dose in 99% of patients treated and sustained a median daily gastric
pH of greater than 4.0 throughout the 14-day trial in 95% of the patients treated. As additional support for the approval of Zegerid Powder for Oral Suspension 40 mg, we
conducted an open-label clinical trial in 243 patients, including approximately 95 patients with
gastric ulcers, to collect safety data related to this product over an eight-week treatment period,
including any potential side effects or other adverse events. We conducted this clinical trial at
the FDAs request because the maximum omeprazole blood concentration for our 40 mg product was
higher than that for delayed-release omeprazole 40 mg, although similar to maximum blood
concentrations resulting from approved higher doses of delayed-release omeprazole. The data from
this trial demonstrated that the safety profile of our 40 mg product is similar to the safety
profile described for delayed-release omeprazole, and the FDA reviewed this data in connection with
its approval of our NDA. During 2004, we also conducted a clinical trial comparing the effects of Zegerid Powder for
Oral Suspension and Protonix® delayed-release pantoprazole tablets on nocturnal gastric
acidity. In this trial, 36 patients with nocturnal symptoms of GERD were enrolled in an open-label
crossover trial, and data from 32 patients were available for analysis. The patients were
randomized to be treated with repeated evening doses of either Zegerid Powder for Oral Suspension
40 mg or Protonix delayed-release tablets 40 mg for one week. After a washout period of one week,
patients were treated with the alternate drug, following the same schedule. After repeated
once-daily dosing, Zegerid Powder for Oral Suspension produced statistically significantly better
nocturnal gastric acid control than Protonix. The patients receiving Zegerid had a median gastric
pH of 4.7, as compared to a median gastric pH of 2.0 for the patients receiving Protonix, and the
percent time that gastric pH was greater than 4.0 was higher for patients receiving Zegerid than
for patients receiving Protonix (55% as compared to 27%). In addition, the percentage of patients
experiencing nocturnal acid breakthrough was lower for patients receiving Zegerid than for patients
receiving Protonix (53% as compared to 78%). We intend to conduct other clinical trials which may help to further differentiate our powder
for oral suspension product from the currently marketed delayed-release PPIs or otherwise expand
its use. Zegerid Product Family  Products Under Development Zegerid (omeprazole) Capsules We are also developing Zegerid (omeprazole) Capsules, which is immediate-release omeprazole in
a capsule formulation, in 20 mg and 40 mg dose strengths. Similarly to Zegerid Powder for Oral
Suspension, Zegerid Capsules utilize an antacid (sodium bicarbonate), instead of an enteric coating
to protect the omeprazole from acid degradation. When the capsule is swallowed, the antacid
neutralizes acid in the stomach, protects the omeprazole from degradation and allows for rapid
absorption of the omeprazole into the bloodstream. We expect the capsule product to provide a
convenient and familiar dosage alternative for many patients. In November 2004, we completed two pivotal PK/PD clinical trials evaluating Zegerid Capsules
20 mg and 40 mg. The trials were open-label, randomized, crossover trials, each conducted at a
single site. Each trial evaluated the pharmacokinetics and pharmacodynamics of single doses and
seven consecutive daily doses of Zegerid Capsules compared to delayed-release omeprazole capsules
in 36 healthy subjects. The primary objective of the trials was to evaluate whether the
immediate-release Zegerid Capsules were pharmacokinetically equivalent to delayed-release
omeprazole capsules with respect to total systemic bioavailability (AUC) on Day 7. The trials also
assessed whether Zegerid Capsules and the delayed-release omeprazole capsules had similar ability
to suppress gastric acidity over 24 hours. The preliminary trial results demonstrated that Zegerid
Capsules and the delayed-release omeprazole capsules were statistically equivalent with respect to
AUC and percent decrease from baseline for integrated gastric acidity on Day 7. As expected for an immediate-release product, the maximum plasma concentration (Cmax) was
greater and the time to maximum plasma concentration (Tmax) was shorter on Day 7 for Zegerid
Capsules than for the delayed-release omeprazole capsules. These 6




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results were similar to those obtained in the pivotal PK/PD trials that were conducted for
Zegerid Powder for Oral Suspension 20 mg and 40 mg. Following final analysis of the pivotal trial data and collection and analysis of sufficient
stability data, we plan to submit a Section 505(b)(2) NDA to the FDA during the third quarter of
2005, seeking approval for the capsule product for the treatment of heartburn and other symptoms
associated with GERD, treatment and maintenance of healing of erosive esophagitis and treatment of
duodenal and gastric ulcers. We also intend to conduct other clinical trials which may help to further differentiate our
capsule product from the currently marketed delayed-release PPIs or otherwise expand its future
use. Zegerid (omeprazole) Chewable Tablets We are also developing Zegerid (omeprazole) Chewable Tablets, which is immediate-release
omeprazole in a chewable tablet formulation, in 20 mg and 40 mg dose strengths. Like our capsule
product, Zegerid Chewable Tablets utilizes antacids (sodium bicarbonate and magnesium hydroxide)
instead of an enteric coating to protect the omeprazole from acid degradation. When the tablet is
chewed and swallowed, the antacid formulation neutralizes acid in the stomach, protects the
omeprazole from degradation and allows for the rapid absorption of the omeprazole into the
bloodstream. We expect the chewable tablet product to provide yet another convenient dosage form
for many patients, including patients who have difficulty swallowing a capsule or a tablet, such as
pediatric and elderly patients. In February 2005, we completed two pivotal PK/PD clinical trials evaluating Zegerid Chewable
Tablets 20 mg and 40 mg. The trials were open-label, randomized, crossover trials, each conducted
at a single site. Each trial evaluated the pharmacokinetics and pharmacodynamics of single doses
and seven consecutive daily doses of Zegerid Chewable Tablets compared to delayed-release
omeprazole capsules in 36 healthy subjects. The primary objective of the trials was to evaluate
whether the immediate-release Zegerid Chewable Tablets were pharmacokinetically equivalent to
delayed-release omeprazole capsules with respect to total systemic bioavailability (AUC) on Day 7.
The trials also assessed whether Zegerid Chewable Tablets and the delayed-release omeprazole
capsules had similar ability to suppress gastric acidity over 24 hours. The preliminary trial
results demonstrated that Zegerid Chewable Tablets and the delayed-release omeprazole capsules were
statistically equivalent with respect to AUC and percent decrease from baseline for integrated
gastric acidity on Day 7. As expected for an immediate-release product, the maximum plasma concentration (Cmax) was
greater and the time to maximum plasma concentration (Tmax) was shorter on Day 7 for Zegerid
Chewable Tablets than for the delayed-release omeprazole capsules. These results were similar to
those obtained in the pivotal PK/PD trials that were conducted for Zegerid Powder for Oral
Suspension 20 mg and 40 mg and Zegerid Capsules 20 mg and 40 mg. Following final analysis of the pivotal trial data and collection and analysis of sufficient
stability data, we plan to submit a Section 505(b)(2) NDA to the FDA during the second half of
2005, seeking approval for the chewable tablet product for the treatment of heartburn and other
symptoms associated with GERD, treatment and maintenance of healing of erosive esophagitis and
treatment of duodenal and gastric ulcers. We also intend to conduct other clinical trials which may help to further differentiate our
chewable tablet product from the currently marketed delayed-release PPIs or otherwise expand its
future use. Strategy Our goal is to become a leading specialty pharmaceutical company that acquires, develops and
commercializes proprietary products to enhance the quality of life for patients with GI diseases
and disorders. Our business strategy is to develop and market proprietary pharmaceutical products
with new formulations, enhanced delivery systems and expanded indications that are based on
currently marketed or late stage products or compounds, which otherwise have clinically
demonstrated safety and efficacy. We believe this strategy will allow us to more rapidly
commercialize our products with potentially reduced development risk and cost as compared with the
development of early stage new chemical entities. Our Zegerid family of products are new immediate-release formulations of omeprazole, a
well-established compound which has been approved by the FDA and marketed for over 15 years. For
Zegerid Powder for Oral Suspension, we were able to move relatively quickly from product concept to
NDA submission by conducting PK/PD studies comparing this product to delayed-release 7




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omeprazole, without the need to conduct preclinical or other early stage clinical testing.
Moreover, we were also able to move directly into a Phase III clinical study to further
differentiate this product from existing products. In order to continue to execute our business strategy, we intend to:  
    Explore Additional Strategic Arrangements to Expand the Promotion of Our Products in the
U.S.We plan to explore additional strategic arrangements with one or more pharmaceutical
companies to expand the promotion of our Zegerid family of products in the U.S. To date,
we have sublicensed our proprietary immediate-release PPI technology to TAP, granting to
TAP the North American rights to develop, manufacture and sell products resulting from the
use of our technology with lansoprazole and derivatives of lansoprazole. We have also
entered into a co-promotion agreement with Otsuka America in October 2004, under which
Otsuka America is co-promoting Zegerid Powder for Oral Suspension and has options to
co-promote our capsule and chewable tablet products in the future. We will continue to
evaluate strategies to expand the promotion of our Zegerid products in the U.S. For
example, in connection with the approval of Zegerid Powder for Oral Suspension 40 mg for
reduction of risk of upper GI bleeding in critically ill patients, we are evaluating
strategies to expand the promotion of Zegerid to the hospital market, including teaching
hospitals and other influential institutions that serve this patient population, in order
to create greater awareness of the Zegerid brand over time.
    Out-License International Development, Distribution and Marketing Rights.Outside of the
U.S., we intend to out-license development, distribution and marketing rights for our
Zegerid family of products to one or more pharmaceutical companies with established
commercialization capabilities outside the U.S. We have filed several patent applications
outside the U.S., and likely will more actively pursue commercialization in particular
territories if and when we obtain issued patents in such territories.
    Enhance Our Product Portfolio through Internal Development, In-Licensing and
Co-Promotion Arrangements.We intend to internally develop and license and acquire
additional products and marketed products targeting upper and lower GI diseases and
disorders. We also plan to explore co-promotion arrangements for marketed products that
are relevant to our target gastroenterologists or primary care physicians. Our management
team has substantial experience in product development, manufacturing, clinical
development, regulatory affairs and sales and marketing through their participation at
other companies in the successful development and commercialization of GI and other
products. We believe this experience will allow us to successfully build our business
organization and distinguish us from specialty pharmaceutical companies that focus solely
on the distribution of products. We also believe that this experience and expanded focus
will help us identify attractive licensing and acquisition opportunities with
pharmaceutical companies, biotechnology companies and universities. Sales and Marketing We have established a commercial sales organization to focus on the highest PPI-prescribing
physicians in the U.S. with a focus on approximately 10,000 gastroenterologists and 26,000 primary
care physicians. We estimate that this group collectively wrote approximately $5.6 billion of PPI
prescriptions in 2004, representing nearly one-half of the total U.S. PPI market. We believe this
concentration of high-volume PPI prescribers will enable us to effectively promote our products
with a relatively small and focused sales and marketing organization. In preparation for the launch of Zegerid Powder for Oral Suspension 20 mg in October 2004, we
built a field sales organization comprised of approximately 230 sales representatives. In addition
to the field sales representatives, we employ approximately 25 district sales managers, 4 regional
sales directors and 18 account managers. Our account managers are seeking formulary acceptance
from managed care organizations similar to that for branded delayed-release PPIs. To complement
our commercial sales organization, we also entered into a co-promotion agreement with Otsuka
America in October 2004, under which Otsuka Americas approximately 170 field sales representatives
are co-promoting Zegerid Powder for Oral Suspension in the first selling position. Additionally,
we use a variety of marketing programs to promote our products, including sales promotional
materials, speaker programs, journal advertising, industry publications, electronic media and
product sampling. Our field sales representatives are positioned in major metropolitan areas across the U.S. and
have an average of five years of pharmaceutical sales experience. Many of the representatives have
prior experience with GI products, including PPIs. Each member of our sales team undergoes a
rigorous training program focused on our product offerings, disease background, competitive
products and our sales techniques. Our program includes significant field-based learning to provide
a comprehensive understanding and perspective as to the upper GI market and the needs of both
physicians and patients. The field sales representatives are compensated in part in accordance with
an incentive bonus program based on performance. 8




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Co-Promotion Agreement with Otsuka America Pharmaceutical, Inc. In October 2004, we entered into a non-exclusive co-promotion agreement with Otsuka America to
co-promote Zegerid Powder for Oral Suspension to U.S. physicians. Otsuka Americas sales
representatives began promoting Zegerid Powder for Oral Suspension 20 mg in early November 2004. Under the terms of the co-promotion agreement, we received a $15.0 million upfront payment
from Otsuka America, and will pay Otsuka America a royalty on total U.S. net sales of Zegerid
Powder for Oral Suspension. Initially, the royalty rate is in the high single digits, presuming a
minimum number of first position sales calls to target physicians. We provide all marketing
materials, and Otsuka America covers all costs related to its sales force. In addition, we have
granted Otsuka America options to extend the co-promotion arrangement under the agreement to
Zegerid Capsules and Zegerid Chewable Tablets, subject to receipt of marketing approval of these
products, with additional milestone payments should those options be exercised. In order to compete effectively, we and Otsuka America may desire to further expand our sales
forces beyond our current combined total of approximately 400 sales representatives. We plan to
evaluate further expansion of our sales force based on the market demand for Zegerid Powder for
Oral Suspension and the status of our planned regulatory submissions for Zegerid Capsules and
Zegerid Chewable Tablets. Under the terms of our co-promotion agreement with Otsuka America,
Otsuka America may increase the size of its sales force up to 400 sales representatives to match
any expansion of our sales force in exchange for an increased royalty rate in the low double
digits. The agreement will terminate automatically on December 31, 2009, unless terminated sooner.
Either party may terminate the agreement if the other party fails to perform any material term of
the agreement and fails to cure such breach, subject to prior written notice within a specified
time period. In addition, either party may terminate the agreement if the other party becomes
insolvent, files or consents to the filing of a petition under any bankruptcy or insolvency law or
has any such petition filed against it, and within a specified time period, such filing has not
been stayed. We may also terminate the agreement under certain additional conditions, subject to
prior written notice to Otsuka America within a specified time period. TAP Pharmaceutical Products Agreement In June 2002, we entered into a strategic sublicense agreement with TAP. Under the agreement,
we granted TAP the North American rights to develop, manufacture and sell products resulting from
the use of our immediate-release PPI technology with lansoprazole, its patented PPI marketed under
the name Prevacid®, and derivatives of lansoprazole. TAP had sales of Prevacid in North
America of approximately $3.8 billion in 2004, according to IMS Health. Under the agreement, TAP is
required to pay a combination of fees for the licensed rights, including an upfront payment and
milestone payments that may exceed $100 million. In addition, we are entitled to royalties on any
future sales of products utilizing our proprietary technology that are commercialized by TAP. The
sublicense is exclusive with respect to lansoprazole and non-exclusive with respect to derivatives
of lansoprazole. We believe that if TAP successfully develops and commercializes one or more new
products based on our licensed patent rights, TAPs commercialization efforts will, in addition to
providing revenue to us, help drive market acceptance of immediate-release PPI products. To date, we have received an $8.0 million upfront payment from TAP in July 2002 following the
execution of the sublicense and a $10.0 million milestone payment in February 2005 related to TAPs
development activities. We received the February 2005 milestone after we prevailed in an
alternative dispute resolution proceeding that we initiated against TAP in August 2003. In the
proceeding, we alleged that TAP had achieved a development milestone, and we were awarded the $10.0
milestone payment, plus interest and legal expenses. We paid 15% of the upfront sublicense fee and
the February 2005 milestone to the University of Missouri and are also obligated to pay 15% of any
further milestone payments, as well as share a portion of any royalty payments, we receive from TAP
pursuant to our license with the University of Missouri. The milestone fees and royalty rates may
be subject to adjustment during the term of the agreement based on a number of factors, including
whether we commercialize or license an immediate-release formulation of any PPI other than
omeprazole. In order for us to receive milestone fees in excess of $100 million under the
agreement with TAP, TAP would generally need to develop and receive NDA approval for one
immediate-release lansoprazole product and either TAP would need to also conduct development
activities for an immediate-release lansoprazole derivative product or Takeda Chemical Industries,
Ltd., or Takeda, would need to exercise its option and receive regulatory approval for lansoprazole
or lansoprazole derivative products outside North America, as described more fully below. TAP is
responsible for all of its product development and commercialization expenses. 9




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Pursuant to the terms of the agreement, we also granted an option to Takeda to receive a
license covering all countries outside of North America to develop, manufacture and sell products
resulting from the use of our immediate-release PPI technology with lansoprazole and derivatives of
lansoprazole. The rights would be exclusive with respect to lansprazole and non-exclusive with
respect to derivatives of lansoprazole. In the event that Takeda exercises its option, we would be
entitled to receive aggregate upfront payments of up to $5.0 million and aggregate milestone
payments of up to $7.75 million, depending on whether Takeda exercises the option for all
territories outside North America and whether Takeda is able to commercialize an immediate-release
lansoprazole or lansoprazole derivative product through regulatory approval. The agreement with TAP will remain in effect in the U.S. or Canada until there is no longer a
valid claim under the patents covering the University of Missouri technology in the U.S. or Canada,
respectively, upon which TAPs improved formulation is based, which we expect will be no earlier
than 2016. In addition, we have the right to terminate the agreement if TAP does not meet diligence
obligations with respect to the development of an improved PPI formulation. Either TAP or we may
terminate the agreement prior to its expiration under other circumstances, including bankruptcy or
uncured breach of any material provision of the agreement. TAP may also terminate the agreement
without cause at any time by giving us 60 days prior written notice. Manufacturing and Distribution We rely on third parties for the manufacture of both clinical and commercial quantities of our
products and for product distribution, and we do not currently have any of our own manufacturing or
distribution facilities. Our third-party manufacturers are subject to extensive governmental
regulation. The FDA mandates that drugs be manufactured, packaged and labeled in conformity with
current good manufacturing practices, or cGMP. In complying with cGMP regulations, manufacturers
must continue to expend time, money and effort in production, record keeping and quality control to
ensure that their services and products meet applicable specifications and other requirements. We
intend to continue to outsource the manufacture and distribution of our products for the
foreseeable future, and we believe this manufacturing strategy will enable us to direct our
financial resources to commercialization without devoting the resources and capital required to
build cGMP compliant manufacturing facilities. We currently rely on Patheon Inc. as our only supplier of Zegerid Powder for Oral Suspension
and have entered into an agreement with Patheon which provides for the commercial supply of this
product. The commercial supply agreement requires that we purchase a significant percentage of our
requirements of this product from Patheon and also obligates us to fund certain equipment
purchases. This agreement has an initial five-year term beginning from July 2004 and thereafter
continues in force indefinitely. Either party may terminate the agreement at any time after the
initial term with 18 months written notice. We can terminate the agreement at any time if we decide
to no longer market our powder for oral suspension product with six months written notice. We can
also terminate this agreement with 30 days written notice in the event any governmental agency
takes any action that prevents us from purchasing or selling the product for a certain period of
time. Either party may terminate the agreement if the other party fails to perform any material
term of the agreement subject to prior written notice within a specified time period. In addition, in September 2004, we entered into a manufacturing and supply agreement with OSG
Norwich Pharmaceuticals, Inc., or Norwich, for the supply of commercial quantities of Zegerid
Capsules, which is currently under development. The agreement provides for an initial four-year
term beginning upon commencement of commercial manufacturing and thereafter continues in force
indefinitely unless terminated with 18 months written notice. We can also terminate the agreement,
effective immediately, at any time if we decide to no longer market the product, in the event any
governmental agency takes any action that prevents us from importing, exporting, purchasing or
selling the product or in the event of certain regulatory proceedings involving the manufacturer.
Either party may terminate the agreement if the other party fails to perform any material term of
the agreement and fails to cure such breach within a specified time period, subject to prior
written notice. We have not yet entered into any commercial supply agreements for Zegerid Chewable
Tablets. We also currently rely on Union Quimico Farmaceutica, S.A., or Uquifa, as our exclusive
supplier of the omeprazole active ingredient in each of our current products. Under our supply
agreement with Uquifa, we must purchase all of our requirements of omeprazole from Uquifa. This
agreement has an initial four-year term with automatic two-year renewal terms. We can terminate the
agreement upon at least 12 months notice prior to the expiration of the initial term or any
extension term. In addition, we can terminate this agreement with 30 days written notice in the
event any governmental agency takes any action that prevents us from purchasing or selling either
omeprazole or the finished product for a certain period of time. Either party may terminate the
agreement if the other party fails to perform any material term of the agreement subject to prior
written notice and an opportunity to cure. Although there are potential sources of supply other than Patheon, Norwich and Uquifa for our
products and active pharmaceutical 10




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ingredients, any new supplier would be required to qualify under applicable regulatory
requirements and would need to have sufficient rights under applicable intellectual property laws
to the method of manufacture of such products or ingredients. We sell our approved products to pharmaceutical wholesalers, who in turn seek to distribute
the products to retail pharmacies, mail order pharmacies, hospitals and other institutional
customers. We have retained third-party service providers to perform a variety of functions related
to the distribution of our approved products, including logistics management, sample
accountability, storage and transportation. In addition, we have retained third parties to perform
various regulatory monitoring services for us, including adverse event reporting, safety database
management and other product maintenance services. We have also entered into channel services
agreements with wholesalers under which we receive certain distribution management services and
data reporting from the wholesalers, in exchange for a fee. Intellectual Property Our goal is to obtain, maintain and enforce patent protection for our products, compounds,
formulations, processes, methods and other proprietary technologies invented, developed, licensed
or acquired by us, preserve our trade secrets, and operate without infringing on the proprietary
rights of other parties, both in the U.S. and in other countries. Our policy is to actively seek to
obtain, where appropriate, intellectual property protection for our products, proprietary
information and proprietary technology through a combination of contractual arrangements and laws,
including patents, both in the U.S. and elsewhere in the world. We regard the protection of
patents, trademarks and other proprietary rights that we own or license as critical to our success
and competitive position. Laws and contractual restrictions, however, may not be sufficient to
prevent unauthorized use or misappropriation of our technology or deter others from independently
developing products that are substantially equivalent or superior to our products. Due to the length of time and expense associated with bringing new pharmaceutical products to
market, we recognize that there are considerable benefits associated with developing, licensing or
acquiring products that are protected by existing patents or for which patent protection can be
obtained. Although we do not currently own any issued patents, all of the products we currently
market and intend to market incorporate patented technology owned by others that we have licensed.
In addition, we have applied and intend to continue to apply for patent protection for new
technology we develop whenever we determine that the benefit of patent protection outweighs the
cost of obtaining patent protection. We also depend upon the skills, knowledge and experience of our scientific and technical
personnel, as well as that of our advisors, consultants and other contractors. To help protect our
proprietary know-how that is not patentable, and for inventions for which patents may be difficult
to enforce, we rely on trade secret protection and confidentiality agreements to protect our
interests. To this end, we require our employees, consultants, advisors and certain other
contractors to enter into confidentiality agreements which prohibit the disclosure of confidential
information and, where applicable, require disclosure and assignment to us of the ideas,
developments, discoveries and inventions important to our business. Additionally, these
confidentiality agreements require that our employees, consultants and advisors do not bring to us,
or use without proper authorization, any third partys proprietary technology. We have received U.S. and EU trademark registration for our corporate name,
Santarus®. In addition, we have received U.S. trademark registration and have applied
for EU trademark registration for our brand name, Zegerid®, and have applied for
trademark registration for various other names. Over time, we intend to introduce new trademarks,
service marks and brand names and maintain registrations on trademarks that remain valuable to our
business. License Rights from the University of Missouri In January 2001, we entered into an exclusive, worldwide license agreement with the University
of Missouri for all of its patents and pending patent applications relating to specific
formulations of PPIs with antacids and other buffering agents. Currently, five U.S. patents have
been issued and several U.S. patent applications and international or foreign counterpart
applications are pending and are subject to this license. The five issued patents, U.S. Patent Nos.
5,840,737, 6,489,346, 6,645,988, 6,699,885 and 6,780,882, together generally cover pharmaceutical
compositions combining PPIs with buffering agents, such as antacids, and methods of treating GI
disorders by administering solid or liquid forms of such compositions, and expire in July 2016. Pursuant to the terms of the license agreement, we paid the University of Missouri an upfront
licensing fee of $1.0 million in 2001, a one-time $1.0 million milestone fee in 2003 following the
filing of our first NDA and a one-time $5.0 million milestone fee in July 2004 following the FDAs
approval of Zegerid Powder for Oral Suspension 20 mg. We are required to make additional milestone
payments to the University of Missouri upon the achievement of certain regulatory events related to
obtaining approvals outside the U.S. which may total up to $3.5 million in the aggregate. We are
also required to make milestone payments based on first-time 11




