UNITED
STATES
 SECURITIES
AND EXCHANGE COMMISSION
 Washington,
D.C. 20549
 
 FORM
10-K
 
 (Mark
One)
 x
              ANNUAL
      REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT
      OF 1934
 For the
fiscal year ended December 31, 2009
 
 OR
 
 o
              TRANSITION
      REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT
      OF 1934
 
 For the
transition period
from                     to
 
 Commission
file number 001-33678
 
 NOVABAY
PHARMACEUTICALS, INC.
 (Exact
name of registrant as specified in its charter)
 
 California
              
              68-0454536(State
      or other jurisdiction of incorporation or organization)
              
              (I.R.S.
      Employer Identification No.)
 
 5980
Horton Street, Suite 550, Emeryville CA 94608
 (Address
of principal executive offices) (Zip Code)
 
 Registrant’s
Telephone Number, Including Area Code: (510) 899-8800
 
 Securities
registered pursuant to Section 12(b) of the Act:
 
 Title
      of each class
              
              Name
      of each exchange on which registeredCommon
      Stock, $0.01 par value per share
              
              NYSE
      Amex
 
 
 Securities
registered pursuant to Section 12(g) of the Act:
 Common
Stock, $0.01 par value per share
 
 
 Indicate
by check mark if the registrant is a well-known seasoned issuer, as defined in
Rule 405 of the Securities Act.  Yes o  
No x
 
 Indicate
by check mark if the registrant is not required to file reports pursuant to
Section 13 or Section 15(d) of the Act.  Yes o  
No x
 
 Indicate
by check mark whether the registrant (1) has filed all reports required to
be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934
during the preceding 12 months (or for such shorter period that the registrant
was required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days.  Yes x  
No o
 
 Indicate
by check mark whether the registrant has submitted electronically and posted on
its corporate Web site, if any, every Interactive Data File required to be
submitted and posted pursuant to Rule 405 of Regulation S-T during the
preceding 12 months (or for such shorter period that the registrant was
required to submit and post such files). Yes x  No  ̈
 
 Indicate
by a 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 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. o
 
 Indicate
by check mark whether the registrant is a large accelerated filer, an
accelerated filer, a non-accelerated filer, or a smaller reporting company. See
the definitions of “large accelerated filer,” “accelerated filer” and “smaller
reporting company” in Rule 12b-2 of the Exchange Act. (Check one):
 Large
      accelerated filer
              o
              Accelerated
      filer
              oNon-accelerated
      filer
              o
              Smaller
      reporting company
              x
 (Do not
check if a smaller reporting company)
 
 1
 Indicate
by check mark whether the registrant is a shell company (as defined in Exchange
Act Rule 12b-2). Yes o No x
 
 As of
June 30, 2009, the aggregate market value of the voting stock held by
non-affiliates of the registrant, computed by reference to the last sale price
of such stock as of such date on the NYSE Amex, was approximately
$38,821,430.  Excludes an aggregate of 4,085,037 shares of common
stock held by officers and directors and by each person known by the registrant
to own 5% or more of the outstanding common stock as of June 30, 2009. Exclusion
of shares held by any of these persons should not be construed to indicate that
such person possesses the power, direct or indirect, to direct or cause the
direction of the management or policies of the registrant, or that such person
is controlled by or under common control with the registrant.
 
 As of
March 19, 2010, there were 23,305,493 shares of the registrant’s common stock
outstanding.
 
 DOCUMENTS
INCORPORATED BY REFERENCE
 
 Portions
of the registrant’s definitive Proxy Statement for the 2010 Annual Meeting of
Stockholders to be filed with the Securities and Exchange Commission pursuant to
Regulation 14A not later than 120 days after the end of the fiscal year covered
by this Form 10-K, are incorporated by reference in Part III, Items 10-14 of
this Form 10-K.
 
 
 2
 
 NOVABAY
PHARMACEUTICALS, INC.
 ANNUAL
REPORT ON FORM 10-K
 FOR
THE FISCAL YEAR ENDED DECEMBER 31, 2009
 
 TABLE
OF CONTENTS
 
 PagePART
      IITEM
      1.
              BUSINESS
              4ITEM 1A.
              RISK FACTORS
              10ITEM 1B.
              UNRESOLVED STAFF COMMENTS
              23ITEM
      2.
              PROPERTIES
              23ITEM
      3.
              LEGAL PROCEEDINGS
              23ITEM
      4.
              (Removed
      and Reserved)
              23PART
      IIITEM
      5.
              MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED
      STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY
      SECURITIES
              24ITEM
      6.
              SELECTED FINANCIAL DATA
              27ITEM
      7.
              MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL
      CONDITION AND RESULTS OF OPERATIONS
              28ITEM 7A.
              QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT
      MARKET RISK
              37ITEM
      8.
              FINANCIAL STATEMENTS AND SUPPLEMENTARY
      DATA
              38ITEM
      9.
              CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON
      ACCOUNTING AND FINANCIAL DISCLOSURE
              66ITEM 9A
              CONTROLS AND PROCEDURES
              66ITEM 9A(T)
              CONTROLS AND PROCEDURES
              66ITEM 9B.
              OTHER INFORMATION
              66PART
      IIIITEM
      10.
              DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE
      GOVERNANCE
              67ITEM
      11.
              EXECUTIVE COMPENSATION
              67ITEM
      12.
              SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS
      AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS
              67ITEM
      13.
              CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS,
      AND DIRECTOR INDEPENDENCE
              67ITEM
      14.
              PRINCIPAL ACCOUNTING FEES AND
      SERVICES
              67PART
      IVITEM
      15.
              EXHIBITS, FINANCIAL STATEMENT
      SCHEDULES
              68
 
 Unless
the context requires otherwise, all references in this report to “we,” “our,”
“us,” the “Company” and “NovaBay” refer to NovaBay Pharmaceuticals, Inc. and its
subsidiaries.
 
 NovaBay
Pharma ®, Aganocide®, NovaBayTM AgaDermTM, AgaNaseTM, and NeutroPhaseTM are
trademarks of NovaBay Pharmaceuticals, Inc. All other trademarks and trade names
are the property of their respective owners.
 
 
 3
 SPECIAL
NOTE REGARDING FORWARD-LOOKING STATEMENTS
 
 This
report contains forward-looking statements that are based on our management’s
beliefs and assumptions and on information currently available to our
management. These forward-looking statements include but are not limited to
statements regarding our product candidates, market opportunities, competition,
strategies, anticipated trends and challenges in our business and the markets in
which we operate, and anticipated expenses and capital requirements. In some
cases, you can identify forward-looking statements by terms such as
“anticipates,” “believes,” “could,” “estimates,” “expects,” “intends,” “may,”
“plans,” “potential,” “predicts,” “projects,” “should,” “will,” “would” and
similar expressions intended to identify forward-looking statements.
Forward-looking statements involve known and unknown risks, uncertainties and
other factors that may cause our actual results, performance or achievements to
be materially different from any future results, performances or achievements
expressed or implied by the forward-looking statements. We discuss many of these
risks in this report in greater detail under the heading “Risk Factors” in
Item 1A of this report. Given these uncertainties, you should not place
undue reliance on these forward-looking statements. You should read this report
and the documents that we reference in this report and have filed as exhibits to
the report completely and with the understanding that our actual future results
may be materially different from what we expect. Also, forward-looking
statements represent our management’s beliefs and assumptions only as of the
date of this report. Except as required by law, we assume no obligation to
update these forward-looking statements publicly, or to update the reasons
actual results could differ materially from those anticipated in these
forward-looking statements, even if new information becomes available in the
future.
 
 PART
I
 
 ITEM 1.
              BUSINESS
 
 Overview
 
 We are a
clinical stage specialty pharmaceutical company engaged in the discovery and
development of novel, and synthetic anti-infective product candidates to treat
and prevent a wide range of infections, without developing resistance, in
hospital and non-hospital environments. Many of these infections are
increasingly difficult to treat because of the rapid and growing rise in drug
resistance.  Our Aganocide® compounds are synthetic forms of
N-chlorinated antimicrobial molecules, which are highly effective and
rapidly-acting anti-infective molecules produced by white blood cells when
defending the body against invading pathogens when used in topical
applications.  We have specifically designed our Aganocide class of
compounds to mimic the human body’s natural defense against
infection.  Importantly, this class of compounds may deliver the same
or better efficacy as currently used antibiotics, but without contributing to
the growing, global epidemic of drug-resistant bacteria.  In
preclinical testing, our Aganocide compounds have demonstrated the ability to
destroy microbial pathogens. We believe that our Aganocide compounds could form
a platform on which to create a variety of products to address differing needs
in the treatment and prevention of non-systemic bacterial, viral and fungal
infections.
 
 We were
incorporated under the laws of the State of California on January 19, 2000
as NovaCal Pharmaceuticals, Inc. We had no operations until July 1, 2002,
on which date we acquired all of the operating assets of NovaCal
Pharmaceuticals, LLC, a California limited liability company. In February 2007,
we changed our name from NovaCal Pharmaceuticals, Inc. to NovaBay
Pharmaceuticals, Inc. In August 2007, we formed two subsidiaries––NovaBay
Pharmaceuticals Canada, Inc., a wholly-owned subsidiary incorporated under the
laws of British Columbia (Canada), which may conduct research and development in
Canada, and DermaBay, Inc., a wholly-owned U.S. subsidiary, which may explore
and pursue dermatological opportunities.
 
 Our
Target Indications and Product Candidates
 
 Our goal
is to advance our product candidates to confirmatory Phase II proof of concept
trials, after which we will evaluate further advancing each program on our own
or entering a co-development collaboration with a proven market leader to
benefit from their expertise and proven capabilities, as well as to defray
costs, while retaining participation in long-term commercial
economics.  We believe that this strategy is appropriate because of
the significant breadth of non-systemic product opportunities that we believe
can be developed from our technology base.  In many instances, we
believe we can build upon the safety data generated in one indication to
accelerate early development of other indications. We are also learning from our
own and our partners’ experience in developing appropriate dosing and usage of
our compounds.  The more development programs that are undertaken by
our partners and by ourselves, the greater the synergy in our
activities.
 
 Eye,
Ear, Sinus and Contact Lens Solution
 
 In August
2006, we entered into a collaboration and license agreement with Alcon
Manufacturing Ltd. (“Alcon”), an affiliate of Alcon, Inc., that provides Alcon
with the exclusive rights to develop, manufacture and commercialize products
incorporating our Aganocide compounds for the treatment of eye, ear and
sinus infections as well as for use in contact lens solutions. Under the terms
of the agreement, Alcon paid an up-front, non-refundable, non-creditable
technology access fee of $10.0 million upon the effective date of the agreement.
In addition to the technology access fee, we are entitled to receive semi-annual
payments from Alcon to support on-going research and development activities over
the four year funding term of the agreement. The collaboration also calls for
Alcon to pay for all development and clinical costs.
 
 4
 The
research and development support payments include amounts to fund a specified
number of personnel engaged in collaboration activities and to reimburse for
qualified equipment, materials and contract study costs. As product candidates
are developed and proceed through clinical trials and approval, we will receive
milestone payments. If the products are commercialized, we will also receive
royalties on any sales of products containing the Aganocide
compounds.   From the inception of the agreement to December 31,
2009, we have received $21.7 million from Alcon including the technology access
fee, milestone payments and R&D funding.
 
 NovaBay
retains the rights to market, via a third-party co-marketing partner, any
products developed for ear or sinus indications in the major Asian markets,
including Japan, China, India and South Korea. NovaBay has also retained such
rights in other markets where Alcon is not committing reasonably sufficient
sales and marketing resources to the particular product. In each instance, the
appointment of the co-marketing partner would be subject to certain conditions,
including that the co-marketing partner be approved by Alcon. The co-marketing
partner, or NovaBay on its behalf, would be required to pay Alcon a royalty
based on net sales of the product in the applicable market and would also be
required to reimburse Alcon for part of its local development costs or, in
markets in which Alcon is not committing reasonably sufficient sales and
marketing resources, all of its local development costs. These products may also
be marketed in those markets by Alcon, its affiliates or
distributors.
 
 In
December 2009 we announced that Alcon has increased its on-going financial
support of the company’s research and development efforts by more than $2
million per year. The additional funding is expected to enhance NovaBay’s
pre-clinical and clinical development programs in the areas of eye, ear and
sinus infections, as well as contact lens care.  Alcon is conducting
Phase II human trials of NovaBay’s lead compound, NVC-422, for the treatment of
viral conjunctivitis, a type of “Pink Eye”. The viral conjunctivitis trials are
under way at 30 medical centers around the U.S. and expect to enroll
approximately 250 patients.
 
 Dermatology
 
 We are
focused on developing products that will potentially eliminate the need to use
antibiotic-based products in the dermatology market. In laboratory testing, we
have shown that our lead Aganocide compound NVC-422 kills P. acne, the bacterium
associated with inflamed acne lesions, and other known dermal pathogens. We have
been in advanced preclinical development of a variety of formulations for use in
the treatment of skin infections.  We are currently conducting Phase
II clinical proof of concept studies for the treatment of
impetigo.  Impetigo is a highly contagious bacterial skin infection
and one of the most common skin diseases among children.  This
infection is increasingly being caused by MRSA (methacillin resistant Staph. aureus).  In
these cases, antibiotic treatments are limited.
 
 On March
25, 2009, we announced that we entered into an agreement with Galderma S.A. to
develop and commercialize our Aganocide compounds, which covers acne and
impetigo and potentially other major dermatological conditions, excluding
onychomycosis (nail fungus) and orphan drug indications.  We amended
this agreement in December 2009.  The agreement is exclusive and
worldwide in scope, with the exception of Asian markets and North
America.  In Asian markets we have commercialization
rights.  In North America we have an option to exercise co-promotion
rights.
 
 Galderma
will be responsible for the development costs of the acne and other indications
with two exceptions.  First, in Japan Galderma has the option to
request that we share such development costs.  Second, at this time we
are supporting the  ongoing development program for impetigo; however,
upon the achievement of a specified milestone, Galderma will reimburse NovaBay
for associated expenses.  NovaBay retains the right to co-market
products resulting from the agreement in Japan.  In addition, NovaBay
has retained all rights in other Asian markets outside Japan, and has the right
to co-promote the products developed under the agreement in the hospital and
other healthcare institutions in North America.
 
 Galderma
paid to NovaBay certain upfront fees at the inception of the contract and will
continue to pay ongoing fees, reimbursements, and milestone payments related to
achieving development and commercialization of its Aganocide compounds. If
products are commercialized under the agreement, NovaBay's royalties will
escalate as sales increase. Upon the termination of the agreement under certain
circumstances, Galderma will grant NovaBay certain technology licenses which
would require NovaBay to make royalty payments to Galderma for such licenses
with royalty rates in the low- to mid-single digits.
 
 We
recently announced that we received $3.75 million in milestone payments from
Galderma: a $2.0 million milestone payment having been triggered by the
completion of formulation feasibility studies with our Aganocide compound for
topical use and a $1.75 million milestone payment was for completing an
exploratory clinical study for the treatment of adult acne.  These
milestones were reached in 2009 and therefore the revenue was recorded in 2009
and the related receivable is included in our balance sheet as of December 31,
2009; we received payment on these receivables in January 2010.
 
 CVC
Lock
 
 Every
year in the United States, physicians place more than 5 million central venous
catheter (CVC) lines, or a catheter placed into a large vein for the purpose of
administering medication or fluids.  Long-term CVC lines are at risk
of infection introduced through the catheter during connections.  The
incidence of catheter related blood stream infection during such use is
significant and its consequences severe and costly to treat.  Heparin
is most commonly used as a lock solution, or a solution to fill the catheter
line, when CVC lines are not being accessed.  No lock solutions
other than heparin and saline are approved in the United States.
 
 5
 NovaBay
is nearing completion of a number of preclinical studies that it believes will
confirm the ability of solutions of NVC-422 to prevent colonization of CVC lines
by a wide spectrum of pathogens with a low potential for resistance at safe
doses.  The company is evaluating development of NVC-422 lock
solutions for prophylaxis against blood stream infections in dialysis, oncology
and parenteral nutrition and intends to follow the pre-market approval
regulatory path in the United States.
 
 Onychomycosis
 
 Onychomycosis
is a nail dermatophytosis of clinical significance caused by dermatophytes, the
fungi that commonly cause skin infections,  like Trichophyton rubrumand Trichophyton mentagrophytes. Onychomycosis is a fungal infection of the toe and finger nails
affecting the components of the nail matrix, nail bed, or nail plate resulting
in deformity of the nail plate, thickening and nail discoloration. Onychomycosis
is not life threatening; however, it can cause disfigurement and pain resulting
in serious occupational and physical limitations. Furthermore, individuals with
a compromised immune system may be at greater risk of additional complications.
Aganocides, like NVC-422, have been shown in laboratory tests to kill the
dermatophytes responsible for Onychomycosis thus providing NovaBay
Pharmaceuticals with an opportunity to provide effective treatment of this
disease.
 
 Catheter
Associated Urinary Tract Infections
 
 Urinary
tract catheters have become a routine part of the management of patients in
intensive care and long-term care settings with an estimated five million
patients undergoing catheterization each year. Catheter associated urinary tract
infections (“CAUTI”) are the most frequent healthcare-associated infections,
accounting for more than 40% of all healthcare-associated infections, or one
million infections per year. These infections generally prolong hospitalization,
require intensive antibiotic therapy and greatly increase the cost of treatment.
A contributing factor in CAUTI is the formation of bacterial biofilm within the
catheter.  This biofilm provides an on-going reservoir of bacteria
that can cause infection. We are developing a formulation of NVC-422 that may
destroy bacteria in the bladder as well as controlling bacteria that have formed
biofilm within the catheter, with the intent of keeping the catheter unblocked,
referred to as maintaining catheter patency.  We successfully
completed Phase I clinical trials that established the safe and
well-tolerated nature of our CAUTI formulation.  We are currently in
Phase IIa clinical trials to explore the therapeutic potential of NVC-422 for
the treatment of bacteruria in the bladder under different dosing regimens and
our eventual initiation of catheter patency trial which we expect to occur in
2010.
 
 Wound
Care
 
 Wound
infections prevent wounds from healing and can cause serious bloodstream
infections. We have developed NVC-101, a solution of hypochlorous acid that we
have trademarked as NeutroPhaseTM, to address this major problem. We have
received two 510K clearances from the FDA for the marketing of this product as a
wound cleanser and debriding agent.  We continue to explore the
potential for NVC-101 and the Aganocide compounds in woundcare.
 
 Our
Technology and Research
 
 We have
developed our lead compounds by understanding the nature of the antimicrobial
molecules that are produced by the human body’s white blood cells to kill
pathogens such as bacteria, viruses and fungi.  Once the body’s defense
system detects these pathogens, white blood cells produce
small, highly active molecules that kill the pathogens in an extremely
efficient manner. These molecules are not readily usable as pharmaceutical
products because our body produces them “on demand” and the molecules are not
naturally stable. We have discovered ways to stabilize one of these naturally
occurring molecules, which we call NVC-101 or NeutroPhase. Through the
modification of another of these natural molecules, we have created NVC-422,
which is our lead Aganocide compound. NVC-422 is a stable analog of naturally
occurring N-chlorotaurine (“NCT”). We
believe NVC-422 is safer and more potent than the naturally occurring NCT
molecule. We have made significant discoveries over the past year that have
enhanced our understanding of why the naturally generated molecules cannot be
kept stable and used as drugs. We have also been exploring different Aganocide
compounds that have been invented by NovaBay’s scientists with the aim of
creating molecules that can penetrate different tissues more effectively, or
that can enhance the duration of antimicrobial activity.  We have also
made great progress in developing different formulations that can enhance the
penetration of the Aganocide molecules.
 
 In 2002,
the World Health Organization predicted that within ten years we will enter a
“post-antibiotic” era, where there will be infections for which there will be no
effective antibiotic treatments. It is beginning to look as if that prediction
may have been overoptimistic as there are more multidrug resistant bacteria
appearing, and even a few pan-resistant species.  By using nature’s
blueprint for the development of new anti-infective products, we start with the
intent that the natural molecules do not allow pathogens to develop resistance.
Extensive laboratory studies appear to confirm that the Aganocide compounds
should exhibit this characteristic. The intended ability of our Aganocide
compounds to be effective without developing resistance would be critical in a
situation where bacteria are continuing to develop ever more sophisticated
mechanisms for protecting themselves from antibiotics.
 
 6
 Additionally,
we continue to expand our understanding of the activity of the Aganocide
compounds against bacteria in biofilm. Just as bacteria are found everywhere, we
now understand that biofilm is a natural, ever present defense mechanism of
bacteria. Biofilm is a cocoon-like shield that forms around a colony of
bacteria. Once the biofilm is formed, bacteria go into dormancy. Dormant
bacteria reproduce once every few days, while an active bacteria reproduces
every 30 to 60 minutes. Antibiotics are generally only effective against fast
reproducing bacteria. In controlled laboratory studies, our Aganocide compounds
were found to be highly effective at killing bacteria in biofilm. We believe
their activity in biofilm is a critical element of their success, particularly
in the prevention of catheter associated urinary tract infections.
 
 Research
and Development
 
 As of
December 31, 2009, we had 29 employees dedicated to research and development.
Our research and development expenses consist primarily of personnel-related
expenses, laboratory supplies and contract research services provided to our
research, development and clinical groups. We expense our research and
development costs as they are incurred. Research and development expenses for
2007, 2008 and 2009 were $7.4 million, $9.6 million, and $7.3 million,
respectively. All of our research and development employees are engaged in drug
research and development activities, including those related to the Alcon and
Galderma agreement described above. We expect to incur significant research and
development expenses for the foreseeable future.
 
 Intellectual
Property
 
 We rely
on a combination of patent, trademark, copyright and trade secret laws in the
United States and other jurisdictions, as well as confidentiality procedures and
contractual provisions, to protect our proprietary technology. We also enter
into confidentiality and invention assignment agreements with our employees and
consultants and confidentiality agreements with other third parties, and we
rigorously control access to our proprietary technology.
 
 We have
pending applications in the United States and major foreign countries for the
following marks:  AgaDerm, AgaNase, Aganocide, NeutroPhase, and
NovaBay.  We have registered the NovaBay Pharma
and Design trademark in the United States, the
NovaBay trademark in the U.S., the European Community, Israel, Mexico, and
Australia; the NeutroPhase trademark in Australia, the European Community,
Ireland and the United Kingdom; the Aganocide trademark in the United States,
the European Community and Japan; and the AgaNase trademark in the U.S., the
European Community Australia, Israel, Japan, Mexico, China, South Korea, and
Taiwan.
 
 We are
the assignee on record for three issued patents, eleven pending utility
applications, and several provisional applications in the United States. In
addition to our U.S. patents and applications, we seek patent protection in key
foreign countries. We have one issued patent in China, Hong Kong, Israel, India,
Mexico, and South Korea, and pending applications filed under the Patent
Cooperation Treaty in various stages of examination.
 
 The
subject matter of our patents and patent applications covers four key areas:
methods relating to the manufacture and use of NVC-101, compositions of matter
of the Aganocide compounds, methods of treatment utilizing the Aganocide
compounds, and formulations.
 
 Our first
issued patent in the U.S. provides coverage for a method of treating burns or
promoting wound healing, or tissue repair or tissue regeneration using a
specific range of formulations of NVC-101. This patent was issued on July 30,
2002 and will expire in 2020 with payment of maintenance fees.  Our
second issued patent in the U.S. provides coverage for a method of disinfecting
open wounds and burns, promoting wound healing or providing ocular
disinfection using a specific range of formulations of NVC-101.  This
patent was issued on July 1, 2008 and will expire in 2020 with payment of
maintenance fees.  Our third issued patent in the U.S. provides
composition-of-matter coverage of our lead development candidate, NVC-422, and
other Aganocide compounds.  This patent was issued on December 9, 2008
and will expire in 2026 with payment of maintenance fees.
 
 Competition
 
 The
market for non-systemic drugs and medical devices designed to treat or prevent
bacterial, fungal or viral infections is highly competitive. If developed, and
commercialized, our products would compete against a wide variety of existing
products, products and technologies that are currently in development, and
products and technologies that could be developed and reach the market before or
after our products.  In particular, we would be competing against
existing antibiotics that are sold by many major pharmaceutical companies, or
generic equivalents that are being distributed, typically at low prices.
NeutroPhase, if launched for use in wound management, will be competing against
multiple products with similar indications for use. However, we believe there is
currently no dominant product in this indication.
 
 Our
potential competitors include large and small pharmaceutical and medical device
companies, such as Pfizer, Inc., Johnson & Johnson, Abbott
Grp. Plc., GlaxoSmithKline Plc, Sanofi-Aventis SA, Novartis AG,
Smith & Nephew Plc, C.R. Bard, Puricore and Oculus Innovative
Sciences.   Some of these competitors may have far greater
resources and experience in the area than we do and may develop and patent
processes or products earlier than we are able to, develop and commercialize
products that are less expensive or more efficient than any products that we may
develop, obtain regulatory approvals for competing products more rapidly than we
are able to, and improve upon existing technological approaches or develop new
or different approaches that render any technology or products we develop
obsolete or uncompetitive.
 
 7
 We
believe the principal competitive factors for our products in our target markets
include their effectiveness in killing bacteria, including bacteria in biofilm,
very low potential for the development of resistance, time to kill bacteria,
safety, side effects and cost effectiveness. We believe that our compounds may,
if approved by the regulatory authorities, have significant advantages over
existing compounds and compounds in development of which we are aware, because
our Aganocide and NVC-101 compounds could be used to prevent infections or to
treat infections where speed of action, action against infections with bacterial
and viral componants such as conjunctivitis, action against bacteria in biofilm,
action in topical indications or action against multi-drug resistant bacteria is
important.
 
 Manufacturing
and Supply
 
 We do not
currently operate manufacturing facilities for clinical or commercial
production, as we rely on and leverage the manufacturing and distribution
infrastructure of third parties. We have no plans to establish our own
manufacturing facilities in the future. Third party vendors supply us with the
Active Pharmaceutical Ingredient (“API”) of NVC-422 and the finished clinical
trials materials for NVC-101, which are manufactured in compliance with the
FDA’s “Current Good Manufacturing Practice”, or CGMP, regulations. We also
intend to work with third parties for future clinical trial materials and
commercial supplies of NVC-422 and our other Aganocide compounds.
 
 The Alcon
and Galderma agreements provide for the manufacture by Alcon and Galderma of
finished dosage forms of products incorporating Aganocide compounds for sale
under our label in those markets where we have retained marketing
rights.
 
 Sales
and Marketing
 
 Our lead
product candidate, NVC-422, as well as many of the product candidates we expect
to develop in the future, are primarily intended to address a variety of
different non-systemic market segments, some of which are large, primary care
markets. We do not currently have, nor do we intend in the near term to create,
a commercialization organization capable of marketing, selling and distributing
our targeted product candidates to large, primary care markets. This applies to
markets in both the United States and elsewhere. Rather, we intend to establish
commercialization partnerships with pharmaceutical, biotechnology or other
leading organizations with the experience and resources to bring our products to
market. In some cases, we may enter into agreements with these organizations
during the development stage of a product candidate to further benefit from
their clinical development, regulatory, market research, pre-marketing and other
expertise, as is the case with Alcon and Galderma. As appropriate, we may
establish a specialty sales force with expertise in marketing and selling any
future approved products to specialty physicians for specific target
indications. We may also establish other complementary capabilities related to
marketing and selling targeted medicines, particularly where those capabilities
may not currently exist at other organizations. Substantially all of our
long-lived assets are located in the United States.
 
 Government
Regulation
 
 The
testing, manufacturing, labeling, advertising, promotion, distribution, export
and marketing of our product candidates are subject to extensive regulation by
the FDA, state agencies and comparable regulatory authorities in other
countries. Because our programs involve product candidates that are considered
as drugs and others that are medical devices, we intend to submit applications
to regulatory agencies for approval or clearance of both drug and medical device
product candidates.
 
 U.S.
Government Regulation
 
 In the
United States, the FDA regulates drugs and medical devices under the Federal
Food, Drug, and Cosmetic Act and the agency’s implementing regulations. If we
fail to comply with the applicable United States requirements at any time during
the product development process, clinical testing, and the approval process or
after approval, we may become subject to administrative or judicial sanctions.
These sanctions could include the FDA’s refusal to approve pending applications,
license suspension or revocation, withdrawal of an approval, warning letters,
adverse publicity, product recalls, product seizures, total or partial
suspension of production or distribution, injunctions, fines, civil penalties or
criminal prosecution. Any agency enforcement action could have a material
adverse effect on us.
 
 Our
products may be classified by the FDA as a drug or a medical device depending
upon the mechanism of action and indications for use or claims. The use of
NVC-101 as a solution for cleansing and debriding wounds is considered a medical
device. Similarly, NVC-422 may be classified as a medical device depending on
the indication for use. For example, we believe if the indication is for
maintaining catheter patency, it would be classified as a medical device,
whereas we believe it would be considered a drug when it is indicated for the
prevention of urinary tract infection. The determination as to whether a
particular product and indication is considered a drug or a device is based in
part upon prior precedent.
 
 Drug
Approval Process
 
 The
process required by the FDA before a drug may be marketed in the United States
generally involves satisfactorily completing each of the following:
 
 8
 •
              preclinical
      laboratory tests, animal studies and formulation studies all performed in
      accordance with the FDA’s Good Laboratory Practice
      regulations;•
              submission
      to the FDA of an Investigational New Drug (“IND”) application for human
      clinical testing, which must become effective before human clinical trials
      may begin;•
              performance
      of adequate and well-controlled clinical trials to establish the safety
      and efficacy of the product candidate for each proposed indication; these
      clinical trials must be conducted in accordance with Good Clinical
      Practice (“GCP”) Guidelines, including Institutional Review Board
      oversight of the consent of subjects and registration of applicable
      studies with clinicaltrials.gov;•
              submission
      to the FDA of a New Drug Application (“NDA”) including payment of
      substantial UserFees;•
              satisfactory
      completion of an FDA inspection of the manufacturing facility or
      facilities, including those of third-parties, at which the product is
      produced to assess compliance with strictly enforced current GMP
      regulations, as well as FDA audit for GCP compliance of one or more
      clinical investigator sites; and•
              FDA
      review and approval of the NDA before any commercial marketing, sale or
      shipment of the product.
 
 There is
continuing and pervasive FDA regulation of drug product manufacturing, labeling,
advertising and promotion once approved.
 
 Medical
Devices
 
 NeutroPhase,
as well as some of our product candidates, may be regulated as medical devices.
Unless an exception applies, each medical device we wish to commercialize in the
United States will require either prior 510(k) clearance or premarket approval
from the FDA. The FDA classifies medical devices into one of three classes.
Devices deemed to pose lower risks are placed in either Class I or II, which
requires the manufacturer to submit to the FDA a premarket notification
requesting permission to commercially distribute the device. This process is
generally known as 510(k) clearance. Some low risk devices are exempt from this
requirement. Any post-clearance modifications made to a 510(k) device may
require the submission of a new 510(k) notification prior to
commercialization.  Devices deemed by the FDA to pose the greatest
risk, such as life-sustaining, life-supporting or implantable devices, or
devices deemed not substantially equivalent to a previously cleared 510(k)
device, are placed in Class III, requiring premarket approval.
 
 Continuing
Food and Drug Administration Regulation of Medical Devices
 
 After the
FDA permits a device to enter commercial distribution, numerous regulatory
requirements apply. These include:
 
 •
              the
      FDA’s Quality Systems Regulations (“QSRs”), which require manufacturers to
      follow stringent design, testing, production, control, labeling,
      packaging, storage, shipping, documentation and other quality assurance
      procedures during all aspects of the manufacturing
  process;•
              labeling
      regulations which impose restrictions on labeling and promotional
      activities, and FDA prohibitions against the promotion of products for
      uncleared, unapproved, or “off-label” uses;•
              post-market
      surveillance requirements which apply when necessary to protect the public
      health or to provide additional safety and effectiveness data for the
      device;•
              the
      FDA Medical Device Reporting regulations, which require that manufacturers
      report to the FDA if their device may have caused or contributed to a
      death or serious injury or malfunctioned in a way that would likely cause
      or contribute to a death or serious injury if it were to recur;
      and•
              notices
      of correction or removal, and recall regulations.
  In
addition, we are required to register our facility and list our products with
the FDA, and are be subject to unannounced inspections by the FDA and the Food
and Drug Branch of the California Department of Health Services to determine
compliance with the QSRs and other regulations, and these inspections may
include the manufacturing facilities of our subcontractors.
 
 International
Regulation
 
 In
addition to being subject to the laws and regulations in the United States, we
will be subject to a variety of laws and regulations in those other countries in
which we seek to study and commercialize products. European and Canadian
regulatory requirements and approval processes are similar in principle to those
in the United States. Whether or not we obtain FDA approval for a product, we
must obtain approval of a product by the comparable regulatory authorities of
the European Union, European countries, Canada and other countries before we can
commence clinical trials or marketing of the product in those respective
countries. The approval process may be longer or shorter than that required for
FDA approval. The requirements governing pricing, reimbursement, clinical
trials, and to a lesser extent, product licensing vary from country to
country.
 
 Third
Party Reimbursement and Pricing Controls
 
 In the
United States and elsewhere, sales of pharmaceutical products depend in
significant part on the availability of reimbursement to the consumer from third
party payors, such as government and private insurance plans. Third party payors
are increasingly challenging the prices charged for medical products and
services. It will be time consuming and expensive for us to go through the
process of seeking reimbursement from Medicare and private payors. Aganocide
products from which we may receive revenue in the future may not be considered
cost-effective, and reimbursement may not be available or sufficient to allow
these products to be sold on a competitive and profitable basis.
 