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achievement of significant sales thresholds, up to a maximum of $86.3 million, and to pay
royalties on net sales of our products. In addition, we are required to bear the costs of
prosecuting and maintaining the licensed patents but the University of Missouri remains responsible
for prosecution of any applications. We issued to the University of Missouri 164,284 shares of our
common stock in connection with the license agreement. Under the license agreement, we are
permitted to sublicense our rights to third parties. We are obligated to pay to the University of
Missouri a portion of any sublicense fees, milestone payments or royalties that we receive from any
sublicense, including our sublicense to TAP. Under the license agreement, we are required to carry
occurrence-based liability insurance with policy limits of at least $5.0 million per occurrence and
a $10.0 million annual aggregate. The license from the University of Missouri expires in each country when the last patent for
licensed technology expires in that country and the last patent application for licensed technology
in that country is abandoned, provided that our obligation to pay certain minimum royalties in
countries in which there are no pending patent applications or existing patents terminates on a
country-by-country basis on the 15th anniversary of our first commercial sale in such country. If
we fail to meet diligence obligations in specified countries, the University of Missouri can
terminate our license or render it non-exclusive with respect to those countries. Our rights under
this license are also generally subject to early termination under specified circumstances,
including our material and uncured breach or our bankruptcy or insolvency. We can terminate this
agreement at any time, in whole or in part, with 60 days written notice. Competition The pharmaceutical industry is subject to intense competition. Our success will depend, in
part, upon our ability to achieve market share at the expense of existing, established and future
products in the relevant target markets. We face, and will continue to face, competition in the
development and commercialization of our products primarily from pharmaceutical and biotechnology
companies, many of which have significantly greater financial and other resources than we do, as
well as from academic institutions, government agencies and research institutions. Our competitors have addressed the market for our Zegerid products through the development and
marketing of many products, including: Prescription Products:  
    PPIs: AstraZeneca plcs Prilosec® and
Nexium®, TAPs Prevacid, Wyeths and
Altanas Protonix, Johnson & Johnsons and Eisai Co.,
Ltd.s Aciphex®, and generic omeprazole,
among others; and
    H2-receptor antagonists: Merck & Co., Inc.s
Pepcid®, GlaxoSmithKline plcs
Zantac® and Tagamet® and Reliant
Pharmaceuticals, Inc.s Axid®, among others. Over-the-Counter Products:  
    PPIs: The Procter & Gamble Companys Prilosec OTC®;
    H2-receptor antagonists: Pfizer Inc.s Zantac,
GlaxoSmithKlines Tagamet, and Johnson & Johnsons and
Mercks Pepcid® AC and Pepcid®
Complete, among others; and
    Antacids: Johnson & Johnsons and Mercks
Mylanta®, Novartis AGs Maalox®,
Pfizers Rolaids® and GlaxoSmithKlines
Gaviscon® and Tums®, among others. Many of our competitors are large, well-established companies in the pharmaceutical
field. Given our relatively small size and the entry of our new products into a market
characterized by well-established drugs, we may not be able to compete effectively. For example,
our competitors may have a greater ability to undertake more extensive research and development,
manufacturing, marketing and other programs. They may also have significantly greater financial and
other resources than we do, and they may have significantly larger field sales force organizations
and invest significant amounts in advertising and marketing their products, including through
television and other direct-to-consumer methods. In addition to competition from existing commercial products, a number of companies and
research institutions have focused research and development resources on developing new products, including reversible acid
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derivatives of current PPIs and motility agents and combinations thereof that may be utilized to treat GI diseases and disorders, and the pace of
technological development and the number of product candidates may increase over the next few
years. Future products that are developed may be based on new and different technology that may
involve faster mechanisms of action than our products or exhibit other benefits relative to our
products. Our ability to compete with products that our competitors develop will depend in part on our
competitors ability to obtain patent protection for their products and product candidates and the
periods of exclusivity resulting from these patents. Many of the patents covering antacids or
H2-receptor antagonists have expired and are subject to generic competition. In addition, among the
currently-marketed PPIs, Prilosec is the only product for which the primary patent has expired. To
date, several generic companies have launched generic delayed-release omeprazole products. As more
PPI patents expire, we expect our competitors to compete with us by introducing additional generic
products as well as allocating additional resources to research relating to potential treatments
with greater potential for patent-based exclusivity, such as prodrugs and isomers of PPIs,
reversible acid inhibitors and motility agents. Government Regulation Governmental authorities in the U.S. and other countries extensively regulate the testing,
manufacturing, labeling, storage, recordkeeping, advertising, promotion, export, marketing and
distribution, among other things, of pharmaceutical products. In the U.S., the FDA, under the
Federal Food, Drug, and Cosmetic Act and other federal statutes and regulations, subjects
pharmaceutical products to rigorous review. If we do not comply with applicable requirements, we
may be fined, the government may refuse to approve our marketing applications or allow us to
manufacture or market our products, and we may be criminally prosecuted. We and our third-party manufacturers, distributors and clinical research organizations may
also be subject to regulations under other federal, state, and local laws, including the
Occupational Safety and Health Act, the Environmental Protection Act, the Clean Air Act and import,
export and customs regulations as well as the laws and regulations of other countries. FDA Approval Process To obtain approval of a new product from the FDA, we must, among other requirements, submit
data supporting safety and efficacy as well as detailed information on the manufacture and
composition of the product and proposed labeling. The testing and collection of data and the
preparation of necessary applications are expensive and time-consuming. The FDA may not act quickly
or favorably in reviewing these applications, and we may encounter significant difficulties or
costs in our efforts to obtain FDA approvals that could delay or preclude us from marketing our
products. The process required by the FDA before a new drug may be marketed in the U.S. generally
involves the following: completion of preclinical laboratory and animal testing in compliance with
FDA regulations; submission of an investigational new drug application which must become effective
before human clinical trials may begin; performance of adequate and well-controlled human clinical
trials to establish the safety and efficacy of the proposed drug for its intended use; and
submission and approval of an NDA by the FDA. The sponsor typically conducts human clinical trials
in three sequential phases, but the phases may overlap. In Phase I clinical trials, the product is
tested in a small number of patients or healthy volunteers, primarily for safety at one or more
doses. In Phase II, in addition to safety, the sponsor evaluates the efficacy of the product on
targeted indications, and identifies possible adverse effects and safety risks, in a patient
population somewhat larger than Phase I clinical trials. Phase III clinical trials typically
involve additional testing for safety and clinical efficacy in an expanded population at
geographically-dispersed test sites. Clinical trials must be conducted in accordance with the FDAs good clinical practices
requirements. The FDA may order the temporary or permanent discontinuation of a clinical trial at
any time or impose other sanctions if it believes that the clinical trial is not being conducted in
accordance with FDA requirements or presents an unacceptable risk to the clinical trial patients.
The Institutional Review Board, or IRB, generally must approve the clinical trial design and
patient informed consent at each clinical site and may also require the clinical trial at that site
to be halted, either temporarily or permanently, for failure to comply with the IRBs requirements,
or may impose other conditions. The applicant must submit to the FDA the results of the preclinical and clinical trials,
together with, among other things, detailed information on the manufacture and composition of the
product and proposed labeling, in the form of an NDA, including payment of a user fee. The FDA
reviews all NDAs submitted before it accepts them for filing and may request additional information
rather than accepting an NDA for filing. Once the submission is accepted for filing, the FDA begins
an in-depth review of the NDA. Under the policies adopted by FDA under the Prescription Drug User
Fee Act, or PDUFA, the FDA has 10 months in which to complete its initial review of the NDA and respond to the applicant. The review process and the target
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extended if the FDA requests or the NDA sponsor otherwise provides additional information or clarification regarding information already provided in the submission.
Following completion of the FDAs initial review of the NDA and the clinical and manufacturing
procedures and facilities, the FDA will issue an action letter, which will either include an
approval authorizing commercial marketing of the drug for certain indications or contain the
conditions that must be met in order to secure final approval of the NDA. According to the FDA, the
median approval time for NDAs approved during calendar year 2003 was approximately 15 months. If
the FDAs evaluation of the NDA submission and the clinical and manufacturing procedures and
facilities is not favorable, the FDA may refuse to approve the NDA. Section 505(b)(2) New Drug Applications As an alternate path to FDA approval for new or improved formulations of previously approved
products, a company may file a Section 505(b)(2) NDA. Section 505(b)(2) of the Federal Food, Drug,
and Cosmetic Act was enacted as part of the Drug Price Competition and Patent Term Restoration Act
of 1984, otherwise known as the Hatch-Waxman Amendments. Section 505(b)(2) permits the filing of an
NDA where at least some of the information required for approval comes from studies not conducted
by or for the applicant and for which the applicant has not obtained a right of reference. The
Hatch-Waxman Amendments permit the applicant to rely upon certain preclinical or clinical studies
conducted for an approved product. The FDA may also require companies to perform additional studies
or measurements to support the change from the approved product. The FDA may then approve the new
product for all or some of the label indications for which the referenced product has been
approved, as well as for any new indication sought by the Section 505(b)(2) applicant. To the extent that the Section 505(b)(2) applicant is relying on studies conducted for an
already approved product, the applicant is required to certify to the FDA concerning any patents
listed for the approved product in the FDAs Orange Book publication. Specifically, the applicant
must certify that: (i) the required patent information has not been filed; (ii) the listed patent
has expired; (iii) the listed patent has not expired, but will expire on a particular date and
approval is sought after patent expiration; or (iv) the listed patent is invalid or will not be
infringed by the new product. A certification that the new product will not infringe the already
approved products listed patents or that such patents are invalid is called a Paragraph IV
certification. If the applicant does not challenge the listed patents, the Section 505(b)(2)
application will not be approved until all the listed patents claiming the referenced product have
expired. The Section 505(b)(2) application also will not be approved until any non-patent
exclusivity, such as exclusivity for obtaining approval of a new chemical entity, listed in the
Orange Book for the referenced product has expired. If the applicant has provided a Paragraph IV certification to the FDA, the applicant must also
send notice of the Paragraph IV certification to the NDA and patent holders once the NDA has been
accepted for filing by the FDA. The NDA and patent holders may then initiate a legal challenge to
the Paragraph IV certification. The filing of a patent infringement lawsuit within 45 days of their
receipt of a Paragraph IV certification automatically prevents the FDA from approving the Section
505(b)(2) NDA until the earlier of 30 months, expiration of the patent, settlement of the lawsuit
or a decision in the infringement case that is favorable to the Section 505(b)(2) applicant. Thus,
the Section 505(b)(2) applicant may invest a significant amount of time and expense in the
development of its products only to be subject to significant delay and patent litigation before
its products may be commercialized. Alternatively, if the listed patent holder does not file a
patent infringement lawsuit within the required 45-day period, the applicants NDA will not be
subject to the 30-month stay. In 2003 and 2004, we submitted Section 505(b)(2) NDAs for our Zegerid Powder for Oral
Suspension 20 mg and 40 mg products, respectively. Each of these NDAs referenced preclinical and
clinical studies conducted for Prilosec. Following submission of our NDAs and filing of the NDAs by
the FDA, we provided notice of our Paragraph IV certifications to AstraZeneca, the holder of the
Prilosec NDA, and certain related companies holding the listed patents, which include various
AstraZeneca and Merck entities. In each case, AstraZeneca did not file a patent infringement
lawsuit within the required 45-day period. Therefore, the NDAs for our Zegerid Powder for Oral
Suspension 20 mg and 40 mg products were not subject to a 30-month stay of approval. We also intend
to submit Section 505(b)(2) NDAs for Zegerid Capsules and Zegerid Chewable Tablets and anticipate
providing similar Paragraph IV certifications, and AstraZeneca may file a patent infringement
lawsuit against us in connection with these NDAs. Any such patent infringement litigation against
us could result in a 30-month stay of approval for the particular NDA, would divert managements
attention and our resources and, if successful, would be materially adverse to our business.
Although AstraZeneca did not file a patent infringement lawsuit against us in connection with our
NDAs for Zegerid Powder for Oral Suspension within the 45-day period, it may decide to pursue
litigation at any time in the future. Other Regulatory Requirements Even though the FDA has approved our Zegerid Powder for Oral Suspension 20 mg and 40 mg
products and to the extent the FDA 14




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approves any of our other products, we will continue to be subject to a number of post-approval regulatory requirements. If we seek to make certain changes to
an approved product, such as the addition of a new labeled indication or making certain
manufacturing changes or product enhancements, we will need FDA review and approval before the
change can be implemented. While physicians may use products for indications that have not been
approved by the FDA, we may not label or promote the product for an indication that has not been
approved. Securing FDA approval for new indications or product enhancements and, in some cases, for
manufacturing and labeling claims, is generally a time-consuming and expensive process that may
require us to conduct clinical studies under the FDAs investigational new drug regulations. Even
if such studies are conducted, the FDA may not approve any change in a timely fashion, or at all.
In addition, adverse experiences associated with use of the products must be reported to the FDA,
and FDA rules govern how we can label, advertise or otherwise commercialize our products. The FDA also may, in its discretion, require post-marketing testing and surveillance to
monitor the effects of approved products or place conditions on any approvals that could restrict
the commercial applications of these products. For example, as part of our post-marketing
commitments to the FDA in connection with the approval of our NDAs for Zegerid Powder for Oral
Suspension 20 mg and 40 mg, we have committed to evaluate the product in pediatric populations,
including in PK/PD and safety studies which we plan to initiate during the second half of 2005. In addition to FDA restrictions on marketing of pharmaceutical products, several other types
of state and federal laws have been applied to restrict certain marketing practices in the
pharmaceutical industry in recent years. These laws include anti-kickback statutes and false claims
statutes. The federal healthcare program anti-kickback statute prohibits, among other things,
knowingly and willfully offering, paying, soliciting or receiving remuneration to induce or in
return for purchasing, leasing, ordering or arranging for the purchase, lease or order of any
healthcare item or service reimbursable under Medicare, Medicaid or other federally financed
healthcare programs. This statute has been interpreted to apply to arrangements between
pharmaceutical manufacturers on the one hand and prescribers, purchasers and formulary managers on
the other. Violations of the anti-kickback statute are punishable by imprisonment, criminal fines,
civil monetary penalties and exclusion from participation in federal healthcare programs. Although
there are a number of statutory exemptions and regulatory safe harbors protecting certain common
activities from prosecution or other regulatory sanctions, the exemptions and safe harbors are
drawn narrowly, and practices that involve remuneration intended to induce prescribing, purchases
or recommendations may be subject to scrutiny if they do not qualify for an exemption or safe
harbor. Federal false claims laws prohibit any person from knowingly presenting, or causing to be
presented, a false claim for payment to the federal government, or knowingly making, or causing to
be made, a false statement to have a false claim paid. Recently, several pharmaceutical and other
healthcare companies have been prosecuted under these laws for allegedly inflating drug prices they
report to pricing services, which in turn are used by the government to set Medicare and Medicaid
reimbursement rates, and for allegedly providing free product to customers with the expectation
that the customers would bill federal programs for the product. In addition, certain marketing
practices, including off-label promotion, may also violate false claims laws. The majority of
states also have statutes or regulations similar to the federal anti-kickback law and false claims
laws, which apply to items and services reimbursed under Medicaid and other state programs, or, in
several states, apply regardless of the payor. In addition, we and the third-party manufacturers on which we rely for the manufacture of our
products are subject to requirements that drugs be manufactured, packaged and labeled in conformity
with cGMP. To comply with cGMP requirements, manufacturers must continue to spend time, money and
effort to meet requirements relating to personnel, facilities, equipment, production and process,
labeling and packaging, quality control, recordkeeping and other requirements. The FDA periodically
inspects drug manufacturing facilities to evaluate compliance with cGMP requirements. Also, as part of the sales and marketing process, pharmaceutical companies frequently provide
samples of approved drugs to physicians. This practice is regulated by the FDA and other
governmental authorities, including, in particular, requirements concerning recordkeeping and
control procedures. Outside of the U.S., our ability to market our products will also depend on receiving
marketing authorizations from the appropriate regulatory authorities. The foreign regulatory
approval process includes all of the risks associated with the FDA approval described above. The
requirements governing the conduct of clinical trials and marketing authorization vary widely from
country to country. Employees As of March 15, 2005, we had 383 employees. A total of 57 employees were engaged in clinical
research, regulatory, product development and manufacturing, and medical affairs, 22 of whom hold
Ph.D., M.D., Pharm.D. or equivalent degrees, 301 were in sales, marketing and business development, and 25 were in administration and finance. 15




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Available Information We make available free of charge on or through our Internet web site our annual reports on
Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and all amendments to those
reports as soon as reasonably practicable after such material is electronically filed with or
furnished to the Securities and Exchange Commission, or the SEC. Our Internet address is
www.santarus.com. Risk Factors The following information sets forth factors that could cause our actual results to differ
materially from those contained in forward-looking statements we have made in this report, the
information incorporated herein by reference and those we may make from time to time. Risks Related to Our Business and Industry At this time, we are largely dependent on the success of our initial approved product, Zegerid
Powder for Oral Suspension 20 mg and 40 mg, and we cannot be certain that we will be able to
successfully commercialize this product. We have invested a significant portion of our time and financial resources in the development
and commercialization of Zegerid Powder for Oral Suspension 20 mg and 40 mg. We anticipate that in
the near term our ability to generate revenues will depend on the commercial success of Zegerid
Powder for Oral Suspension, which in turn, will depend on several factors, including our ability
to:  
    generate commercial sales of the product through our own sales
force and our co-promotion arrangement with Otsuka America
Pharmaceutical, Inc., or Otsuka America, or any other collaboration
with pharmaceutical companies or contract sales organizations that
we may later establish;
    establish effective marketing programs and build brand identity;
    obtain acceptance of the product by physicians, patients and
third-party payors and obtain and maintain distribution at the
retail level;
    establish and maintain our agreements with wholesalers and distributors on commercially reasonable terms; and
    demonstrate commercial manufacturing capabilities as necessary to meet commercial demand for the product,
including samples, and maintain commercial manufacturing arrangements with third-party manufacturers. We will continue to incur significant and increasing costs as we continue to support the
commercial launch of Zegerid Powder for Oral Suspension, and we have encountered low initial demand
for the 20 mg dosage strength. We generated a net loss of $33.3 million for the three months ended
December 31, 2004, as compared to a net loss of $21.2 million for the three months ended September
30, 2004, which increase was primarily attributable to increased costs associated with our
commercial activities and personnel. As of December 31, 2004, we had recognized only approximately
$634,000 in net sales of Zegerid Powder for Oral Suspension and had an accumulated deficit of
approximately $138.3 million, which includes our net loss of $81.5 million for 2004. We cannot be certain that our recent launch of Zegerid Powder for Oral Suspension 40 mg and
our continued marketing of the 20 mg dosage strength will result in increased demand for the
product. If we fail to successfully commercialize this product or are significantly delayed in
doing so, we may be unable to generate sufficient revenues to sustain and grow our business and
attain profitability, and our business, financial condition and results of operations will be
materially adversely affected. Our other Zegerid products under development may not be approved by the FDA, and any failure or
delay associated with our product development and clinical trials or the FDAs approval of such
products would increase our product development costs and time to market. We face substantial risks of failure inherent in developing pharmaceutical products. The
pharmaceutical industry is subject to stringent regulation by many different agencies at the
federal, state and international levels. Our products must satisfy rigorous standards of safety and efficacy before the U.S. Food and Drug Administration, or FDA, and any
foreign regulatory authorities will 16




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approve them for commercial use. Only Zegerid Powder for Oral Suspension 20 mg and 40 mg has been approved for commercial sale
by the FDA. We have recently completed pivotal pharmacokinetic/pharmacodynamic, or PK/PD, clinical
trials evaluating the 20 mg and 40 mg doses of Zegerid Capsules and Zegerid Chewable Tablets, and
we plan to submit new drug applications, or NDAs, to the FDA seeking approval for these products
during the second half of 2005. In connection with its review of our NDAs, the FDA may request
additional information from us, including data from additional clinical trials. In addition, the
FDA ultimately may not grant marketing approval for these products. To the extent we are not able to obtain regulatory approval for or demonstrate adequate
stability for Zegerid Capsules and Zegerid Chewable Tablets, we may in the future need to develop
alternative formulations of these products. Product development is generally a long, expensive and
uncertain process. Successful development of formulations for our Zegerid products under
development will depend on many factors, including:  
    our ability to select key components, establish a stable formulation and optimize taste and other sensory characteristics;
    our ability to develop a formulation that demonstrates our intended safety and efficacy profile; and
    our ability to transfer from development stage to commercial-scale
operations and the costs associated with commercial manufacturing. If we are required to develop alternative formulations of our capsule and chewable tablet
products or are significantly delayed in doing so, our ability to commercialize these products will
be adversely affected. Once we have manufactured formulations of our products that we believe will be suitable for
pivotal clinical testing, we then must complete our clinical testing, and failure can occur at any
stage of testing. These clinical tests must comply with FDA and other applicable regulations. We
may encounter delays or rejections based on our inability to enroll enough patients to complete our
clinical trials. We may suffer significant setbacks in advanced clinical trials, even after showing
promising results in earlier trials. The results of later clinical trials may not replicate the
results of prior clinical trials. Based on results at any stage of clinical trials, we may decide
to discontinue development of a product. We, or the FDA, may suspend clinical trials at any time if
the patients participating in the trials are exposed to unacceptable health risks or if the FDA
finds deficiencies in our applications to conduct the clinical trials or in the conduct of our
trials. Moreover, not all products in clinical trials will receive timely, or any, regulatory
approval. Even if clinical trials are completed as planned, their results may not support our
assumptions or our product claims. The clinical trial process may fail to demonstrate that our
products are safe for humans or effective for their intended uses. Our product development costs
will increase and our product revenues will be delayed if we experience delays in testing or
regulatory approvals or if we need to perform more or larger clinical trials than planned. In
addition, such failures could cause us to abandon a product entirely. If we fail to take any
current or future product from the development stage to market, we will have incurred significant
expenses without the possibility of generating revenues, and our business will be adversely
affected. Failure of our Zegerid products to achieve and maintain market acceptance would seriously impair
our ability to reach profitability. The commercial success of Zegerid Powder for Oral Suspension 20 mg and 40 mg and any other
subsequently-approved products will depend upon acceptance of our products by the medical
community, particularly gastroenterologists and primary care physicians, as well as patients and
third-party payors. Market acceptance will depend upon several factors, including:  
    the efficacy and safety of our products and our ability to
differentiate our products from products offered by our competitors;
    effectiveness of our and any collaborators sales and marketing efforts;
    our ability to obtain sufficient third-party insurance coverage or reimbursement;
    pricing and cost effectiveness;
    the prevalence and severity of any adverse side effects; 17




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
    availability of alternative treatments;
    relative convenience and ease of administration; and
    taste and other sensory characteristics of our products. In addition, even if our products achieve market acceptance, we may not be able to maintain
that market acceptance over time if new products or technologies are introduced that are more
favorably received than our products, are more cost-effective or otherwise render our products
obsolete. If we are unable to obtain favorable reimbursement for our products, their commercial success may
be severely hindered. Our ability to sell our approved product and any subsequently-approved products may depend in
large part on the extent to which reimbursement for the costs of our products is available from
private health insurers, managed care organizations, government entities and others. Third-party
payors are increasingly attempting to contain their costs. We cannot predict actions third-party
payors may take, or whether they will limit the coverage and level of reimbursement for our
products or refuse to provide any coverage at all. Reduced or partial reimbursement coverage could
make our products less attractive to patients, suppliers and prescribing physicians and may not be
adequate for us to maintain price levels sufficient to realize an appropriate return on our
investment in our products or compete on price. In some cases, insurers and other healthcare payment organizations try to encourage the use of
less expensive generic brands and over-the-counter, or OTC, products through their prescription
benefits coverage and reimbursement policies. These organizations may make the generic alternative
more attractive to the patient by providing different amounts of reimbursement so that the net cost
of the generic product to the patient is less than the net cost of a prescription brand product.
Aggressive pricing policies by our generic product competitors and the prescription benefit
policies of insurers could have a negative effect on our product revenues and profitability. Many managed care organizations negotiate the price of medical services and products and
develop formularies for that purpose. Exclusion of a product from a formulary can lead to its
sharply reduced usage in the managed care organization patient population. If our products are not
included within an adequate number of formularies or adequate reimbursement levels are not
provided, or if those policies increasingly favor generic or OTC products, our market share and
gross margins could be negatively affected, as could our overall business and financial condition. The competition among pharmaceutical companies to have their products approved for
reimbursement may also result in downward pricing pressure in the industry or in the markets where
our products will compete. We may not be successful in any efforts we take to mitigate the effect
of a decline in average selling prices for our products. Any decline in our average selling prices
would also reduce our gross margins. In addition, managed care initiatives to control costs may influence primary care physicians
to refer fewer patients to gastroenterologists and other specialists. Reductions in these referrals
could have a material adverse effect on the size of our potential market and increase costs to
effectively promote gastrointestinal, or GI, products. In connection with the launches of Zegerid Powder for Oral Suspension 20 mg and 40 mg, our
approximately 18 account managers have initiated contacts with private health insurers, managed
care organizations, government entities and other third-party payors, seeking reimbursement
coverage for our products similar to that for branded delayed-release proton pump inhibitor, or
PPI, products. The process for obtaining coverage can be lengthy and time-consuming, in some cases
taking several months before a particular payor initially reviews our product, and we may
ultimately be unsuccessful in obtaining coverage. Our competitors generally have larger account
management organizations, as well as existing business relationships with third-party payors
relating to their PPI products, as well as other portfolio products. Moreover, the current
availability of generic and OTC delayed-release omeprazole products may make obtaining
reimbursement coverage for our immediate-release products more difficult because our products also
utilize omeprazole as the active ingredient. If we fail to successfully secure reimbursement
coverage for our products or are significantly delayed in doing so, we will have difficulty
achieving market acceptance of our products and our business will be materially adversely affected. 18




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The market for the GI pharmaceutical industry is intensely competitive and many of our competitors
have significantly more resources and experience, which may limit our commercial opportunity. The pharmaceutical industry is intensely competitive, particularly in the GI field, where
currently marketed products are well-established and successful. Competition in our industry occurs
on a variety of fronts, including developing and bringing new products to market before others,
developing new technologies to improve existing products, developing new products to provide the
same benefits as existing products at lower cost and developing new products to provide benefits
superior to those of existing products. In addition, our ability and that of our competitors to
compete in our industry will depend upon our and their relative abilities to obtain and maintain
intellectual property protection for products. Many of our competitors are large, well-established companies in the pharmaceutical field. Our
competitors include, among others, AstraZeneca plc, TAP Pharmaceutical Products Inc., or TAP,
Wyeth, Altana, Eisai Co., Ltd., Johnson & Johnson, Axcan Pharma Inc., Ferring Pharmaceuticals A/S,
Merck & Co., Inc., Novartis AG, Pfizer Inc., Salix Pharmaceuticals, Inc., Shire Pharmaceuticals
Group plc and The Procter & Gamble Company. Many of these companies already offer products in the
U.S. and Europe that target gastroesophageal reflux disease, or GERD, and other GI diseases and
disorders that we intend to target. Given our relatively small size and the entry of our new
products into a market characterized by well-established drugs, we may not be able to compete
effectively. In addition, many of our competitors, either alone or together with their collaborative
partners, may have significantly greater experience in:  
    developing drugs;
    undertaking preclinical testing and human clinical trials;
    obtaining FDA and other regulatory approvals of drugs;
    formulating and manufacturing drugs; and
    launching, marketing, distributing and selling drugs. As a result, they may have a greater ability to undertake more extensive research and
development, manufacturing, marketing and other programs. Many of these companies may succeed in
developing products earlier than we do, completing the regulatory process and showing safety and
efficacy of products more rapidly than we do or developing products that are more effective than
our products. Further, the products they develop may be based on new and different technology that
may involve faster mechanisms of action than our products or exhibit other benefits relative to our
products. Many of these companies also have significantly greater financial and other resources than we
do. Larger pharmaceutical companies typically have significantly larger field sales force
organizations and invest significant amounts in advertising and marketing their products, including
through the purchase of television advertisements and the use of other direct-to-consumer methods.
As a result, these larger companies are able to reach a greater number of physicians and reach them
more frequently than we can with our smaller sales organization. It is also possible that our
competitors may be able to reduce their cost of production so that they can aggressively price
their products and secure a greater market share to our detriment. In addition, our competitors
may be able to attract and retain qualified personnel and to secure capital resources more
effectively than we can. Any of these events could adversely affect our business. Our approved product and our products under development will compete with many other drug products
focused on upper GI diseases and disorders which could put downward pressure on pricing and market
share and limit our ability to generate revenues. Our approved product and our products under development will compete with many prescription
and OTC products, including: Prescription Products:  
    PPIs: AstraZenecas Prilosec and Nexium, TAPs Prevacid, Wyeths
and Altanas Protonix, Johnson & Johnsons and 19




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Eisais Aciphex, and generic omeprazole, among others; and
    H2-receptor antagonists: Mercks Pepcid, GlaxoSmithKline plcs
Zantacand Tagametand Reliant
Pharmaceuticals, Inc.s Axid, among others. OTC Products:  
    PPIs: Procter & Gambles Prilosec OTC;
    H2-receptor antagonists: Pfizers Zantac, GlaxoSmithKlines Tagamet
and Johnson & Johnsons and Mercks PepcidAC and Pepcid Complete,
among others; and
    Antacids: Johnson & Johnsons and Mercks Mylanta, Novartis
Maalox, Pfizers Rolaidsand GlaxoSmithKlines
Gavisconand Tums, among others. In addition, various companies are developing new products, including motility agents,
reversible acid inhibitors, cytoprotective compounds and new PPIs. We may be required to compete
with these or other new products that have greater efficacy, faster onset of action or other
benefits relative to our products. Many of the currently marketed competitive products are available in generic formulations. For
example, there are several generic delayed-release omeprazole products currently available in 10 mg
and 20 mg dose strengths in the U.S. market, and we anticipate that over time additional generic
delayed-release omeprazole products, including 40 mg dose strengths, as well as other generic
delayed-release PPIs, will enter the market. In addition, with the introduction of Prilosec OTC,
delayed-release omeprazole is available in a 20 mg dose as an OTC product. The existence of
generic and OTC delayed-release PPI products could make it more difficult for branded prescription
PPI products, including our Zegerid products, to gain or maintain market share and could cause
prices for PPIs to drop, each of which could adversely affect our business. Moreover, the current
availability of generic and OTC delayed-release omeprazole products may have an additional impact
on demand and pricing for our immediate-release products because our products also utilize
omeprazole as the active ingredient. We have only recently established our sales and marketing capabilities and we will need to retain
qualified sales and marketing personnel and collaborate successfully with our co-promotion partner,
Otsuka America, to successfully commercialize Zegerid Powder for Oral Suspension and any other
products that we develop, acquire or license. We began the commercial sale of Zegerid Powder for Oral Suspension 20 mg in October 2004 and
Zegerid Powder for Oral Suspension 40 mg in February 2005, and thus our company has very limited
experience in selling and marketing our products. In preparation for the launch of Zegerid Powder
for Oral Suspension 20 mg, we built our sales and marketing infrastructure and assembled a field
sales organization comprised of approximately 230 sales representatives who target high-prescribing
gastroenterologists and primary care physicians treating GI diseases and disorders in the U.S.
Because our field sales force is newly established, the representatives have only recently received
training and education concerning our products, and we will continue to incur significant
additional expenses associated with the training and compensation of our sales representatives. To
the extent we are not successful in retaining qualified sales and marketing personnel, we will not
be able to effectively market our currently approved product or any future products. In addition, we entered into a non-exclusive agreement with Otsuka America in October 2004 for
Otsuka America to co-promote Zegerid Powder for Oral Suspension to U.S. physicians. Otsuka
Americas approximately 170 sales representatives began actively promoting Zegerid Powder for Oral
Suspension to physicians in November 2004. While our agreement with Otsuka America requires its
sales representatives to promote Zegerid Powder for Oral Suspension in a minimum number of first
position sales calls to target physicians, we cannot be sure that Otsuka Americas efforts will be
successful or that our own sales force, together with any efforts made by Otsuka America to promote
our product, will generate sufficient awareness or demand for our product. Even if we determine to
pursue a relationship with another pharmaceutical company or contract sales organization to
facilitate our sales efforts, we may not be able to enter into agreements with these entities on commercially reasonable terms, or at
all. Any revenues we receive from sales of our products generated by Otsuka America or any other
third parties will depend upon the efforts of those other parties, which in many instances will not
be within our control. If we are unable to maintain our co-promotion agreement with Otsuka America
or to effectively establish an alternative arrangement to market our products more broadly than we
can through our internal sales force, our business could be adversely affected. 20