 9
 
 Anti-Kickback
and False Claims Laws
 
 In the
United States, we are subject to various federal and state laws pertaining to
healthcare “fraud and abuse,” including anti-kickback and false claims laws. The
federal Anti-Kickback Law makes it illegal for any person, including a
prescription drug or medical device manufacturer (or a party acting on its
behalf) to knowingly and willfully solicit, offer, receive or pay any
remuneration, directly or indirectly, in exchange for, or to induce, the
referral of business, including the purchase, order or prescription of a
particular drug or device, for which payment may be made under federal
healthcare programs such as Medicare and Medicaid. Violations of the law are
punishable by up to five years in prison, criminal fines, administrative
civil money penalties, and exclusion from participation in federal healthcare
programs. In addition, many states have adopted laws similar to the federal
Anti-Kickback Law. Some of these state prohibitions apply to referral of
patients for healthcare services reimbursed by any source, not only the Medicare
and Medicaid programs. Due to the breadth of these laws, it is possible that our
future sales and marketing practices or our future relationships with physicians
might be challenged under anti-kickback laws, which could harm us.
 
 False
claims laws prohibit anyone from knowingly presenting, or causing to be
presented, for payment to third party payors (including Medicare and Medicaid)
claims for reimbursed items or services, including drugs and medical devices,
that are false or fraudulent, claims for items or services not provided as
claimed, or claims for medically unnecessary items or services. Our future
activities relating to the reporting of wholesaler or estimated retail prices
for our products, the reporting of Medicaid rebate information and other
information affecting federal, state and third party reimbursement of our
products, and the sale and marketing of our products, will be subject to
scrutiny under these laws. In addition, pharmaceutical and medical device
companies have been prosecuted under the federal False Claims Act in connection
with their off-label promotion of products. Suits filed under the False Claims
Act, known as “qui tam” actions, can be brought by any individual on behalf of
the government and such individuals (known as “relators” or, more commonly, as
“whistleblowers”) may share in the amounts paid by the entity to the government
in fines or settlement.
 
 Employees
 
 As of
December 31, 2009, we had 39 full-time employees, including 12 with doctoral
degrees. Of our full time workforce, 29 employees were engaged in research and
development, and 10 in finance and administration. None of our employees are
represented by labor unions or covered by collective bargaining agreements. We
consider our relationship with our employees to be good.
 
 Available
Information
 
 Our
annual reports on Form 10-K, quarterly reports on Form 10-Q, current
reports on Form 8-K, and amendments to those reports filed or furnished
pursuant to Sections 13(a) and 15(d) of the Securities Exchange Act of
1934, as amended, are available free of charge on our corporate website, located
atwww.novabaypharma.com,  as
soon as reasonably practicable after we electronically file such material with,
or furnish it to, the Securities and Exchange Commission (“SEC”).
 
 ITEM 1A.
              RISK
      FACTORS
 
 Our
business is subject to a number of risks, the most important of which are
discussed below. You should consider carefully the following risks in addition
to the other information contained in this report and our other filings with the
SEC, before deciding to buy, sell or hold our common stock. The risks and
uncertainties described below are not the only ones facing our company.
Additional risks and uncertainties not presently known to us or that we
currently believe are not important may also impair our business operations. If
any of the following risks actually occur, our business, financial condition or
results of operations could be materially adversely affected, the value of our
common stock could decline and you may lose all or part of your
investment.
 
 Risks
Relating to Our Business
 
 Current
worldwide economic conditions may limit our access to capital, adversely affect
our business and financial condition, as well as further decrease our stock
price.
 
 General
worldwide economic conditions have experienced a downturn due to the effects of
the subprime lending crisis, general credit market crisis, collateral effects on
the finance and banking industries, concerns about inflation, slower economic
activity, decreased consumer confidence, reduced corporate profits and capital
spending, adverse business conditions and liquidity concerns. Although the
impact of the downturn on our business is uncertain at this time, downturn may
adversely affect our business and operations in a number of ways, including
making it more difficult for us to raise capital as well as making it more
difficult to enter into collaboration agreements with other parties. Like many
other stocks, our stock price has been subject to fluctuations and has decreased
substantially in recent months. Our stock price could further decrease due to
concerns that our business, operating results and financial condition will be
negatively impacted by a worldwide economic downturn.
 
 10
 We
may be unable to raise additional capital on acceptable terms in the future
which may in turn limit our ability to develop and commercialize products and
technologies.
 
 We expect
our capital outlays and operating expenditures to substantially increase over at
least the next several years as we expand our product pipeline and increase
research and development efforts and clinical and regulatory activities.
Conducting clinical trials is very expensive, and we expect that we will need to
raise additional capital, through future private or public equity offerings,
strategic alliances or debt financing, before we achieve commercialization of
any of our Aganocide compounds. In addition, we may require even more
significant capital outlays and operating expenditures if we do not continue
to  partner with third parties to develop and commercialize our
products.
 
 Our
future capital requirements will depend on many factors, including:
 
 •
              the
      scope, rate of progress and cost of our pre-clinical studies and clinical
      trials and other research and development activities;•
              future
      clinical trial results;•
              the
      terms and timing of any collaborative, licensing and other arrangements
      that we may establish;•
              the
      cost and timing of regulatory approvals;•
              the
      cost of establishing clinical and commercial supplies of our product
      candidates and any products that we may develop;•
              the
      effect of competing technological and market developments;•
              the
      cost of filing, prosecuting, defending and enforcing any patent claims and
      other intellectual property rights; and•
              the
      extent to which we acquire or invest in businesses, products and
      technologies, although we currently have no commitments or agreements
      relating to any of these types of
transactions.
 
 We do not
currently have any commitments for future external funding. Additional financing
may not be available on favorable terms, or at all. Our ability to obtain
additional financing may be negatively affected by the recent volatility in the
financial markets and the credit crisis, as well as the general downturn in the
economy and decreased consumer confidence. Even if we succeed in selling
additional securities to raise funds, our existing shareholders’ ownership
percentage would be diluted and new investors may demand rights, preferences or
privileges senior to those of existing shareholders. If we raise additional
capital through strategic alliance and licensing arrangements, we may have to
trade our rights to our technology, intellectual property or products to others
on terms that may not be favorable to us. If we raise additional capital through
debt financing, the financing may involve covenants that restrict our business
activities.
 
 In
addition, it is often the case that the cost of pharmaceutical development can
be significantly greater than initially anticipated. This may be due to any of a
large number of possible reasons, some of which could have been anticipated,
while others may be caused by unpredictable circumstances. A significant
increase in our costs would cause the amount of financing that would be required
to enable us to achieve our goals to be likewise increased.
 
 If we
determine that we need to raise additional funds and we are not successful in
doing so, we may be unable to complete the clinical development of some or all
of our product candidates or to seek or obtain FDA approval of our product
candidates. Such events could force us to discontinue product development, enter
into a relationship with a strategic partner earlier than currently intended,
reduce sales and marketing efforts or forego attractive business
opportunities.
 
 We
are an early stage company with a history of losses. Although we were profitable
in 2009, we do not have any commercial products, and expect that we will incur
net losses in the future, and that we may never achieve or maintain sustained
profitability.
 
 We have
incurred net losses since our inception through 2008. For the years ended
December 31, 2007 and 2008 we had net losses of approximately $5.4 million
and $8.1 million, respectively, and for the year ended December 31, 2009, we had
net income of $2.7 million.  We were able to record a profit in 2009
due to our receipt of a $3.75 million milestone payment under our agreement with
Galderma; however, there is no assurance that we will receive any additional
large milestone payments under this agreement and, as a result, we may not be
able to continue to be profitable. . Through December 31, 2009, we had an
accumulated deficit of approximately $23.9 million. We have been, and expect
to remain for the foreseeable future, mostly in a research and development
stage. We have incurred substantial research and development expenses, which
were approximately $7.4 million, $9.6 million and $7.3 million for the years
ended December 31, 2007, 2008 and 2009, respectively. We expect to continue
to make, for at least the next several years, significant expenditures for the
development of products that incorporate our Aganocide compounds, as well as
continued research into the biological activities of our Aganocide compounds,
which expenditures are accounted for as research and development expenses. We do
not expect any of our current product candidates to be commercialized within the
next several years, if at all. We expect to incur substantial losses for the
foreseeable future, and we may never achieve or maintain sustained
profitability. We anticipate that our expenses will increase substantially in
the foreseeable future as we:
 
 11
 •
              conduct
      pre-clinical studies and clinical trials for our product candidates in
      different indications;•
              develop,
      formulate, manufacture and commercialize our product candidates either
      independently or with partners;•
              pursue,
      acquire or in-license additional compounds, products or technologies, or
      expand the use of our technology;•
              maintain,
      defend and expand the scope of our intellectual property;
    and•
              hire
      additional qualified personnel.
 
 We will
need to generate significant revenues to achieve and maintain profitability. If
we cannot successfully develop, obtain regulatory approval for and commercialize
our product candidates, either independently or with partners, we will not be
able to generate such revenues or achieve or maintain profitability in the
future. Our failure to achieve and subsequently maintain profitability could
have a material adverse impact on the market price of our common
stock.
 
 We
have very limited data on the use of our products in humans and will need to
perform costly and time consuming clinical trials in order to bring our products
to market.
 
 Most of
the data that we have on our products is from in-vitro (laboratory) studies or
in-vivo animal studies and our human data is from Phase I safety studies or
small-scale Phase IIa exploratory- studies. We will need to conduct Phase I, II
and III human clinical trials to confirm such results in order to obtain
approval from the FDA of our drug product candidates. Often, positive in-vitro
or in-vivo animal studies are not followed by positive results in human clinical
trials, and we may not be able to demonstrate that our products arc safe and
effective for indicated uses in humans. In addition, for each indication, we
estimate that it will take between three and five years to conduct the necessary
clinical trials.
 
 We
currently do not have any marketable products, and if we are unable to develop
and obtain regulatory approval for products that we develop, we may never
generate product revenues.
 
 To date,
our revenues have been derived solely from research and development
collaboration and license agreements. We have never generated revenues from
sales of products and we cannot guarantee that we will ever have marketable
drugs or other products. Satisfaction of all regulatory requirements applicable
to our product candidates typically takes many years, is dependent upon the
type, complexity, novelty and classification of the product candidates, and
requires the expenditure of substantial resources for research and development
and testing. Before proceeding with clinical trials, we will conduct
pre-clinical studies, which may, or may not be, valid predictors of potential
outcomes in humans. If pre-clinical studies are favorable, we will then begin
clinical trials. We must demonstrate that our product candidates satisfy
rigorous standards of safety and efficacy before we can submit for and gain
approval from the FDA and regulatory authorities in other countries. In
addition, to compete effectively, our products will need to be easy to use,
cost-effective and economical to manufacture on a commercial scale. We may not
achieve any of these objectives. We cannot be certain that the clinical
development of any of our current product candidates or any other product that
we may develop in the future will be successful, that they will receive the
regulatory approvals required to commercialize them, or that any of our other
in-licensing efforts or pre-clinical testing will yield a product suitable for
entry into clinical trials. Our commercial revenues from sales of products will
be derived from sales of products that may not be commercially available for at
least the next several years, if at all.
 
 We
have limited experience in developing drugs and medical devices, and we may be
unable to commercialize any of the products we develop.
 
 Development
and commercialization of drugs and medical devices involves a lengthy and
complex process. We have limited experience in developing products and have
never commercialized, any of our product candidates. In addition, no one has
ever developed or commercialized a product based on our Aganocide compounds, and
we cannot assure you that it is possible to develop, obtain regulatory approval
for or commercialize any products based on these compounds or that we will be
successful in doing so.
 
 Before we
can develop and commercialize any new products, we will need to expend
significant resources to:
 
 •
              undertake
      and complete clinical trials to demonstrate the efficacy and safety of our
      product candidates;•
              maintain
      and expand our intellectual property rights;•
              obtain
      marketing and other approvals from the FDA and other regulatory agencies;
      and•
              select
      collaborative partners with suitable manufacturing and commercial
      capabilities.
 
 12
 The
process of developing new products takes several years. Our product development
efforts may fail for many reasons, including:
 
 •
              the
      failure of our product candidates to demonstrate safety and
      efficacy;•
              the
      high cost of clinical trials and our lack of financial and other
      resources; and•
              our
      inability to partner with firms with sufficient resources to assist us in
      conducting clinical trials.
  Success
in early clinical trials often is not replicated in later studies, and few
research and development projects result in commercial products. At any point,
we may abandon development of a product candidate or we may be required to
expend considerable resources repeating clinical trials, which would eliminate
or adversely impact the timing for revenues from those product candidates. If a
clinical study fails to demonstrate the safety and effectiveness of our product
candidates, we may abandon the development of the product or product feature
that was the subject of the clinical trial, which could harm our
business.
 
 Even if
we develop products for commercial use, these products may not be accepted by
the medical and pharmaceutical marketplaces or be capable of being offered at
prices that will enable us to become profitable. We cannot assure you that our
products will be approved by regulatory authorities or ultimately prove to be
useful for commercial markets, meet applicable regulatory standards, or be
successfully marketed.
 
 We
must maintain and expand expensive finance and accounting systems, procedures
and controls in order to grow our business and organization, which will increase
our costs and require additional management resources.
 
 We
completed our initial public offering, or IPO, in October 2007. As a public
reporting company, we are required to comply with the Sarbanes-Oxley Act of 2002
and the related rules and regulations of the SEC and Canadian securities
regulatory authorities, including expanded disclosure and accelerated reporting
requirements and more complex accounting rules. We are also required to comply
with marketplace rules and the heightened corporate governance standards of the
NYSE Amex. Compliance with these rules has been expensive, and there are
additional rules with which we have not yet needed to comply but which we will
need to comply with in the future.  For example, for this Form 10-K we
are not required to have our independent auditors audit our internal control
over financial reporting, but next year we expect to be required to do so. If
our independent registered public accounting firm is unable to provide us with
an unqualified report as to the effectiveness of our internal control over
financial reporting as of the date of our Annual Report on Form 10-K for 2010,
or our business grows and we are not able to comply with accelerated reporting
obligations, our ability to obtain additional financing could be impaired. In
addition, investors could lose confidence in the reliability of our internal
control over financial reporting and in the accuracy of our periodic reports
filed with the SEC and with Canadian securities regulatory authorities. A lack
of investor confidence in the reliability and accuracy of our public reporting
could cause our stock price to decline.
 
 Our
current research collaborations with Alcon and Galderma may fail, and entering
into additional collaborations may not happen,  resulting in a
decrease in funding and inhibition of our ability to continue developing
products.
 
 We have
entered into a collaborative arrangement with Alcon, and we rely on Alcon for
joint intellectual property creation and for substantially all of our near-term
revenues. Under the agreement, we licensed to Alcon the exclusive rights (except
for certain retained marketing rights) to develop, manufacture and commercialize
products incorporating the Aganocide compounds for application in connection
with the eye, ear and sinus and for use in contact lens solutions. We have also
entered into an agreement with Galderma S.A. to develop and commercialize our
Aganocide® compounds, which covers acne and impetigo and potentially other major
dermatological conditions, excluding onychomycosis (nail fungus) and orphan drug
indications.
 
 We cannot
assure you that our collaborations with Alcon or Galderma or any other
collaborative arrangement will be successful, or that we will receive the full
amount of research funding, milestone payments or royalties, or that any
commercially valuable intellectual property will be created, from these
arrangements. If Alcon or Galderma were to breach or terminate its agreement
with us or otherwise fail to conduct its collaborative activities successfully
and in a timely manner, the research contemplated by our collaboration with them
could be delayed or terminated and our costs of performing studies may increase.
We plan on entering into additional collaborations and licensing arrangements.
We may not be able to negotiate additional collaborations on acceptable terms,
if at all, and these collaborations may not be successful. Our current and
future success depends in part on our ability to enter into successful
collaboration arrangements and maintain the collaboration arrangement we
currently have. If we are unable to enter into, maintain or extend successful
collaborations, our business may be harmed.
 
 Our
long-term success depends upon the successful development and commercialization
of other products from our research and development activities
 
 Our
long-term viability and growth will depend upon the successful development and
commercialization of other products from our research and development
activities. Product development and commercialization is very expensive and
involves a high degree of risk. Only a small number of research and development
programs result in the commercialization of a product. Success in early stage
clinical trials or preclinical work does not ensure that later stage or larger
scale clinical trials will be successful. Even if later stage clinical trials
are successful, the risk remains that unexpected concerns may arise from
additional data or analysis or that obstacles may arise or issues may be
identified in connection with review of clinical data with regulatory
authorities or that regulatory authorities may disagree with our view of the
data or require additional data or information or additional
studies.
 
 13
 Conducting
clinical trials is a complex, time-consuming and expensive process. Our ability
to complete our clinical trials in a timely fashion depends in large part on a
number of key factors including protocol design, regulatory and institutional
review board approval, the rate of patient enrollment in clinical trials, and
compliance with extensive current good clinical practice requirements. We are in
many cases using the services of third-party contract clinical trial providers.
If we fail to adequately manage the design, execution and regulatory aspects of
our clinical trials, our studies and ultimately our regulatory approvals may be
delayed or we may fail to gain approval for our product candidates
altogether.
 
 If
we do not successfully execute our growth initiatives through the acquisition,
partnering and in-licensing of products, technologies or companies, our future
performance could be adversely affected.
 
 In
addition to the expansion of our pipeline through spending on internal
development projects, we anticipate growing through external growth
opportunities, which include the acquisition, partnering and in-licensing of
products, technologies and companies or the entry into strategic alliances and
collaborations. If we are unable to complete or manage these external growth
opportunities successfully, we may not be able to grow our business in the way
that we currently expect. The availability of high quality opportunities is
limited and we are not certain that we will be able to identify suitable
candidates or complete transactions on terms that are acceptable to us. In order
to pursue such opportunities, we may require significant additional financing,
which may not be available to us on favorable terms, if at all. The availability
of such financing is limited by the recent tightening of the global credit
markets.
 
 We
may acquire other businesses or form joint ventures or in-license compounds that
could disrupt our business, harm our operating results, dilute your ownership
interest in us, or cause us to incur debt or significant expense.
 
 As part
of our business strategy, we may pursue acquisitions of complementary businesses
and assets, and enter into technology or pharmaceutical compound licensing
arrangements. We also may pursue strategic alliances that leverage our core
technology and industry experience to enhance our ability to commercialize our
product candidates and expand our product offerings or distribution. We have no
experience with respect to acquiring other companies and limited experience with
respect to the formation of commercial partnering agreements, strategic
alliances, joint ventures or in-licensing of compounds. If we make any
acquisitions, we may not be able to integrate these acquisitions successfully
into our existing business, and we could assume unknown or contingent
liabilities. If we in-license any additional compounds, we may fail to develop
the product candidates, and spend significant resources before determining
whether a compound we have in-licensed will produce revenues. Any future
acquisitions or in-licensing by us also could result in significant write-offs
or the incurrence of debt and contingent liabilities, any of which could harm
our operating results. Integration of an acquired company also may require
management resources that otherwise would be available for ongoing development
of our existing business. We may not identify or complete these transactions in
a timely manner, on a cost-effective basis, or at all, and we may not realize
the anticipated benefits of any acquisition, technology license, strategic
alliance or joint venture.
 
 To
finance any acquisitions, we may choose to issue shares of our common stock as
consideration, which would dilute your interest in us. If the price of our
common stock is low or volatile, we may not be able to acquire other companies
for stock. Alternatively, it may be necessary for us to raise additional funds
for acquisitions by incurring indebtedness. Additional funds may not be
available on terms that are favorable to us, or at all.
  We
do not have our own manufacturing capacity, and we plan to rely on partnering
arrangements or third-party manufacturers for the manufacture of our potential
products.
 
 We do not
currently operate manufacturing facilities for clinical or commercial production
of our product NeutroPhase and other product candidates. We have no experience
in drug formulation or manufacturing, and we lack the resources and the
capabilities to manufacture NeutroPhase or any of our product candidates on a
clinical or commercial scale. As a result, we have partnered and expect to
partner with third parties to manufacture our products or rely on contract
manufacturers to supply, store and distribute product supplies for our clinical
trials. Any performance failure on the part of our commercial partners or
future manufacturers could delay clinical development or regulatory approval of
our product candidates or commercialization of our products, producing
additional losses and reducing the potential for product revenues.
 
 Our
products, if developed and commercialized, will require precise, high quality
manufacturing. The failure to achieve and maintain high manufacturing standards,
including the incidence of manufacturing errors, could result in patient injury
or death, product recalls or withdrawals, delays or failures in product testing
or delivery, cost overruns or other problems that could seriously harm our
business. Contract manufacturers and partners often encounter difficulties
involving production yields, quality control and quality assurance, as well as
shortages of qualified personnel. These manufacturers and partners are subject
to ongoing periodic unannounced inspection by the FDA and corresponding state
agencies to ensure strict compliance with current Good Manufacturing Practice
and other applicable government regulations and corresponding foreign standards;
however, we do not have control over third-party compliance with these
regulations and standards. If any of our manufacturers or partners fails to
maintain compliance, the production of our products could be interrupted,
resulting in delays, additional costs and potentially lost
revenues.
 
 In
addition, if the FDA or other regulatory agencies approve any of our product
candidates for commercial sale, we will need to manufacture them in larger
quantities. Significant scale-up of manufacturing will require validation
studies, which the FDA must review and approve. If we are unable to successfully
increase the manufacturing capacity for a product, the regulatory approval or
commercial launch of any drugs may be delayed or there may be a shortage in
supply and our business may be harmed as a result.
 
 14
 We
depend on skilled and experienced personnel to operate our business effectively.
If we are unable to recruit, hire and retain these employees, our ability to
manage and expand our business will be harmed, which would impair our future
revenue and profitability.
 
 Our
success largely depends on the skills, experience and efforts of our officers,
especially our Chief Executive Officer, Chief Financial Officer, Chief
Scientific Officer, Chief Alliance Officer and Vice President of Product
Development, Vice President of Medical Affairs, Vice President of Business and
Corporate Development and other key employees. The efforts of each of these
persons is critical to us as we continue to develop our technologies and as we
attempt to transition into a company with commercial products. Any of our
officers and other key employees may terminate their employment at any time. The
loss of any of our senior management team members could weaken our management
expertise and harm our ability to compete effectively, develop our technologies
and implement our business strategies.
 
 Our
ability to retain our skilled labor force and our success in attracting and
hiring new skilled employees will be a critical factor in determining whether we
will be successful in the future. Our research and development programs and
collaborations depend on our ability to attract and retain highly skilled
scientists and technicians. We may not be able to attract or retain qualified
scientists and technicians in the future due to the intense competition for
qualified personnel among life science businesses, particularly in the San
Francisco Bay Area. We also face competition from universities and public and
private research institutions in recruiting and retaining highly qualified
scientific personnel. We have also encountered difficulties in recruiting
qualified personnel from outside the San Francisco Bay Area, due to the high
housing costs in the area.
 
 If
we fail to manage our growth effectively, we may be unable to execute our
business plan.
 
 Our
future growth, if any, may cause a significant strain on our management, and our
operational, financial and other resources. Our ability to manage our growth
effectively will require us to implement and improve our operational, financial
and management information systems and to expand, train, manage and motivate our
employees. These demands may require the hiring of additional management
personnel and the development of additional expertise by management. Any
increase in resources devoted to research and product development without a
corresponding increase in our operational, financial and management information
systems could have a material adverse effect on our business, financial
condition, and results of operations.
 
 If
our facilities become inoperable, we will be unable to perform our research and
development activities, fulfill the requirements under our collaboration
agreement and continue developing products and, as a result, our business will
be harmed.
 
 We do not
have redundant laboratory facilities. We perform substantially all of our
research, development and testing in our laboratory located in Emeryville,
California. Emeryville is situated on or near active earthquake fault lines. Our
facility and the equipment we use to perform our research, development and
testing would be costly to replace and could require substantial lead time to
repair or replace. The facility may be harmed or rendered inoperable by natural
or man-made disasters, including earthquakes, flooding and power outages, which
may render it difficult or impossible for us to perform our research,
development and testing for some period of time. The inability to perform our
research and development activities may result in the loss of partners or harm
our reputation, and we may be unable to regain those partnerships in the future.
Our insurance coverage for damage to our property and the disruption of our
business may not be sufficient to cover all of our potential losses, including
the loss of time as well as the costs of lost opportunities, and may not
continue to be available to us on acceptable terms, or  at
all.
 
 Obtaining regulatory approval in the
United States does not ensure we will obtain regulatory approval in other
countries.
 
 We will
aim to obtain regulatory approval in the United States as well as in other
countries. To obtain regulatory approval to market our proposed products outside
of the United States, we and any collaborator must comply with numerous and
varying regulatory requirements in other countries regarding safety and
efficacy. Approval procedures vary among countries and can involve additional
product testing and additional administrative review periods. The time required
to obtain approval in other countries might differ significantly from that
required to obtain FDA approval. The regulatory approval process in other
countries include all of the risk associated with FDA approval as well as
additional, presently unanticipated risks. Regulatory approval in one country
does not ensure regulatory approval in another, but a failure or delay in
obtaining regulatory approval in one country may negatively impact the
regulatory process in others. Failure to obtain regulatory approval in other
countries or any delay or setback in obtaining such approval could have the same
adverse effects associated with regulatory approval in the United States,
including the risk that our product candidates may not be approved for all
indications requested and that such approval may be subject to limitations on
the indicated uses for which the product may be marketed. In addition, failure
to comply with applicable regulatory requirements in other countries can result
in, among other things, warning letters, fines, injunctions, civil penalties,
recall or seizure of products, total or partial suspension of production,
refusal of the government to renew marketing applications and criminal
prosecution.
 
 15
 If
we are unable to design, conduct and complete clinical trials successfully, we
will not be able to obtain regulatory approval for our products.
 
 In order
to obtain FDA approval for our drug product candidates, we must submit to the
FDA a New Drug Application, or NDA, demonstrating that the product candidate is
safe and effective for its intended use. This demonstration requires significant
research and animal tests, which are referred to as preclinical studies, as well
as human tests, which are referred to as clinical trials.
 
 Any
clinical trials we conduct or that are conducted by our partners may not
demonstrate the safety or efficacy of our product candidates. Success in
pre-clinical testing and early clinical trials does not ensure that later
clinical trials will be successful. Results of later clinical trials may not
replicate the results of prior clinical trials and pre-clinical testing. Even if
the results of one or more of our clinical trials are positive, we may have to
commit substantial time and additional resources to conducting further
preclinical studies or clinical trials before we can submit NDAs or obtain FDA
approvals for our product candidates, and positive results of a clinical trial
may not be replicated in subsequent trials.
 
 Clinical
trials are very expensive and difficult to design and implement. The clinical
trial process is also time-consuming. Furthermore, if participating patients in
clinical studies suffer drug-related adverse reactions during the course of such
trials, or if we or the FDA believe that participating patients are being
exposed to unacceptable health risks, we will have to suspend or terminate our
clinical trials. Failure can occur at any stage of the trials, and we could
encounter problems that cause us to abandon clinical trials or to repeat
clinical studies. Further,
because our product candidates are all in the same class of compounds, failure
in one clinical trial may cause us or our partners to have to suspend or
terminate other clinical trials. For example, if toxicity issues were to arise
in one clinical trial, it could indicate that all of our product candidates have
toxicity issues.
 
 In
addition, the completion of clinical trials can be delayed by numerous factors,
including:
 
 •
              delays
      in identifying and agreeing on acceptable terms with prospective clinical
      trial sites;•
              slower
      than expected rates of patient recruitment and enrollment;•
              increases
      in time required to complete monitoring of patients during or after
      participation in a trial; and•
              unexpected
      need for additional patient-related data.
 
 Any of
these delays, if significant, could impact the timing, approval and
commercialization of our product candidates and could significantly increase our
overall costs of drug development.
 
 Even if
our clinical trials are completed as planned, their results may not support our
expectations or intended marketing claims. The clinical trials process may fail
to demonstrate that our products are safe and effective for indicated uses. Such
failure would cause us to abandon a product candidate for some indications and
could delay development of other product candidates.
 
 Government
agencies may establish usage guidelines that directly apply to our proposed
products or change legislation or regulations to which we are
subject.
 
 Government
usage guidelines typically address matters such as usage and dose, among other
factors. Application of these guidelines could limit the use of products that we
may develop. In addition there can be no assurance that government regulations
applicable to our proposed products or the interpretation thereof will not
change and thereby prevent the marketing of some or all of our products for a
period of time or permanently. The FDA’s policies may change and additional
government regulations may be enacted that could prevent or delay regulatory
approval of our product candidates. We cannot predict the likelihood, nature or
extent of adverse government regulation that may arise from future legislation
or administrative action, either in the United States or in other
countries.
 
 Our
product candidates may be classified as a drug or a medical device, depending on
the mechanism of action, indication for use and prior precedent, and a change in
the classification may have an adverse impact on our revenues or our ability to
obtain necessary regulatory approvals.
 
 Several
potential indications for our product candidates may be regulated under the
medical device regulations of the FDA administered by the Center for Devices and
Radiological Health and the same physical product may be regulated by the FDA’s
Center for Drug Evaluation and Research for another indication. Our products may
be classified by the FDA as a drug or a medical device depending upon their
mechanism of action, indications for use or claims. For example, for NVC-422, if
the indication is for bladder lavage, we believe it would be classified as a
medical device, whereas we believe it would be considered a drug when it is
indicated for the prevention of urinary tract infection. Similarly, the use of
NVC-101 as a solution for cleansing and debriding wounds is considered a medical
device. The determination as to whether a particular indication is considered a
drug or a device is based in part upon prior precedent. A reclassification by
the FDA of an indication from a device to a drug indication during our
development for that indication could have a significant adverse impact due to
the more rigorous approval process required for drugs, as compared to medical
devices. Such a change in classification can significantly increase development
costs and prolong the time for development and approval, thus delaying revenues.
A reclassification of an indication after approval from a drug to a device could
result in a change in classification for reimbursement. In many cases,
reimbursement for devices is significantly lower than for drugs and there could
be a significant negative impact on our revenues.
 
 16
 We
and our collaborators are and will be subject to ongoing FDA obligations and
continued regulatory review, such as continued safety reporting requirements,
and we and our collaborators may also be subject to additional FDA
post-marketing obligations or new regulations, all of which may result in
significant expense and which may limit our ability to commercialize our medical
device and drug products candidates.
 
 Any
regulatory approvals that we receive may also be subject to limitations on the
indicated uses for which the product may be marketed or contain requirements for
potentially costly post-marketing follow-up studies. The FDA may require us to
commit to perform lengthy Phase IV post-approval studies (as further described
below), for which we would have to expend additional resources, which could have
an adverse effect on our operating results and financial condition. In addition,
if the FDA approves any of our drug product candidates, the labeling, packaging,
adverse event reporting, storage, advertising, promotion and record keeping for
the drug will be subject to extensive regulatory requirements. The subsequent
discovery of previously unknown problems with the drugs, including adverse
events of unanticipated severity or frequency, may result in restrictions on the
marketing of the drugs or the withdrawal of the drugs from the market. If we are
not able to maintain regulatory compliance, we may be subject to fines,
suspension or withdrawal of regulatory approvals, product recalls, seizure of
products, operating restrictions and criminal prosecution. Any of these events
could prevent us from marketing any products we may develop and our business
could suffer.
 
 Conducting
clinical trials of our product candidates may expose us to expensive liability
claims, and we may not be able to maintain liability insurance on reasonable
terms or at all.
 
 The risk
of clinical trial liability is inherent in the testing of pharmaceutical and
medical device products. If we cannot successfully defend ourselves against any
clinical trial claims, we may incur substantial liabilities or be required to
limit or terminate testing of one or more of our product candidates. Our
inability to obtain sufficient clinical trial insurance at an acceptable cost to
protect us against potential clinical trial claims could prevent or inhibit the
commercialization of our product candidates. Our current clinical trial
insurance covers individual and aggregate claims up to $3 million. This
insurance may not cover all claims and we may not be able to obtain additional
insurance coverage at a reasonable cost, if at all, in the future. In addition,
if our agreements with any future corporate collaborators entitle us to
indemnification against product liability losses and clinical trial liability,
such indemnification may not be available or adequate should any claim
arise.
 
 If
we use biological and hazardous materials in a manner that causes injury, we
could be liable for damages. Compliance with environmental regulations can
be expensive, and noncompliance with these regulations may result in adverse
publicity and potentially significant monetary damages and fines.
 
 Our
activities currently require the controlled use of potentially harmful
biological materials and other hazardous materials and chemicals and may in the
future require the use of radioactive compounds. We cannot eliminate the risk of
accidental contamination or injury to employees or third parties from the use,
storage, handling or disposal of these materials. In the event of contamination
or injury, we could be held liable for any resulting damages, and any liability
could exceed our resources or any applicable insurance coverage we may have.
Additionally, we are subject, on an ongoing basis, to U.S. federal, state and
local laws and regulations governing the use, storage, handling and disposal of
these materials and specified waste products. The cost of compliance with these
laws and regulations might be significant and could negatively affect our
operating results. In addition, if more stringent laws and regulations are
adopted in the future, the costs of compliance with these new laws and
regulations could be substantial or could impose significant changes in our
testing and production process.
 