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In order to compete effectively, we and Otsuka America may desire to further expand our sales
forces. We plan to evaluate further expansion of our sales force based on the market demand for
Zegerid Powder for Oral Suspension and the status of our planned regulatory submissions for Zegerid
Capsules and Zegerid Chewable Tablets. Under the terms of our co-promotion agreement with Otsuka
America, Otsuka America may increase the size of its sales force up to 400 sales representatives to
match any expansion of our sales force in exchange for an increased royalty rate. However, we may
not be successful in our efforts to recruit a larger sales force, and Otsuka America may choose not
to expand its sales force. In order to cover all of the PPI prescribing physicians at the same
level of reach and frequency as our competitors with branded PPI products, we and Otsuka America
would need to significantly expand our collective sales force beyond these levels or we would need
to partner with another company with a substantial primary care sales organization. We recently commenced the commercial sale of our first approved product and could experience
significant differences between actual and estimated demand for the product. We have very limited experience selling Zegerid Powder for Oral Suspension 20 mg and 40 mg.
Therefore, it has been and will continue to be difficult to estimate demand for this product with
any certainty. If we overestimate demand, we may be required to write off inventories. As of
December 31, 2004, we reserved approximately $1.7 million against on-hand inventories and accrued
approximately $627,000 for firm purchase commitments related to excess inventories. If demand for
our products increases beyond what we forecast, our third-party suppliers may not be able to
increase production rapidly enough to meet the demand. Our failure to meet market demand could lead
to missed opportunities to fulfill orders for our products, which would lead to lost opportunities
to generate revenues and could adversely affect our relationships with physicians, patients and our
wholesale customers. If we are unable to manufacture our products on a commercial basis, our commercialization efforts
will be materially harmed. Although we have commenced commercial manufacturing of Zegerid Powder for Oral Suspension 20
mg and 40 mg, the quantities that our supplier is able to manufacture in the future may fail to
meet our quality specifications or may not be sufficient to meet potential commercial demand for
the product. In addition, we will need to prepare in the future for potential commercial
manufacturing of our capsule and chewable tablet products. Any problems or delays experienced in
the commercial manufacturing of Zegerid Powder for Oral Suspension 20 mg and 40 mg or in preparing
for commercial manufacturing of our other products may impair our ability to manufacture commercial
quantities of the products, which would limit our ability to sell the products and would adversely
affect our business. While we believe we ultimately could redesign our manufacturing processes or
identify alternative suppliers in response to problems we may encounter as we prepare for
commercial manufacturing, it could take significant time to do so and may require regulatory
approval, and our products may not be available from alternate manufacturers at favorable prices. We do not currently have any manufacturing facilities and instead rely on third-party
manufacturers. We have no manufacturing facilities, and we will rely on third-party manufacturers to provide
us with an adequate and reliable supply of our products on a timely basis. Our manufacturers must
comply with U.S. regulations, including the FDAs current good manufacturing practices, applicable
to the manufacturing processes related to pharmaceutical products, and their facilities must be
inspected and approved by the FDA and other regulatory agencies as part of their business. In
addition, because many of our key manufacturers are located outside of the U.S., they must also
comply with applicable foreign laws and regulations. We will have limited control over the manufacturing processes of our third-party
manufacturers, including with respect to regulatory compliance and quality assurance matters. Any
delay or interruption of supply related to a third-party manufacturers failure to comply with
regulatory requirements or otherwise would limit our ability to make sales of our products. Any
manufacturing defect or error discovered after products have been produced and distributed could
result in even more significant consequences, including costly recall procedures, re-stocking
costs, damage to our reputation and potential for product liability claims. With respect to our
products still under development, if the FDA finds significant issues with any of our manufacturers
during the FDAs pre-approval inspection process, the approval of those products could be delayed
while the manufacturer addresses the FDAs concerns, or we may be required to identify and obtain
the FDAs approval of a new supplier. This could result in significant delays before manufacturing
of our products can begin, which in turn would delay commercialization of our products. In
addition, the importation of pharmaceutical products into the U.S. is subject to regulation by the FDA, and the FDA can
refuse to allow an imported product into the U.S. if it is not satisfied that the product complies
with applicable laws or regulations. We rely on a single third-party manufacturer located outside of the U.S., Patheon Inc., for
the supply of Zegerid Powder for Oral Suspension 20 mg and 40 mg, and we are obligated under our
supply agreement to purchase a significant portion of our requirements of this product from
Patheon. In addition, we have entered into a commercial supply agreement with OSG Norwich
Pharmaceuticals, 21




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Inc., which provides for supply of our capsule product in the event that we are
able to obtain regulatory approval, and we have not yet entered into commercial supply agreements
for supply of our chewable tablet product. We also currently rely on a single third-party supplier
located outside of the U.S., Union Quimico Farmaceutica, S.A., or Uquifa, for the supply of
omeprazole, which is the active pharmaceutical ingredient in each of our current products. We are
obligated under our supply agreement with Uquifa to purchase all of our requirements of omeprazole
from this supplier. Any significant problem that our sole source suppliers experience could result
in a delay or interruption in the supply to us until the supplier cures the problem or until we
locate an alternative source of supply. In addition, because our sole source suppliers provide
manufacturing services to a number of other pharmaceutical companies, our suppliers may experience
capacity constraints or chose to prioritize one or more of their other customers over us. Although alternative sources of supply exist, the number of third-party manufacturers with the
expertise, required regulatory approvals and facilities to manufacture pharmaceutical products or
active pharmaceutical ingredients on a commercial scale is very limited, and it would take a
significant amount of time to arrange for alternative manufacturers. Any new supplier of products
or active pharmaceutical ingredients would be required to qualify under applicable regulatory
requirements and would need to have sufficient rights under applicable intellectual property laws
to the method of manufacturing such products or ingredients. The FDA may require us to conduct
additional clinical trials, collect stability data and provide additional information concerning
any new supplier before we could distribute products from that supplier. Obtaining the necessary
FDA approvals or other qualifications under applicable regulatory requirements and ensuring
non-infringement of third-party intellectual property rights could result in a significant
interruption of supply and could require the new supplier to bear significant additional costs
which may be passed on to us. In addition, we have not entered into commercial supply agreements
for our chewable tablet product and may not be able to establish or maintain commercial
manufacturing arrangements for that product on commercially reasonable terms. Regulatory approval of Zegerid Powder for Oral Suspension is limited by the FDA to those
indications and conditions for which we are able to support clinical safety and efficacy, and any
approval we may receive for our products under development will be similarly limited. Any regulatory approval is limited to those diseases and indications for which our products
are deemed to be safe and effective by the FDA. Zegerid Powder for Oral Suspension has been
approved by the FDA for the treatment of heartburn and other symptoms associated with GERD,
treatment and maintenance of healing of erosive esophagitis, treatment of duodenal and gastric
ulcers and reduction of risk of upper GI bleeding in critically ill patients. In addition to the
FDA approval required for new formulations, any new indication to an approved product also requires
FDA approval. If we are not able to obtain FDA approval for a broad range of indications for our
products, our ability to effectively market and sell our products may be greatly reduced and our
business will be adversely affected. While physicians may choose to prescribe drugs for uses that are not described in the
products labeling and for uses that differ from those tested in clinical studies and approved by
the regulatory authorities, our regulatory approvals will be limited to those indications that are
specifically submitted to the FDA for review. These off-label uses are common across medical
specialties and may constitute an appropriate treatment for many patients in varied circumstances.
Regulatory authorities in the U.S. generally do not regulate the behavior of physicians in their
choice of treatments. Regulatory authorities do, however, restrict communications by pharmaceutical
companies on the subject of off-label use. If our promotional activities fail to comply with these
regulations or guidelines, we may be subject to warnings from, or enforcement action by, these
authorities. In addition, our failure to follow FDA rules and guidelines relating to promotion and
advertising may cause the FDA to delay its approval or refuse to approve a product, the suspension
or withdrawal of an approved product from the market, recalls, fines, disgorgement of money,
operating restrictions, injunctions or criminal prosecution, any of which could harm our business. We are subject to ongoing regulatory review of Zegerid Powder for Oral Suspension, and we will be
subject to ongoing regulatory review of any of our other products that may be approved in the
future. Zegerid Powder for Oral Suspension and any of our products under development which may be
approved for sale by the FDA will continue to be subject to extensive regulation. These regulations
impact many aspects of our operations, including the manufacture, labeling, packaging, adverse
event reporting, storage, advertising, promotion and record keeping related to the products. The
FDA also may require post-marketing testing and surveillance to monitor the effects of approved
products or place conditions on any approvals that could restrict the commercial applications of
these products. For example, in connection with the approval of our NDAs for Zegerid Powder for
Oral Suspension, we have committed to evaluate the product in pediatric populations, including in
PK/PD and safety studies which we plan to initiate during the second half of 2005. In addition,
the subsequent discovery of previously unknown problems with the product may result in restrictions
on the product, including withdrawal of the product from the market. If we fail to comply with
applicable regulatory requirements, we may be subject to fines, suspension or withdrawal of
regulatory approvals, 22




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product recalls, seizure of products, disgorgement of money, operating restrictions and criminal prosecution. In addition to FDA restrictions on marketing of pharmaceutical products, several other types
of state and federal laws have been applied to restrict certain marketing practices in the
pharmaceutical industry in recent years. These laws include anti-kickback statutes and false claims
statutes. The federal healthcare program anti-kickback statute prohibits, among other things,
knowingly and willfully offering, paying, soliciting or receiving remuneration to induce or in
return for purchasing, leasing, ordering or arranging for the purchase, lease or order of any
healthcare item or service reimbursable under Medicare, Medicaid or other federally financed
healthcare programs. This statute has been interpreted to apply to arrangements between
pharmaceutical manufacturers on the one hand and prescribers, purchasers and formulary managers on
the other. Violations of the anti-kickback statute are punishable by imprisonment, criminal fines,
civil monetary penalties and exclusion from participation in federal healthcare programs. Although
there are a number of statutory exemptions and regulatory safe harbors protecting certain common
activities from prosecution or other regulatory sanctions, the exemptions and safe harbors are
drawn narrowly, and practices that involve remuneration intended to induce prescribing, purchases
or recommendations may be subject to scrutiny if they do not qualify for an exemption or safe
harbor. Our practices may not in all cases meet all of the criteria for safe harbor protection from
anti-kickback liability. Federal false claims laws prohibit any person from knowingly presenting, or causing to be
presented, a false claim for payment to the federal government, or knowingly making, or causing to
be made, a false statement to have a false claim paid. Recently, several pharmaceutical and other
healthcare companies have been prosecuted under these laws for allegedly inflating drug prices they
report to pricing services, which in turn are used by the government to set Medicare and Medicaid
reimbursement rates, and for allegedly providing free product to customers with the expectation
that the customers would bill federal programs for the product. In addition, certain marketing
practices, including off-label promotion, may also violate false claims laws. The majority of
states also have statutes or regulations similar to the federal anti-kickback law and false claims
laws, which apply to items and services reimbursed under Medicaid and other state programs, or, in
several states, apply regardless of the payor. Sanctions under these federal and state laws may
include civil monetary penalties, exclusion of a manufacturers products from reimbursement under
government programs, criminal fines and imprisonment. In addition, as part of the sales and marketing process, pharmaceutical companies frequently
provide samples of approved drugs to physicians. This practice is regulated by the FDA and other
governmental authorities, including, in particular, requirements concerning record keeping and
control procedures. Any failure to comply with the regulations may result in significant criminal
and civil penalties as well as damage to our credibility in the marketplace. Because of the breadth of these laws and the narrowness of the safe harbors, it is possible
that some of our business activities could be subject to challenge under one or more of such laws.
Such a challenge could have a material adverse effect on our business, financial condition and
results of operations. Our resources are currently dedicated to our Zegerid family of products, and we may be unable to
expand our product portfolio or integrate new products successfully. Our product development, clinical research and commercialization activities are currently
dedicated to developing our Zegerid family of products. Because each of these products  powder for
oral suspension, capsules and chewable tablets  is derived from the same technology licensed from
the University of Missouri, each product is vulnerable to substantially the same risks stemming
from potential patent invalidity, misappropriation of intellectual property by third parties,
reliance upon a third-party for patent prosecution and maintenance and unexpected early termination
of our license agreement. Similarly, because our current regulatory strategy for these products
depends, in part, on the successful filing and acceptance of NDAs under a provision known as
Section 505(b)(2) of the Federal Food, Drug, and Cosmetic Act, any positions taken by the FDA
concerning any Section 505(b)(2) NDAs we submit, or Section 505(b)(2) NDAs in general, could impact
any subsequent NDAs we may submit. To date, we have received FDA approval of two Section 505(b)(2)
NDAs, for the 20 mg and 40 mg doses of Zegerid Powder for Oral Suspension, and plan to submit
additional Section 505(b)(2) NDAs for our capsule and chewable tablet products to the FDA during
the second half of 2005. Our ability to successfully commercialize our products could also be
jeopardized by the emergence of a single competitive product that exhibits greater efficacy, more
rapid onset of action or other benefits relative to our products. Furthermore, to the extent our single approved product, Zegerid Powder for Oral Suspension, fails to gain market
acceptance, it may be more difficult for us to generate sufficient credibility with physicians and
patients to commercialize other products in the Zegerid product family. Our success will depend in part on our ability to develop and commercialize future products
based on different technology than the technology on which the Zegerid family of products is based.
Our internal development efforts will be time-consuming and expensive and may not be successful in
developing new products. We may not be able to identify appropriate licensing or acquisition 23




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opportunities to diversify our pipeline of products. Even if we identify an appropriate product,
competition for it may be intense. We may not be able to successfully negotiate the terms of a
license or acquisition agreement on commercially acceptable terms. The negotiation of agreements to
obtain rights to additional products or to acquire companies or their products or product lines
could divert our managements time and resources from other elements of our existing business.
Moreover, we may be unable to finance the licensing or other acquisition of a new product or an
acquisition target. If we issue shares of our common stock in one or more significant acquisitions,
our stockholders could suffer significant dilution of their ownership interests. We might also
incur debt or experience a decrease in cash available for our operations, or incur contingent
liabilities and amortization expenses relating to identifiable intangible assets, in connection
with any future acquisitions. Even if we can develop or acquire new products, our growth and acquisition strategy depends
upon the successful integration of licensed or acquired products or companies with our existing
products and business. Any failure of this integration process could delay new product development
and introduction, impair our ability to market and sell our products and adversely affect our
reputation. We are dependent on our sublicense agreement with TAP Pharmaceutical Products Inc. as one source of
near-term revenue. In June 2002, we entered into a sublicense agreement with TAP, granting TAP the right to
develop one or more products based on its lansoprazole PPI product and derivatives of lansoprazole.
The amount of revenues from this agreement in the future is uncertain and primarily tied to TAPs
success in developing a commercial product, over which we have no control. Under the terms of the
agreement, TAP has the right to discontinue its development efforts and terminate the agreement
without cause by giving us 60 days prior written notice. In August 2003, we initiated an alternative dispute resolution proceeding against TAP under
the terms of the sublicense agreement. In this proceeding, we asserted that TAP owed us $10.0
million in connection with the achievement of a development milestone. TAP asserted that the
milestone has not yet been achieved, and a formal hearing on the matter was held in January 2005.
In February 2005, we prevailed in the proceeding and were awarded the $10.0 million milestone
payment, plus interest and legal expenses. To the extent that TAP successfully develops products based on our licensed technology, those
products will compete directly with our development, marketing and sales efforts. Because TAPs
lansoprazole PPI product is a well-established product and TAP has greater financial and other
resources than we do, TAP may be able to develop its product more rapidly and market its product
more extensively than we can. As a result, we may not be able to compete successfully with TAP and
our ability to gain market share and revenue for our products could be adversely affected. We are subject to new legislation, regulatory proposals and managed care initiatives that may
increase our costs of compliance and adversely affect our ability to market our products, obtain
collaborators and raise capital. There have been a number of legislative and regulatory proposals aimed at changing the
healthcare system and pharmaceutical industry, including reductions in the cost of prescription
products, changes in the levels at which consumers and healthcare providers are reimbursed for
purchases of pharmaceutical products, proposals concerning reimportation of pharmaceutical products
and proposals concerning safety matters. For example, the Medicare Prescription Drug, Improvement,
and Modernization Act of 2003 provides a new Medicare prescription drug benefit beginning in 2006
and mandates other reforms. Although we cannot predict the full effect on our business of the
implementation of this new legislation, it is possible that the new benefit, which will be managed
by private health insurers, pharmacy benefit managers and other managed care organizations, will
result in decreased reimbursement for prescription drugs, which may further exacerbate
industry-wide pressure to reduce the prices charged for prescription drugs. This could harm our
ability to market our products and generate revenues. It is also possible that other proposals will
be adopted. As a result of the new Medicare prescription drug benefit or any other proposals, we
may determine to change our current manner of operation, provide additional benefits or change our
contract arrangements, any of which could harm our ability to operate our business efficiently,
obtain collaborators and raise capital. We face a risk of product liability claims and may not be able to obtain adequate insurance. Our business exposes us to potential liability risks that may arise from the clinical testing
of our products and the manufacture and sale of Zegerid Powder for Oral Suspension and our other
products under development. These risks exist even if a product is approved for commercial sale by
the FDA and manufactured in facilities licensed and regulated by the FDA. Any product liability
claim or series of claims brought against us could significantly harm our business by, among other
things, reducing demand for our products, injuring our reputation and creating significant adverse
media attention and costly litigation. Plaintiffs have received substantial damage awards in some
jurisdictions against pharmaceutical companies based upon claims for injuries allegedly caused by
the use of 24




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their products. Any judgment against us that is in excess of our insurance policy limits
would have to be paid from our cash reserves, which would reduce our capital resources. Although we
have product and clinical trials liability insurance with a coverage limit of $10.0 million, this
coverage may prove to be inadequate. Furthermore, we cannot be certain that our current insurance
coverage will continue to be available for our commercial or clinical trial activities on
reasonable terms, if at all. Further, we may not have sufficient capital resources to pay a
judgment, in which case our creditors could levy against our assets, including our intellectual
property. We rely on third parties to perform many necessary commercial services for our products, including
services related to the distribution, storage and transportation of our products. We have retained third-party service providers to perform a variety of functions related to
the sale and distribution of our approved product, key aspects of which will be out of our direct
control. For example, we rely on one third-party service provider to provide key services related
to warehousing and inventory management, distribution, contract administration and chargeback
processing, accounts receivable management and call center management. We place substantial
reliance on this provider as well as other third-party providers that perform services for us,
including entrusting our inventories of products to their care and handling. If these third-party
service providers fail to comply with applicable laws and regulations, fail to meet expected
deadlines, or otherwise do not carry out their contractual duties to us, our ability to deliver
product to meet commercial demand would be significantly impaired. In addition, we utilize third
parties to perform various other services for us relating to sample accountability and regulatory
monitoring, including adverse event reporting, safety database management and other product
maintenance services. If the quality or accuracy of the data maintained by these service providers
is insufficient, our ability to continue to market our approved product could be jeopardized or we
could be subject to regulatory sanctions. We do not currently have the internal capacity to perform
these important commercial functions, and we may not be able to maintain commercial arrangements
for these services on reasonable terms. Our reliance on third-party clinical investigators and clinical research organizations may result
in delays in completing, or a failure to complete, clinical trials or we may be unable to use the
clinical data gathered if they fail to comply with regulatory requirements or perform under our
agreements with them. As an integral component of our clinical development program, we engage clinical investigators
and clinical research organizations, or CROs, to enroll patients and conduct and manage our
clinical studies. Because we presently engage and intend to continue to engage CROs to help us
conduct and manage our clinical trials, many key aspects of this process have been and will be out
of our direct control. If the CROs and other third parties that we rely on for patient enrollment
and other portions of our clinical trials fail to perform the clinical trials in a satisfactory
manner and in compliance with applicable U.S. and foreign regulations, or fail to perform their
obligations under our agreements with them, we could face significant delays in completing our
clinical trials. For example, the FDA has inspected and will continue to inspect certain of our
CROs operations and trial procedures and may issue notices of any observations of failure to
comply with FDA-approved good clinical practices and other regulations. If our CROs or clinical
investigators are unable to respond to such notices of observations in a satisfactory manner or
otherwise resolve any issues identified by the FDA or other regulatory authorities, we may be
unable to use the data gathered at those sites. To the extent a single CRO conducts clinical trials
for us for multiple products, the CROs failure to comply with U.S. and foreign regulations could
negatively impact each of the trials. If these clinical investigators and CROs do not carry out
their contractual duties or obligations or fail to meet expected deadlines, or if the quality or
accuracy of the clinical data they obtain is compromised due to their failure to adhere to our
clinical protocols, regulatory requirements or for other reasons, our clinical trials may be
extended, delayed or terminated, and we may be unable to obtain regulatory approval for or
successfully commercialize our products. Our approved product and our products under development could be rendered obsolete by technological
change and medical advances which would materially affect the performance of our business. Our approved product and our products under development may be rendered obsolete or
uneconomical by the development of medical advances to treat the conditions that they address. The
treatment of GI diseases and disorders is the subject of active research and development by many
potential competitors, including major pharmaceutical companies, specialized biotechnology firms,
universities and other research institutions. While we will seek to expand our technological
capabilities to remain competitive, research and development by others may render our technology or
products obsolete or noncompetitive or result in treatments or cures superior to any therapy we developed. Technological advances affecting costs of production
also could adversely affect our ability to sell products. 25




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Our regulatory strategy currently depends upon a provision of the Federal Food, Drug, and Cosmetic
Act that is the subject of litigation that may have the effect of delaying or preventing the
regulatory approval of our products. Our current regulatory strategy relies upon Section 505(b)(2) of the Federal Food, Drug, and
Cosmetic Act, which permits the filing of an NDA where at least some of the information required
for product approval comes from studies not conducted by or for the applicant and for which the
applicant has not obtained a right of reference. Over the last few years, certain pharmaceutical
companies and others have objected to the FDAs interpretation of Section 505(b)(2) and one
pharmaceutical company has sued the FDA on the matter. Although the issues in that litigation are
specific to the products involved, if the FDA does not prevail, it may be required to change its
interpretation of Section 505(b)(2). The FDA approved our first Section 505(b)(2) NDA for Zegerid
Powder for Oral Suspension 20 mg in June 2004 and our second Section 505(b)(2) NDA for Zegerid
Powder for Oral Suspension 40 mg in December 2004. However, a subsequent change in the FDAs
interpretation of Section 505(b)(2), whether as a result of the FDAs pending litigation with the
third party or otherwise, could prevent or delay approval of our other planned Section 505(b)(2)
NDA submissions. If we are unable to rely on Section 505(b)(2) as part of the regulatory approval
process for our products, we may be required to negotiate rights of reference to NDAs held by third
parties or conduct preclinical or additional clinical studies before we can commercialize our
products. Any obligation to conduct preclinical or additional clinical trials would result in
increased costs and delay the commercialization of our products. If we were to pursue obtaining
rights of reference, these NDA holders would have no obligation to grant any rights to us, and we
may be unable to enter into agreements with them on a timely basis or on commercially acceptable
terms. If we are unable to attract and retain key personnel, our business will suffer. We are a small company and, as of March 15, 2005, had only 383 employees. Our success depends
on our continued ability to attract, retain and motivate highly qualified management, clinical,
manufacturing, product development, business development and sales and marketing personnel. We may
not be able to recruit and retain qualified personnel, particularly for senior clinical and sales
and marketing positions, in the future due to intense competition for personnel among
pharmaceutical businesses, and the failure to do so could have a significant negative impact on our
future product revenues and business results. Our success depends on a number of key senior management personnel, particularly Gerald T.
Proehl, our President and Chief Executive Officer. Although we have employment agreements with our
executive officers, these agreements are terminable at will at any time with or without notice and,
therefore, we cannot assure you that we will be able to retain their services. We are not aware of
any present intention of these individuals to leave our company. In addition, although we have a
key person insurance policy on Mr. Proehl, we do not have key person insurance policies on any
of our other employees that would compensate us for the loss of their services. If we lose the
services of one or more of these individuals, replacement could be difficult and may take an
extended period of time and could impede significantly the achievement of our business objectives. We have significantly increased the size of our organization in recent months, and we may encounter
difficulties managing our growth, which could adversely affect our results of operations. We have significantly expanded the size of our organization in recent months as we established
our commercial organization and launched our first product. We increased the number of our
employees from 49 as of December 31, 2003 to 383 as of March 15, 2005, and we expect the number of
employees to continue to grow to the extent we meet our strategic objectives. Our recent growth in
number of employees and scope of activities as well as any future growth and expansion are expected
to place a significant demand on our financial, managerial and operational resources. Our success will also depend on the ability of our executive officers and senior management to
continue to implement and improve our operational, management information and financial control
systems and to expand, train and manage our employee base. Our inability to manage growth
effectively could cause our operating costs to grow even faster than we are currently anticipating. Risks Related to Our Financial Results and Need for Financing We have incurred significant operating losses since our inception, and we expect to incur
significant additional operating losses and may not achieve profitability. The extent of our future operating losses and the timing of profitability are highly
uncertain, and we may never achieve profitability. We have been engaged in developing drugs and
have consistently generated operating losses since our inception in December 1996. Our commercial
launch activities, and continued product development and clinical activities will require
significant 26




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expenditures. As of December 31, 2004, we had recognized only approximately $634,000 in
net sales of our products, and we had an accumulated deficit of approximately $138.3 million, which
includes our net loss of $81.5 million in 2004. We expect to continue to incur additional operating
losses and capital expenditures and anticipate that our expenses will increase substantially in the
foreseeable future as we continue to support the commercial launch of Zegerid Powder for Oral
Suspension 40 mg, and continue our product development and clinical research programs. We will need to raise additional funds to pursue our growth strategy or continue our operations and
we may be unable to raise capital when needed. We believe that our current cash, cash equivalents and short-term investments, including the
$10.0 million milestone payment received from TAP in February 2005, will be sufficient to fund our
operations for at least the next 12 months. Until we can generate significant cash from our
operations, we expect to continue to fund our operations with existing cash resources that were
primarily generated from the proceeds of offerings of our equity securities. In addition, we may
receive revenue from our potential milestone payments from our co-promotion agreement with Otsuka
America and our sublicense agreement with TAP. We may finance future cash needs through the sale
of other equity securities, strategic collaboration agreements and debt financing. We likely will
pursue raising additional funds during 2005, as we continue to build our business and in
anticipation of the potential launch of our capsule and chewable tablet products in 2006. We cannot be certain that our existing cash and marketable securities resources will be
adequate, and failure to obtain adequate financing may adversely affect our ability to continue to
operate as a going concern. We also cannot be certain that additional funding will be available to
us on acceptable terms, or at all. For example, we may not be successful in obtaining collaboration
agreements, or in receiving milestone or royalty payments under those agreements. In addition, if
we raise additional funds through collaboration, licensing or other similar arrangements, it may be
necessary to relinquish potentially valuable rights to our products or proprietary technologies, or
grant licenses on terms that are not favorable to us. To the extent that we raise additional
capital by issuing equity securities, our stockholders ownership will be diluted. Any debt
financing we enter into may involve covenants that restrict our operations. If adequate funds are
not available on terms acceptable to us at that time, our ability to achieve profitability or to
respond to competitive pressures would be significantly limited, and we may be required to delay,
scale back or eliminate some or all of our product and clinical development programs or delay the
launch of our future products. Our quarterly financial results are likely to fluctuate significantly because our sales prospects
are uncertain. Our quarterly operating results are difficult to predict and may fluctuate significantly from
period to period, particularly because the commercial success of, and demand for, Zegerid Powder
for Oral Suspension as well as any other products we may develop are uncertain and therefore our
sales prospects are uncertain. The level of our revenues, if any, and results of operations at any
given time will be based primarily on the following factors:  
    success of the commercial launch of our first product and any other products that may be approved;
    our ability to maintain a productive sales force;
    demand and pricing of products we may offer;
    physician and patient acceptance of our products;
    levels of third-party reimbursement for our products;
    changes in our ability to obtain FDA approval for other products;
    interruption in the manufacturing or distribution of our products;
    results of our clinical trials;
    timing of new product offerings, acquisitions, licenses or other significant events by us or our competitors;
    regulatory approvals and legislative changes affecting the products we may offer or those of our competitors; and 27




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
    the effect of competing technological and market developments. It will be difficult for us to forecast demand for our products with any degree of certainty,
particularly during the early stages of our sales efforts for our first product. In addition, we
will be increasing our operating expenses as we build our commercial capabilities and promote the
product. Accordingly, we may experience significant, unanticipated quarterly losses. Because of
these factors, our operating results in one or more future quarters may fail to meet the
expectations of securities analysts or investors, which could cause our stock price to decline
significantly. Our short operating history makes it difficult to evaluate our business and prospects. We were incorporated in December 1996 and have only been conducting operations with respect to
our Zegerid family of products since January 2001. We launched the commercial sale of our first
product in October 2004. Our operations to date have involved organizing and staffing our company,
acquiring, developing and securing our technology, undertaking product development and clinical
trials for our products and commercially launching our first product. We only recently commercially
launched our first product, and we have not yet demonstrated an ability to successfully
commercialize a product. Consequently, any predictions about our future performance may not be as
accurate as they could be if we had a history of successfully developing and commercializing
products. We are recording non-cash compensation expense that may result in an increase of our net losses for
a given period. Stock-based compensation represents an expense associated with the recognition of the
difference between the deemed fair value of common stock at the time of an option grant or stock
issuance and the option exercise price or price paid for the stock. Stock-based compensation is
amortized over the vesting period of the option or issuance. As of December 31, 2004, deferred
stock-based compensation related to option grants and stock issuances to our employees totaled $4.6
million, which will be amortized to expense on an accelerated basis as the options or stock are
earned, generally over a period of four years. Also, we have granted options to consultants which,
for compensation purposes, must be remeasured at each reporting date during the vesting period.
This remeasurement and the corresponding effect on the related expense may result in an increase in
our net losses for a given period. Changes in, or interpretations of, accounting rules and regulations, such as expensing of stock
options, could result in unfavorable accounting charges or require us to change our compensation
policies. Accounting methods and policies for specialty pharmaceutical companies, including policies
governing revenue recognition, expenses, accounting for stock options and in-process research and
development costs are subject to further review, interpretation and guidance from relevant
accounting authorities, including the Securities and Exchange Commission. Changes to, or
interpretations of, accounting methods or policies in the future may require us to reclassify,
restate or otherwise change or revise our financial statements, including those contained in this
report. For example, in accordance with new standards finalized in December 2004, the Financial
Accounting Standards Board is requiring all companies to treat the fair value of stock options
granted to employees as an expense effective for the first interim reporting period that begins
after June 15, 2005. Currently, we are generally not required to record compensation expense in
connection with stock option grants to employees, and we have relied heavily on stock options to
motivate existing employees and attract new employees. When this change becomes effective, we and
other companies will be required to record a compensation expense equal to the fair value of each
stock option granted. The change will have a significant impact on our results of operations,
although it will have no impact on our overall financial position. The specific impact of the new
standards, however, cannot be predicted at this time because it will depend on levels of stock
options or other share-based payments granted in the future. When we are required to expense the
fair value of stock option grants, it may reduce the attractiveness of granting stock options. If
we reduce our use of stock options, it may be more difficult for us to attract and retain qualified
employees. Risks Related to Our Intellectual Property and Potential Litigation The protection of our intellectual property rights is critical to our success and any failure on
our part to adequately secure such rights would materially affect our business. Patents. Our commercial success will depend in part on the patent rights we have licensed or
will license and on patent protection for our own inventions related to the products that we market
and intend to market. Our success also depends on maintaining these patent rights against
third-party challenges to their validity, scope or enforceability. Our patent position is subject
to the same 28




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uncertainty as other biotechnology and pharmaceutical companies. For example, the U.S.
Patent and Trademark Office, or PTO, or the courts may deny, narrow or invalidate patent claims,
particularly those that concern biotechnology and pharmaceutical inventions. We may not be successful in securing or maintaining proprietary or patent protection for our
products, and protection that we have and do secure may be challenged and possibly lost. Our
competitors may develop products similar to ours using methods and technologies that are beyond the
scope of our intellectual property rights. Other drug companies may be able to develop generic
versions of our products if we are unable to maintain our proprietary rights. For example, although
we believe that we have valid patent protection in the U.S. for our products until at least 2016,
it is possible that generic drug makers will attempt to introduce generic immediate-release
omeprazole products similar to ours prior to the expiration of our patents. Any patents related
specifically to our Zegerid products will be method and/or formulation patents and will not protect
the use of the active pharmaceutical ingredient outside of the formulations described in the
patents and patent applications licensed to us. In addition, our competitors or other third
parties, including generic drug companies, may challenge the scope, validity or enforceability of
our patent claims. As a result, these patents may be narrowed in scope, invalidated or deemed
unenforceable and may fail to provide us with any market exclusivity or competitive advantage even
after our investment of significant amounts of money. We also may not be able to protect our
intellectual property rights against third-party infringement, which may be difficult to detect. If
we become involved in any dispute regarding our intellectual property rights, regardless of whether
we prevail, we could be required to engage in costly, distracting and time-consuming litigation
that could harm our business. To date, five U.S. patents have been issued relating to technology we license from the
University of Missouri and several U.S. and international or foreign counterpart patent
applications are pending. The initial U.S. patent from the University of Missouri does not have
corresponding international or foreign counterpart applications and there can be no assurance that
we will be able to obtain foreign patent rights to protect our products. We consult with the
University of Missouri in its pursuit of the patent applications that we have licensed, but the
University of Missouri remains primarily responsible for prosecution of the applications. We cannot
control the amount or timing of resources that the University of Missouri devotes on our behalf. It
may not assign as great a priority to prosecution of patent applications relating to technology we
license as we would if we were undertaking such prosecution ourselves. As a result of this lack of
control and general uncertainties in the patent prosecution process, we cannot be sure that any
additional patents will ever be issued. Issued patents generally require the payment of maintenance
or similar fees to continue their validity. We rely on the University of Missouri to do this,
subject to our obligation to provide reimbursement, and the Universitys failure to do so could
result in the forfeiture of patents not maintained. Trade Secrets and Proprietary Know-how. We also rely upon unpatented proprietary know-how and
continuing technological innovation in developing our products. Although we require our employees,
consultants, advisors and current and prospective business partners to enter into confidentiality
agreements prohibiting them from disclosing or taking our proprietary information and technology,
these agreements may not provide meaningful protection for our trade secrets and proprietary
know-how. Further, people who are not parties to confidentiality agreements may obtain access to
our trade secrets or know-how. Others may independently develop similar or equivalent trade secrets
or know-how. If our confidential, proprietary information is divulged to third parties, including
our competitors, our competitive position in the marketplace will be harmed and our ability to
successfully penetrate our target markets could be severely compromised. Trademarks. Our trademarks will be important to our success and competitive position. We have
received U.S. and European Union, or EU, trademark registration for our corporate name,
Santarus®. We also have received U.S. trademark registration and have applied for EU
trademark registration for our brand name, Zegerid®, and have applied for trademark
registration for various other names. Any objections we receive from the PTO, foreign trademark
authorities or third parties relating to our pending applications could require us to incur
significant expense in defending the objections or establishing alternative names. There is no
guarantee we will be able to secure any of our trademark registrations with the PTO or comparable
foreign authorities. If we do not adequately protect our rights in our various trademarks from infringement, any
goodwill that has been developed in those marks would be lost or impaired. We could also be forced
to cease using any of our trademarks that are found to infringe upon or otherwise violate the
trademark or service mark rights of another company, and, as a result, we could lose all the
goodwill which has been developed in those marks and could be liable for damages caused by any such
infringement or violation. Our Zegerid products depend on technology licensed from the University of Missouri and any loss of
our license rights would harm our business and seriously affect our ability to market our products. Our approved product and our products under development are based on patented technology and
technology for which patent applications are pending that we have exclusively licensed from the
University of Missouri. A loss or adverse modification of our 29




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technology license from the University of Missouri would materially harm our ability to develop and commercialize our current
products and other products based on that licensed technology that we may attempt to develop or
commercialize in the future. The licenses from the University of Missouri expire in each country when the last patent for
licensed technology expires in that country and the last patent application for licensed technology
in that country is abandoned. In addition, our rights under the University of Missouri license are
subject to early termination under specified circumstances, including our material and uncured
breach of the license agreement or our bankruptcy or insolvency. Further, we are required to use
commercially reasonable efforts to develop and sell products based on the technology we licensed
from the University of Missouri to meet market demand. If we fail to meet these obligations in
specified countries, after giving us an opportunity to cure the failure, the University of Missouri
can terminate our license or render it nonexclusive with respect to those countries. To date, we
believe we have met all of our obligations under the University of Missouri agreement. However, in
the event that the University of Missouri is able to terminate the license agreement for one of the
reasons specified in the license agreement, we would lose our rights to develop, market and sell
our current Zegerid products and we would not be able to develop, market and sell future products
based on those licensed technologies. We would also lose the right to receive potential milestone
and royalty payments from TAP based on its development of products under our sublicense to TAP of
the University of Missouri technology. Our ability to market our products is subject to the intellectual property rights of third parties. The products we currently intend to market, and those we may market in the future, may
infringe patent and other rights of third parties. In addition, our competitors, many of which have
substantially greater resources than us and have made significant investments in competing
technologies or products, may seek to apply for and obtain patents that will prevent, limit or
interfere with our ability to make, use and sell products either in the U.S. or international
markets. Intellectual property litigation in the pharmaceutical industry is common, and we expect
this to continue. In particular, intellectual property litigation among companies targeting the
treatment of upper GI diseases and disorders is particularly common and may increase due to the
large market for these products. We submitted NDAs for Zegerid Powder for Oral Suspension 20 mg and 40 mg (later approved in
June 2004 and December 2004) and we intend to submit NDAs for our capsule and chewable tablet
products, under Section 505(b)(2) of the Federal Food, Drug, and Cosmetic Act relying in part on
clinical data relating to AstraZenecas Prilosec, a delayed-release omeprazole product. In
connection with these filings, we were and will be required to provide notice to AstraZeneca, as
the NDA holder, and the owners of the listed patents, which include various AstraZeneca and Merck
entities, of our certification that our products do not infringe the patents listed in the Orange
Book for Prilosec or that those patents are invalid. Currently, there are six unexpired patents
listed for Prilosec in the Orange Book. Two of the patents relate to enteric-coated formulations of
omeprazole and expire in 2007. The remaining four patents relate generally to omeprazole and the
process for making omeprazole and expire in 2018 and 2019, including certain marketing exclusivity. In connection with any of our future Section 505(b)(2) NDA filings relating to omeprazole,
AstraZeneca will have 45 days from the date of its receipt of notice of these certifications to
file suit against us for infringement of those patents. If AstraZeneca brings suit against us
within this time period based on those patents, approval of the related products would be delayed
until the earliest of a court decision in our favor, a settlement of the claim involving licenses
to the patents at issue or 30 months from the date of receipt of the notice of the certifications,
or longer, if there is a court decision that is adverse to us. Thus, AstraZeneca will have an
opportunity to file suit against us and trigger the 30-month stay with respect to any future
Section 505(b)(2) NDA submissions we make, which litigation would be costly, time consuming and
distracting to management. Furthermore, if there is a court decision in such an infringement matter
that is adverse to us and upheld, we could become subject to an injunction for the life of the
patents. In addition, although AstraZeneca did not file suit against us within the 45-day notice
period regarding our NDAs for our Zegerid Powder for Oral Suspension 20 mg and 40 mg products, it
may choose to do so in the future. Although there would not be a 30-month stay in the FDA approval
process for these products, any such litigation would nevertheless be costly, time-consuming and
distracting to management. Historically, AstraZeneca has aggressively asserted its patent rights related to its Prilosec
product. For example, AstraZeneca has initiated patent infringement lawsuits against several drug
companies that have announced plans to sell generic versions of Prilosec. The patent litigations to
date have primarily focused on patents listed by AstraZeneca in the Orange Book that relate to
enteric-coated formulations of omeprazole. In addition to the patents listed in the Orange Book for Prilosec, AstraZeneca, as well as
other competitors and companies, including aaiPharma, TAP and Takeda Chemical Industries Ltd., hold
various other patents relating to omeprazole and PPI products generally and could file an
infringement suit claiming our current products infringe their patents. For example, we are aware
that 30




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aaiPharma initiated a patent infringement lawsuit against a generic omeprazole maker in
connection with the launch of its generic omeprazole product. Our third-party manufacturers may
also receive claims of infringement and could be subject to injunctions and temporary or permanent
exclusionary orders in the U.S. or in the countries in which they are based. While we believe that
we would have meritorious defenses to such claims, the outcome of any such litigation is uncertain
and defending such litigation would be expensive, time-consuming and distracting to management. If we or our third-party manufacturers are unsuccessful in any challenge to our rights to
market and sell our products, we may be required to license the disputed rights, if the holder of
those rights is willing, or to cease marketing the challenged products, or, if possible, to modify
our products to avoid infringing upon those rights. If we or our third-party manufacturers are
unsuccessful in defending our rights, we could be liable for royalties on past sales or more
significant damages, and we could be required to obtain and pay for licenses if we are to continue
to manufacture and sell our products. These licenses may not be available and, if available, could
require us to pay substantial upfront fees and future royalty payments. Any patent owner may seek
preliminary injunctive relief in connection with an infringement claim, as well as a permanent
injunction, and, if successful in the claim, may be entitled to lost profits from infringing sales,
attorneys fees and interest and other amounts. Any damages could be increased if there is a
finding of willful infringement. Even if we and our third-party manufacturers are successful in
defending an infringement claim, the expense, time delay and burden on management of litigation
could have a material adverse effect on our business. We may be subject to damages resulting from claims that we or our employees have wrongfully used or
disclosed alleged trade secrets of their former employers or otherwise breached the terms of
agreements with former employers. Many of our employees were previously employed at other biotechnology or pharmaceutical
companies, including our competitors or potential competitors. In addition, certain of our
employees are parties to non-compete, non-solicitation and non-disclosure agreements with their
prior employers. We may be subject to claims that these employees or we have inadvertently or
otherwise breached these non-compete and non-solicitation agreements or used or disclosed trade
secrets or other proprietary information of their former employers. Litigation may be necessary to
defend against these claims. Even if we are successful in defending against these claims,
litigation could result in substantial costs and be a distraction to management. If we fail in
defending such claims, in addition to paying money claims, we may lose valuable intellectual
property rights or personnel. A loss of key personnel or their work product could hamper or prevent
our ability to commercialize products, which could severely harm our business. Risks Related to the Securities Markets and Ownership of Our Common Stock Our stock price may be volatile and you may not be able to sell your shares at an attractive price. Our common stock had not been publicly traded prior to our initial public offering, which was
completed in April 2004, and an active trading market may not develop or be sustained. We have not
paid cash dividends since our inception and do not intend to pay cash dividends in the foreseeable
future. Therefore, investors will have to rely on appreciation in our stock price and a liquid
trading market in order to achieve a gain on their investment. The market prices for securities of
specialty pharmaceutical companies in general have been highly volatile and may continue to be
highly volatile in the future. Investors may not be able to sell their shares at or above the
offering price. For example, during the year ended December 31, 2004, the closing trading prices
for our common stock ranged from a high of $15.83 to a low of $8.38, and on March 15, 2005, the
closing trading price for our common stock was $5.50. The trading price of our common stock may continue to fluctuate substantially as a result of
one or more of the following factors:  
    announcements concerning our commercial activities, product
development programs, results of our clinical trials or status of
our regulatory submissions;
    the publication of prescription trend data concerning our products or competitive products;
    regulatory developments and related announcements in the U.S., including announcements by
the FDA, and foreign countries;
    disputes or other developments concerning proprietary rights,
including patents and trade secrets, litigation matters, and our
ability to patent or otherwise protect our products and
technologies;
    conditions or trends in the pharmaceutical and biotechnology industries; 31




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
    fluctuations in stock market prices and trading volumes of similar companies or of the markets generally;
    changes in, or our failure to meet or exceed, investors and securities analysts expectations;
    announcements of technological innovations or new commercial products by us or our competitors;
    actual or anticipated fluctuations in our or our competitors quarterly or annual operating results;
    sales of large blocks of our common stock, including sales by our
executive officers, directors or venture capital investors;
    our entering into licenses, strategic partnerships and similar arrangements, or the termination of such arrangements;
    acquisition of products or businesses by us or our competitors;
    announcements made by, or events affecting, our co-promotion
partner, our suppliers or other third parties that provide services
to us;
    litigation and government inquiries; or
    economic and political factors, including wars, terrorism and political unrest. Future sales of our common stock may depress our stock price. Persons who were our stockholders prior to the sale of shares in our initial public offering
continue to hold a substantial number of shares of our common stock that they will be able to sell
in the public market in the near future. Significant portions of these shares are held by a small
number of stockholders. Sales by our current stockholders of a substantial number of shares, or
the expectation that such sales may occur, could significantly reduce the market price of our
common stock. Moreover, the holders of a substantial number of shares of common stock, including
shares issuable upon exercise of outstanding warrants, may have rights, subject to certain
conditions, to require us to file registration statements to permit the resale of their shares in
the public market or to include their shares in registration statements that we may file for
ourselves or other stockholders. We have also registered all common stock that we may issue under our employee benefits plans.
As a result, these shares can be freely sold in the public market upon issuance, subject to
restrictions under the securities laws. In addition, certain of our executive officers, other than
our president and chief executive officer, have established programmed selling plans under Rule
10b5-1 of the Securities Exchange Act for the purpose of effecting sales of common stock, and other
employees and affiliates, including our directors, president and chief executive officer and other
executive officers, may choose to establish similar plans in the future. If any of our stockholders
cause a large number of securities to be sold in the public market, the sales could reduce the
trading price of our common stock. These sales also could impede our ability to raise future
capital. Our stock price could decline in connection with future issuances of equity or debt securities. Although we believe that our current cash, cash equivalents and short-term investments,
including the $10.0 million milestone payment received from TAP in February 2005, will be
sufficient to fund our operations for at least the next 12 months, we likely will pursue raising
additional funds during 2005, as we continue to build our business and in anticipation of the
potential launch of our capsule and chewable tablet products in 2006. Accordingly, we may conduct
substantial future offerings of equity or debt securities, which, in turn, could cause our stock
price to decline. The exercise of outstanding options and warrants and future equity issuances,
including future public offerings or future private placements of equity securities and any
additional shares issued in connection with acquisitions, will also result in dilution to
investors. We may become involved in securities class action litigation that could divert managements
attention and harm our business. The stock market has from time to time experienced significant price and volume fluctuations
that have affected the market prices for the common stock of pharmaceutical and biotechnology
companies. These broad market fluctuations may cause the market price of our common stock to
decline. In the past, following periods of volatility in the market price of a particular companys
securities, securities class action litigation has often been brought against that company. We may
become involved in this type of litigation in the future. Litigation often is expensive and diverts
managements attention and resources, which could adversely affect our business. 32




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We are exposed to increased costs and risks related to complying with recently enacted and proposed
changes in laws and regulations. Recently enacted and proposed changes in the laws and regulations affecting public companies,
including the provisions of the Sarbanes-Oxley Act of 2002 and rules proposed by the Securities and
Exchange Commission and by the Nasdaq Stock Market, will result in increased costs to us. In
particular, we expect to incur additional administrative expense as we implement Section 404 of the
Sarbanes-Oxley Act, which requires management to report on, and our independent registered public
accounting firm to attest to, our internal controls as of the end of 2005. In addition, the new
rules could make it more difficult or more costly for us to obtain certain types of insurance,
including directors and officers liability insurance, and we may be forced to accept reduced
policy limits and coverage or incur substantially higher costs to obtain the same or similar
coverage. The impact of these events could also make it more difficult for us to attract and retain
qualified persons to serve on our board, our board committees or as executive officers. We are
presently evaluating and monitoring developments with respect to new and proposed rules and cannot
predict or estimate the amount of the additional costs we may incur or the timing of such costs. If
we fail to comply with any of these laws or regulations, or if our auditors cannot timely attest to
our evaluation of our internal controls, we could be subject to regulatory scrutiny and a loss of
public confidence in our corporate governance or internal controls, which could have an adverse
effect on our business and our stock price. Our executive officers and directors and their affiliates may exercise influence over stockholder
voting matters in a manner that may not be in the best interests of all of our stockholders. Our executive officers and directors and their affiliates together control approximately 14.2%
of our outstanding common stock, as of December 31, 2004. As a result, these stockholders may
collectively be able to influence matters requiring approval of our stockholders, including the
election of directors and approval of significant corporate transactions. The concentration of
ownership may delay, prevent or deter a change in control of our company even when such a change
may be in the best interests of all stockholders, could deprive our stockholders of an opportunity
to receive a premium for their common stock as part of a sale of our company or our assets and
might affect the prevailing market price of our common stock. Anti-takeover provisions in our organizational documents and Delaware law may discourage or prevent
a change in control, even if an acquisition would be beneficial to our stockholders, which could
adversely affect our stock price and prevent attempts by our stockholders to replace or remove our
current management. Our amended and restated certificate of incorporation and amended and restated bylaws contain
provisions that may delay or prevent a change in control, discourage bids at a premium over the
market price of our common stock and adversely affect the market price of our common stock and the
voting and other rights of the holders of our common stock. These provisions include:  
    dividing our board of directors into three classes serving staggered three-year terms;
    prohibiting our stockholders from calling a special meeting of stockholders;
    permitting the issuance of additional shares of our common stock or preferred stock without stockholder approval;
    prohibiting our stockholders from making certain changes to our
amended and restated certificate of incorporation or amended and
restated bylaws except with 66 2/3% stockholder approval; and
    requiring advance notice for raising business matters or nominating directors at stockholders meetings. We are also subject to provisions of the Delaware corporation law that, in general, prohibit
any business combination with a beneficial owner of 15% or more of our common stock for five years unless the holders
acquisition of our stock was approved in advance by our board of directors. Together, these charter
and statutory provisions could make the removal of management more difficult and may discourage
transactions that otherwise could involve payment of a premium over prevailing market prices for
our common stock. In addition, in November 2004, we adopted a stockholder rights plan. Although the rights plan
will not prevent a takeover, it is intended to encourage anyone seeking to acquire our company to
negotiate with our board prior to attempting a takeover by potentially significantly diluting an
acquirers ownership interest in our outstanding capital stock. The existence of the rights plan
may also discourage transactions that otherwise could involve payment of a premium over prevailing
market prices for our common stock. 33




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Item 2 . Properties Our corporate headquarters facility consists of approximately 24,000 square feet in San Diego,
California. We lease our corporate headquarters facility pursuant to a lease agreement that expires
in March 2008. To the extent that we are able to successfully commercialize our products and
continue to grow our business, we believe that we will need to lease additional office space. 
 Item 3. Legal Proceedings We are not currently a party to any material legal proceedings. 
 Item 4. Submission of Matters to a Vote of Security Holders Not applicable. 34




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PART II 
 Item 5. Market for Registrants Common Equity, Related Stockholder Matters and Issuer
Purchases of Equity Securities Market Information Our common stock has been traded on the Nasdaq National Market since April 1, 2004 under the
symbol SNTS. Prior to such time, there was no public market for our common stock. The following
table sets forth the high and low sales prices for our common stock as reported on the Nasdaq
National Market for the periods indicated. High
    
    
    LowYear Ended December 31, 2004Second Quarter
    
    $
    15.88
    
    
    $
    8.67Third Quarter
    
    $
    14.99
    
    
    $
    8.69Fourth Quarter
    
    $
    10.80
    
    
    $
    8.36
 As of March 15, 2005, there were approximately 118 holders of record of our common stock. Dividend Policy We have never declared or paid any cash dividends on our capital stock. We currently intend to
retain all available funds and any future earnings to support operations and finance the growth and
development of our business and do not intend to pay cash dividends on our common stock for the
foreseeable future. Any future determination related to our dividend policy will be made at the
discretion of our board of directors. Recent Sales of Unregistered Securities During the year ended December 31, 2004, we issued and sold the following unregistered
securities:  
    Between January 1, 2004 and March 31, 2004, we granted options to purchase 410,700
shares of common stock to employees and directors under our stock incentive plan at
exercise prices ranging from $5.25 to $10.99 per share. During such time, 219,850 shares of
common stock were purchased pursuant to exercises of stock options, and no shares were
repurchased and returned to the stock incentive plan option pool. The offers, sales, and
issuances of the options and common stock were deemed to be exempt from registration under
the Securities Act in reliance on Rule 701 in that the transactions were under compensatory
benefit plans and contracts relating to compensation as provided under such rule. The
recipients of such options and common stock were our employees and directors and received
the securities under our stock incentive plan. Appropriate legends were affixed to the
share certificates issued in such transactions. Each of these recipients had adequate
access, through employment or other relationships, to information about us. Use of Proceeds Our initial public offering of common stock was effected through a Registration Statement on
Form S-1 (File No. 333-111515) that was declared effective by the Securities and Exchange
Commission on March 31, 2004. On April 6, 2004, 6,000,000 shares of common stock were sold on our
behalf at an initial public offering price of $9.00 per share, for an aggregate offering price of
$54.0 million, managed by SG Cowen & Co., LLC, UBS Securities LLC, Thomas Weisel Partners LLC and
RBC Capital Markets Corporation. On April 16, 2004, in connection with the full exercise of the
underwriters over-allotment option, 900,000 additional shares of common stock were sold on our
behalf at the initial public offering price of $9.00 per share, for an aggregate offering price of
$8.1 million. Following the sale of the 6,900,000 shares, the offering terminated. We paid to the underwriters underwriting discounts and commissions totaling approximately $4.3
million in connection with the offering. In addition, we incurred additional expenses of
approximately $1.9 million in connection with the offering, which when added to the underwriting
discounts and commissions paid by us, amounts to total expenses of approximately $6.2 million.
Thus, the net offering proceeds to us, after deducting underwriting discounts and commissions and
offering expenses, were approximately $55.9 million. No offering expenses were paid directly or
indirectly to any of our directors or officers (or their associates) or persons owning ten percent
or more of any class of our equity securities or to any other affiliates. 35




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As of December 31, 2004, we had used all of the net proceeds from our initial public offering
to continue the development and commercial launch of Zegerid Powder for Oral Suspension 20 mg and
40 mg and the development of our other products, as well as to fund other working capital and
general corporate purposes. 
 Item 6. Selected Financial Data The selected statement of operations data for the years ended December 31, 2001 and 2000, and
the selected balance sheet data as of December 31, 2002, 2001 and 2000, are derived from audited
financial statements, which have been audited by our independent registered public accounting firm
for such years and as of such dates, which are not included in this Form 10-K. The selected
statement of operations data for the years ended December 31, 2004, 2003 and 2002 and the selected
balance sheet data as of December 31, 2004 and 2003, are derived from the audited financial
statements for such years and as of such dates, which are included elsewhere in this Form 10-K. You
should read these selected financial data together with Managements Discussion and Analysis of
Financial Condition and Results of Operations and our financial statements and related notes
included elsewhere in this Form 10-K. Year Ended December 31,2004
    
    
    2003
    
    
    2002
    
    
    2001
    
    
    2000(in thousands, except per share data)Statement of Operations Data:Revenues:Product sales, net
    
    $
    634
    
    
    $
    
    
    
    $
    
    
    
    $
    
    
    
    $
    Sublicense and co-promotion revenue
    
    
    714
    
    
    
    
    
    
    
    8,000
    
    
    
    
    
    
    
    Total revenues
    
    
    1,348
    
    
    
    
    
    
    
    8,000
    
    
    
    
    
    
    
    Costs and expenses:Cost of sales
    
    
    1,968
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    License fees and royalties
    
    
    5,089
    
    
    
    1,000
    
    
    
    1,400
    
    
    
    1,294
    
    
    
    107Research and development
    
    
    23,199
    
    
    
    13,176
    
    
    
    15,398
    
    
    
    5,672
    
    
    
    2,027Selling, general and administrative
    
    
    48,306
    
    
    
    6,548
    
    
    
    6,034
    
    
    
    3,241
    
    
    
    1,391Stock-based compensation
    
    
    5,672
    
    
    
    2,252
    
    
    
    277
    
    
    
    87
    
    
    
    9Total costs and expenses
    
    
    84,234
    
    
    
    22,976
    
    
    
    23,109
    
    
    
    10,294
    
    
    
    3,534Loss from operations
    
    
    (82,886
    )
    
    
    (22,976
    )
    
    
    (15,109
    )
    
    
    (10,294
    )
    
    
    (3,534
    )Interest and other income (expense), net
    
    
    1,391
    
    
    
    465
    
    
    
    414
    
    
    
    726
    
    
    
    (3
    )Net loss
    
    
    (81,495
    )
    
    
    (22,511
    )
    
    
    (14,695
    )
    
    
    (9,568
    )
    
    
    (3,537
    )Accretion to redemption value of redeemable
convertible preferred stock
    
    
    (1,124
    )
    
    
    (2,940
    )
    
    
    
    
    
    
    
    
    
    
    Beneficial conversion of short-term notes
payable to related parties
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (135
    )
    
    
    (95
    )Net loss attributable to common stockholders
    
    $
    (82,619
    )
    
    $
    (25,451
    )
    
    $
    (14,695
    )
    
    $
    (9,703
    )
    
    $
    (3,632
    )Basic and diluted net loss per share
    
    $
    (3.30
    )
    
    $
    (13.71
    )
    
    $
    (9.13
    )
    
    $
    (7.08
    )
    
    $
    (3.62
    )Weighted average shares outstanding to calculate
basic and diluted net loss per share
    
    
    25,017
    
    
    
    1,857
    
    
    
    1,610
    
    
    
    1,371
    
    
    
    1,002
 As of December 31,2004
    
    
    2003
    
    
    2002
    
    
    2001
    
    
    2000(in thousands)Balance Sheet Data:Cash, cash equivalents and short-term investments
    
    $
    114,008
    
    
    $
    45,648
    
    
    $
    11,804
    
    
    $
    22,281
    
    
    $
    228Working capital (deficit)
    
    
    94,346
    
    
    
    42,376
    
    
    
    7,697
    
    
    
    21,526
    
    
    
    (1,053
    )Total assets
    
    
    122,216
    
    
    
    48,188
    
    
    
    14,207
    
    
    
    24,332
    
    
    
    849Short-term notes payable to related parties
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    788Deferred revenue, less current portion
    
    
    11,429
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Long-term debt, less current portion
    
    
    38
    
    
    
    224
    
    
    
    479
    
    
    
    
    
    
    
    50Redeemable convertible preferred stock
    
    
    
    
    
    
    57,625
    
    
    
    
    
    
    
    
    
    
    
    Total stockholders equity (deficit)
    
    
    85,843
    
    
    
    (13,751
    )
    
    
    9,074
    
    
    
    23,288
    
    
    
    (676
    )
 First
    
    
    Second
    
    
    Third
    
    
    FourthQuarter
    
    
    Quarter
    
    
    Quarter
    
    
    Quarter(in thousands, except per share data)Selected Quarterly Financial Data:2004:Product sales, net
    
    $
    
    
    
    $
    
    
    
    $
    
    
    
    $
    634Total revenues
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    1,348Cost of sales
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    1,968Total costs and expenses
    
    
    10,301
    
    
    
    17,109
    
    
    
    21,640
    
    
    
    35,184Net loss
    
    
    (10,187
    )
    
    
    (16,856
    )
    
    
    (21,192
    )
    
    
    (33,260
    )Net loss attributable to common stockholders
    
    
    (11,311
    )
    
    
    (16,856
    )
    
    
    (21,192
    )
    
    
    (33,260
    )Basic and diluted net loss per share
    
    
    (4.94
    )
    
    
    (0.61
    )
    
    
    (0.62
    )
    