 The
pharmaceutical and biopharmaceutical industries are characterized by patent
litigation and any litigation or claim against us may cause us to incur
substantial costs, and could place a significant strain on our financial
resources, divert the attention of management from our business and harm our
reputation.
 
 There has
been substantial litigation in the pharmaceutical and biopharmaceutical
industries with respect to the manufacture, use and sale of new products that
are the subject of conflicting patent rights. For the most part, these lawsuits
relate to the validity, enforceability and infringement of patents. Generic
companies are encouraged to challenge the patents of pharmaceutical products in
the United States because a successful challenger can obtain nine months of
exclusivity as a generic product under the Waxman-Hatch Act. We expect that we
will rely upon patents, trade secrets, know-how, continuing technological
innovations and licensing opportunities to develop and maintain our competitive
position and we may initiate claims to defend our intellectual property rights
as a result. Other parties may have issued patents or be issued patents that may
prevent the sale of our products or know-how or require us to license such
patents and pay significant fees or royalties in order to produce our products.
In addition, future patents may issue to third parties which our technology may
infringe. Because patent applications can take many years to issue, there may be
applications now pending of which we are unaware that may later result in issued
patents that our products may infringe.
 
 17
 Intellectual
property litigation, regardless of outcome, is expensive and time-consuming,
could divert management’s attention from our business and have a material
negative effect on our business, operating results or financial condition. If
such a dispute were to be resolved against us, we may be required to pay
substantial damages, including treble damages and attorneys fees if we were to
be found to have willfully infringed a third party’s patent, to the party
claiming infringement, develop non-infringing technology, stop selling any
products we develop, cease using technology that contains the allegedly
infringing intellectual property or enter into royalty or license agreements
that may not be available on acceptable or commercially practical terms, if at
all. Our failure to develop non-infringing technologies or license the
proprietary rights on a timely basis could harm our business. Modification of
any products we develop or development of new products thereafter could require
us to conduct additional clinical trials and to revise our filings with the FDA
and other regulatory bodies, which would be time-consuming and expensive. In
addition, parties making infringement claims may be able to obtain an injunction
that would prevent us from selling any products we develop, which could harm our
business.
 
 We
may be subject to damages resulting from claims that we or our employees have
wrongfully used or disclosed alleged trade secrets of their former
employers.
 
 Some of
our employees may have been previously employed at universities or other
biotechnology or pharmaceutical companies, including our competitors or
potential competitors. Although no claims against us are currently pending, we
may be subject to claims that these employees or we have inadvertently or
otherwise used or disclosed trade secrets or other proprietary information of
their former employers. Litigation may be necessary to defend against these
claims. Even if we are successful in defending against these claims, litigation
could result in substantial costs and be a distraction to management. If we fail
in defending such claims, in addition to paying money damages, we may lose
valuable intellectual property rights or personnel. A loss of key research
personnel or their work product could hamper or prevent our ability to
commercialize product candidates, which could severely harm our
business.
 
 If
product liability lawsuits are brought against us, they could result in costly
litigation and significant liabilities.
 
 The
product candidates we are developing or attempting to develop will, in most
cases, undergo extensive clinical testing and will require approval from the
applicable regulatory authorities prior to sale. However, despite all reasonable
efforts to ensure safety, it is possible that we or our collaborators will sell
products which are defective, to which patients react in an unexpected manner,
or which are alleged to have side effects. The manufacture and sale of such
products may expose us to potential liability, and the industries in which our
products are likely to be sold have been subject to significant product
liability litigation. Any claims, with or without merit, could result in costly
litigation, reduced sales, significant liabilities and diversion of our
management’s time and attention and could have a material adverse effect on our
financial condition, business and results of operations.
 
 If a
product liability claim is brought against us, we may be required to pay legal
and other expenses to defend the claim and, if the claim is successful, damage
awards may not be covered, in whole or in part, by our insurance. We may not
have sufficient capital resources to pay a judgment, in which case our creditors
could levy against our assets. We may also be obligated to indemnify our
collaborators and make payments to other parties with respect to product
liability damages and claims. Defending any product liability claims, or
indemnifying others against those claims, could require us to expend significant
financial and managerial resources.
 
 Failure
to obtain sufficient quantities of products and substances necessary for
research and development, pre-clinical trials, human clinical trials and product
commercialization that are of acceptable quality at reasonable prices or at all
could constrain our product development and have a material adverse effect on
our business.
 
 We have
relied and will continue to rely on contract manufacturers for the foreseeable
future to produce quantities of products and substances necessary for research
and development, pre-clinical trials, human clinical trials and product
commercialization. It will be important to us that such products and substances
can be manufactured at a cost and in quantities necessary to make them
commercially viable. At this point in time, we have not attempted to identify,
and do not know whether there will be, any third party manufacturers which will
be able to meet our needs with respect to timing, quantity and quality for
commercial production. In addition, if we are unable to contract for a
sufficient supply or required products and substances on acceptable terms, or if
we should encounter delays or difficulties in our relationships with
manufacturers, our research and development, pre-clinical and clinical testing
would be delayed, thereby delaying the submission of product candidates for
regulatory approval or the market introduction and subsequent sales of products.
Any such delay may have a material adverse effect on our business, financial
condition and results of operations.
 
 Because
our clinical development activities rely heavily on sensitive and personal
information, an area which is highly regulated by privacy laws, we may not be
able to generate, maintain or access essential patient samples or data to
continue our research and development efforts in the future on reasonable terms
and conditions, which may adversely affect our business.
 
 As a
result of our clinical development, we will have access to very sensitive data
regarding the patients enrolled in our clinical trials. This data will contain
information that is personal in nature. The maintenance of this data is subject
to certain privacy-related laws, which impose upon us administrative and
financial burdens, and litigation risks. For instance, the rules promulgated by
the Department of Health and Human Services under the Health Insurance
Portability and Accountability Act, or HIPAA, creates national standards to
protect patients’ medical records and other personal information in the United
States. These rules require that healthcare providers and other covered entities
obtain written authorizations from patients prior to disclosing protected health
care information of the patient to companies like NovaBay. If the patient fails
to execute an authorization or the authorization fails to contain all required
provisions, then we will not be allowed access to the patient’s information and
our research efforts can be substantially delayed. Furthermore, use of protected
health information that is provided to us pursuant to a valid patient
authorization is subject to the limits set forth in the authorization (i.e., for
use in research and in submissions to regulatory authorities for product
approvals). As such, we are required to implement policies, procedures and
reasonable and appropriate security measures to protect individually
identifiable health information we receive from covered entities, and to ensure
such information is used only as authorized by the patient. Any violations of
these rules by us could subject us to civil and criminal penalties and adverse
publicity, and could harm our ability to initiate and complete clinical studies
required to support regulatory applications for our proposed products. In
addition, HIPAA does not replace federal, state, or other laws that may grant
individuals even greater privacy protections. We can provide no assurance that
future legislation will not prevent us from generating or maintaining personal
data or that patients will consent to the use of their personal information,
either of which may prevent us from undertaking or publishing essential
research. These burdens or risks may prove too great for us to reasonably bear,
and may adversely affect our ability to function profitably in the
future.
 
 18
 We
may be subject to fines, penalties, injunctions and other sanctions if we are
deemed to be promoting the use of our products for non-FDA-approved, or
off-label, uses.
 
 Our
business and future growth depend on the development, use and ultimate sale of
products that are subject to FDA regulation, clearance and approval. Under the
U.S. Federal Food, Drug, and Cosmetic Act and other laws, we are prohibited from
promoting our products for off-label uses. This means that we may not make
claims about the safety or effectiveness of our products and may not proactively
discuss or provide information on the use of our products, except as allowed by
the FDA.
 
 There is
a risk that the FDA or other federal or state law enforcement authorities could
determine that the nature and scope of our sales and marketing activities may
constitute the promotion of our products for a non-FDA-approved use in violation
of applicable law. We also face the risk that the FDA or other regulatory
authorities might pursue enforcement based on past activities that we have
discontinued or changed, including sales activities, arrangements with
institutions and doctors, educational and training programs and other
activities.
 
 Government
investigations concerning the promotion of off-label uses and related issues are
typically expensive, disruptive and burdensome and generate negative publicity.
If our promotional activities are found to be in violation of applicable law or
if we agree to a settlement in connection with an enforcement action, we would
likely face significant fines and penalties and would likely be required to
substantially change our sales, promotion, grant and educational activities. In
addition, were any enforcement actions against us or our senior officers to
arise, we could be excluded from participation in U.S. government healthcare
programs such as Medicare and Medicaid.
 
 If
we are unable to protect our intellectual property, our competitors could
develop and market products similar to ours that may reduce demand for our
products.
 
 Our
success, competitive position and potential future revenues will depend in
significant part on our ability to protect our intellectual property. We rely on
the patent, trademark, copyright and trade secret laws of the United States and
other countries, as well as confidentiality and nondisclosure agreements, to
protect our intellectual property rights. We apply for patents covering our
technologies as we deem appropriate.
 
 NovaBay
aggressively protects and enforces its patent rights
worldwide.  However, certain risks remain.  There is no
assurance that patents will issue from any of our applications or, for those
patents we have or that do issue, that the claims will be sufficiently broad to
protect our proprietary rights, or that it will be economically possible to
pursue sufficient numbers of patents to afford significant protection. For
example, we do not have any composition of matter patent directed to the NVC-101
composition. If a potential competitor introduces a similar method of using
NVC-101 with a similar composition that does not fall within the scope of the
method of treatment claims, then we or a potential marketing partner would be
unable to rely on the allowed claims to protect its market position for the
method of using the NVC-101 composition, and any revenues arising from such
protection would be adversely impacted.
 
 In
addition, there is no assurance that any patents issued to us or licensed or
assigned to us by third parties will not be challenged, invalidated, found
unenforceable or circumvented, or that the rights granted thereunder will
provide competitive advantages to us. If we or our collaborators or licensors
fail to file, prosecute or maintain certain patents, our competitors could
market products that contain features and clinical benefits similar to those of
any products we develop, and demand for our products could decline as a result.
Further, although we have taken steps to protect our intellectual property and
proprietary technology, third parties may be able to design around our patents
or, if they do infringe upon our technology, we may not be successful or have
sufficient resources in pursuing a claim of infringement against those third
parties. Any pursuit of an infringement claim by us may involve substantial
expense and diversion of management attention.
 
 We also
rely on trade secrets and proprietary know-how that we seek to protect by
confidentiality agreements with our employees, consultants and collaborators. If
these agreements are not enforceable, or are breached, we may not have adequate
remedies for any breach, and our trade secrets and proprietary know-how may
become known or be independently discovered by competitors.
 
 19
 We
operate in the State of California.  The laws of the State prevent us
from imposing a delay before an employee who may have access to trade secrets
and proprietary know-how can commence employment with a competing company.
Although we may be able to pursue legal action against competitive companies
improperly using our proprietary information, we may not be aware of any use of
our trade secrets and proprietary know-how until after significant damage has
been done to our company.
 
 Furthermore,
the laws of foreign countries may not protect our intellectual property rights
to the same extent as the laws of the United States. If our intellectual
property does not provide significant protection against foreign or domestic
competition, our competitors, including generic manufacturers, could compete
more directly with us, which could result in a decrease in our market share. All
of these factors may harm our competitive position.
 
 If
bacteria develop resistance to Aganocide compounds, our revenues could be
significantly reduced.
 
 Based on
our understanding of the hypothesis of the mechanism of action of our Aganocide
compounds, we do not expect bacteria to be able to develop resistance to
Aganocide compounds. However, we cannot assure you that one or more strains of
bacteria will not develop resistance to our compounds, either because our
hypothesis of the mechanism of action is incorrect or because a strain of
bacteria undergoes some unforeseen genetic mutation that permits it to survive.
Since we expect lack of resistance to be a major factor in the commercialization
of our product candidates, the discovery of such resistance would have a major
adverse impact on the acceptability and sales of our products.
 
 If
physicians and patients do not accept and use our products, we will not achieve
sufficient product revenues and our business will suffer.
 
 Even if
the FDA approves product candidates that we develop, physicians and patients may
not accept and use them. Acceptance and use of our products may depend on a
number of factors including:
 
 •
              perceptions
      by members of the healthcare community, including physicians, about the
      safety and effectiveness of our products;•
              published
      studies demonstrating the cost-effectiveness of our products relative to
      competing products;•
              availability
      of reimbursement for our products from government or healthcare payers;
      and•
              effectiveness
      of marketing and distribution efforts by us and our licensees and
      distributors, if any.
  The
failure of any of our products to find market acceptance would harm our business
and could require us to seek additional financing.
 
 If
we are unable to develop our own sales, marketing and distribution capabilities,
or if we are not successful in contracting with third parties for these services
on favorable terms, or at all, revenues from any products we develop could be
disappointing.
 
 We
currently have no internal sales, marketing or distribution capabilities. In
order to commercialize any product candidates approved by the FDA, we will
either have to develop such capabilities internally or collaborate with third
parties who can perform these services for us. If we decide to commercialize any
products we develop, we may not be able to hire the necessary experienced
personnel and build sales, marketing and distribution operations which are
capable of successfully launching new products and generating sufficient product
revenues. In addition, establishing such operations will take time and involve
significant expense.
 
 If we
decide to enter into co-promotion or other licensing arrangements with third
parties, we may be unable to identify acceptable partners because the number of
potential partners is limited and because of competition from others for similar
alliances with potential partners. Even if we are able to identify one or more
acceptable partners, we may not be able to enter into any partnering
arrangements on favorable terms, or at all. If we enter into any partnering
arrangements, our revenues are likely to be lower than if we marketed and sold
our products ourselves.
 
 In
addition, any revenues we receive would depend upon our partners’ efforts which
may not be adequate due to lack of attention or resource commitments, management
turnover, change of strategic focus, further business combinations or other
factors outside of our control. Depending upon the terms of our agreements, the
remedies we have against an under-performing partner may be limited. If we were
to terminate the relationship, it may be difficult or impossible to find a
replacement partner on acceptable terms, or at all.
 
 If
we cannot compete successfully for market share against other companies, we may
not achieve sufficient product revenues and our business will
suffer.
 
 The
market for our product candidates is characterized by intense competition and
rapid technological advances. If our product candidates receive FDA approval and
are launched they will compete with a number of existing and future drugs,
devices and therapies developed, manufactured and marketed by others. Existing
or future competing products may provide greater therapeutic convenience or
clinical or other benefits for a specific indication than our products, or may
offer comparable performance at a lower cost. If our products are unable to
capture and maintain market share, we may not achieve sufficient product
revenues and our business will suffer.
 
 20
 We will
compete for market share against fully integrated pharmaceutical and medical
device companies or other companies that develop products independently or
collaborate with larger pharmaceutical companies, academic institutions,
government agencies and other public and private research organizations. In
addition, many of these competitors, either alone or together with their
collaborative partners, have substantially greater capital resources, larger
research and development staffs and facilities, and greater financial resources
than we do, as well as significantly greater experience in:
 
 •
              developing
      drugs and devices;•
              conducting
      preclinical testing and human clinical trials;•
              obtaining
      FDA and other regulatory approvals of product
  candidates;•
              formulating
      and manufacturing products; and•
              launching,
      marketing, distributing and selling
products.
  Our
competitors may:
 
 •
              develop
      and patent processes or products earlier than we will;•
              develop
      and commercialize products that are less expensive or more efficient than
      any products that we may develop;•
              obtain
      regulatory approvals for competing products more rapidly than we will;
      and•
              improve
      upon existing technological approaches or develop new or different
      approaches that render any technology or products we develop obsolete or
      uncompetitive.
 
 We cannot
assure you that our competitors will not succeed in developing technologies and
products that are more effective than any developed by us or that would render
our technologies and any products we develop obsolete. If we are unable to
compete successfully against current or future competitors, we may be unable to
obtain market acceptance for any product candidates that we create, which could
prevent us from generating revenues or achieving profitability and could cause
the market price of our common stock to decline.
 
 Our
ability to generate revenues from any products we develop will be diminished if
we fail to obtain acceptable prices or an adequate level of reimbursement for
our products from healthcare payers.
 
 Our
ability to commercialize our product candidates will depend, in part, on the
extent to which health insurers, government authorities and other third-party
payers will reimburse the costs of products which may be developed by us or our
partners. We expect that a portion of our economic return from partnering
arrangements with pharmaceutical companies and other collaborators will be
derived from royalties, fees or other revenues linked to final sales of products
that we or our partners develop. Newly-approved pharmaceuticals and other
products which are developed by us or our partners will not necessarily be
reimbursed by third-party payers or may not be reimbursed at levels sufficient
to generate significant sales. Government and other third-party payers are
increasingly attempting to contain health care costs by limiting both coverage
and the level of reimbursement for new drugs or medical devices. Cost control
initiatives such as these could adversely affect our or our collaborators’
ability to commercialize products. In addition, real or anticipated cost control
initiatives for final products may reduce the willingness of pharmaceutical
companies or other potential partners to collaborate with us on the development
of new products.
 
 Significant
uncertainty exists as to the reimbursement status of newly-approved healthcare
products. Healthcare payers, including Medicare, health maintenance
organizations and managed care organizations, are challenging the prices charged
for medical products or are seeking pharmacoeconomic data to justify formulary
acceptance and reimbursement practices. We currently have not generated
pharmacoeconomic data on any of our product candidates. Government and other
healthcare payers increasingly are attempting to contain healthcare costs by
limiting both coverage and the level of reimbursement for drugs and medical
devices, and by refusing, in some cases, to provide coverage for uses of
approved products for disease indications for which the FDA has or has not
granted labeling approval. Adequate third-party insurance coverage may not be
available to patients for any products we discover and develop, alone or with
collaborators. If government and other healthcare payers do not provide adequate
coverage and reimbursement levels for our products, market acceptance of our
product candidates could be limited.
 
 Risks
Relating to Owning Our Common Stock
 
 The
price of our common stock may fluctuate substantially, which may result in
losses to our shareholders.
 
 The stock
prices of many companies in the pharmaceutical and biotechnology industry have
generally experienced wide fluctuations, which are often unrelated to the
operating performance of those companies. The market price of our common stock
is likely to be volatile and could fluctuate in response to, among other
things:
 
 21
 •
              the
      results of preclinical or clinical trials relating to our product
      candidates;•
              the
      announcement of new products by us or our competitors;•
              announcement
      of partnering arrangements by us or our competitors;•
              quarterly
      variations in our or our competitors’ results of
    operations;•
              announcements
      by us related to litigation;•
              changes
      in our earnings estimates, investors’ perceptions, recommendations by
      securities analysts or our failure to achieve analysts’ earning
      estimates;•
              developments
      in our industry; and•
              General,
      economic and market conditions, including the recent volatility in the
      financial markets and decrease in consumer confidence and other
      factors unrelated to our operating performance or the operating
      performance of our competitors.
 
 The
volume of trading of our common stock may be low, leaving our common stock open
to risk of high volatility.
 
 The
number of shares of our common stock being traded may be very low. Any
shareholder wishing to sell his/her stock may cause a significant fluctuation in
the price of our stock. In addition, low trading volume of a stock increases the
possibility that, despite rules against such activity, the price of the stock
may be manipulated by persons acting in their own self-interest. We may not have
adequate market makers and market making activity to prevent
manipulation.
 
 Our
directors, executive officers and principal shareholders have significant voting
power and may take actions that may not be in the best interests of our other
shareholders.
 
 As of
December 31, 2009, our officers and directors collectively controlled
approximately 4,158,640 shares of our outstanding common stock (and
approximately 5,445,570 shares of our common stock when including options held
by them which were exercisable as of or within 60 days of December 31, 2009).
Furthermore, as of December 31, 2009, our largest shareholder, a family trust
established and controlled by Dr. Ramin Najafi, our Chairman and Chief
Executive Officer, beneficially owned 3,128,700 shares or 13.4 % of our
outstanding common stock. As a result, Dr. Najafi can significantly
influence the management and affairs of our company and most matters requiring
shareholder approval, including the election of directors and approval of
significant corporate transactions. This concentration of ownership may have the
effect of delaying or preventing a change in control and might adversely affect
the market price of our common stock. This concentration of ownership may not be
in the best interests of our other shareholders.
 
 Our
limited operating history may make it difficult for you to evaluate our business
and to assess our future viability.
 
 Our
operations to date have been limited to organizing and staffing our company,
developing our technology, researching and developing our compounds, and
conducting preclinical studies and early-stage clinical trials of our compounds.
We have not demonstrated the ability to succeed in achieving clinical endpoints,
obtain regulatory approvals, formulate and manufacture products on a commercial
scale or conduct sales and marketing activities. Consequently, any predictions
you make about our future success or viability are unlikely to be as accurate as
they could be if we had a longer operating history.
 
 Our
amended and restated articles of incorporation and bylaws and California law,
contain provisions that could discourage a third party from making a takeover
offer that is beneficial to our shareholders.
 
 Anti-takeover
provisions of our amended and restated articles of incorporation, amended and
restated bylaws and California law may have the effect of deterring or delaying
attempts by our shareholders to remove or replace management, engage in proxy
contests and effect changes in control. The provisions of our charter documents
include:
 
 •
              a
      classified board so that only one of the three classes of directors on our
      Board of Directors is elected each year;•
              elimination
      of cumulative voting in the election of directors;•
              procedures
      for advance notification of shareholder nominations and
      proposals;•
              the
      ability of our Board of Directors to amend our bylaws without shareholder
      approval; and•
              the
      ability of our Board of Directors to issue up to 5,000,000 shares of
      preferred stock without shareholder approval upon the terms and conditions
      and with the rights, privileges and preferences as our Board of Directors
      may determine.
  In
addition, as a California corporation, we are subject to California law, which
includes provisions that may have the effect of deterring hostile takeovers or
delaying or preventing changes in control or management of our company.
Provisions of the California Corporations Code could make it more difficult for
a third party to acquire a majority of our outstanding voting stock by
discouraging a hostile bid, or delaying, preventing or deterring a merger,
acquisition or tender offer in which our shareholders could receive a premium
for their shares, or effect a proxy contest for control of NovaBay or other
changes in our management.
 
 22
 We
have not paid dividends in the past and do not expect to pay dividends in the
future, and any return on investment may be limited to the value of our
stock.
 
 We have
never paid cash dividends on our common stock and do not anticipate paying cash
dividends on our common stock in the foreseeable future. The payment of
dividends on our common stock will depend on our earnings, financial condition
and other business and economic factors affecting us at such time as our Board
of Directors may consider relevant. If we do not pay dividends, you will
experience a return on your investment in our shares only if our stock price
appreciates. We cannot assure you that you will receive a return on your
investment when you do sell your shares or that you will not lose the entire
amount of your investment.
 
 ITEM 1B.
              UNRESOLVED
      STAFF COMMENTS
 
 None.
 
 ITEM 2.
              PROPERTIES
 
 Our
principal executive offices and our research and development and administrative
operations are located in Emeryville, California. In total, we lease
approximately 18,100 square feet of office space in the facility pursuant to a
lease agreement expiring on October 31, 2015.
 
 ITEM 3.
              LEGAL
      PROCEEDINGS
 
 We are
currently not a party to, nor is our property the subject matter of, any pending
or, to our knowledge, contemplated material legal proceedings.  From
time to time, we may become party to litigation and subject to claims arising in
the ordinary course of our business.
 
 ITEM 4.
              (REMOVED
      AND RESERVED)
 
 
 23
 
 PART
II
 
 ITEM 5.
              MARKET
      FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER
      PURCHASES OF EQUITY SECURITIES
 
 Market
Information
 
 Since
October 25, 2007, our common stock has been listed on the NYSE Amex,
formerly American Stock Exchange, and the Toronto Stock Exchange (TSX) under the
symbol “NBY.” Prior to such time, there was no established public trading market
for our common stock.   On December 31, 2008, we notified the TSX
of our intent to voluntarily remove our listing of common stock from the TSX in
order to consolidate trading on the NYSE Amex. The following table sets forth,
for the periods indicated, the high and low sales prices for our common stock as
reported by the NYSE Amex:
  2009
                
                
                2008High
                
                
                Low
                
                
                High
                
                
                LowFirst
      Quarter
                
                
                2.95
                
                
                
                1.02
                
                
                
                2.41
                
                
                
                2.15Second
      Quarter
                
                
                3.24
                
                
                
                1.95
                
                
                
                2.10
                
                
                
                2.09Third
      Quarter
                
                
                2.57
                
                
                
                1.62
                
                
                
                1.70
                
                
                
                1.57Fourth
      Quarter
                
                
                2.39
                
                
                
                1.63
                
                
                
                1.14
                
                
                
                1.02
 
 On
March 19, 2010, the last reported sale price of our common stock on the
NYSE Amex was $2.08.
 
 Holders
 
 As of
March 19, 2010, there were approximately 304 holders of record of our
common stock. This figure does not reflect persons or entities that hold their
stock in nominee or “street” name through various brokerage firms.
 
 Dividend
Policy
 
 We have
not paid cash dividends on our common stock since our inception. We currently
expect to retain earnings primarily for use in the operation and expansion of
our business, and therefore, do not anticipate paying any cash dividends in the
near future. Any future determination to pay cash dividends will be at the
discretion of our Board of Directors and will be dependent upon our financial
condition, results of operations, capital requirements, restrictions under any
existing indebtedness and other factors the Board of Directors deems
relevant.
 
 24
 
 Performance
Graph(1)
 
 The
following graph compares our total stockholder returns for the past 26 months to
two indices: the Amex Composite Index and the RDG MicroCap Biotechnology Index.
The total return for each index assumes the reinvestment of all dividends, if
any, paid by companies included in these indices and are calculated as of
December 31 of each year.
 
 As a
member of the Amex Composite Index, we are required under applicable regulations
to use this index as a comparator, and we believe the RDG MicroCap Biotechnology
Index is a relevant comparator since it is composed of peer companies in
lines-of-business similar to ours.
 
 The
stockholder return shown on the graph below is not necessarily indicative of
future performance, and we do not make or endorse any predictions as to future
stockholder returns.
  
 (1) This
section is not “soliciting material,” is not deemed “filed” with the SEC and is
not to be incorporated by reference in any of our filings under the Securities
Act or the Exchange Act whether made before or after the date hereof and
irrespective of any general incorporation language in any such
filing.
  10/07
                
                
                
                12/07
                
                
                
                12/08
                
                
                
                12/09NovaBay
      Pharmaceuticals, Inc.
                
                
                100.00
                
                
                
                
                103.84
                
                
                
                
                28.18
                
                
                
                
                56.91NYSE
      Amex Composite
                
                
                100.00
                
                
                
                
                101.45
                
                
                
                
                61.54
                
                
                
                
                83.49RDG
      MicroCap Biotechnology
                
                
                100.00
                
                
                
                
                84.69
                
                
                
                
                39.20
                
                
                
                
                41.48
 
 25
 Purchases
of Equity Securities by the Issuer and Affiliated Purchaser
 
 We did
not repurchase any of our outstanding equity securities during the most recent
quarter covered by this report.
 
 Use
of Proceeds from Sales of Registered Securities
 
 On
October 24, 2007, a Registration Statement on Form S-1 (File. No. 333-140714)
relating to our initial public offering was declared effective by the SEC. The
closing was held October 31, 2007.   The net proceeds to us from
the offering were approximately $17.1 million.
 
 From the
effective date of the registration statement until December 31, 2009, we
estimate we had used the entire balance of our proceeds as follows: $12.0
million for research and development, $2.0 million for working capital and $3.1
million for other general purposes.
 
 The
amounts reflected above included expenditures for:  the Phase I and II
clinical development of NVC-422 in pre-surgical nasal
preparation;  pre-clinical, Phase I and initial Phase II studies of
NVC-422 in the prevention of catheter associated urinary tract
infections;  and pre-clinical studies to select among additional
indications to be taken into development.  These expenditures did not
represent a material change from the use of proceeds described in the prospectus
related to the offering.
 
 26
  ITEM
      6.
                SELECTED
      FINANCIAL DATA
 
 The
following selected financial information as of and for the dates and periods
indicated have been derived from our audited consolidated financial statements.
The information set forth below is not necessarily indicative of results of
future operations, and should be read in conjunction with “Management’s
Discussion and Analysis of Financial Condition and Results of Operation” in Part
II, Item 7 of this report and our consolidated financial statements and
related notes included elsewhere in this report.
 
 
 Year
      Ended December 31,2005
                
                
                2006
                
                
                2007
                
                
                2008
                
                
                2009(in
      thousands, except per share data)Statements
      of Operations Data:Revenue
                
                $
                -
                
                
                $
                1,533
                
                
                $
                5,913
                
                
                $
                6,722
                
                
                $
                15,684Operating
      expenses:Research
      and development
                
                
                1,952
                
                
                
                4,087
                
                
                
                7,421
                
                
                
                9,595
                
                
                
                7,337General
      and administrative
                
                
                1,617
                
                
                
                2,972
                
                
                
                4,368
                
                
                
                5,636
                
                
                
                5,607Total
      operating expenses
                
                
                3,569
                
                
                
                7,059
                
                
                
                11,789
                
                
                
                15,231
                
                
                
                12,944Other
      income (expense), net
                
                
                106
                
                
                
                240
                
                
                
                488
                
                
                
                397
                
                
                
                (36
                )Net
      income (loss) before income taxes
                
                
                (3,463
                )
                
                
                (5,286
                )
                
                
                (5,388
                )
                
                
                (8,112
                )
                
                
                2,704Provision
      for income taxes
                
                
                -
                
                
                
                -
                
                
                
                (12
                )
                
                
                (2
                )
                
                
                (7
                )Net
      income (loss) before income taxes
                
                $
                (3,463
                )
                
                $
                (5,286
                )
                
                $
                (5,400
                )
                
                $
                (8,114
                )
                
                $
                2,697Net
      income (loss) per share:Basic
                
                $
                (0.71
                )
                
                $
                (0.92
                )
                
                $
                (0.60
                )
                
                $
                (0.38
                )
                
                $
                0.12Diluted
                
                $
                (0.71
                )
                
                $
                (0.92
                )
                
                $
                (0.60
                )
                
                $
                (0.38
                )
                
                $
                0.12Shares
      used in per share calculations:Basic
                
                
                4,852
                
                
                
                5,715
                
                
                
                8,974
                
                
                
                21,312
                
                
                
                22,404Diluted
                
                
                4,852
                
                
                
                5,715
                
                
                
                8,974
                
                
                
                21,312
                
                
                
                23,115
 
  Year
      Ended December 31,2005
                
                
                2006
                
                
                2007
                
                
                2008
                
                
                2009(in
      thousands)Balance
      Sheet Data:Cash,
      cash equivalents and short-term investments
                
                $
                3,212
                
                
                $
                11,086
                
                
                $
                22,353
                
                
                $
                12,099
                
                
                $
                10,992Working
      capital
                
                
                2,985
                
                
                
                7,926
                
                
                
                18,194
                
                
                
                8,033
                
                
                
                11,568Total
      assets
                
                
                3,562
                
                
                
                11,866
                
                
                
                23,922
                
                
                
                13,969
                
                
                
                17,523Capital
      lease obligation—current and non-current
                
                
                -
                
                
                
                -
                
                
                
                86
                
                
                
                49
                
                
                
                7Equipment
      loan—current and non-current
                
                
                -
                
                
                
                -
                
                
                
                716
                
                
                
                836
                
                
                
                470Deferred
      revenue—current and non-current
                
                
                -
                
                
                
                9,167
                
                
                
                7,517
                
                
                
                4,167
                
                
                
                2,167Convertible
      notes payable
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                -Convertible
      preferred stock
                
                
                175
                
                
                
                192
                
                
                
                -
                
                
                
                -
                
                
                
                -Common
      stock and additional paid-in capital
                
                
                10,869
                
                
                
                14,683
                
                
                
                32,797
                
                
                
                33,933
                
                
                
                37,236Total
      stockholders’ equity
                
                
                3,252
                
                
                
                1,813
                
                
                
                14,320
                
                
                
                7,345
                
                
                
                13,345
 
 27
  ITEM 7.
                MANAGEMENT’S
      DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
      OPERATIONS
 
 The
following discussion of our financial condition and results of operations should
be read together with our consolidated financial statements and related notes
included in Part II, Item 8 of this report. This discussion contains
forward-looking statements that involve risks and uncertainties. As a result of
many factors, such as those set forth under the section entitled “Risk Factors”
in Item 1A and elsewhere in this report, our actual results may differ
materially from those anticipated in these forward-looking
statements.
 
 Overview
 
 We are
clinical stage specialty pharmaceutical company engaged in the discovery and
development of innovative product candidates for the treatment or prevention of
a wide range of non-systemic infections in hospital and non-hospital
environments. Many of these infections have become increasingly difficult to
treat because of the rapid rise in drug resistance. We have discovered and are
developing a class of non-antibiotic anti-infective compounds, which we have
named Aganocide compounds. These compounds are based upon small molecules that
are naturally generated by white blood cells when defending the body against
invading pathogens. We believe that our Aganocide compounds could form a
platform on which to create a variety of products to address differing needs in
the treatment and prevention of bacterial and viral infections. In laboratory
testing, our Aganocide compounds have demonstrated the ability to destroy all
bacteria against which they have been tested. Furthermore, because of their
mechanism of action, we believe that bacteria are unlikely to develop resistance
to our Aganocide compounds.
 