    
    (0.92
    )2003:Product sales, net
    
    $
    
    
    
    $
    
    
    
    $
    
    
    
    $
    Total revenues
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Cost of sales
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Total costs and expenses
    
    
    4,421
    
    
    
    4,555
    
    
    
    6,011
    
    
    
    7,989Net loss
    
    
    (4,390
    )
    
    
    (4,399
    )
    
    
    (5,868
    )
    
    
    (7,854
    )Net loss attributable to common stockholders
    
    
    (4,390
    )
    
    
    (5,090
    )
    
    
    (6,993
    )
    
    
    (8,978
    )Basic and diluted net loss per share
    
    
    (0.60
    )
    
    
    (2.81
    )
    
    
    (3.78
    )
    
    
    (4.47
    )
 36




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Item 7. Managements Discussion and Analysis of Financial Condition and Results of Operations You should read the following discussion and analysis together with Selected Financial Data
and the financial statements and related notes included elsewhere in thisForm 10-K. This
discussion may contain forward-looking statements that involve risks and uncertainties. Our actual
results could differ materially from those anticipated in any forward-looking statements as a
result of many factors, including those set forth in our filings with the Securities and Exchange
Commission. Overview We are a specialty pharmaceutical company focused on acquiring, developing and commercializing
proprietary products to enhance the quality of life for patients with gastrointestinal diseases and
disorders. The primary focus of our current efforts is the development and commercialization of
next generation proton pump inhibitor, or PPI, products  the most frequently prescribed drugs for
the treatment of many upper gastrointestinal, or GI, diseases and disorders. Our Zegerid products are proprietary immediate-release formulations of the PPI omeprazole in
powder for oral suspension, capsule and chewable tablet formulations and are intended to treat or
reduce the risk of a variety of upper GI diseases and disorders. We received approval from the
U.S. Food and Drug Administration, or FDA, to market Zegerid Powder for Oral Suspension 20 mg in
June 2004 for the treatment of heartburn and other symptoms associated with gastroesophageal reflux
disease, or GERD, treatment and maintenance of healing of erosive esophagitis and treatment of
duodenal ulcers. We received FDA approval to market the 40 mg dose in December 2004 for the
treatment of gastric ulcers and the reduction of risk of upper GI bleeding in critically ill
patients. We are also developing immediate-release capsule and chewable tablet formulations, and
we intend to submit new drug applications for these products to the FDA during the second half of
2005. Zegerid Powder for Oral Suspension is currently being marketed through a field sales force of
approximately 400 representatives, which includes approximately 230 Santarus sales representatives
in addition to approximately 170 sales representatives from our co-promotion partner, Otsuka
America Pharmaceutical, Inc., or Otsuka America. The combined commercial sales organizations are
targeting the highest PPI-prescribing physicians in the U.S., with a focus on approximately 10,000
gastroenterologists and 26,000 primary care physicians, who we estimate were responsible for
writing approximately $5.6 billion of PPI prescriptions in 2004. We were formed in December 1996 and commenced significant business activities in late 1998.
From 1998 to 2000, we entered into various license agreements with universities and non-profit
institutions for patented technology rights for the development of products utilizing azathioprine
or cytoprotective compounds in the treatment of lower and upper GI diseases. We evaluated these
compounds in preclinical and clinical trials, as appropriate, and in 2001 shifted our focus to the
immediate-release PPI technology that represents our current efforts. We have terminated our
development programs regarding the azathioprine compound and, in 2002, we terminated the
cytoprotective compound license agreements that we had entered into in prior years. In January 2001, we entered into an exclusive, worldwide license agreement with the University
of Missouri, under which we licensed rights to all of its patents and patent applications relating
to specific formulations of immediate-release PPIs with antacids for treating upper GI diseases and
disorders. This licensed technology forms the basis of our Zegerid family of products. We paid
the University of Missouri an upfront licensing fee of $1.0 million in 2001 and a one-time $1.0
million milestone fee upon the filing of our first new drug application, or NDA, in 2003. In July
2004, we paid a one-time $5.0 million milestone fee based upon the FDAs approval of Zegerid Powder
for Oral Suspension 20 mg, and we are required to make additional milestone payments to the
University of Missouri upon the achievement of certain regulatory events related to obtaining
approvals outside the U.S. which may total up to $3.5 million in the aggregate. We are also
required to make milestone payments based on first-time achievement of significant sales
thresholds, up to a maximum of $86.3 million, and to pay royalties on net sales of our products. In June 2002, under a strategic sublicense agreement, we granted TAP Pharmaceutical Products
Inc., or TAP, the North American rights to develop, manufacture and sell products resulting from
the use of our immediate-release PPI technology with lansoprazole and derivatives of lansoprazole.
Under the agreement, TAP is required to pay a combination of fees for the licensed rights,
including an upfront payment and milestone payments that may exceed $100 million. To date, we have
received an upfront fee of $8.0 million in July 2002 and a $10.0 million milestone payment in
February 2005 related to TAPs development activities. We received the February 2005 milestone
after we prevailed in an alternative dispute resolution proceeding in which we alleged that TAP had
achieved a development milestone. We paid 15% of the upfront fee and the February 2005 milestone
to the University of Missouri and are also obligated to pay 15% of any further milestone payments,
as well as a portion of any royalty payments, we receive from TAP to the University of Missouri.
TAP is responsible for all of its product development and commercialization expenses. 37




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In October 2004, we entered into a non-exclusive agreement with Otsuka America, for Otsuka
America to co-promote Zegerid Powder for Oral Suspension to U.S. physicians. Under the terms of
the agreement, we received a $15.0 million upfront payment from Otsuka America, and have agreed to
pay Otsuka America a royalty on total U.S. net sales of Zegerid Powder for Oral Suspension. We
also granted Otsuka America options to extend the co-promotion arrangement to Zegerid Capsules and
Zegerid Chewable Tablets, subject to receipt of marketing approval of these products, with
additional milestone payments should those options be exercised. We have incurred significant losses since our inception. We had an accumulated deficit of
approximately $138.3 million as of December 31, 2004. These losses have resulted principally from
costs incurred in connection with license fees, research and development activities, including
costs of clinical trial activities associated with our current products, initial commercialization
activities and general and administrative expenses. We expect to continue to incur additional operating losses and capital expenditures and
anticipate that our expenses will increase substantially in the foreseeable future as we continue
to support the commercial launch of Zegerid Powder for Oral Suspension and our commercial
organization, enhance our product portfolio through internal development, product and patent
licensing and strategic acquisitions and grow our administrative support activities. On April 6, 2004, we completed an initial public offering of 6,000,000 shares of common stock
at a price to the public of $9.00 per share, raising net proceeds of approximately $48.3 million,
net of underwriting discounts and offering expenses. On April 16, 2004, in connection with the
exercise of the underwriters over-allotment option, we completed the sale of 900,000 additional
shares of common stock at the initial public offering price of $9.00 per share, raising net
proceeds of approximately $7.5 million, net of underwriting discounts and estimated offering
expenses. On July 28, 2004, we completed a follow-on public offering of 6,900,000 shares of common stock
at a price to the public of $9.50 per share, raising net proceeds of approximately $61.0 million,
net of underwriting discounts and offering expenses. The completed offering included the full
exercise of the underwriters over-allotment option. Revenues Product sales consist of sales of Zegerid Powder for Oral Suspension 20 mg, which we
commercially launched in the U.S. in October 2004. Sublicense and co-promotion revenue consist of upfront fees associated with our strategic
sublicense agreement with TAP entered into in June 2002 and our co-promotion agreement with Otsuka
America entered into in October 2004. Costs and Expenses Cost of Sales.Cost of sales consists primarily of raw materials, third party manufacturing
costs, freight and indirect personnel and other overhead costs associated with the sales of Zegerid
Powder for Oral Suspension 20 mg and reserves for excess, dated or obsolete commercial inventories. License Fees and Royalties.License fees and royalties consist of upfront and milestone
payments, common stock issuances, annual license maintenance fees and royalty obligations under our
technology license and co-promotion agreements, and payments made to a licensor in connection with
our receipt of sublicense fees. We have expensed amounts paid to obtain patents or acquire
licenses, as the ultimate recoverability of the amounts paid is uncertain and the technology has no
alternative future use when acquired. Future acquisitions of patents and technology licenses will
be charged to expense or capitalized based upon our assessment regarding the ultimate
recoverability of the amounts paid and the potential for alternative future use. Amounts
capitalized would be amortized over the useful life of the technology using the straight-line
method and reviewed annually or sooner, when indicators occur, for impairment. Research and Development.Research and development expenses consist primarily of costs
associated with clinical trials of our products under development, including the costs of
developing and manufacturing our products under development, compensation and other expenses
related to research and development personnel and facilities expenses. Our research and development activities are primarily focused on the development of our
Zegerid family of products, which are immediate-release omeprazole products in powder for oral
suspension, capsule and chewable tablet formulations. We completed a pivotal
pharmacokinetic/pharmacodynamic, or PK/PD, clinical trial for Zegerid Powder for Oral Suspension 20
mg in 2002, submitted 38




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our first NDA to the FDA in 2003 and received FDA approval in June 2004. We also completed a
pivotal PK/PD clinical trial in 2002, as well as a pivotal Phase III clinical trial in 2003, for
Zegerid Powder for Oral Suspension 40 mg, submitted our second NDA to the FDA in February 2004 and
received FDA approval in December 2004. We conducted an open-label clinical trial to evaluate the
safety of Zegerid Powder for Oral Suspension 40 mg as additional support for the FDA approval.
During 2004, we also conducted a Phase IIIb clinical trial evaluating Zegerid Powder for Oral
Suspension as compared to Protonix (delayed-release pantoprazole capsules) for control of nocturnal
gastric acidity. In November 2004, we completed two pivotal PK/PD clinical trials evaluating
Zegerid Capsules 20 mg and 40 mg and plan to submit our NDA to the FDA in the third quarter of
2005. In February 2005, we completed two pivotal PK/PD clinical trials evaluating Zegerid Chewable
Tablets 20 mg and 40 mg and plan to submit our NDA to the FDA in the second half of 2005. From the
time that we entered into our license agreement with the University of Missouri in January 2001
through December 31, 2004, our costs associated with the research and development of the Zegerid
products have represented over 95% of our research and development expenses for all program areas.
In addition, during the year ended December 31, 2004, costs associated with the research and
development of the Zegerid products represented over 98% of our research and development expenses
for all program areas, reflecting an even greater focus on these products. In addition to continued development of Zegerid Capsules and Zegerid Chewable Tablets, we have
committed to initiate PK/PD and safety studies evaluating Zegerid Powder for Oral Suspension in
pediatric populations during the second half of 2005. We are unable to estimate with any certainty
the costs we will incur in the continued development of our Zegerid family of products. Although
we are currently focused primarily on advancing our Zegerid family of products, we anticipate that
we will make determinations as to which development projects to pursue and how much funding to
direct to each project on an ongoing basis in response to the scientific and clinical success of
each product. Product development timelines and costs may vary significantly for each of our Zegerid
products and are difficult to estimate. The lengthy process of seeking regulatory approvals, and
the subsequent compliance with applicable regulations, requires the expenditure of substantial
resources. Any failure by us to obtain, or any delay in obtaining, regulatory approvals could
cause our research and development expenditures to increase and, in turn, have a material adverse
effect on our results of operations. Although we received FDA approval for Zegerid Powder for Oral
Suspension 20 mg in June 2004 and Zegerid Powder for Oral Suspension 40 mg in December 2004, we
cannot be certain when or if any net cash inflow from these products or any of our other
development projects will commence. Selling, General and Administrative.Selling, general and administrative expenses consist
primarily of compensation and other expenses related to our commercial operations and corporate
administrative employees, legal fees and other professional services expenses. As we only recently
commercially launched our Zegerid Powder for Oral Suspension 20 mg in October 2004 and our Zegerid
Powder for Oral Suspension 40 mg in February 2005, we expect our selling, general and
administrative expenses to increase. Stock-Based Compensation.Stock-based compensation represents the amortization of deferred
compensation resulting from the difference between the exercise price and the deemed fair value, as
estimated by us for financial reporting purposes, of our common stock on the date stock options
were granted to employees and the fair value of stock awards to non-employees. Interest and Other Income (Expense), Net Interest and other income (expense), net consists primarily of interest income earned on our
cash, cash equivalents, and short-term investments and interest expense associated with our
short-term notes payable to related parties and long-term debt. The short-term notes were paid in
full in February 2001. Critical Accounting Policies Our discussion and analysis of our financial condition and results of operations are based on
our financial statements, which have been prepared in accordance with U.S. generally accepted
accounting principles, or GAAP. The preparation of these financial statements requires us to make
estimates and judgments that affect the reported amounts of assets, liabilities, revenues and
expenses and related disclosure of contingent assets and liabilities. We review our estimates on
an on-going basis. We base our estimates on historical experience and on various other assumptions
that we believe to be reasonable under the circumstances, the results of which form the basis for
making judgments about the carrying values of assets and liabilities. Actual results may differ
from these estimates under different assumptions or conditions. While our significant accounting
policies are described in more detail in Note 1 to our financial statements included in this annual
report, we believe the following accounting policies to be critical to the judgments and estimates
used in the preparation of our financial statements. 39




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Revenue Recognition Product sales, net.We recognize revenue from product sales in accordance with Statement of
Financial Accounting Standard (SFAS) No. 48, Revenue Recognition When Right of Return Exists,
when there is persuasive evidence that an arrangement exists, when title has passed, the price is
fixed or determinable, and we are reasonably assured of collecting the resulting receivable. We
recognize product sales net of estimated allowances for product returns, managed care rebates,
reimbursements relating to Medicaid, chargebacks from distributors and prompt payment and other
discounts. Such estimates require our most subjective and complex judgment due to the need to make
estimates about matters that are inherently uncertain. If actual future payments for returns,
rebates, chargebacks and discounts exceed the estimates we made at the time of sale, our financial
position, results of operations and cash flows would be negatively impacted. We are obligated to accept from customers the return of products that are within six months of
their expiration date or 12 months beyond their expiration date. We authorize returns for damaged
products and exchanges for expired products in accordance with our return goods policy and
procedures, and have established allowances for such amounts at the time of sale. We recently
commercially launched our first product, Zegerid Powder for Oral Suspension 20 mg, in the fourth
quarter of 2004, and to date, we have had no product returns. Given our limited history, we have
established our allowances for potential product returns based on an analysis of product shipments
to our wholesale distributors in excess of prescription demand for Zegerid Powder for Oral
Suspension 20 mg in 2004. Although we believe that our estimates and assumptions are reasonable as
of the date when made, actual results may differ significantly from these estimates. Our financial
position, results of operations and cash flows may be materially and negatively impacted if actual
returns exceed our estimated allowance for returns. Sublicense and co-promotion revenue.We recognize sublicense and co-promotion revenue
consistent with the provisions of the Securities and Exchange Commission Staff Accounting Bulletin
(SAB) No. 104, Revenue Recognition,which sets forth guidelines in the timing of revenue
recognition based upon factors such as passage of title, installation, payments and customer
acceptance. We analyze each element of our sublicense and co-promotion agreements, to determine
the appropriate revenue recognition. We recognize revenue on upfront payments over the term of the
related agreements unless the fee is in exchange for products delivered or services rendered that
represent the culmination of a separate earnings process and no further performance obligation
exists under the contract. We evaluate the criteria outlined in Emerging Issues Task Force (EITF) Issue 99-19,
Reporting Revenue Gross as a Principal Versus Net as an Agent, in determining whether it is
appropriate to record the gross amount of sublicense revenues and related costs or the net amount
earned under the arrangement. We have recognized the gross amount of sublicense revenue and
related costs as we have no future obligations pursuant to the arrangement, we are the primary
obligor in the arrangement, we had latitude in establishing the amounts received under the
arrangement and we were involved in the determination of the scope of technology sublicensed under
the agreement. Clinical Trial Expenses Research and development expenditures are charged to operations as incurred. Our expenses
related to clinical trials are based on estimates of the services received and efforts expended
pursuant to contracts with multiple research institutions and clinical research organizations that
conduct and manage clinical trials on our behalf. The financial terms of these agreements are
subject to negotiation and vary from contract to contract and may result in uneven payment flows.
Generally, these agreements set forth the scope of work to be performed at a fixed fee or unit
price. Payments under the contracts depend on factors such as the successful enrollment of
patients or the completion of clinical trial milestones. Expenses related to clinical trials
generally are accrued based on contracted amounts applied to the level of patient enrollment and
activity according to the protocol. If timelines or contracts are modified based upon changes in
the clinical trial protocol or scope of work to be performed, we modify our estimates accordingly
on a prospective basis. Stock-Based Compensation In December 2002, SFAS No. 148, Accounting for Stock-Based Compensation  Transition and
Disclosure  an Amendment of FASB Statement No. 123, was issued. SFAS No. 148 provides alternative
methods of transition for a voluntary change to the fair value based method of accounting for
stock-based employee compensation from the intrinsic value-based method of accounting prescribed by
APB Opinion No. 25, Accounting for Stock Issued to Employees, or APB 25. In addition, SFAS No. 148
amends the disclosure requirements of SFAS No. 123, Accounting for Stock-Based Compensation. We
adopted the disclosure requirements of SFAS No. 148 effective December 31, 2002. As allowed by
SFAS No. 123, we have elected to continue to apply the intrinsic value- 40




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based method of accounting prescribed in APB 25 and, accordingly, do not recognize
compensation expense for stock option grants made at an exercise price equal to or in excess of the
estimated fair value of the stock at the date of grant. Deferred compensation is recognized and
amortized on an accelerated basis in accordance with Financial Accounting Standards Board
Interpretation No. 28, Accounting for Stock Appreciation Rights and Other Variable Stock Option or
Award Plans, over the vesting period of the related options. We account for options issued to non-employees under SFAS No. 123 and EITF Issue 96-18,
Accounting for Equity Investments that are Issued to Other than Employees for Acquiring or in
Conjunction with Selling Goods or Services. As such, the value of such options is periodically
remeasured and income or expense is recognized during their vesting terms. Income Taxes We record a valuation allowance to reduce our deferred tax assets to the amount that is more
likely than not to be realized. We have considered future taxable income and ongoing tax planning
strategies in assessing the need for the valuation allowance. In the event we were to determine
that we would be able to realize our deferred tax assets in the future in excess of their net
recorded amounts, an adjustment to the deferred tax assets would increase our income in the period
such determination was made. Likewise, should we determine that we would not be able to realize
all or part of our net deferred tax assets in the future, an adjustment to the deferred tax assets
would be charged to income in the period such determination was made. We had $54.1 million as of
December 31, 2004 and $21.7 million as of December 31, 2003 in gross deferred tax assets, which
were fully offset by a valuation allowance. The above listing is not intended to be a comprehensive list of all of our accounting
policies. In many cases, the accounting treatment of a particular transaction is specifically
dictated by GAAP. There are also areas in which our managements judgment in selecting any
available alternative would not produce a materially different result. Please see our audited
financial statements and notes thereto included elsewhere in this annual report, which contain
accounting policies and other disclosures required by GAAP. Results of Operations Comparison of Years Ended December 31, 2004, 2003 and 2002 Product Sales, Net.Product sales, net were $634,000 for 2004 and consisted of sales of
Zegerid Powder for Oral Suspension 20 mg, which we commercially launched in the U.S. in October
2004. In accordance with our revenue recognition policy, we recognize sales net of allowances for
product returns, managed care rebates, reimbursements relating to Medicaid, chargebacks from
distributors and prompt payment and other discounts. These sales allowances are generally
reflected either as a direct reduction to accounts receivable through an allowance, or as an
addition to accrued expenses if the payment is due to a party other than the wholesale or retail
customer. Given our limited history, we have established sales allowances for potential product
returns based on an analysis of product shipments to our wholesale distributors in excess of
prescription demand for Zegerid Powder for Oral Suspension 20 mg in 2004. Sublicense and Co-Promotion Revenue.Sublicense and co-promotion revenue was $714,000 for
2004 and $8.0 million for 2002. There were no sublicense and co-promotion revenues in 2003. In
2004, sublicense and co-promotion revenue consisted of the upfront fee received pursuant to our
co-promotion agreement with Otsuka America entered into in October 2004, which is being amortized
to revenue over the term of the agreement. In 2002, sublicense and co-promotion revenue consisted
of the upfront fee received pursuant to our strategic sublicense agreement with TAP. Cost of Sales.Cost of sales was $2.0 million for 2004, or approximately 310% of net product
sales. Cost of sales includes estimated reserves for excess, dated or obsolete inventories based
on an analysis of inventory on hand and on firm purchase commitments and inventory in the
distribution channel, compared to forecasts of future sales. Based upon review of initial
prescription trends for Zegerid Powder for Oral Suspension 20 mg subsequent to the commercial
launch in October 2004, and in light of our receipt of FDA approval to market Zegerid Powder for
Oral Suspension 40 mg in December 2004, commercial inventory reserves of approximately $1.6 million
were recorded in cost of sales in 2004. License Fees and Royalties.License fees and royalties were $5.1 million for 2004, $1.0
million for 2003 and $1.4 million for 2002. In 2004, license fees and royalties consisted of the
one-time $5.0 million milestone fee paid to the University of Missouri based upon the FDAs
approval of Zegerid Powder for Oral Suspension 20 mg and royalties due to the University of
Missouri and Otsuka America based upon net product sales. License fees and royalties in 2003
consisted of our $1.0 million milestone fee paid to the University of Missouri upon the filing of
our first NDA. License fees and royalties in 2002 primarily consisted of $1.2 million paid to 41




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the University of Missouri, which represented 15% of the upfront fee received pursuant to our
strategic sublicense agreement with TAP, and license maintenance fees associated with our license
agreement related to the azathioprine technology. We are not currently conducting any development
activities related to the azathioprine technology. Research and Development.Research and development expenses were $23.2 million for 2004,
$13.2 million for 2003 and $15.4 million for 2002. The $10.0 million increase in our research and
development expenses from 2003 to 2004 was primarily attributable to increased costs associated
with preparation for commercial manufacturing of Zegerid Powder for Oral Suspension, the
formulation development and production of clinical trial materials for our other products under
development, Zegerid Capsules and Zegerid Chewable Tablets, and the hiring of additional personnel.
The increase was also attributable to the initiation and completion of pivotal PK/PD clinical
trials evaluating Zegerid Capsules 20 mg and 40 mg, initiation of pivotal PK/PD clinical trials
evaluating Zegerid Chewable Tablets 20 mg and 40 mg, spending associated with our Phase IIIb
clinical trial evaluating Zegerid Powder for Oral Suspension as compared to Protonix
(delayed-release pantoprazole capsules) for control of nocturnal gastric acidity and payment of the
user fee associated with the submission of our second NDA for Zegerid Powder for Oral Suspension 40
mg in February 2004. These increases in our research and development expenses were offset in part
by decreased clinical trial costs associated with our pivotal Phase III clinical trial evaluating
Zegerid Powder for Oral Suspension 40 mg for the reduction of risk of upper GI bleeding in
critically ill patients that was completed in June 2003 and completion of our clinical trial to
evaluate the safety of Zegerid Powder for Oral Suspension 40 mg which was initiated in October
2003. The $2.2 million decrease in our research and development expenses from 2002 to 2003 was
primarily attributable to decreased clinical costs associated with the timing of initiation and
completion of various clinical trials for our Zegerid products under development. In addition to
the costs associated with our pivotal Phase III clinical trial, costs associated with our pivotal
PK/PD clinical trials evaluating Zegerid Powder for Oral Suspension 20 mg and 40 mg were included
in 2002. In 2003, we did not conduct pivotal PK/PD clinical trials, and we completed our pivotal
Phase III clinical trial in June 2003. These decreases in clinical costs were offset in part by
spending associated with our clinical trial to evaluate the safety of Zegerid Powder for Oral
Suspension 40 mg which was initiated in October 2003, and increased manufacturing and formulation
development costs associated with Zegerid Capsules and Zegerid Chewable Tablets. Expenses related to clinical trials pursuant to contracts with research institutions and
clinical research organizations represented 23% of our research and development expenses in 2004,
31% of our total research and development expenses in 2003 and 46% of our total research and
development expenses in 2002. Accrued clinical trial expenses are based on estimates of the work
completed under the contracts, milestones achieved and level of patient enrollment. Actual
services performed, number of patients enrolled and the rate of patient enrollment may vary from
our estimates, resulting in adjustments to clinical trial expenses in future periods. In the past,
we have not experienced any material deviations between accrued clinical trial expenses and actual
clinical trial expenses, and management does not anticipate material deviations in the future. Selling,General and Administrative.Selling, general and administrative expenses were $48.3
million for 2004, $6.5 million for 2003 and $6.0 million for 2002. The $41.8 million increase in
our selling, general and administrative expenses from 2003 to 2004 was primarily attributable to

the hiring of additional sales and marketing personnel, including our field sales organization,
which grew to more than 200 sales representatives in the third quarter of 2004 and to approximately
230 sales representatives at December 31, 2004. Additionally, outside services and professional
fees associated with the commercial launch of our first product, Zegerid Powder for Oral Suspension
20 mg, increased in 2004, including advertising and promotion, holding our first national sales
meeting, medical education and the cost of product samples. The $514,000 increase in our selling,
general and administrative expenses from 2002 to 2003 was primarily attributable to the hiring of
additional personnel throughout 2002, resulting in partial year expenditures in 2002 and full year
expenditures in 2003 for such personnel. This increase was offset in part by decreased consulting
fees as certain of our administrative support activities were assumed by in-house personnel. Stock-Based Compensation.We recorded non-cash compensation charges of $5.7 million in 2004,
$2.3 million in 2003 and $277,000 in 2002. In connection with the grant of stock options to
employees, we recorded deferred compensation of $1.4 million in 2004 and $10.5 million in 2003. We
recorded this amount as a component of stockholders equity and will amortize the amount as a
charge to operations over the vesting period of the options. The compensation charges in 2004
related to research and development personnel in the amount of $1.6 million and selling, general
and administrative personnel in the amount of $4.1 million. The compensation charges in 2003
related to research and development personnel in the amount of $488,000 and selling, general and
administrative personnel in the amount of $1.8 million. The compensation charges in 2002 represent
the fair value of stock awards to non-employees and related to selling, general and administrative
personnel. 42




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Interest and Other Income (Expense), Net.Interest and other income, net was $1.4 million in
2004, $465,000 in 2003 and $414,000 in 2002. The $926,000 increase from 2003 to 2004 was primarily
attributable to an increase in interest income resulting from higher cash balances from our initial
public offering of common stock in April 2004 and follow-on public offering of common stock in July
2004. The $51,000 increase in interest and other income, net from 2002 to 2003 was primarily
attributable to an increase in our interest income resulting from higher cash balances from our
financing activities in 2003. Income Taxes.We have incurred net operating losses since inception and, consequently, have
not recorded any federal or state income tax benefit. Our deferred tax assets primarily consist of
net operating loss carryforwards and research and development tax credits. We have recorded a
valuation allowance for the full amount of our deferred tax asset, as the realization of the
deferred tax asset is uncertain. As of December 31, 2004, we had federal and state tax net
operating loss carryforwards of approximately $109.7 million and $76.3 million, respectively.
These federal and state tax loss carryforwards are available to reduce future taxable income. If
not utilized, the net operating loss carryforwards will begin expiring in 2012 for federal purposes
and 2007 for state purposes. Annual limitations may result in the expiration of net operating loss
and credit carryforwards before they are used. Under the provisions of the Internal Revenue Code,
substantial changes in our ownership may limit the amount of net operating loss carryforwards that
could be utilized annually in the future to offset taxable income. Liquidity and Capital Resources As of December 31, 2004, cash, cash equivalents and short-term investments were $114.0
million, compared to $45.6 million as of December 31, 2003, an increase of $68.4 million. This
increase resulted primarily from the proceeds from the issuance of common stock in our initial
public offering in April 2004 and our follow-on public offering in July 2004, and the $15.0 million
upfront payment we received from Otsuka America in October 2004 under our co-promotion agreement
for Zegerid Powder for Oral Suspension, offset in part by our net loss for 2004. Net cash used in operating activities was $47.4 million for 2004, $20.9 million for 2003 and
$10.9 million for 2002. The primary use of cash was to fund our net losses for these periods,
adjusted for non-cash expenses, including $446,000 for 2004, $312,000 for 2003 and $251,000 for
2002 in depreciation and amortization, $5.7 million for 2004, $2.3 million for 2003 and $277,000
for 2002 in stock-based compensation, and changes in operating assets and liabilities. Accounts
payable and accrued liabilities increased in 2004 primarily due to increased spending levels
associated with the commercial launch of Zegerid Powder for Oral Suspension 20 mg, increased
accrued compensation and benefits associated with our increase in personnel and allowances for
product returns. Additionally, we have approximately $14.3 million in deferred revenue as of
December 31, 2004 related to the $15.0 million upfront payment we received from Otsuka America in
October 2004, which is being amortized over the term of the agreement. Net cash provided by (used in) investing activities was $(49.0) million for 2004, $(25.4)
million for 2003 and $1.9 million for 2002. These activities primarily consisted of purchases,
offset by sales and maturities of short-term investments and purchases of property and equipment.
Additionally, in 2004, we made deposits of approximately $1.0 million on certain manufacturing
equipment. Net cash provided by financing activities was $117.7 million for 2004, $54.8 million for 2003
and $860,000 for 2002. These activities consisted primarily of the issuance of common stock in our
initial public offering and our follow-on public offering in 2004, private sales of preferred stock
in 2003, proceeds from equipment notes payable in 2002 and the exercise of stock options, which
were offset in part by ongoing repayment of our notes payable. The principal balance of our
equipment notes payable was $224,000 with an annual interest rate of 9.23% at December 31, 2004. We expect our cash requirements to increase significantly in the foreseeable future to support
the commercialization of Zegerid Powder for Oral Suspension 20 mg and 40 mg, while we continue to
sponsor clinical trials for, seek regulatory approvals of, and develop and manufacture our current
products and new product opportunities. As we support our commercial organization, expand our
research and development efforts and pursue additional product opportunities, we anticipate
significant cash requirements for personnel costs, advertising and promotional activities, capital
expenditures and investment in additional office space, internal systems and infrastructure. In preparation for the launch of our first product, we entered into a commercial supply
agreement with Patheon in December 2003 which, among other things, obligates us to fund up to
approximately $1.9 million in manufacturing equipment for Patheon. Patheon is obligated to
reimburse us for this amount in the event that we purchase a specified aggregate number of units.
Through December 31, 2004, we have funded approximately $1.0 million of the manufacturing
equipment, and we believe we will expend an additional $210,000 in the first half of 2005. We
purchase commercial quantities of Zegerid Powder for Oral Suspension 20 mg and 40 mg from Patheon
as well as commercial quantities of the active ingredient from our omeprazole supplier. At December
31, 2004, we had 43




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finished goods and raw materials inventory purchase commitments of approximately $3.5 million,
of which we have expensed approximately $627,000 in 2004 related to excess inventories of Zegerid
Powder for Oral Suspension 20 mg. The following summarizes our long-term contractual obligations as of December 31, 2004: Payments Due by PeriodLess than
    
    
    One to
    
    
    Four toContractual Obligations
    
    Total
    
    
    One Year
    
    
    Three Years
    
    
    Five Years
    
    
    Thereafter(in thousands)Operating leases
    
    $
    3,155
    
    
    $
    1,007
    
    
    $
    2,139
    
    
    $
    9
    
    
    $
    Equipment financing
    
    
    224
    
    
    
    186
    
    
    
    38
    
    
    
    
    
    
    
    Sponsored research agreements
    
    
    263
    
    
    
    150
    
    
    
    113
    
    
    
    
    
    
    
    Other long-term contractual obligations
    
    
    1,454
    
    
    
    888
    
    
    
    566
    
    
    
    
    
    
    
    Total
    
    $
    5,096
    
    
    $
    2,231
    
    
    $
    2,856
    
    
    $
    9
    
    
    $
    
 In November 2004, we entered into a master lease agreement giving us the ability to lease
vehicles under operating leases. As of December 31, 2004, we had not entered into any vehicle lease
obligations under the master agreement. In connection with accepting delivery of vehicles and
entering into lease obligations in January 2005, we established a letter of credit for $1,000,000
naming the lessor as beneficiary. The letter of credit is fully secured by restricted cash and has
automatic annual extensions. The amount and timing of cash requirements will depend on market acceptance of Zegerid Powder
for Oral Suspension and any other products that may receive regulatory approval, the resources we
devote to researching, developing, formulating, manufacturing, commercializing and supporting our
products, and our ability to enter into third-party collaborations. We believe that our current cash, cash equivalents and short-term investments, including the
$10.0 million milestone payment received in February 2005 from TAP under our sublicense agreement,
will be sufficient to fund our operations for at least the next 12 months. Until we can generate
significant cash from our operations, we expect to continue to fund our operations with existing
cash resources that were primarily generated from the proceeds of offerings of our equity
securities. In addition, we may receive revenue from our potential milestone payments from our
co-promotion agreement with Otsuka America and our sublicense agreement with TAP. We may finance
future cash needs through the sale of other equity securities, strategic collaboration agreements
and debt financing. We likely will pursue raising additional funds during 2005, as we continue to
build our business and in anticipation of the potential launch of our capsule and chewable tablet
products in 2006. We cannot be certain that our existing cash and marketable securities resources will be
adequate, and failure to obtain adequate financing may adversely affect our ability to continue to
operate as a going concern. We also cannot be certain that additional funding will be available to
us on acceptable terms, or at all. For example, we may not be successful in obtaining collaboration
agreements, or in receiving milestone or royalty payments under those agreements. In addition, if
we raise additional funds through collaboration, licensing or other similar arrangements, it may be
necessary to relinquish potentially valuable rights to our products or proprietary technologies, or
grant licenses on terms that are not favorable to us. To the extent that we raise additional
capital by issuing equity securities, our stockholders ownership will be diluted. Any debt
financing we enter into may involve covenants that restrict our operations. If adequate funds are
not available on terms acceptable to us at that time, our ability to achieve profitability or to
respond to competitive pressures would be significantly limited, and we may be required to delay,
scale back or eliminate some or all of our product and clinical development programs or delay the
launch of our future products. As of December 31, 2004 and 2003, we did not have any relationships with unconsolidated
entities or financial partnerships, such as entities often referred to as structured finance or
special purpose entities, which would have been established for the purpose of facilitating
off-balance sheet arrangements or other contractually narrow or limited purposes. In addition, we
do not engage in trading activities involving non-exchange traded contracts. As such, we are not
materially exposed to any financing, liquidity, market or credit risk that could arise if we had
engaged in these relationships. Recent Accounting Pronouncements On December 16, 2004, the Financial Accounting Standards Board (FASB) issued SFAS No. 123
(revised 2004), Share-Based Payment, which is a revision of SFAS No. 123, Accounting for
Stock-Based Compensation(SFAS No. 123(R)). SFAS No. 123(R) supersedes APB 25, Accounting for
Stock Issued to Employees, and amends SFAS No. 95, Statement of Cash Flows. Generally, the
approach in SFAS No. 123(R) is similar to the approach described in SFAS No. 123. However, SFAS
No. 123(R) requires all share-based payments to employees, including grants of employee stock
options, to be recognized in the income statement based on their fair values. Pro forma disclosure
is no longer an alternative. SFAS No. 123(R) must be adopted no later than July 1, 2005. Early 44




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adoption will be permitted in periods in which financial statements have not been issued. We
expect to adopt SFAS 123(R) on July 1, 2005. As permitted by SFAS No. 123, we currently account for share-based payments to employees using
APB 25s intrinsic value method and, as such, generally recognize no compensation cost for employee
stock options when the exercise price is equal to or in excess of the
fair value of the stock at the date of grant. Accordingly, the adoption of SFAS No. 123(R)s fair value method will have a
significant impact on our results of operations, although it will have no impact on our overall
financial position. The impact of adoption of SFAS No. 123(R) cannot be predicted at this time
because it will depend on levels of share-based payments granted in the future. However, had we
adopted SFAS No. 123(R) in prior periods, the impact of that standard would have approximated the
impact of SFAS No. 123 as described in the disclosure of pro forma net loss and net loss per share
in Note 1 to our financial statements. SFAS No. 123(R) also requires the benefits of tax
deductions in excess of recognized compensation cost to be reported as a financing cash flow,
rather than as an operating cash flow as required under current literature. This requirement will
reduce net operating cash flows and increase net financing cash flows in periods after adoption. In November 2004, the FASB issued SFAS No. 151, Inventory Costs, an amendment of ARB No. 43,
Chapter 4.This statement amends the guidance in ARB No. 43 Chapter 4, Inventory Pricing, to
clarify the accounting for abnormal amounts of idle facility expense, freight, handling costs and
wasted material (spoilage). The provision of this statement will be effective for inventory costs
during the fiscal years beginning after June 15, 2005. As a
result of our manufacturing process being outsourced, we do not believe that the adoption of this
statement will have a material impact on our financial condition or results of operations. 
 Item 7A. Quantitative and Qualitative Disclosures about Market Risk Our primary exposure to market risk is interest income sensitivity, which is affected by
changes in the general level of U.S. interest rates, particularly because the majority of our
investments are in short-term marketable securities. The primary objective of our investment
activities is to preserve principal while at the same time maximizing the income we receive from
our investments without significantly increasing risk. Some of the securities that we invest in
may be subject to market risk. This means that a change in prevailing interest rates may cause the
value of the investment to fluctuate. For example, if we purchase a security that was issued with
a fixed interest rate and the prevailing interest rate later rises, the value of our investment
will probably decline. To minimize this risk, we intend to continue to maintain our portfolio of
cash equivalents and short-term investments in a variety of securities including commercial paper,
money market funds and government and non-government debt securities. In general, money market
funds are not subject to market risk because the interest paid on such funds fluctuates with the
prevailing interest rate. As of December 31, 2004, we did not have any holdings of derivative
financial or commodity instruments, or any foreign currency denominated transactions, and all of
our cash and cash equivalents were in money market funds and other highly liquid investments. 
 Item 8. Financial Statements and Supplementary Data See the list of financial statements filed with this report under Item 15 below. 
 Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure Not applicable. 
 Item 9A. Controls and Procedures We maintain disclosure controls and procedures that are designed to ensure that information
required to be disclosed in our Exchange Act reports is recorded, processed, summarized and
reported within the time periods specified in the Securities and Exchange Commissions rules and
forms and that such information is accumulated and communicated to our management, including our
chief executive officer and chief financial officer, as appropriate, to allow for timely decisions
regarding required disclosure. In designing and evaluating the disclosure controls and procedures,
management recognizes that any controls and procedures, no matter how well designed and operated,
can provide only reasonable assurance of achieving the desired control objectives, and management
is required to apply its judgment in evaluating the cost-benefit relationship of possible controls
and procedures. As required by Securities and Exchange Commission Rule 13a-15(b), we carried out an
evaluation, under the supervision and with the participation of our management, including our chief
executive officer and chief financial officer, of the effectiveness of the design and operation of
our disclosure controls and procedures as of the end of the period covered by this report. Based on
the foregoing, our chief executive officer and chief financial officer concluded that our
disclosure controls and procedures were effective at the reasonable assurance level. 45




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There has been no change in our internal controls over financial reporting during our most
recent fiscal quarter that has materially affected, or is reasonably likely to materially affect,
our internal controls over financial reporting. 
 Item 9B. Other Information Not applicable. 46




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PART III 
 Item 10. Directors and Executive Officers of the Registrant The information required by this item will be contained in our definitive proxy statement, or
Proxy Statement, to be filed with the Securities and Exchange Commission in connection with the
Annual Meeting of our Stockholders, which is expected to be filed not later than 120 days after the
end of our fiscal year ended December 31, 2004, and is incorporated in this report by reference. 
 Item 11. Executive Compensation The information required by this item will be set forth in the Proxy Statement and is
incorporated in this report by reference. 
 Item 12. Security Ownership of Certain Beneficial Owners and Management The information required by this item will be set forth in the Proxy Statement and is
incorporated in this report by reference. 
 Item 13. Certain Relationships and Related Transactions The information required by this item will be set forth in the Proxy Statement and is
incorporated in this report by reference. 
 Item 14. Principal Accounting Fees and Services The information required by this item will be set forth in the Proxy Statement and is
incorporated in this report by reference. 47




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##### Table of Contents



PART IV 
 Item 15. Exhibits and Financial Statement Schedules (a) Documents filed as part of this report. 1. The following financial statements of Santarus, Inc. and Report of Independent
Registered Public Accounting Firm, are included in this report: Report of Independent Registered Public Accounting Firm Balance Sheets as of December 31, 2004 and 2003 Statements of Operations for the years ended December 31, 2004, 2003 and 2002 Statements of Stockholders Equity (Deficit) for the years ended December 31, 2004, 2003 and
2002 Statements of Cash Flows for the years ended December 31, 2004, 2003 and 2002 Notes to Financial Statements 2. List of financial statement schedules: Schedule II  Valuation and Qualifying Accounts Schedules not listed above have been omitted because they are not applicable or the required
information is shown in the financial statements or notes thereto. 3. List of exhibits required by Item 601 of Regulation S-K. See part (b) below. (b) Exhibits.The following exhibits are filed as a part of this report: ExhibitNumber
    
    Description3.1(1)
    
    Amended and Restated Certificate of Incorporation3.2(1)
    
    Amended and Restated Bylaws4.1(2)
    
    Form of Common Stock Certificate4.2(3)
    
    Amended and Restated Investors Rights Agreement, dated April 30, 2003, among us and the parties named
therein4.3(3)
    
    Amendment No. 1 to Amended and Restated Investors Rights Agreement, dated May 19, 2003, among us and the
parties named therein4.4(3)
    
    Stock Restriction and Registration Rights Agreement, dated January 26, 2001, between us and The Curators
of the University of Missouri4.5(3)
    
    Form of Series C Preferred Stock Purchase Warrant4.6(3)
    
    Form of Common Stock Purchase Warrant4.7(3)
    
    Warrant to Purchase Shares of Common Stock, dated April 30, 2003, issued to Rockport Venture Securities,
LLC4.8(2)
    
    Rights Agreement, dated as of November 12, 2004, between us and American Stock Transfer & Trust Company,
which includes the form of Certificate of Designations of the Series A Junior Participating Preferred
Stock of Santarus, Inc. as Exhibit A, the form of Right Certificate as Exhibit B and the Summary of Rights
to Purchase Preferred Shares as Exhibit C10.1(3)
    
    Stock Purchase Agreement, dated January 26, 2001, between us and The Curators of the University of Missouri10.2(3)
    
    Exclusive License Agreement, dated January 26, 2001, between us and The Curators of the University of
Missouri10.3(3)
    
    Amendment No. 1 to Exclusive License Agreement, dated February 21, 2003, between us and The Curators of
the University of Missouri10.4(3)
    
    License Agreement, dated June 27, 2002, among us, TAP Pharmaceutical Products Inc. and Takeda Chemical
Industries, Ltd.
 48




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ExhibitNumber
    
    Description10.5(3)
    
    Omeprazole Supply Agreement, dated September 25, 2003, among us, InterChem Trading Corporation and Union
Quimico Farmaceutica, S.A.10.6(3)
    
    Manufacturing and Supply Agreement, dated December 19, 2003, between us and Patheon Inc.10.7(3)
    
    Capital Reimbursement Agreement, dated December 19, 2003, between us and Patheon Inc.10.8(4)+
    
    Manufacturing and Supply Agreement, dated September 27, 2004, between us and OSG Norwich Pharmaceuticals,
Inc.10.9(4)+
    
    Co-Promotion Agreement, dated October 4, 2004, between us and Otsuka America Pharmaceutical, Inc.10.10(3)
    
    Office Building Lease, dated August 24, 2001, between us and Torrey View Associates LP10.11(3)
    
    Irrevocable Stand-by Letter of Credit, dated August 24, 2001, issued by UBS Paine Webber Inc.10.12(3)#
    
    Form of Indemnification Agreement between us and each of our directors and officers10.13(3)#
    
    1998 Stock Option Plan10.14(5)#
    
    Amended and Restated 2004 Equity Incentive Award Plan10.15(6)#
    
    Form of Stock Option Agreement under Amended and Restated 2004 Equity Incentive Award Plan10.16(7)#
    
    Form of Immediately Exerciseable Stock Option Agreement under Amended and Restated 2004 Equity Incentive
Award Plan10.17(5)#
    
    Amended and Restated Employee Stock Purchase Plan10.18(3)#
    
    Employment Agreement, dated March 31, 2004, between us and Gerald T. Proehl10.19(3)#
    
    Employment Agreement, dated March 31, 2004, between us and Debra P. Crawford10.20(3)#
    
    Employment Agreement, dated March 31, 2004, between us and William C. Denby, III10.21(3)#
    
    Employment Agreement, dated March 31, 2004, between us and Warren E. Hall10.22(3)#
    
    Employment Agreement, dated March 31, 2004, between us and Bonnie Hepburn, M.D.10.23(3)#
    
    Employment Agreement, dated March 31, 2004, between us and Julie A. DeMeules10.24(5)#
    
    Employment Agreement, dated July 27, 2004, between us and C. Christine Simmons, Pharm.D.10.25(6)#
    
    Employment Agreement, dated February 7, 2005, between us and Michael D. Step10.26(8)#
    
    2004 Bonus Plan10.27(8)#
    
    2005 Bonus Plan23.1
    
    Consent of Independent Registered Public Accounting Firm31.1
    
    Certification of Chief Executive Officer pursuant to Rules 13a-14 and 15d-14 promulgated under the
Securities Exchange Act of 193431.2
    
    Certification of Chief Financial Officer pursuant to Rules 13a-14 and 15d-14 promulgated under the
Securities Exchange Act of 193432.1*
    
    Certifications of Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C. Section 1350,
as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
   (1)
    
    Incorporated by reference to the Companys Quarterly Report on
Form 10-Q for the quarter ended March 31, 2004, filed with the
Securities and Exchange Commission on May 13, 2004.(2)
    
    Incorporated by reference to the Companys Current Report on Form
8-K, filed with the Securities and Exchange Commission on November
17, 2004.(3)
    
    Incorporated by reference to the Companys Registration Statement
on Form S-1, filed with the Securities and Exchange Commission on
December 23, 2003, as amended (File No. 333-111515).(4)
    
    Incorporated by reference to the Companys Quarterly Report on
Form 10-Q for the quarter ended September 30, 2004, filed with the
Securities and Exchange Commission on November 12, 2004.(5)
    
    Incorporated by reference to the Companys Quarterly Report on
Form 10-Q for the quarter ended June 30, 2004, filed with the
Securities and Exchange Commission on August 13, 2004.(6)
    
    Incorporated by reference to the Companys Current Report on Form
8-K, filed with the Securities and Exchange Commission on February
8, 2005. 49




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##### Table of Contents



(7)
    
    Incorporated by reference to the Companys Current Report on Form
8-K, filed with the Securities and Exchange Commission on February
16, 2005.(8)
    
    Incorporated by reference to the Companys Current Report on Form
8-K, filed with the Securities and Exchange Commission on February
22, 2005.
    
    Confidential treatment has been granted as to
certain portions, which portions have been omitted
and filed separately with the Securities and
Exchange Commission.+
    
    Application has been made to the Securities and
Exchange Commission to seek confidential treatment
of certain provisions. Omitted material for which
confidential treatment has been requested has been
filed separately with the Securities and Exchange
Commission.#
    
    Indicates management contract or compensatory plan.*
    
    These certifications are being furnished solely to
accompany this annual report pursuant to 18 U.S.C.
Section 1350, and are not being filed for purposes
of Section 18 of the Securities Exchange Act of
1934 and are not to be incorporated by reference
into any filing of Santarus, Inc., whether made
before or after the date hereof, regardless of any
general incorporation language in such filing. (c) Financial Statement Schedule. See Item 15(a)(2) above. 50




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SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities and Exchange Act of
1934, the registrant has duly caused this report to be signed on its behalf by the undersigned,
thereunto duly authorized. SANTARUS, INC.Dated: March 23, 2005

 
    

By:
    /s/ GERALD T. PROEHLGerald T. ProehlPresident and Chief Executive Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been
signed below by the following persons on behalf of the registrant and in the capacities and on the
dates indicated. Name
    
    Title
    
    Date/s/ GERALD T. PROEHL
    
    President, Chief Executive Officer and Director
    
    March 23, 2005(Principal Executive Officer)Gerald T. Proehl/s/ DEBRA P. CRAWFORD
    
    Senior Vice President and Chief Financial Officer
    
    March 23, 2005(Principal Financial and
Accounting Officer)Debra P. Crawford/s/ DAVID F. HALE
    
    Director
    
    March 23, 2005(Chairman of the Board of
Directors)David F. Hale/s/ DANIEL D. BURGESS
    
    Director
    
    March 23, 2005Daniel D. Burgess/s/ MICHAEL G. CARTER, M.B., CH.B., F.R.C.P. (U.K.)
    
    Director
    
    March 23, 2005Michael G. Carter, M.B., Ch.B., F.R.C.P. (U.K.)/s/ RODNEY A. FERGUSON, J.D., PH.D.
    
    Director
    
    March 23, 2005Rodney A. Ferguson, J.D., Ph.D./s/ MICHAEL E. HERMAN
    
    Director
    
    March 23, 2005Michael E. Herman/s/ TED W. LOVE, M.D.
    
    Director
    
    March 23, 2005Ted W. Love, M.D./s/ KENT SNYDER
    
    Director
    
    March 23, 2005Kent Snyder
 51




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##### Table of Contents



SANTARUS, INC. INDEX TO FINANCIAL STATEMENTS PageAUDITED FINANCIAL STATEMENTSReport of Independent Registered Public Accounting Firm
    
    F-2Balance Sheets as of December 31, 2004 and 2003
    
    F-3Statements of Operations for the years ended December 31, 2004, 2003 and 2002
    
    F-4Statements of Stockholders Equity (Deficit) for the years ended December 31, 2004, 2003 and 2002
    
    F-5Statements of Cash Flows for the years ended December 31, 2004, 2003 and 2002
    
    F-7Notes to Financial Statements
    
    F-8FINANCIAL STATEMENT SCHEDULESchedule II  Valuation and Qualifying Accounts
    
    F-21
 F-1




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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM The Board of Directors and Stockholders
Santarus, Inc. We have audited the accompanying balance sheets of Santarus, Inc. as of December 31, 2004 and
2003, and the related statements of operations, stockholders equity (deficit), and cash flows for
each of the three years in the period ended December 31, 2004. These financial statements are the
responsibility of the Companys management. Our audits also included the financial schedule listed
in the Index at Item 15(a). Our responsibility is to express an opinion on these financial
statements based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting
Oversight Board (United States). Those standards require that we plan and perform the audit to
obtain reasonable assurance about whether the financial statements are free of material
misstatement. We were not engaged to perform an audit of the Companys internal control over
financial reporting. Our audit included consideration of internal control over financial reporting
as a basis for designing audit procedures that are appropriate in the circumstances, but not for
the purposes of expressing an opinion on the effectiveness of the Companys internal control over
financial reporting. Accordingly, we express no such opinion. An audit also includes examining,
on a test basis, evidence supporting the amounts and disclosures in the financial statements,
assessing the accounting principles used and significant estimates made by management, and
evaluating the overall financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material
respects, the financial position of Santarus, Inc. at December 31, 2004 and 2003, and the results
of its operations and its cash flows for each of the three years in the period ended December 31,
2004, in conformity with U.S. generally accepted accounting principles. Also, in our opinion, the
related financial statement schedule, when considered in relation to the basic financial statements
taken as a whole, presents fairly in all material respects the information set forth therein. /s/ Ernst & Young LLP San Diego, California
March 17, 2005 F-2




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##### Table of Contents



Santarus, Inc. 
 Balance Sheets December 31,2004
    
    
    2003AssetsCurrent assets:Cash and cash equivalents
    
    $
    34,402,352
    
    
    $
    13,063,211Short-term investments
    
    
    79,605,745
    
    
    
    32,585,088Accounts receivable, net
    
    
    800,719
    
    
    
    Inventories, net
    
    
    1,961,789
    
    
    
    Other current assets
    
    
    2,481,414
    
    
    
    817,216Total current assets
    
    
    119,252,019
    
    
    
    46,465,515Long-term restricted cash
    
    
    950,000
    
    
    
    950,000Property and equipment, net
    
    
    948,745
    
    
    
    616,076Other assets
    
    
    1,065,006
    
    
    
    156,563Total assets
    
    $
    122,215,770
    
    
    $
    48,188,154Liabilities and stockholders equity (deficit)Current liabilities:Accounts payable and accrued liabilities
    
    $
    14,805,809
    
    
    $
    3,834,257Allowance for product returns
    
    
    7,057,208
    
    
    
    Current portion of deferred revenue
    
    
    2,857,143
    
    
    
    Current portion of long-term debt
    
    
    185,980
    
    
    
    255,274Total current liabilities
    
    
    24,906,140
    
    
    
    4,089,531Deferred revenue, less current portion
    
    
    11,428,571
    
    
    
    Long-term debt, less current portion
    
    
    38,019
    
    
    
    223,999Series D redeemable convertible preferred stock, $.0001 par value;
no shares and 43,900,000 shares authorized, issued and outstanding
at December 31, 2004 and 2003, respectively
    
    
    
    
    
    
    57,625,278Stockholders equity (deficit):Series A convertible preferred stock, $.0001 par value; no shares and 620,000 shares
authorized, issued, and outstanding at December 31, 2004 and 2003, respectively
    
    
    
    
    
    
    62Series B convertible preferred stock, $.0001 par value; no shares and 5,276,000 shares
authorized, issued and outstanding at December 31, 2004 and 2003, respectively
    
    
    
    
    
    
    528Series C convertible preferred stock, $.0001 par value; no shares and 13,845,648
shares authorized at December 31, 2004 and 2003, respectively; no shares and
13,701,208 shares issued and outstanding at December 31, 2004 and 2003, respectively
    
    
    
    
    
    
    1,370Preferred stock, $.0001 par value; 10,000,000 shares and no shares authorized at
December 31, 2004 and 2003, respectively; no shares issued and outstanding at
December 31, 2004 and 2003
    
    
    
    
    
    
    Common stock, $.0001 par value; 100,000,000 and 104,000,000 shares authorized at
December 31, 2004 and 2003, respectively; 36,328,461 and 2,398,440 shares issued
and outstanding at December 31, 2004 and 2003, respectively
    
    
    3,633
    
    
    
    240Additional paid-in capital
    
    
    228,881,141
    
    
    
    50,568,886Deferred compensation
    
    
    (4,572,598
    )
    
    
    (8,646,845
    )Accumulated other comprehensive loss
    
    
    (187,538
    )
    
    
    (13,114
    )Accumulated deficit
    
    
    (138,281,598
    )
    
    
    (55,661,781
    )Total stockholders equity (deficit)
    
    
    85,843,040
    
    
    
    (13,750,654
    )Total liabilities and stockholders equity (deficit)
    
    $
    122,215,770
    
    
    $
    48,188,154
 See accompanying notes. F-3




---



##### Table of Contents



Santarus, Inc. 
 Statements of Operations Years Ended December 31,2004
    
    
    2003
    
    
    2002Revenues:Product sales, net
    
    $
    633,468
    
    
    $
    
    
    
    $
    Sublicense and co-promotion revenue
    
    
    714,286
    
    
    
    
    
    
    
    8,000,000Total revenues
    
    
    1,347,754
    
    
    
    
    
    
    
    8,000,000Costs and expenses:Cost of sales
    
    
    1,968,388
    
    
    
    
    
    
    
    License fees and royalties
    
    
    5,088,686
    
    
    
    1,000,000
    
    
    
    1,400,000Research and development
    
    
    23,198,637
    
    
    
    13,175,952
    
    
    
    15,397,706Selling, general and administrative
    
    
    48,306,599
    
    
    
    6,548,123
    
    
    
    6,033,741Stock-based compensation
    
    
    5,671,588
    
    
    
    2,252,268
    
    
    
    277,121Total costs and expenses
    
    
    84,233,898
    
    
    
    22,976,343
    
    
    
    23,108,568Loss from operations
    
    
    (82,886,144
    )
    
    
    (22,976,343
    )
    
    
    (15,108,568
    )Interest and other income, net
    
    
    1,390,837
    
    
    
    465,306
    
    
    
    413,746Net loss
    
    
    (81,495,307
    )
    
    
    (22,511,037
    )
    
    
    (14,694,822
    )Accretion to redemption value of redeemable
convertible preferred stock
    
    
    (1,124,510
    )
    
    
    (2,940,163
    )
    
    
    Net loss attributable to common stockholders
    
    $
    (82,619,817
    )
    
    $
    (25,451,200
    )
    
    $
    (14,694,822
    )Basic and diluted net loss per share
    
    $
    (3.30
    )
    
    $
    (13.71
    )
    
    $
    (9.13
    )Weighted average shares outstanding to calculate
basic and diluted net loss per share
    
    
    25,016,720
    
    
    
    1,856,879
    
    
    
    1,610,230The composition of stock-based
compensation is as follows:Research and development
    
    $
    1,623,846
    
    
    $
    487,936
    
    
    $
    Selling, general and administrative
    
    
    4,047,742
    
    
    
    1,764,332
    
    
    
    277,121$
    5,671,588
    
    
    $
    2,252,268
    
    
    $
    277,121
 See accompanying notes. F-4




---



##### Table of Contents



Santarus, Inc. 
 Statements of Stockholders Equity (Deficit) AccumulatedotherConvertible
    
    
    
    
    
    
    
    
    
    
    Additional
    
    
    
    
    
    
    
    
    
    
    comprehensivepreferred stock
    
    
    Common Stock
    
    
    paid-in
    
    
    Stockholder
    
    
    Deferred
    
    
    income
    
    
    AccumulatedShares
    
    
    Amount
    
    
    Shares
    
    
    Amount
    
    
    capital
    
    
    receivables
    
    
    compensation
    
    
    (loss)
    
    
    deficit
    
    
    TotalBalance at December 31, 2001
    
    
    19,597,208
    
    
    $
    19,597
    
    
    
    1,656,520
    
    
    $
    1,656
    
    
    $
    38,760,405
    
    
    $
    (25,000
    )
    
    $
    
    
    
    $
    46,858
    
    
    $
    (15,515,759
    )
    
    $
    23,287,757Issuance of common stock for stockholder note
upon exercise of options
    
    
    
    
    
    
    
    
    
    
    108,571
    
    
    
    109
    
    
    
    93,891
    
    
    