 In August
2006, we entered into a collaboration and license agreement with Alcon
Manufacturing Ltd. (“Alcon”),, to license to Alcon the exclusive rights to
develop, manufacture and commercialize products incorporating the Aganocide
compounds for application in connection with the eye, ear and sinus and for use
in contact lens care. Under the terms of the agreement, Alcon paid an up-front,
non-refundable, non-creditable technology access fee of $10.0 million upon the
effective date of the agreement. In addition to the technology access fee, we
are entitled to receive semi-annual payments from Alcon to support on-going
research and development activities over the four year funding term of the
agreement. The research and development support payments include amounts to fund
a specified number of personnel engaged in collaboration activities and to
reimburse for qualified equipment, materials and contract study costs. As
product candidates are developed and proceed through clinical trials and
approval, we will receive milestone payments. If the products are
commercialized, we will also receive royalties on any sales of products
containing the Aganocide compounds. Alcon has the right to terminate the
agreement in its entirety upon nine months’ notice, or terminate portions of the
agreement upon 135 days’ notice, subject to certain provisions. Both parties
have the right to terminate the agreement for breach upon 60 days’ notice. In
addition, NovaBay retains the rights to market, via a third-party co-marketing
partner, any products developed for ear or sinus indications in the major Asian
markets, including Japan, China, India and South Korea. NovaBay has also
retained such rights in other markets where Alcon is not committing reasonably
sufficient sales and marketing resources to the particular product. In each
instance, the appointment of the co-marketing partner would be subject to
certain conditions, including that the co-marketing partner be approved by
Alcon. The co-marketing partner, or NovaBay on its behalf, would be required to
pay Alcon a royalty based on net sales of the product in the applicable market
and would also be required to reimburse Alcon for part of its local development
costs or, in markets in which Alcon is not committing reasonably sufficient
sales and marketing resources, all of its local development costs. These
products may also be marketed in those markets by Alcon, its affiliates or
distributors.
 
 Alcon is
responsible for all of the costs that it incurs in developing the products using
the Aganocide compounds.  We recently announced that Alcon has
increased its on-going financial support of the company’s research and
development efforts by more than $2 million per year. The additional funding is
expected to enhance NovaBay’s pre-clinical and clinical development programs in
the areas of eye, ear and sinus infections, as well as contact lens
solutions.  Alcon is conducting Phase II trials of NovaBay’s lead
compound, NVC-422, for the treatment of viral conjunctivitis, a type of “Pink
Eye”. The viral conjunctivitis trials are under way at 30 medical centers around
the U.S. and expect to enroll approximately 250
patients.    The achievement of the milestones and product
commercialization is subject to many risks and uncertainties, including, but not
limited to Alcon’s ability to obtain regulatory approval from the FDA and
Alcon’s ability to execute its clinical initiatives. Therefore, we cannot
predict when, if ever, the milestones specified in the Alcon agreement will be
achieved or when we will receive royalties on sales of commercialized
product.
 
 On March
25, 2009, we announced that we entered into an agreement with Galderma S.A. to
develop and commercialize our Aganocide compounds, which covers acne and
impetigo and potentially other major dermatological conditions, excluding
onychomycosis (nail fungus) and orphan drug indications.  We amended
this agreement in December 2009.  The agreement is exclusive and
worldwide in scope, with the exception of Asian markets and North
America.  In Asian markets we have commercialization
rights.  In North America we have an option to exercise co-promotion
rights.
 
 Galderma
will be responsible for the development costs of the acne and other indications
with two  exceptions.  First, in Japan Galderma has the
option to request that we share such development costs.  Second, at
this time we are supporting the  ongoing development program for
impetigo; however, upon the achievement of a specified milestone, Galderma will
reimburse NovaBay for associated expenses.  NovaBay retains the right
to co-market products resulting from the agreement in Japan.  In
addition, NovaBay has retained all rights in other Asian markets outside Japan,
and has the right to co-promote the products developed under the agreement in
the hospital and other healthcare institutions in North America.
 
 28
 Galderma
paid to NovaBay certain upfront fees at the inception of the contract and will
continue to pay ongoing fees, reimbursements, and milestone payments related to
achieving development and commercialization of its Aganocide compounds. If
products are commercialized under the agreement, NovaBay's royalties will
escalate as sales increase. Upon the termination of the agreement under certain
circumstances, Galderma will grant NovaBay certain technology licenses which
would require NovaBay to make royalty payments to Galderma for such licenses
with royalty rates in the low- to mid-single digits.
 
 We
recently announced that we received $3.75 million in milestone payments from
Galderma; a $2.0 million milestone payment having been triggered by the
completion of formulation feasibility studies with our Aganocide compound for
topical use, and a $1.75 million milestone payment was for completing an
exploratory clinical study for the treatment of adult acne.  These
milestones were reached in 2009 and therefore the revenue was recorded in 2009
and the related receivable is included in our balance sheet as of December 31,
2009; we received payment on these receivables in January 2010.
 
 Our
business model is to develop our Aganocide compounds and enter into
collaboration and license agreements with other entities for different
indications using our Aganocide compounds.  For example, in June 2007,
we entered into a license agreement with KCI, under which KCI paid to us a
non-refundable technology access fee of $200,000. The agreement was terminated
in November 2009.  If products covered by the license had been
commercially launched, we would also have received royalty payments based on net
revenues from sales by KCI of such products. We did not receive any milestone or
other payments under this agreement since the initial technology access
fee.
 
 To date,
we have generated no revenue from product sales, and we have financed our
operations and internal growth primarily through the sale of our capital stock,
and the fees received from Alcon and Galderma. We are a development stage
company and have incurred significant losses since commencement of our
operations in July 2002, as we have devoted substantially all of our resources
to research and development. As of December 31, 2009, we had an accumulated
deficit of $23.9 million. Our accumulated deficit resulted from research and
development expenses and general and administrative expenses. Although we were
profitable in 2009, we expect to incur net losses over the next several years as
we continue our clinical and research and development activities and as we apply
for patents and regulatory approvals.
 
 Significant
Events in 2009 and 2010
 
 In
January 2009, the FDA accepted the Investigational New Drug application (IND)
submitted by Alcon to permit the clinical development of our NVC-422 for
infections of the eye. The IND clearance triggered the immediate payment of the
first milestone of $1.0 million from Alcon.
 
 On
January 9, 2009, we announced that the United States Patent and Trademark Office
has approved the issuance of a patent for novel Aganocide compounds, including
our current lead compound, NVC-422.
 
 On March
7, 2009, we announced preclinical animal data showing that NVC-422, our lead
Aganocide compound, is effective in treating topical fungal
infections.
 
 On March
25, 2009, we announced that it has entered into an agreement with Galderma S.A.
to develop and commercialize our novel proprietary Aganocide compounds. We
amended this agreement in December 2009.  The exclusive agreement is
worldwide in scope, except in certain Asian markets, where we have
commercialization rights, and North America, where we have an option to exercise
co-promotion rights, and covers acne and impetigo and potentially other major
dermatological conditions, excluding onychomycosis (nail fungus) and orphan drug
indications.
 
 On April
22, 2009 we announced an exclusive agreement with Professors Markus Nagl M.D.
and Waldemar Gottardi, Ph.D. of the Medical University of Innsbruck, Austria.
The agreement was entered into to advance the development of NovaBay’s
Aganocide®
compounds by integrating extensive and on-going clinical work at the university
with NovaBay’s development program.
 
 On August
26, 2009, we closed a registered direct offering of 1,225,000 units, with each
unit consisting of (i) one share of the NovaBay common stock, par value $0.01
per share, and (ii) one warrant to purchase one share of NovaBay common stock.
The purchase price for each unit was $2.00. Each warrant has an exercise price
of $2.75 and will expire five years from the date of issuance. Neither the units
nor warrants trade on any exchange or are listed for quotation on any
market.
 
 In
July 2009, we announced that Alcon has begun treating patients in a Phase II
clinical trial of NovaBay’s patented lead Aganocide compound, NVC-422, for viral
conjunctivitis, a type of “pink eye.”
 
 In
September 2009, we announced that we initiated our Phase IIa proof-of-concept
study for the treatment of impetigo.
 
 In
October 2009, we announced that our Aganocides show penetration and efficacy in
a pre-clinical infected human nail model of Onychomycosis. This data was
presented at the 47th Annual Meeting of the Infectious Diseases Society of
America (IDSA) in Philadelphia.
 
 29
 In
December 2009, we announced that Alcon has increased its on-going financial
support of the company’s research and development efforts by more than $2
million per year. The additional funding is expected to enhance NovaBay’s
pre-clinical and clinical development programs in the areas of eye, ear and
sinus infections, as well as contact lens solutions.
 
 In
January 2010, we announced that we received $3.75 million in milestone payments
from Galderma, a $2 million milestone payment having been triggered by the
completion of formulation feasibility studies with our Aganocide compounds for
topical use and a $1.75 million milestone payment for completing an exploratory
clinical study for the treatment of adult acne.  Both of these studies
were concluded in 2009 and the resulting revenues were recorded in our 2009
results.
 
 Critical
Accounting Policies and Estimates
 
 Our
financial statements have been prepared in accordance with accounting principles
generally accepted in the United States (US GAAP). The preparation of these
financial statements requires us to make estimates, assumptions and judgments
that affect the reported amounts of assets and liabilities and the disclosure of
contingent assets and liabilities at the date of the financial statements as
well as the reported revenues and expenses during the reporting periods.
In preparing these financial statements, management has made its best
estimates and judgments of certain amounts included in the financial statements
giving due consideration to materiality. On an ongoing basis, we evaluate our
estimates and judgments related to revenue recognition, research and development
costs, patent costs, stock-based compensation, income taxes and other
contingencies. We base our estimates on historical experience and on various
other factors that we believe are reasonable under the circumstances, the
results of which form the basis for making judgments about the carrying value of
assets and liabilities that are not readily apparent from other sources. Actual
results may differ from these estimates under different assumptions or
conditions.
 
 While our
significant accounting policies are more fully described in Note 2 of the Notes
to Consolidated Financial Statements, included in Part II, Item 8 of this
report, we believe that the following accounting policies are most critical to
fully understanding and evaluating our reported financial results.
 
 Revenue
Recognition
 
 License
and collaboration revenue is primarily generated through agreements with
strategic partners for the development and commercialization of our product
candidates. The terms of the agreements typically include non-refundable upfront
fees, funding of research and development activities, payments based upon
achievement of certain milestones and royalties on net product sales. In
accordance with authoritative guidance, we analyze our multiple element
arrangements to determine whether the elements can be separated. We perform our
analysis at the inception of the arrangement and as each product or service is
delivered. If a product or service is not separable, the combined deliverables
are accounted for as a single unit of accounting and recognized over the
performance obligation period.  Revenue is recognized when the
following criteria have been met: persuasive evidence of an arrangement exists;
delivery has occurred and risk of loss has passed; the seller’s price to the
buyer is fixed or determinable; and collectibility is reasonably
assured.  If these factors were to vary the resulting change could
have a material effect on our revenue recognition and on our results of
operations.
 
 Assuming
the elements meet the revenue recognition guidelines, the revenue recognition
methodology prescribed for each unit of accounting is summarized
below:
 
 Upfront Fees—We defer
recognition of non-refundable upfront fees if we have continuing performance
obligations without which the technology licensed has no utility to the
licensee. If we have continuing involvement through research and development
services that are required because our know-how and expertise related to the
technology is proprietary to us, or can only be performed by us, then such
up-front fees are deferred and recognized over the estimated period of
continuing involvement.  We base the estimate of the period of
continuing involvement on factors in the contract.  Actual time frames
could vary and could result in material changes to our results of
operations.
 
 Funded Research and
Development—Revenue from research and development services is recognized
during the period in which the services are performed and is based upon the
number of full-time-equivalent personnel working on the specific project at the
agreed-upon rate. The full-time equivalent amount can vary each year if the
contracts allow for a percentage increase determined by relevant salary surveys,
if applicable. Reimbursements from collaborative partners for agreed upon direct
costs including direct materials and outsourced, or subcontracted, pre-clinical
studies are classified as revenue and recognized in the period the reimbursable
expenses are incurred. Payments received in advance are recorded as deferred
revenue until the research and development services are performed or costs are
incurred.
 
 Milestones—Substantive
milestone payments are considered to be performance bonuses that are recognized
upon achievement of the milestone only if all of the following conditions are
met: the milestone payments are non-refundable; achievement of the milestone
involves a degree of risk and was not reasonably assured at the inception of the
arrangement; substantive effort is involved in achieving the milestone; the
amount of the milestone is reasonable in relation to the effort expended or the
risk associated with achievement of the milestone; and a reasonable amount of
time passes between the up-front license payment and the first
milestone payment as well as between each subsequent milestone payment. If
any of these conditions are not met, the milestone payments are deferred and
recognized as revenue over the term of the arrangement as we complete our
performance obligations.
 
 30
 Royalties—We recognize
royalty revenues from licensed products upon the sale of the related
products.
 
 Research
and Development Costs
 
 We charge
research and development costs to expense as incurred. These costs include
salaries and benefits for research and development personnel, costs associated
with clinical trials managed by contract research organizations, and other costs
associated with research, development and regulatory activities.  Research
and development costs may vary depending on the type of item or service
incurred, location of performance or production, or lack of availability of the
item or service, and specificity required in production for certain
compounds.  We use external service providers to conduct clinical trials,
to manufacture supplies of product candidates and to provide various other
research and development-related products and services.  Our on-going
research, clinical and development activities are often performed under
agreements we enter into with external service providers.  We accrue the
costs incurred under these agreements based on factors such as milestones
achieved, patient enrollment, estimates of work performed, and historical data
for similar arrangements.  As actual costs are incurred we will adjust our
accruals.  Historically, our accruals have been consistent with
management’s estimates, and no material adjustments to research and development
expenses have been recognized.  Subsequent changes in estimates may result
in a material change in our expenses, which could also materially affect our
results of operations.
 
 Patent
Costs
 
 We
expense patent costs, including legal expenses, in the period in which they are
incurred. Patent expenses are included as general and administrative expenses in
our statements of operations. Patent costs may vary depending on the location,
domestic or foreign, in which the patent is being secured.
 
 Stock-Based
Compensation
 
 Stock-based
compensation expense is measured at the grant date for all stock-based awards to
employees and directors and is recognized as expense over the requisite service
period, which is generally the vesting period. Forfeitures are estimated at the
time of grant and reduce compensation expense ratably over the vesting period.
This estimate is adjusted periodically based on the extent to which actual
forfeitures differ, or are expected to differ, from the previous
estimate.  See Note 10 for further information regarding stock-based
compensation expense and the assumptions used in estimating that expense. For
stock options granted to employees, the fair value of the stock options is
estimated using a Black-Scholes-Merton valuation model.
 
 Stock
compensation arrangements with non-employees are recorded at their fair value on
the measurement date. The measurement of stock-based compensation is subject to
periodic adjustment as the underlying equity instruments vest. Non-employee
stock-based compensation charges are amortized over the vesting period on a
straight-line basis. For stock options granted to non-employees, the fair value
of the stock options is estimated using a Black-Scholes-Merton valuation
model.
 
 Income
Taxes
 
 We
account for income taxes under the asset and liability method. Deferred tax
assets and liabilities are recognized for the future tax consequences
attributable to differences between the financial statement carrying amounts of
existing assets and liabilities and their respective tax bases and operating
loss and tax credit carryforwards. Deferred tax assets and liabilities are
measured using enacted tax rates expected to apply to taxable income in the
years in which those temporary differences are expected to be recovered or
settled. The effect on deferred tax assets and liabilities of a change in tax
rates is recognized in income in the period that includes the enactment date. A
valuation allowance is recognized if it is more likely than not that some
portion or all of the deferred tax asset will not be
recognized.  Valuation allowances are based, in part, on estimates
that management must make as to our results in future periods. The actual
outcome may not be consistent with our estimate, which would require that we
make changes in our valuation allowance.
 
 Recent
Accounting Pronouncements
 
 During
the third quarter of 2009, we adopted the FASB Accounting Standards Codification
and the Hierarchy of Generally Accepted Accounting Principles in accordance with
FASB ASC Topic 105,”Generally Accepted Accounting Principles”(the
Codification).  The Codification has become the source of
authoritative U.S. generally accepted accounting principles (GAAP) recognized by
the FASB to be applied by nongovernmental entities.  Rules and
interpretive releases of the Securities and Exchange Commission (SEC) under
authority of federal securities laws are also sources of authoritative GAAP for
SEC registrants.  Effective with our adoption on July 1, 2009, the
Codification has superseded all prior non-SEC accounting and reporting
standards.  All other non-grandfathered non-SEC accounting literature
not included in the Codification has become non-authoritative.  As the
adoption of the Codification only affected how specific references to GAAP
literature have been disclosed in the notes to our condensed consolidated
financial statements, it did not result in any impact on our results of
operations, financial condition, or cash flows.
 