    (94,000
    )
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Forgiveness of stockholder note
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    94,000
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    94,000Issuance of common stock for cash upon
exercise of options net of 2,065 unvested
shares repurchased
    
    
    
    
    
    
    
    
    
    
    216,858
    
    
    
    217
    
    
    
    147,940
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    148,157Change in par value of preferred and common
stock from $.001 to $.0001
    
    
    
    
    
    
    (17,637
    )
    
    
    
    
    
    
    (1,784
    )
    
    
    19,421
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Compensation related to non-employee stock
options
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    277,121
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    277,121Net loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (14,694,822
    )
    
    
    (14,694,822
    )Unrealized loss on investments
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (37,842
    )
    
    
    
    
    
    
    (37,842
    )Comprehensive loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (14,732,664
    )Balance at December 31, 2002
    
    
    19,597,208
    
    
    
    1,960
    
    
    
    1,981,949
    
    
    
    198
    
    
    
    39,298,778
    
    
    
    (25,000
    )
    
    
    
    
    
    
    9,016
    
    
    
    (30,210,581
    )
    
    
    9,074,371Issuance of common stock for cash upon
exercise of options
    
    
    
    
    
    
    
    
    
    
    416,491
    
    
    
    42
    
    
    
    370,995
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    371,037Forgiveness of stockholder note
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    25,000
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    25,000Accretion to redemption value of redeemable
convertible preferred stock
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (2,940,163
    )
    
    
    (2,940,163
    )Deferred compensation related to issuance of
stock options to employees
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    10,512,825
    
    
    
    
    
    
    
    (10,512,825
    )
    
    
    
    
    
    
    
    
    
    
    Amortization of deferred compensation
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    1,865,980
    
    
    
    
    
    
    
    
    
    
    
    1,865,980Compensation related to non-employee stock
options
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    386,288
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    386,288Net loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (22,511,037
    )
    
    
    (22,511,037
    )Unrealized loss on investments
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (22,130
    )
    
    
    
    
    
    
    (22,130
    )Comprehensive loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (22,533,167
    )Balance at December 31, 2003
    
    
    19,597,208
    
    
    $
    1,960
    
    
    
    2,398,440
    
    
    $
    240
    
    
    $
    50,568,886
    
    
    $
    
    
    
    $
    (8,646,845
    )
    
    $
    (13,114
    )
    
    $
    (55,661,781
    )
    
    $
    (13,750,654
    )
 F-5




---



##### Table of Contents



AccumulatedotherConvertible
    
    
    
    
    
    
    
    
    
    
    Additional
    
    
    
    
    
    
    
    
    
    
    comprehensivepreferred stock
    
    
    Common Stock
    
    
    paid-in
    
    
    Stockholder
    
    
    Deferred
    
    
    income
    
    
    AccumulatedShares
    
    
    Amount
    
    
    Shares
    
    
    Amount
    
    
    capital
    
    
    receivables
    
    
    compensation
    
    
    (loss)
    
    
    deficit
    
    
    TotalBalance at December 31, 2003
    
    
    19,597,208
    
    
    $
    1,960
    
    
    
    2,398,440
    
    
    $
    240
    
    
    $
    50,568,886
    
    
    $
    
    
    
    $
    (8,646,845
    )
    
    $
    (13,114
    )
    
    $
    (55,661,781
    )
    
    $
    (13,750,654
    )Issuance of common stock for cash upon
exercise of options
    
    
    
    
    
    
    
    
    
    
    309,420
    
    
    
    31
    
    
    
    620,857
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    620,888Issuance of common stock under employee
stock purchase plan
    
    
    
    
    
    
    
    
    
    
    64,611
    
    
    
    6
    
    
    
    494,268
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    494,274Issuance of common stock at $4.395 per share upon
exercise of warrants, net
    
    
    
    
    
    
    
    
    
    
    14,376
    
    
    
    1
    
    
    
    (1
    )
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Issuance of common stock for cash upon
exercise of warrants
    
    
    
    
    
    
    
    
    
    
    855
    
    
    
    1
    
    
    
    1,396
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    1,397Accretion to redemption value of redeemable
convertible preferred stock
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (1,124,510
    )
    
    
    (1,124,510
    )Issuance of common stock in initial public
offering, net of issuance costs of $6,247,000
    
    
    
    
    
    
    
    
    
    
    6,900,000
    
    
    
    690
    
    
    
    55,852,310
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    55,853,000Issuance of common stock in follow-on public
offering, net of issuance costs of $4,553,000
    
    
    
    
    
    
    
    
    
    
    6,900,000
    
    
    
    690
    
    
    
    60,996,310
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    60,997,000Conversion of redeemable convertible preferred
stock into common stock
    
    
    
    
    
    
    
    
    
    
    12,542,697
    
    
    
    1,254
    
    
    
    58,748,534
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    58,749,788Conversion of convertible preferred stock into
common stock
    
    
    (19,597,208
    )
    
    
    (1,960
    )
    
    
    7,198,062
    
    
    
    720
    
    
    
    1,240
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Deferred compensation related to issuance of
stock options to employees
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    1,392,895
    
    
    
    
    
    
    
    (1,392,895
    )
    
    
    
    
    
    
    
    
    
    
    Unamortized deferred compensation on
cancelled stock options
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (290,340
    )
    
    
    
    
    
    
    290,340
    
    
    
    
    
    
    
    
    
    
    
    Amortization of deferred compensation
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    5,176,802
    
    
    
    
    
    
    
    
    
    
    
    5,176,802Compensation related to non-employee stock
options
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    494,786
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    494,786Net loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (81,495,307
    )
    
    
    (81,495,307
    )Unrealized loss on investments
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (174,424
    )
    
    
    
    
    
    
    (174,424
    )Comprehensive loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (81,669,731
    )Balance at December 31, 2004
    
    
    
    
    
    $
    
    
    
    
    36,328,461
    
    
    $
    3,633
    
    
    $
    228,881,141
    
    
    $
    
    
    
    $
    (4,572,598
    )
    
    $
    (187,538
    )
    
    $
    (138,281,598
    )
    
    $
    85,843,040
 See accompanying notes. F-6




---



##### Table of Contents



Santarus, Inc. 
 Statements of Cash Flows
 Years ended December 31,2004
    
    
    2003
    
    
    2002Operating activitiesNet loss
    
    $
    (81,495,307
    )
    
    $
    (22,511,037
    )
    
    $
    (14,694,822
    )Adjustments to reconcile net loss to net cash used in
operating activities:Depreciation and amortization
    
    
    446,311
    
    
    
    312,386
    
    
    
    251,087Stock-based compensation
    
    
    5,671,588
    
    
    
    2,252,268
    
    
    
    277,121Forgiveness of stockholder note
    
    
    
    
    
    
    25,000
    
    
    
    94,000Changes in operating assets and liabilities:Accounts receivable, net
    
    
    (800,719
    )
    
    
    
    
    
    
    Inventories, net
    
    
    (1,961,789
    )
    
    
    
    
    
    
    Other current assets
    
    
    (1,664,198
    )
    
    
    (270,569
    )
    
    
    (257,409
    )Other assets
    
    
    93,274
    
    
    
    (93,562
    )
    
    
    15,006Accounts payable and accrued liabilities
    
    
    10,971,552
    
    
    
    (586,371
    )
    
    
    3,376,866Allowance for product returns
    
    
    7,057,208
    
    
    
    
    
    
    
    Deferred revenue
    
    
    14,285,714
    
    
    
    
    
    
    
    Net cash used in operating activities
    
    
    (47,396,366
    )
    
    
    (20,871,885
    )
    
    
    (10,938,151
    )Investing activitiesPurchase of short-term investments
    
    
    (96,448,301
    )
    
    
    (45,402,660
    )
    
    
    (10,217,160
    )Sales and maturities of short-term investments
    
    
    49,253,220
    
    
    
    20,119,000
    
    
    
    12,450,000Purchases of property and equipment
    
    
    (733,525
    )
    
    
    (84,769
    )
    
    
    (361,220
    )Deposits on manufacturing equipment
    
    
    (1,047,172
    )
    
    
    
    
    
    
    Net cash provided by (used in) investing activities
    
    
    (48,975,778
    )
    
    
    (25,368,429
    )
    
    
    1,871,620Financing activitiesExercise of stock options
    
    
    620,888
    
    
    
    371,037
    
    
    
    148,157Issuance of common stock, net
    
    
    117,345,671
    
    
    
    
    
    
    
    Issuance of Series D redeemable convertible preferred stock, net
    
    
    
    
    
    
    54,685,116
    
    
    
    Proceeds from equipment notes payable
    
    
    
    
    
    
    
    
    
    
    809,309Payments on equipment notes payable
    
    
    (255,274
    )
    
    
    (232,936
    )
    
    
    (97,100
    )Net cash provided by financing activities
    
    
    117,711,285
    
    
    
    54,823,217
    
    
    
    860,366Increase (decrease) in cash and cash equivalents
    
    
    21,339,141
    
    
    
    8,582,903
    
    
    
    (8,206,165
    )Cash and cash equivalents at beginning of the year
    
    
    13,063,211
    
    
    
    4,480,308
    
    
    
    12,686,473Cash and cash equivalents at end of the year
    
    $
    34,402,352
    
    
    $
    13,063,211
    
    
    $
    4,480,308Supplemental disclosure of cash flow information:Interest paid
    
    $
    33,626
    
    
    $
    55,964
    
    
    $
    28,983Supplemental schedule of noncash investing
and financing activities:Issuance of stock in exchange for stockholder
receivables
    
    $
    
    
    
    $
    
    
    
    $
    94,000Accretion to redemption value of redeemable convertible
preferred stock
    
    $
    1,124,510
    
    
    $
    2,940,163
    
    
    $
    Conversion of redeemable convertible preferred stock to common
stock upon closing of initial public offering
    
    $
    58,749,788
    
    
    $
    
    
    
    $
    
 See accompanying notes. F-7




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##### Table of Contents



SANTARUS, INC. 
 NOTES TO FINANCIAL STATEMENTS 1. Organization and Summary of Significant Accounting Policies Organization and Business Santarus, Inc. (Santarus or the Company) is a specialty pharmaceutical company focused on
acquiring, developing and commercializing proprietary products to enhance the quality of life for
patients with gastrointestinal diseases and disorders. Santarus was incorporated on December 6,
1996 as a California corporation and did not commence significant business activities until late
1998. The Company, previously named TBG Pharmaceuticals, Inc., was formed as a result of a
spin-off from Prometheus Laboratories, Inc. On July 9, 2002, the Company reincorporated in the
State of Delaware. In October 2004, the Company commercially launched in the U.S. its first product, Zegerid
Powder for Oral Suspension 20 mg, an immediate-release formulation of the proton pump inhibitor
(PPI) omeprazole. This product is approved by the U.S. Food and Drug Administration (FDA) for
the treatment of heartburn and other symptoms associated with gastroesophageal reflux disease
(GERD), treatment and maintenance of healing of erosive esophagitis and treatment of duodenal
ulcers. In February 2005, the Company commercially launched Zegerid Powder for Oral Suspension 40
mg, approved by the FDA for the treatment of gastric ulcers and the reduction of risk of upper
gastrointestinal (GI) bleeding in critically ill patients. Use of Estimates in the Preparation of Financial Statements The preparation of financial statements in conformity with U.S. generally accepted accounting
principles requires management to make estimates and assumptions that affect the reported amounts
of assets and liabilities as well as disclosures of contingent assets and liabilities at the date
of the financial statements. Estimates also affect the reported amounts of revenues and expenses
during the reporting period. Actual results could differ from those estimates. Reclassification Certain previously reported amounts have been reclassified to conform to the current period
presentation. Cash and Cash Equivalents Cash and cash equivalents consist of highly liquid investments with a remaining maturity of
less than three months when purchased. Investments The Company has classified its debt securities as available-for-sale and, accordingly, carries
its short-term investments at fair value, and unrealized holding gains or losses on these
securities are carried as a separate component of stockholders equity (deficit). The cost of debt
securities is adjusted for amortization of premiums or accretion of discounts to maturity, and such
amortization is included in interest income. Realized gains and losses and declines in value
judged to be other-than-temporary (of which there have been none to date) on available-for-sale
securities are included in interest income. The cost of securities sold is based on the specific
identification method. Concentration of Credit Risk and Sources of Supply The Company invests its excess cash in highly liquid debt instruments of financial
institutions, government municipalities, and corporations with strong credit ratings. The Company
has established guidelines relative to diversification of its cash investments and their maturities
that are intended to maintain safety and liquidity. These guidelines are periodically reviewed and
modified to take advantage of trends in yields and interest rates and changes in the Companys
operations and financial position. To date, the Company has not experienced any losses on its cash
and cash equivalents and short-term investments. The Company sells its products to established wholesale distributors in the pharmaceutical
industry. Credit is extended based on an evaluation of the customers financial condition, and
collateral is not required. Approximately 67% of the accounts receivable F-8




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##### Table of Contents



balance as of December 31, 2004 represents amounts due from three customers. The Company
evaluates the collectibility of its accounts receivable based on a variety of factors including the
length of time the receivables are past due, the financial health of the customer and historical
experience. Based upon the review of these factors, and the fact that all balances were current,
the Company did not record an allowance for doubtful accounts at December 31, 2004. The Company relies on a single third-party manufacturer located outside of the U.S. for the
supply of Zegerid Powder for Oral Suspension 20 mg and 40 mg, and the Company is obligated to
purchase a significant portion of its requirements from this manufacturer. The Company also relies
on a single third-party supplier located outside of the U.S. for the supply of omeprazole, which is
the active pharmaceutical ingredient in each of the Companys current products. The Company is
obligated to purchase all of its requirements of omeprazole from this supplier. Inventories, Net Inventories are stated at the lower of cost or market and consist of finished goods and raw
materials used in the manufacture of the Companys Zegerid Powder for Oral Suspension 20 mg and 40
mg products. The Company provides reserves for potentially excess, dated or obsolete inventories
based on an analysis of inventory on hand and on firm purchase commitments and inventory in the
distribution channel, compared to forecasts of future sales. Based upon review of initial
prescription trends for Zegerid Powder for Oral Suspension 20 mg subsequent to the commercial
launch in October 2004, and in light of the Companys receipt of FDA approval to market Zegerid
Powder for Oral Suspension 40 mg in December 2004, the Company reserved approximately $1.7
million against on-hand inventories and accrued approximately $627,000 for firm purchase
commitments related to excess Zegerid Powder for Oral Suspension 20 mg inventories as of December
31, 2004. Property and Equipment Property and equipment are carried at cost less accumulated depreciation and amortized over
the estimated useful lives of the assets, ranging from three to five years or the term of the
related lease using the straight-line method. Fair Value of Financial Instruments The Companys financial instruments, including cash, cash equivalents, short-term investments
and accounts payable and accrued liabilities are carried at cost which approximates fair value due
to the relative short-term maturities of these instruments. Based on the borrowing rates currently
available to the Company for debt with similar terms, management believes the fair value of the
long-term debt approximates its carrying value. Impairment of Long-Lived Assets In accordance with Statement of Financial Accounting Standards (SFAS) No. 144, Accounting
for the Impairment or Disposal of Long-Lived Assets, the Company assesses the recoverability of the
affected long-lived assets by determining whether the carrying value of such assets can be
recovered through undiscounted future operating cash flows. If impairment is indicated, the
Company measures the amount of such impairment by comparing the fair value to the carrying value.
There have been no indicators of impairment through December 31, 2004. Revenue Recognition Product sales, net.The Company recognizes revenue from product sales in accordance with
Statement of Financial Accounting Standard (SFAS) No. 48, Revenue Recognition When Right of
Return Exists,when there is persuasive evidence that an arrangement exists, when title has passed,
the price is fixed or determinable, and the Company is reasonably assured of collecting the
resulting receivable. The Company recognizes product sales net of estimated allowances for product
returns, managed care rebates, reimbursements relating to Medicaid, chargebacks from distributors
and prompt payment and other discounts. Such estimates require managements most subjective and
complex judgment due to the need to make estimates about matters that are inherently uncertain. If
actual future payments for returns, rebates, chargebacks and discounts exceed the estimates made at
the time of sale, the Companys financial position, results of operations and cash flows would be
negatively impacted. The Company is obligated to accept from customers the return of products that are within six
months of their expiration date or 12 months beyond their expiration date. The Company authorizes
returns for damaged products and exchanges for expired products in accordance with its return goods
policy and procedures, and has established allowances for such amounts at the time of sale. The F-9




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##### Table of Contents



Company recently commercially launched its first product, Zegerid Powder for Oral Suspension
20 mg, in the fourth quarter of 2004, and to date, the Company has had no product returns. Given
the Companys limited history, allowances for potential product returns have been established based
on an analysis of product shipments to wholesale distributors in excess of prescription demand for
Zegerid Powder for Oral Suspension 20 mg in 2004. Although management believes that the estimates
and assumptions are reasonable as of the date when made, actual results may differ significantly
from these estimates. The Companys financial position, results of operations and cash flows may
be materially and negatively impacted if actual returns exceed estimated allowance for returns. Sublicense and co-promotion revenue.The Company recognizes sublicense and co-promotion
revenue consistent with the provisions of the Securities and Exchange Commission Staff Accounting
Bulletin (SAB) No. 104, Revenue Recognition,which sets forth guidelines in the timing of revenue
recognition based upon factors such as passage of title, installation, payments and customer
acceptance. The Company analyzes each element of sublicense and co-promotion agreements, to
determine the appropriate revenue recognition. The Company recognizes revenue on upfront payments
over the term of the related agreements unless the fee is in exchange for products delivered or
services rendered that represent the culmination of a separate earnings process and no further
performance obligation exists under the contract. The Company evaluates the criteria outlined in Emerging Issues Task Force (EITF) Issue
99-19, Reporting Revenue Gross as a Principal Versus Net as an Agent, in determining whether it is
appropriate to record the gross amount of sublicense revenues and related costs or the net amount
earned under the arrangement. The Company has recognized the gross amount of sublicense revenue
and related costs as the Company has no future obligations pursuant to the arrangement, is the
primary obligor in the arrangement, had latitude in establishing the amounts received under the
arrangement and was involved in the determination of the scope of technology sublicensed under the
agreement. Patent Costs Costs related to filing and pursuing patent applications are expensed as incurred as
recoverability of such expenditures is uncertain. License Fees and Research and Development Expenses Research and development expenditures consist primarily of costs associated with clinical
trials of the Companys products under development, including the costs of developing and
manufacturing the Companys products under development, compensation related to research and
development personnel and facilities expenses. Clinical trial costs include fees paid to clinical
research organizations, research institutions and other service providers, which conduct certain
research activities on behalf of the Company. Research and development expenditures are charged to expense as incurred. Expenses related to
clinical trials are generally accrued based on contracted amounts applied to the level of patient
enrollment and activity according to the protocol. If timelines or contracts are modified based on
changes in the clinical trial protocol or scope of work to be performed, the Company modifies its
estimates accordingly on a prospective basis. The Company has expensed amounts paid to obtain patents or acquire licenses, as the ultimate
recoverability of the amounts paid is uncertain and the technology has no alternative future use
when acquired. Future acquisitions of patents and technology licenses will be charged to expense
or capitalized based upon managements assessment regarding the ultimate recoverability of the
amounts paid and the potential for alternative future use. Amounts capitalized would be amortized
over the useful life of the technology using the straight-line method and reviewed annually for
impairment. Annual license maintenance fees under cancellable agreements are capitalized and
charged to expense over the corresponding twelve months. Quarterly sponsored research fees under
cancellable agreements are charged to expense as paid. Shipping and Handling Costs The Company does not charge its customers for freight. The amounts of such costs are included
in selling, general and administrative expenses and are not material. F-10




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##### Table of Contents



Advertising Expense The Company records the cost of its advertising efforts when services are performed or goods
are delivered. The Company recorded approximately $4.4 million in advertising expense for the year
ended December 31, 2004. There were no advertising expenses recorded in the years ended December
31, 2003 or 2002. Stock-Based Compensation In December 2002, SFAS No. 148, Accounting for Stock-Based Compensation  Transition and
Disclosure  an amendment of FASB Statement No. 123was issued. SFAS No. 148 provides alternative
methods of transition for a voluntary change to the fair value based method of accounting for
stock-based employee compensation from the intrinsic value-based method of accounting prescribed by
Accounting Principles Board (APB) Opinion No. 25, Accounting for Stock Issued to Employees. In
addition, SFAS No. 148 amends the disclosure requirements of SFAS No. 123, Accounting for
Stock-Based Compensation. The Company adopted the disclosure requirements of SFAS No. 148 effective
December 31, 2002. As allowed by SFAS No. 123, the Company has elected to continue to apply the
intrinsic value-based method of accounting prescribed in APB Opinion No. 25 and, accordingly, does
not recognize compensation expense for stock option grants made at an exercise price equal to or in
excess of the fair value of the stock at the date of grant. Deferred compensation is recognized
and amortized on an accelerated basis in accordance with Financial Accounting Standards Board
Interpretation No. 28, Accounting for Stock Appreciation Rights and Other Variable Stock Option or
Award Plans, over the vesting period of the related options. Had compensation cost for the Companys outstanding employee stock options and Employee Stock
Purchase Plan (ESPP) purchase rights been determined based on the fair value at the grant dates
for those options and rights consistent with SFAS No. 123, the Companys net loss and basic and
diluted net loss per share would have been changed to the following pro forma amounts: Years Ended December 31,2004
    
    
    2003
    
    
    2002Net loss attributable to common stockholders as reported
    
    $
    (82,619,817
    )
    
    $
    (25,451,200
    )
    
    $
    (14,694,822
    )Add: Stock-based employee compensation expense included in net loss
    
    
    5,176,802
    
    
    
    1,865,980
    
    
    
    Deduct: Stock-based employee compensation expense determined under
fair value method
    
    
    (9,748,804
    )
    
    
    (2,497,906
    )
    
    
    (206,326
    )Pro forma net loss attributable to common stockholders
    
    $
    (87,191,819
    )
    
    $
    (26,083,126
    )
    
    $
    (14,901,148
    )Basic and diluted net loss per share as reported
    
    $
    (3.30
    )
    
    $
    (13.71
    )
    
    $
    (9.13
    )Basic and diluted pro forma net loss per share
    
    $
    (3.49
    )
    
    $
    (14.05
    )
    
    $
    (9.25
    )
 SFAS No. 123 pro forma information regarding net loss is required by SFAS No. 123, and has
been determined as if the Company had accounted for its stock-based employee compensation under the
fair value method prescribed in SFAS No. 123. The fair value of the options was estimated at the
date of grant using the Black-Scholes pricing model with the following assumptions for 2004, 2003
and 2002: weighted average risk-free interest rates of 3.2%, 2.5% and 3.0%, respectively; a
dividend yield of 0%; a volatility of 70%; and a weighted-average life of the option of 6.2, 6.7
and 6.5 years, respectively. The weighted average grant date fair value for accounting purposes of
options granted in 2004, 2003 and 2002 was $6.78, $5.81 and $0.93, respectively. The fair value of
the ESPP purchase rights was estimated at the date of grant using the Black-Scholes pricing model
with the following assumptions for 2004: weighted average risk-free interest rate of 2.8%; a
dividend yield of 0%; a volatility of 70%; and a weighted-average life of the rights of 1.2 years.
As the Companys ESPP was implemented on April 1, 2004, no purchase rights existed in 2003 and
2002. The weighted average grant date fair value for accounting purposes of ESPP purchase rights
granted in 2004 was $4.31. The effects of applying SFAS No. 123 in this pro forma disclosure are
not indicative of future amounts. Stock option grants are expensed over their respective vesting
periods. The Company accounts for options issued to non-employees under SFAS No. 123 and EITF Issue
96-18, Accounting for Equity Investments that are Issued to Other than Employees for Acquiring or
in Conjunction with Selling Goods or Services. As such, the value of options issued to
non-employees is periodically remeasured and income or expense is recognized during their vesting
terms. For the years ended 2004, 2003 and 2002, stock-based compensation related to stock options
issued to non-employees was approximately $495,000, $386,000, and $277,000, respectively. Included
in non-employee stock-based compensation for the year ended December 31, 2004 was approximately
$361,000 in expense associated with the accelerated vesting of certain shares of common stock that
the Companys former chairman of the board of directors and his affiliates acquired in connection
with earlier options grants. F-11




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##### Table of Contents



Comprehensive Income (Loss) Comprehensive income (loss) consists of net income (loss) and other comprehensive income
(loss). Other comprehensive income (loss) includes certain changes in stockholders equity that
are excluded from net income (loss), specifically unrealized gains and losses on securities
available-for-sale. Comprehensive loss consists of the following: Years Ended December 31,2004
    
    
    2003
    
    
    2002Net loss
    
    $
    (81,495,307
    )
    
    $
    (22,511,037
    )
    
    $
    (14,694,822
    )Unrealized loss on investments
    
    
    (174,424
    )
    
    
    (22,130
    )
    
    
    (37,842
    )Comprehensive loss
    
    $
    (81,669,731
    )
    
    $
    (22,533,167
    )
    
    $
    (14,732,664
    )
 Net Loss Per Share The Company calculated net loss per share in accordance with SFAS No. 128, Earnings Per Share,
and SAB No. 98. Basic loss per share is calculated by dividing the net loss by the weighted
average number of common shares outstanding for the period, without consideration for common stock
equivalents. Diluted loss per share is computed by dividing the net loss by the weighted average
number of common share equivalents outstanding for the period determined using the treasury-stock
method. For purposes of this calculation, common stock subject to repurchase by the Company,
preferred stock, options, and warrants are considered to be common stock equivalents and are only
included in the calculation of diluted earnings per share when their effect is dilutive. Under the
provisions of SAB No. 98, common shares issued for nominal consideration (as defined), if any,
would be included in the per share calculations as if they were outstanding for all periods
presented. No common shares have been issued for nominal consideration. The net loss per share for the year ended December 31, 2004 includes the effect of the
6,900,000 shares of common stock issued in the Companys follow-on public offering of common stock
in July 2004, the 6,900,000 shares of common stock issued in the Companys initial public offering
of common stock in April 2004 and the 19,740,759 shares of common stock issued upon conversion of
the Companys redeemable convertible preferred stock and convertible preferred stock (collectively,
the Preferred Stock) in conjunction with the initial public offering. The pro forma shares used
to compute basic and diluted net loss per share represent the weighted average common shares
outstanding, reduced by the weighted average unvested common shares subject to repurchase, and
includes the assumed conversion of all outstanding shares of preferred stock into shares of common
stock using the as-if converted method as of the beginning of each period presented or the date of
issuance, if later. Years Ended December 31,2004
    
    
    2003
    
    
    2002Historical:Numerator:Net loss
    
    $
    (81,495,307
    )
    
    $
    (22,511,037
    )
    
    $
    (14,694,822
    )Accretion to redemption value of redeemable convertible preferred stock
    
    
    (1,124,510
    )
    
    
    (2,940,163
    )
    
    
    Net loss attributable to common stockholders
    
    $
    (82,619,817
    )
    
    $
    (25,451,200
    )
    
    $
    (14,694,822
    )Denominator:Weighted average common shares
    
    
    25,230,528
    
    
    
    2,023,077
    
    
    
    1,919,460Weighted average unvested common shares subject to repurchase
    
    
    (213,808
    )
    
    
    (166,198
    )
    
    
    (309,230
    )Denominator for basic and diluted net loss per share
    
    
    25,016,720
    
    
    
    1,856,879
    
    
    
    1,610,230Basic and diluted net loss per share
    
    $
    (3.30
    )
    
    $
    (13.71
    )
    
    $
    (9.13
    )Pro forma:Pro forma net loss
    
    $
    (81,495,307
    )
    
    $
    (22,511,037
    )
    
    $
    (14,694,822
    )Basic and diluted pro forma net loss per share (unaudited)
    
    $
    (2.70
    )
    
    $
    (1.30
    )
    
    $
    (1.67
    )Pro forma adjustments to reflect assumed weighted average effect of
conversion of preferred stock (unaudited)
    
    
    5,177,904
    
    
    
    15,478,178
    
    
    
    7,198,062Weighted average shares outstanding to calculate basic and diluted pro
forma net loss per share (unaudited)
    
    
    30,194,624
    
    
    
    17,335,057
    
    
    
    8,808,292Historical outstanding antidilutive securities not included in diluted
net loss per share calculation:Redeemable convertible and convertible preferred stock
    
    
    
    
    
    
    63,497,208
    
    
    
    19,597,208Common stock subject to repurchase
    
    
    117,095
    
    
    
    237,963
    
    
    
    245,037Options to purchase common stock
    
    
    3,890,914
    
    
    
    2,362,757
    
    
    
    687,626Stock warrants
    
    
    59,405
    
    
    
    167,057
    
    
    
    145,8664,067,414
    
    
    
    66,264,985
    
    
    
    20,675,737
 F-12




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##### Table of Contents



Segment Reporting Management has determined that the Company operates in one business segment which is the
development and commercialization of pharmaceutical products. Income Taxes In accordance with SFAS No. 109, Accounting for Income Taxes, a deferred tax asset or
liability is determined based on the difference between the financial statement and tax basis of
assets and liabilities, as measured by the enacted tax rates that will be in effect when these
differences reverse. The Company provides a valuation allowance against net deferred tax assets
unless, based upon the available evidence, it is more likely than not that the deferred tax assets
will be realized. New Accounting Pronouncements On December 16, 2004, the Financial Accounting Standards Board (FASB) issued SFAS No. 123
(revised 2004), Share-Based Payment, which is a revision of SFAS No. 123, Accounting for
Stock-Based Compensation(SFAS No. 123(R)). SFAS No. 123(R) supersedes APB Opinion No. 25,
Accounting for Stock Issued to Employees, and amends SFAS No. 95, Statement of Cash Flows.
Generally, the approach in SFAS No. 123(R) is similar to the approach described in SFAS No. 123.
However, SFAS No. 123(R) requires all share-based payments to employees, including grants of
employee stock options, to be recognized in the income statement based on their fair values. Pro
forma disclosure is no longer an alternative. SFAS No. 123(R) must be adopted no later than July
1, 2005. Early adoption will be permitted in periods in which financial statements have not been
issued. The Company expects to adopt SFAS 123(R) on July 1, 2005. As permitted by SFAS No. 123, the Company currently accounts for share-based payments to
employees using APB Opinion No. 25s intrinsic value method and, as such, generally recognizes no
compensation cost for employee stock options when the exercise price
is equal to or in excess of the fair value of the stock at the date
of grant. Accordingly, the adoption of Statement SFAS No.
123(R)s fair value method will have a significant impact on the Companys results of operations,
although it will have no impact on the Companys overall financial position. The impact of adoption
of SFAS No. 123(R) cannot be predicted at this time because it will depend on levels of share-based
payments granted in the future. However, had the Company adopted SFAS No. 123(R) in prior periods,
the impact of that standard would have approximated the impact of SFAS No. 123 as described in the
disclosure of pro forma net loss and net loss per share in Note 1 to the financial statements.
SFAS No. 123(R) also requires the benefits of tax deductions in excess of recognized compensation
cost to be reported as a financing cash flow, rather than as an operating cash flow as required
under current literature. This requirement will reduce net operating cash flows and increase net
financing cash flows in periods after adoption. In November 2004, the FASB issued SFAS No. 151, Inventory Costs, an amendment of ARB No. 43,
Chapter 4.This statement amends the guidance in ARB No. 43 Chapter 4, Inventory Pricing, to
clarify the accounting for abnormal amounts of idle facility expense, freight, handling costs and
wasted material (spoilage). The provision of this statement will be effective for inventory costs
during the fiscal years beginning after June 15, 2005. As a
result of the manufacturing process being outsourced, the Company does not believe that the
adoption of this statement will have a material impact on the Companys financial condition or
results of operations. 2. Investments The following is a summary of investments as of December 31, 2004 and 2003, which includes
amounts classified as cash, cash equivalents, short-term investments and restricted cash. All
investments held as of December 31, 2004 and 2003 have contractual maturities within one year. Amortized
    
    
    
    
    
    
    UnrealizedCost
    
    
    Market Value
    
    
    LossDecember 31, 2004:U.S. government and state agencies
    
    $
    44,259,412
    
    
    $
    44,164,289
    
    
    $
    (95,123
    )Corporate debt securities
    
    
    63,667,138
    
    
    
    63,574,723
    
    
    
    (92,415
    )Money market funds
    
    
    7,219,085
    
    
    
    7,219,085
    
    
    
    Total
    
    $
    115,145,635
    
    
    $
    114,958,097
    
    
    $
    (187,538
    )December 31, 2003:U.S. government and state agencies
    
    $
    30,128,767
    
    
    $
    30,124,964
    
    
    $
    (3,803
    )Corporate debt securities
    
    
    12,669,436
    
    
    
    12,660,125
    
    
    
    (9,311
    )Money market funds
    
    
    3,813,210
    
    
    
    3,813,210
    
    
    
    Total
    
    $
    46,611,413
    
    
    $
    46,598,299
    
    
    $
    (13,114
    )
 F-13




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##### Table of Contents



There were no gross realized gains or losses on sales of available-for-sale securities for the
years ended December 31, 2004 and 2003. 3. Balance Sheet Details Inventories, net consist of the following: December 31,2004
    
    
    2003Raw materials
    
    $
    2,563,767
    
    
    $
    Finished goods
    
    
    1,126,602
    
    
    
    3,690,369
    
    
    
    Allowance for excess and obsolete inventory
    
    
    (1,728,580
    )
    
    
    $
    1,961,789
    
    
    $
    
 Property and equipment, net consist of the following: December 31,2004
    
    
    2003Computer equipment and software
    
    $
    917,767
    
    
    $
    574,798Office equipment and furniture
    
    
    757,106
    
    
    
    577,612Leasehold improvements
    
    
    345,724
    
    
    
    178,4832,020,597
    
    
    
    1,330,893Less accumulated depreciation and amortization
    
    
    (1,071,852
    )
    
    
    (714,817
    )$
    948,745
    
    
    $
    616,076
 Accounts payable and accrued liabilities consist of the following: December 31,2004
    
    
    2003Accounts payable
    
    $
    3,045,659
    
    
    $
    968,205Accrued compensation and benefits
    
    
    4,940,634
    
    
    
    1,367,509Accrued research and development expenses
    
    
    3,583,739
    
    
    
    1,012,660Other accrued liabilities
    
    
    3,235,777
    
    
    
    485,883$
    14,805,809
    
    
    $
    3,834,257
 For the years ended December 31, 2004, 2003 and 2002, depreciation expense was approximately
$401,000, $312,000 and $251,000, respectively. 4. Technology License Agreements In October 2004, the Company entered into a non-exclusive agreement with Otsuka America
Pharmaceutical, Inc. (Otsuka America) for Otsuka America to co-promote Zegerid Powder for Oral
Suspension to U.S. physicians. Under the terms of the agreement, the Company received a $15.0
million upfront payment from Otsuka America, and has agreed to pay Otsuka America a royalty on
total U.S. net sales of the product. The Company also granted Otsuka America options to extend the
co-promotion arrangement to Zegerid Capsules and Zegerid Chewable Tablets subject to receipt of
marketing approval of these products, with additional milestone payments should those options be
exercised. The agreement expires on December 31, 2009, subject to earlier termination under
certain circumstances. The $15.0 million upfront payment is being amortized to co-promotion
revenue on a straight-line basis over the term of the co-promotion agreement, which expires on
December 31, 2009. In January 2001, the Company entered into a technology license agreement with The Curators of
the University of Missouri (Missouri). Under the technology license agreement, Missouri granted
the Company an exclusive, worldwide license to certain technologies and patent rights. Pursuant to
the terms of the license agreement, the Company issued to Missouri 164,284 shares of the Companys
common stock and paid an upfront licensing fee of $1.0 million, a one-time $1.0 million milestone
fee upon the filing of the Companys first NDA in 2003 and a one-time $5.0 million milestone fee
upon the FDAs approval of Zegerid Powder for Oral Suspension 20 mg in 2004. The Company is
required to make additional milestone payments to Missouri upon the achievement of certain
regulatory events related to obtaining approvals outside the U.S. which may total up to $3.5
million in the aggregate. The Company is also required to make milestone payments based on
first-time achievement of significant sales thresholds, up to a F-14




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##### Table of Contents



maximum of $86.3 million, and to pay royalties on net sales of the Companys products. The
license agreement is valid through the last to expire patent issued pursuant to the license
agreement, or in countries in which there are no pending patent applications or existing patents,
terminates on a country-by-country basis on the fifteenth anniversary of the Companys first
commercial sale in such country. The Company recorded license fee expenses of $5.0 million and
$1.0 million in 2004 and 2003, respectively, related to the milestone fees paid to Missouri. The
rights under the Missouri license are subject to early termination under specified circumstances.
Management believes that it has currently met all of its obligations under the license agreement. Under the Missouri technology license agreement, the Company entered into a five-year
sponsored research agreement in August 2001. The Company supports the program by granting cash,
which is being paid and expensed in 20 equal quarterly installments. In June 2002, the Company entered into a sublicense agreement which grants TAP Pharmaceutical
Products Inc. (TAP) certain rights to the technologies the Company licenses from Missouri, in
exchange for an upfront fee of $8.0 million, milestone payments and royalties on any future sales,
subject to conditions contained in the agreement. The Company paid 15% of the upfront fee to
Missouri and is also obligated to pay 15% of any milestone payments, as well as a portion of any
royalty payments received from TAP to Missouri. TAP is responsible for all of its product
development and commercialization expenses. Under the terms of the agreement, TAP has the right to
discontinue its development efforts and terminate the agreement without cause by giving 60 days
prior written notice. In
February 2005, the Company received a $10.0 million milestone payment from TAP, after the
Company prevailed in an alternative dispute resolution proceeding,
which is being recognized as revenue in the first quarter of 2005. The Company initiated the
alternative dispute resolution process in August 2003, asserting that TAP achieved a development
milestone under the terms of the sublicense agreement. The assertion was contested by TAP, and in
the proceeding, it was determined that the Company was entitled to the milestone payment plus
interest and legal expenses. In March 2005, the Company paid 15% of the milestone payment received
from TAP to Missouri. 5. Long-Term Debt In August 2002, the Company entered into a financing agreement, which provided up to $1.4
million of net financing for furniture, equipment and tenant improvements through April 3, 2003.
Borrowings under the loan schedule are payable over a thirty-six or forty-eight month period
including principal and interest based on three- or four-year U.S. Treasury maturities
(approximately 9.23% under the outstanding loan schedule). Principal payments due in 2005 and 2006
are approximately $186,000 and $38,000, respectively. The credit agreement provides the lender with
security interest in all equipment financed under the line and requires payment of a security
deposit should the Companys cash balances fall below certain minimum levels. As of December 31,
2004, the Company is in compliance with the required minimum cash balance provisions. 6. Commitments Leases The Company leases its primary office facility and certain equipment under various operating
leases. The facility lease provides for monthly rental payments and expires in March 2008. The
annual rent is subject to annual increases of 3.5%. In conjunction with the facilities lease, the
Company established a letter of credit for $950,000 naming the landlord as beneficiary. The letter
of credit is fully secured by restricted cash and has automatic extensions each year until May
2008. The letter of credit will be reduced to $700,000, $400,000, and $100,000 at March 31, 2006,
2007, and 2008, respectively, and the entire balance may be excused if the Company has $40,000,000
in cash, cash equivalents and short-term investments on hand. At December 31, 2004, estimated
annual future minimum payments under the Companys operating leases are as follows: 2005
    
    $
    1,007,0002006
    
    
    1,032,0002007
    
    
    877,0002008
    
    
    230,0002009
    
    
    9,000Total minimum lease payments
    
    $
    3,155,000
 Rent expense on facilities and equipment was approximately $1.0 million, $810,000 and $754,000
for the years ended December 31, 2004, 2003 and 2002, respectively. F-15




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##### Table of Contents



In November 2004, the Company entered into a master lease agreement giving the Company the
ability to lease vehicles under operating leases. As of December 31, 2004, the Company had not
entered into any vehicle lease obligations under the master agreement. In connection with the
Company accepting delivery of vehicles and entering into lease obligations in January 2005, the
Company established a letter of credit for $1,000,000 naming the lessor as beneficiary. The letter
of credit is fully secured by restricted cash and has automatic annual extensions. Commercial Supply Agreement In December 2003, the Company entered into a commercial supply agreement, which among other
things, obligates the Company to fund up to approximately $1.9 million in manufacturing equipment
for the supplier. The supplier is obligated to reimburse the Company for this amount in the event
the Company purchases a specified aggregate number of units. Through December 31, 2004, the
Company funded approximately $1.0 million of the manufacturing equipment. Other Long-Term Obligations The Company has entered into other long-term commitments for services requiring the Company to
make payments of approximately $888,000 and $566,000 in 2005 and 2006, respectively. 7. Redeemable Convertible Preferred Stock and Stockholders Equity (Deficit) Authorized Shares Effective with the Companys initial public offering in April 2004,the Companys certificate
of incorporation was amended and restated to provide for authorized capital stock of 100,000,000
shares of common stock and 10,000,000 shares of undesignated preferred stock. In November 2004, in
connection with the Companys adoption of the Stockholder Rights Plan, the Company designated
100,000 shares of preferred stock as Series A Junior Participating Preferred Stock. Reverse Stock Split In March 2004, the Companys stockholders approved a 1-for-3.5 reverse stock split of the
Companys outstanding common stock. The accompanying financial statements give retroactive effect
to the 1-for-3.5 reverse stock split for all periods presented. Initial Public Offering On April 6, 2004, the Company completed an initial public offering of 6,000,000 shares of
common stock at a price to the public of $9.00 per share raising net proceeds of approximately
$48.3 million, net of underwriting discounts and offering expenses. Upon completion of the initial
public offering, all outstanding shares of the Companys preferred stock automatically converted
into an aggregate of 19,740,759 shares of common stock. On April 16, 2004, in connection with the
full exercise of the underwriters over-allotment option, the Company completed the sale of 900,000
additional shares of common stock at the initial public offering price of $9.00 per share raising
net proceeds of approximately $7.5 million, net of underwriting discounts and offering expenses. On July 28, 2004, the Company completed a follow-on public offering of 6,900,000 shares of
common stock at a price to the public of $9.50 per share raising net proceeds of approximately
$61.0 million, net of underwriting discounts and offering expenses. The completed offering
included the full exercise of the underwriters over-allotment option. Preferred Stock Since inception, the Company has issued shares of preferred stock, including series A
convertible preferred stock, series B convertible preferred stock, series C convertible preferred
stock and series D redeemable convertible preferred stock. All outstanding shares of the Companys
preferred stock automatically converted into an aggregate of 19,740,759 shares of common stock upon
the completion of the Companys initial public offering. A listing of preferred stock issued since
the Companys inception is as follows:  
    In April 2003, the Company issued 36,102,536 shares of series D redeemable convertible
preferred stock (series D preferred stock) at $1.2557 per share for net proceeds of
approximately $44.9 million after deducting issuance costs of approximately $420,000. In
May and June 2003, the Company issued an additional 7,797,464 shares of series D preferred
stock at $1.2557 per share for net proceeds of approximately $9.8 million after deducting
issuance costs of approximately $20,000. F-16




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##### Table of Contents




    In February 2001, the Company issued 13,034,166 shares of series C convertible preferred
stock at $2.43 per share for net proceeds received in February and March 2001 of
approximately $31.6 million, after deducting issuance costs of approximately $113,000. In
conjunction with the Companys private placement of series C convertible preferred stock,
the Company converted approximately $1.5 million principal amount and associated accrued
interest due of approximately $24,000 under subordinated convertible notes into 643,586
shares of series C convertible preferred stock.
    In December 1998, the Company converted a $232,000 short-term loan into 580,000 shares
of series B convertible preferred stock at $0.40 per share. In December 1998, the Company
issued 4,696,000 shares of series B convertible preferred stock at $1.00 per share for net
proceeds of approximately $4.6 million after deducting issuance costs of approximately
$67,000. The Company received the proceeds from the issuance of series B convertible
preferred stock in January 1999.
    In December 1996, the Company issued 620,000 shares of its series A convertible
preferred stock to the stockholders of Prometheus Laboratories, Inc. at $0.01 per share in
conjunction with the spin-off and formation of the Company. The series D preferred stock was redeemable at any time after April 30, 2008 upon written
notice of the holders of at least two-thirds of the outstanding shares of series D preferred stock.
The redemption price of the series D preferred stock was equal to the stated price of the series D
preferred stock plus 8% per year (not compounded). The Company increased the carrying amount of the
series D preferred stock by periodic accretions, so that the carrying amounts would equal the
minimum redemption values on the earliest redemption date. Increases in the carrying amounts of
the series D preferred stock were recorded as increases in the Companys accumulated deficit. The series D preferred stock was convertible at the option of the holder into the number of
shares of the Companys common stock that results from dividing the stated price of $1.2557 by the
conversion price in effect at the time of conversion. The conversion price was initially set at
$1.2557 subject to certain adjustments including adjustments for stock splits or specified dilutive
issuances. After giving effect to the Companys 1-for-3.5 reverse stock split, the conversion
price was adjusted to $4.395. The series A, series B and series C convertible preferred stock were convertible at the option
of the holder into the number of shares of the Companys common stock that resulted from dividing
the stated prices of $0.10, $1.00 and $2.43, respectively, by the conversion prices in effect at
the time of conversion. In connection with the Companys private placement of series D preferred
stock in April 2003, the conversion prices for the series A, series B and series C convertible
preferred stock were set at $0.10, $1.00 and $1.7253, respectively, subject to certain adjustments
including adjustments for stock splits or specified dilutive issuances. After giving effect to the
Companys 1-for-3.5 reverse stock split, the conversion prices for the series A, series B and
series C convertible preferred stock were adjusted to $0.35, $3.50 and $6.0386, respectively. Stockholder Rights Plan In November 2004, the Company adopted a Stockholder Rights Plan (the Rights Plan). The
Rights Plan provides for a dividend distribution of one Preferred Share Purchase Right (a Right)
on each outstanding share of the Companys common stock held on November 22, 2004. Subject to
limited exceptions, the Rights will be exercisable if a person or group acquires 15% or more of the
Companys common stock or announces a tender offer for 15% or more of the common stock. Under
certain circumstances, each Right will entitle stockholders to buy one one-thousandth of a share of
newly created Series A Junior Participating Preferred Stock of the Company at an exercise price of
$100. The Companys Board of Directors will be entitled to redeem the Rights at $0.01 per Right at
any time before a person has acquired 15% or more of the outstanding common stock. Warrants In April 2003, in connection with the Companys series D financing, the Company issued to its
placement agent warrants to purchase 20,478 shares of its common stock. The warrants were
exercisable for a period of five years with an exercise price of $4.395 per share. The fair value
of the warrant was not material and accordingly, none of the proceeds were allocated to the
warrant. The warrants were exercised in full in 2004. In 2000 and 2001, in connection with the issuance of short-term unsecured subordinated
convertible notes, the Company issued warrants to purchase shares of preferred stock, which
converted into common stock warrants with the closing of the Companys initial public offering.
The warrants are exercisable for a period of five years with an exercise price equivalent to
$6.0386 per share. As of December 31, 2004, warrants to purchase 59,405 shares of common stock
were outstanding. F-17




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##### Table of Contents



Stock Option Plans The Company has two stock option plans for the benefit of its eligible employees, consultants,
and independent directors. In October 1998, the Company adopted the Santarus, Inc. 1998 Stock
Option Plan (the 1998 Plan). The 1998 Plan was approved by the Companys stockholders in
November 1998. The 1998 Plan initially authorized the Company to issue options to purchase up to
285,714 shares of its common stock. In August 2000, February 2001, January 2002 and April 2003, the
1998 Plan was amended to authorize the Company to issue options to purchase up to 457,142,
1,071,428, 1,314,285 and 4,171,428 shares of its common stock, respectively. Under the terms of
the 1998 Plan, nonqualified and incentive options were granted at prices not less than 85% and 100%
of the fair value on the date of grant, respectively. With the completion of the Companys initial
public offering, no additional options will be granted under the 1998 Plan, and all options that
are repurchased, forfeited, cancelled or expire will become available for grant under the 2004
Plan. In January 2004, the Company adopted the 2004 Equity Incentive Award Plan (the 2004 Plan).
The 2004 Plan was approved by the Companys stockholders in February 2004, became effective with
the Companys initial public offering on April 1, 2004 and was subsequently amended and restated in
July 2004. The Company initially reserved 3,500,000 shares of common stock for issuance under the
2004 Plan. The number of shares initially reserved for issuance was increased by 397,784 shares,
which was the number of shares of common stock available for issuance under the 1998 Plan as of the
completion of the Companys initial public offering, and will be further increased by any options
that are repurchased, forfeited, cancelled or expire under the 1998 Plan. In addition, the 2004
Plan contains an evergreen provision that allows for an annual increase in the number of shares
available for issuance on the first day of the fiscal year, equal to the lesser of 5% of the
outstanding capital stock on each January 1, 2,500,000 shares, or an amount determined by the
Companys board of directors. Options generally vest over periods ranging from one to five years and expire ten years from
the date of grant. Certain options are immediately exercisable, and unvested common shares
obtained upon early exercise of options are subject to repurchase by the Company at the original
issue price. At December 31, 2004 and 2003, 117,095 and 237,963 shares issued from the early
exercise of unvested options were subject to repurchase by the Company, respectively. A summary of stock option activity is as follows: Weighted-Average ExerciseShares
    
    
    PriceOutstanding at December 31, 2001
    
    
    779,425
    
    
    
    $  0.72Granted
    
    
    246,699
    
    
    
    1.43Exercised
    
    
    (327,494
    )
    
    
    0.74Cancelled
    
    
    (11,004
    )
    
    
    1.12Outstanding at December 31, 2002
    
    
    687,626
    
    
    
    0.96Granted
    
    
    2,130,645
    
    
    
    1.59Exercised
    
    
    (416,491
    )
    
    
    0.89Cancelled
    
    
    (39,023
    )
    
    
    1.81Outstanding at December 31, 2003
    
    
    2,362,757
    
    
    
    1.52Granted
    
    
    1,962,075
    
    
    
    9.56Exercised
    
    
    (309,423
    )
    
    
    2.01Cancelled
    
    
    (124,495
    )
    
    
    5.23Outstanding at December 31, 2004
    
    
    3,890,914
    
    
    
    5.42
 F-18




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##### Table of Contents



A summary of stock options outstanding as of December 31, 2004 is as follows: Options Outstanding
    
    
    Options ExercisableWeighted-
    
    
    Weighted-
    
    
    
    
    
    
    Weighted-Options
    
    
    Average Remaining
    
    
    Average Exercise
    
    
    Number
    
    
    Average ExerciseExercise Prices
    
    Outstanding
    
    
    Life in Years
    
    
    Price
    
    
    Exercisable
    
    
    Price$0.70-$1.05
    
    
    1,421,020
    
    
    
    8.1
    
    
    
    $  0.89
    
    
    
    1,421,020
    
    
    
    $  0.89$1.225-$2.10
    
    
    99,281
    
    
    
    8.5
    
    
    
    1.79
    
    
    
    99,281
    
    
    
    1.79$3.50
    
    
    501,869
    
    
    
    9.0
    
    
    
    3.50
    
    
    
    501,869
    
    
    
    3.50$5.25
    
    
    287,891
    
    
    
    9.1
    
    
    
    5.25
    
    
    
    287,891
    
    
    
    5.25$9.00-$12.89
    
    
    1,499,853
    
    
    
    9.6
    
    
    
    10.13
    
    
    
    379,579
    
    
    
    9.78$13.80-$14.75
    
    
    81,000
    
    
    
    9.5
    
    
    
    14.46
    
    
    
    
    
    
    
    3,890,914
    
    
    
    8.9
    
    
    
    5.42
    
    
    
    2,689,640
    
    
    
    3.13
 As of December 31, 2004 and 2003, respectively, 2,689,640 and 2,362,757 options outstanding
are exercisable, and 2,465,190 and 802,770 shares remain available for future grant under the Plan.
In February 2005, the Company granted options to purchase 1,248,592 shares in connection with
annual option grants to all eligible employees. In connection with the granting of employee stock options during 2004 and 2003, the Company
recorded deferred compensation of approximately $1.4 million and $10.5 million, respectively,
representing the difference between the exercise price and the fair value of the Companys common
stock on the date of grant. Deferred compensation is being amortized over the vesting period of
the options resulting in stock-based compensation expense of approximately $5.2 million and $1.9
million for the years ended December 31, 2004 and 2003, respectively. For the years ended December 31, 2003 and 2002, the Company granted a total of 4,998 and
4,998, respectively, in stock options to consultants. No stock options were granted to
non-employees in 2004. In 2004, the Company entered into employment agreements with each of its executive officers.
The employment agreements provide additional vesting of stock options under certain circumstances,
among other benefits. The agreements provide for 12 months accelerated vesting of the executives
outstanding stock options under the applicable vesting schedules in certain circumstances,
including termination by death or permanent disability. In addition, the agreements provide for
automatic acceleration of unvested stock options outstanding in the event the executives
employment is terminated within three months prior to a change of control, which is in addition to
the change of control provisions outlined in the stock option agreements. The Company is unable to
estimate the number of options that executives will ultimately retain that otherwise would have
been forfeited, absent these employment agreements, and therefore, no compensation expense has been
recognized to date relating to these agreements. As of December 31, 2004, the intrinsic value of
12 months accelerated vesting and 100% vesting of unvested shares is approximately $1.6 million and
$3.6 million, respectively, related to stock options outstanding for executive officers. Employee Stock Purchase Plan On April 1, 2004, the Company implemented the employee stock purchase plan, which was approved
by the Companys stockholders in February 2004 and subsequently amended and restated in July 2004.
Under the Amended and Restated Employee Stock Purchase Plan (the ESPP), employees may contribute
up to 20%, subject to certain maximums, of their cash earnings through payroll deductions, to be
used to purchase shares of the Companys common stock on each semi-annual purchase date. The
purchase price will be equal to 85% of the market value per share on the employees entry date into
the offering period, or if lower, 85% of the fair market value on the specified purchase date. The
Company initially reserved 400,000 shares of common stock for issuance under the ESPP. In
addition, the ESPP contains an evergreen provision that allows for an annual increase in the
number of shares available for issuance on the first day of the fiscal year, equal to the lesser of
1% of the outstanding capital stock on each January 1, 500,000 shares, or an amount determined by
the Companys board of directors. As of December 31, 2004, the Company had issued 64,611 shares of
common stock under the Purchase Plan and had 335,389 shares available for future issuance. F-19




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##### Table of Contents



Shares Reserved for Future Issuance Common stock reserved for future issuance as of December 31, 2004 and 2003 are as follows: December 31,2004
    
    
    2003Conversion of redeemable convertible and convertible preferred stock
    
    
    
    
    
    
    19,740,759Stock options issued and outstanding
    
    
    3,890,914
    
    
    
    2,362,757Authorized for future issuance under equity compensation plans
    
    
    2,800,579
    
    
    
    802,770Stock warrants outstanding
    
    
    59,405
    
    
    
    80,7386,750,898
    
    
    
    22,987,024
 11. 401(k) Plan The Company maintains a defined contribution 401(k) plan available to eligible employees.
Employee contributions are voluntary and are determined on an individual basis, limited to the
maximum amount allowable under federal tax regulations. The Company, at its discretion, may make
certain contributions to the 401(k) plan. However, through December 31, 2004 no such contributions
have been made. 12. Income Taxes Significant components of the Companys net deferred tax assets as of December 31, 2004 and
2003 are shown below. A valuation allowance of $54.1 million as of December 31, 2004 has been
recognized as realization of such assets is uncertain. The valuation allowance increased by $32.4
million in 2004, primarily due to operating loss carryforwards and research and development tax
credits for which management does not believe the benefit is more likely than not of being
realized. December 31,2004
    
    
    2003Deferred tax assets:Net operating loss carryforwards
    
    $
    41,765,000
    
    
    $
    16,548,000Research and development credits
    
    
    4,011,000
    
    
    
    2,472,000Capitalized research and development
    
    
    3,145,000
    
    
    
    1,732,000Depreciation and amortization
    
    
    1,952,000
    
    
    
    9,000Accrued liabilities and other
    
    
    3,207,000
    
    
    
    909,000Total deferred tax assets
    
    
    54,080,000
    
    
    
    21,670,000Valuation allowance
    
    
    (54,080,000
    )
    
    
    (21,670,000
    )Net deferred tax assets
    
    $
    
    
    
    $
    
 As of December 31, 2004, the Company has federal and state tax net operating loss
carryforwards of approximately $109.7 million and $76.3 million, respectively. The federal and
state tax loss carryforwards will begin expiring in 2012 and 2007, respectively, unless previously
utilized. The Company also has federal and state research and development tax credit carryforwards
of approximately $3.3 million and $1.1 million, respectively. The federal research and development
credit will begin to expire in 2019 unless previously utilized. The California research and
development credits do not expire. Pursuant to Sections 382 and 383 of the Internal Revenue Code, annual use of the Companys net
operating loss and credit carryforwards may be limited in the event a cumulative change in
ownership of more than 50% has occurred within a three-year period. F-20




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##### Table of Contents



Schedule II  Valuation and Qualifying Accounts Additions
    
    
    Additions
    
    
    AdditionsBalance at
    
    
    Charged
    
    
    Charged to
    
    
    Charged to
    
    
    
    
    
    
    Balance atBeginning of
    
    
    Against
    
    
    Costs and
    
    
    Asset
    
    
    
    
    
    
    End ofPeriod
    
    
    Revenues
    
    
    Expenses
    
    
    Accounts
    
    
    Deductions(1)
    
    
    PeriodAllowance for cash discounts, chargebacks
and other sales discounts:For the year ended December 31, 2004
    
    $
    
    
    
    $
    (737,935
    )
    
    $
    
    
    
    $
    
    
    
    $
    478,034
    
    
    $
    (259,901
    )Allowance for excess and obsolete
inventory:For the year ended December 31, 2004
    
    
    
    
    
    
    
    
    
    
    (1,420,425
    )
    
    
    (308,155
    )
    
    
    
    
    
    
    (1,728,580
    )Allowance for product returns:For the year ended December 31, 2004
    
    
    
    
    
    
    (7,057,208
    )
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (7,057,208
    )
   (1)
    
    Deductions under allowance for cash discounts, chargebacks and other sales discounts represent actual cash discounts, chargebacks and other sales discounts taken. F-21