 31
 In
September 2009, the FASB issued authoritative guidance regarding
multiple-deliverable revenue arrangements.  This guidance addresses
how to separate deliverables and how to measure and allocate consideration to
one or more units of accounting.  Specifically, the guidance requires
that consideration be allocated among multiple deliverables based on relative
selling prices.  The guidance establishes a selling price hierarchy of
(1) vendor-specific objective evidence, (2) third-party evidence and (3)
estimated selling price.  This guidance is effective for annual
periods beginning after June 15, 2010 but may be early adopted as of the
beginning of an annual period.  We are currently evaluating the effect
that this guidance will have on our consolidated financial position and results
of operations.
 
 ASC
855-10-20, “Subsequent Events” establishes accounting and reporting standards
for events that occur after the balance sheet date but before financial
statements are issued or are available to be issued and requires the disclosure
of the date through which a company has evaluated subsequent
events.  This statement was effective for our third quarter ended
September 30, 2009 and the adoption did not have an impact on our condensed
consolidated financial statements.  See Note 13 for the required
disclosures.
 
 In April
2009, the FASB issued ASC 820-10-65 formerly FASB Staff Position FAS 157-4,
“Determining Fair Value When the Volume and Level of Activity for the Asset or
Liability Have Significantly Decreased and Identifying Transactions That Are Not
Orderly” (“FSP 157-4”). This provides significant guidance for determining
when a market has become inactive as well as guidance for determining whether
transactions are not orderly. It also provides guidance on the use of valuation
techniques and the use of broker quotes and pricing services. It reiterates that
fair value is based on an exit price and also that fair value is market-driven
and not entity-specific. The accounting standard of codification applies to
all assets and liabilities within the scope of ASC 820 and is effective for all
interim and annual periods ending after June 15, 2009. The adoption of ASC
820-10-65 did not have a material effect on our results of operations, financial
position, and cash flows.
 
 In April
2009, the FASB issued ASC 320-10-65, formerly FASB Staff Position FAS 115-2, FAS
124-2 and EITF 99-20-2, “Recognition and Presentation of Other-Than-Temporary
Impairments” (“FSP 115-2”). This accounting standard provides guidance related
to determining the amount of an other-than-temporary impairment (OTTI) of debt
securities and prescribes the method to be used to present information about an
OTTI in the financial statements.  It is effective for all interim and
annual periods ending after June 15, 2009. The adoption of ASC 320-10-65 did not
have a material effect on our results of operations, financial position, and
cash flows.
 
 In April
2009, the FASB issued ASC 825-10-65, formerly FASB Staff Position FAS 107-1 and
APB 28-1, “Interim Disclosures about Fair Value of Financial Instruments” (“FSP
107-1”), which increases the frequency of fair value disclosures to a quarterly
basis instead of an annual basis. The guidance relates to fair value disclosures
for any financial instruments that are not currently reflected on the balance
sheet at fair value. This ASC is effective for interim and annual periods ending
after June 15, 2009. The adoption of ASC 825-10-65 did not have a material
effect on our results of operations, financial position, and cash
flows.
 
 Results
of Operations
 
 Comparison
of Years Ended December 31, 2009, 2008 and 2007
 
 License
and Collaboration Revenue
 
 Total
license and collaboration revenue was $15.7 million for the year ended December
31, 2009, compared to $6.7 million for the year ended December 31, 2008, and
$5.9 million for the year ended December 31, 2007.
 
 On March
25, 2009, we entered into the agreement with Galderma.  Under the
terms of this agreement Galderma will pay to NovaBay certain upfront fees,
ongoing fees, reimbursements, and milestone payments related to achieving
development and commercialization of its Aganocide compounds.  We
received an upfront technology access fee from Galderma of $1 million,
which  is being amortized into revenue over the term of the
contract.  During 2009, $0.5 million of the upfront technology access
fee was recognized.  We also recognized $1.2 million in ongoing
research and development fees and $4.8 million in materials, equipment and
contract study costs, which includes the $3.75 million milestone payment from
Galderma earned in December 2009.
  In August
2006, we entered into the collaboration and license agreement with
Alcon.   The upfront technology access fee of $10.0 million from
Alcon is being amortized into revenue on a straight-line basis over the
four year funding term of the agreement, through August 2010.  During
2009, $2.5 million of the upfront technology access fee was
recognized.  We also recognized $5.3 million in ongoing research and
development fees and $1.3 million in materials, equipment and contract study
costs.  During 2008, $2.5 million of the upfront technology access fee
was recognized, and we recognized $2.7 million in ongoing research and
development fees and $1.4 million in materials, equipment and contract study
costs.    During 2007, $2.5 million of the upfront
technology access fee was recognized, and we recognized $2.7 million in ongoing
research and development fees and $611,000  in materials, equipment
and contract study costs.
 
 32
 Research
and Development
 
 Total
research and development expenses decreased by 24% to $7.3 million for the year
ended December 31, 2009 from $9.6 million for the year ended December 31,
2008.  This decrease was primarily due to the following:
 
 -
                  a
      decrease in clinical costs of $1.7 million resulting from lower costs
      related to our trials in
2009;
 -
                a
      decrease in employee costs of $0.5 million resulting from staffing cuts in
      late 2008; and
 -
                a
      decrease of $0.3 million in development costs due to reduced process
      development activites;
 
 These
decreases were partially offset by an increase in professional fees of $0.2
million and an increase of $0.1 million in research costs due to additional
contract study costs.
 
 Total
research and development expenses increased by 29% to $9.6 million for the year
ended December 31, 2008 from $7.4 million for the year ended December 31, 2007.
This increase was due in part to an increase in related employee costs
of $0.5 million, as the average number of research and development personnel
increased for most of 2008.  In addition, research expenses increased
by 26% to $0.6 million as a result of  increased contract studies in
bio-sciences and discovery research, and an increase in related lab services and
supplies, and development expenses increased by 92% to $1.4 million, mainly due
to an increase in process development, method development, and formulation
studies. In addition, $0.7 million of overhead expenses were allocated to
research and development.
 
 We expect
to incur increasing research and development expenses in 2010 and in subsequent
years as we continue to increase our focus on developing product candidates,
both independently and in collaboration with Alcon and Galderma. In particular,
we expect to incur ongoing clinical, chemistry, and manufacturing expenses
during 2010 in connection with the common cold, dermatology, and catheter
associated urinary tract infections programs.
 
 General
and Administrative
 
 General
and administrative expenses in 2009 and 2008 were $5.6 million, compared to $4.4
million for the year ended December 31, 2007. This increase from 2007 was due in
part to an increase in employee costs of 53%, to $2.5 million. The increase in
employee costs was mainly due to a 53% increase in salaries and wages to $1.4
million and related increases in other employee benefits and recruiting
expenses, due primarily to increased headcount.
 
 We expect
that general and administrative expenses will increase during 2010 and in
subsequent years due to increasing public company expenses and business
development costs and our expanding operational infrastructure. In particular,
we expect to incur increasing legal, accounting, investor relations, equity
administration and insurance costs in order to continue operations as a public
company.
 
 Other
Income(expense), Net
 
 Other
income (expense), net decreased to an expense of $36,000 for the year ended
December 31, 2009 from an income of $397,000 for the year ended December
31, 2008 and an income of $488,000 for the year ended December 31, 2007.
The decrease in 2009 was primarily attributable to decreased interest income
related to decreased average investment balances and decreased interest rates
throughout the year.  Interest income relates primarily to interest
earned on cash, cash equivalents and investments in marketable
securities.
 
 The
decrease in 2008 was primarily attributable to increased interest expense
related to borrowings secured by capital equipment, due to paying interest for
the full year instead of a partial year. The 2008 decrease was also attributed
to increased finance and service charges related to increased borrowings on the
line of credit secured by the capital equipment loan.
 
 We expect
that other income, net will vary based on fluctuations in our cash balances and
borrowings under equipment loans and the interest rate paid on such balances and
borrowings.
 
 Liquidity
and Capital Resources
 
 We have
incurred cumulative net losses of $23.9 million since inception through December
31, 2009. We do not expect to generate significant revenue from product
candidates for several years. Since inception, we have funded our operations
primarily through the private placement of our preferred stock. We raised total
net proceeds of $12.6 million from sales of our preferred stock in 2002 through
2006. In October 2007, we completed our IPO in which we raised a total of $20.0
million, or approximately $17.1 million in net cash proceeds after deducting
underwriting discounts and commissions of $1.4 million and other offering costs
of $1.5 million.  In August 2009, we completed a registered direct
offering and had net proceeds of $1.9 million.
  In August
2006, we entered into a collaboration and license agreement with Alcon. Under
the terms of this agreement, we received an up-front technology access fee of
$10.0 million in September 2006. Additionally, we are entitled to receive
semi-annual payments each January and July over the four year term of the
agreement to support on-going research and development efforts. In both January
and July 2007, we received a payment of $1.4 million to support the performance
of research and development activities throughout 2007. The Alcon agreement also
provides for milestone payments upon the achievement of specified milestones in
each field of use and royalty payments upon the sale of commercialized products.
The aggregate milestone payments payable in connection with the ophthalmic, otic
and sinus fields are $19 million, $12 million and $39 million, respectively. As
of December 31, 2009, we have achieved our first milestone under this
agreement, but product has not been commercialized to date. The achievement of
the milestones and product commercialization is subject to many risks and
uncertainties, including, but not limited to Alcon’s ability to obtain
regulatory approval from the FDA and Alcon’s ability to execute its clinical
initiatives. Therefore, we cannot predict when, if ever, the remaining
milestones specified in the Alcon agreement will be achieved or when we will
receive royalties on sales of commercialized products.
 
 33
 During
April 2007, we entered into a master security agreement to establish a $1.0
million equipment loan facility with a financial institution. The purpose of the
loan is to finance equipment purchases, principally in the build-out of our
laboratory facilities. Borrowings under the loan are secured by eligible
equipment purchased from January 2006 through April 2008 and will be repaid over
40 months at an interest rate equal to the greater of 5.94% over the three year
Treasury rate in effect at the time of funding or 10.45%. There are no loan
covenants specified in the agreement. As of December 31, 2009, we had an
outstanding equipment loan balance of $470,000 carrying a weighted-average
interest rate of 10.99%. The principal and interest due under the loan will be
repaid in equal monthly installments through April 2011. As of December 31,
2009 there was $216,000 available for borrowing under this equipment loan
facility.
 
 In March
2009, we entered into a license agreement with Galderma.  We amended
this agreement in December 2009.  Under the terms of the agreement, we
received an initial upfront payment.   In addition, in December
2009, we recorded revenues of $3.75 million related to milestones from Galderma
S.A.  These milestones consist of $2 million having been triggered by
the completion of formulation feasibility studies with our Aganocide compounds
for topical use and $1.75 million was for completing an exploratory clinical
study for the treatment of adult acne.   In addition, Galderma
will pay to NovaBay certain upfront fees, ongoing fees, reimbursements, and
additional milestone payments related to achieving development and
commercialization of its Aganocide compounds
 
 Cash
and Cash Equivalents
 
 As of
December 31, 2009, we had cash, cash equivalents, and short-term investments of
$11.3 million compared to $12.1 million and $22.4 million at December 31, 2008
and 2007, respectively.
 
 Cash
Used in Operating Activities
 
 For the
years ended December 31, 2009 and 2008, cash used in operating activities
of $1.6 million and $9.9 million, respectively, was primarily attributable to
our research and development and general administrative expenses in running our
company.  The decrease in 2009 of cash used in operating activities is
primarily due to our decreases in research and development expenses as discussed
above, and to our collection of ongoing research and development fees from Alcon
and the addition of the Galderma contract in 2009.
 
 For the
year ended December 31, 2007, cash used in operating activities of $6.3
million, was primarily attributable to our research and development and general
administrative expenses in running our company, and lack of any meaningful cash
inflow, as the revenue we recognized was primarily related to amortization of
the $10.0 million upfront technology access fee received from Alcon in
2006.
 
 Cash  Provided
by (Used in) Investing Activities
 
 For the
year ended December 31, 2009, cash used by investing activities of $1.1
million was attributable to purchases of short-term investments (net of sales)
of $340,000 and purchases of property and equipment of $731,000.
 
 For the
year ended December 31, 2008, cash provided by investing activities of
$10.9 million was attributable to sales of short-term investments (net of
purchases) of $11.5 million and purchases of property and equipment of
$610,000.
 
 For the
year ended December 31, 2007, cash used in investing activities of $5.7
million was attributable to purchases of short-term investments (net of
maturities or sales) of $5.0 million and purchases of property and equipment of
$663,000.
 
 Cash
Provided by Financing Activities
 
 Net cash
provided by financing activities of $1.6 million for the year ended
December 31, 2009 was primarily attributable to the $1.9 million received
through our shelf offering, partially offset by principle payments on our
equipment loan.
 
 Net cash
provided by financing activities of $236,000 for the year ended
December 31, 2008 was primarily attributable to the $422,000 increase in
proceeds from borrowings under our equipment loan, net of payments on the
outstanding balance.
 
 Net cash
provided by financing activities of $18.0 million for the year ended
December 31, 2007 was primarily attributable to the net proceeds of $17.1
million received upon the close of the IPO and $794,000 in proceeds from
borrowings under our equipment loan.
 
 34
 Quarterly
Results of Operations
 
 The
following table presents unaudited quarterly results of operations for the eight
most recent quarters ending with the quarter ended December 31, 2009. This
information has been derived from our unaudited financial statements and has
been prepared by us on a basis consistent with our audited annual financial
statements and includes all adjustments, consisting only of normal recurring
adjustments, which management considers necessary for a fair presentation of the
information for the periods presented.
 
 Quarter
      EndedMarch
      31,
                
                
                June
      30,
                
                
                Sept.
      30,
                
                
                Dec.
      31,
                
                
                March
      31,
                
                
                June
      30,
                
                
                Sept.
      30,
                
                
                Dec.
      31,2008
                
                
                2008
                
                
                2008
                
                
                2008
                
                
                2009
                
                
                2009
                
                
                2009
                
                
                2009(in
      thousands, except per share data)Statements
      ofOperations
      Data:Revenue
                
                $
                1,492
                
                
                $
                1,442
                
                
                $
                1,592
                
                
                $
                2,196
                
                
                $
                2,611
                
                
                $
                2,357
                
                
                $
                3,224
                
                
                $
                7,492Operating
      expenses:Research
      anddevelopment
                
                
                2,762
                
                
                
                2,307
                
                
                
                1,599
                
                
                
                2,927
                
                
                
                1,361
                
                
                
                1,444
                
                
                
                2,004
                
                
                
                2,528General
      andadministrative
                
                
                1,569
                
                
                
                1,640
                
                
                
                1,559
                
                
                
                868
                
                
                
                1,579
                
                
                
                1,191
                
                
                
                1,309
                
                
                
                1,528Total
      operatingexpenses
                
                
                4,331
                
                
                
                3,947
                
                
                
                3,158
                
                
                
                3,795
                
                
                
                2,940
                
                
                
                2,635
                
                
                
                3,313
                
                
                
                4,056Other
      income(expense),
      net
                
                
                163
                
                
                
                94
                
                
                
                77
                
                
                
                63
                
                
                
                11
                
                
                
                (11
                )
                
                
                (22
                )
                
                
                (14
                )Net
      income (loss)before
      income taxes
                
                
                (2,676
                )
                
                
                (2,411
                )
                
                
                (1,489
                )
                
                
                (1,536
                )
                
                
                (318
                )
                
                
                (289
                )
                
                
                (111
                )
                
                
                3,422Provision
      for incometaxes
                
                
                (2
                )
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                (7
                )Net
      income (loss)after
      income taxes
                
                $
                (2,678
                )
                
                $
                (2,411
                )
                
                $
                (1,489
                )
                
                $
                (1,536
                )
                
                $
                (318
                )
                
                $
                (289
                )
                
                $
                (111
                )
                
                $
                3,415Net
      income (loss)per
      share:Basic
                
                $
                (0.13
                )
                
                $
                (0.11
                )
                
                $
                (0.07
                )
                
                $
                (0.07
                )
                
                $
                (0.01
                )
                
                $
                (0.01
                )
                
                $
                (0.00
                )
                
                $
                0.15Diluted
                
                $
                (0.13
                )
                
                $
                (0.11
                )
                
                $
                (0.07
                )
                
                $
                (0.07
                )
                
                $
                (0.01
                )
                
                $
                (0.01
                )
                
                $
                (0.00
                )
                
                $
                0.14Shares
      used in pershare
      calculations:Basic
                
                
                21,288
                
                
                
                21,334
                
                
                
                21,443
                
                
                
                21,469
                
                
                
                21,620
                
                
                
                21,931
                
                
                
                23,251
                
                
                
                23,253Diluted
                
                
                21,288
                
                
                
                21,334
                
                
                
                21,443
                
                
                
                21,469
                
                
                
                21,620
                
                
                
                21,931
                
                
                
                23,251
                
                
                
                23,935
  Net
Operating Losses and Tax Credit Carryforwards
 
 As of
December 31, 2009 we had net operating loss carryforwards for both federal and
state income tax purposes of $20 million. If not utilized, the federal and state
net operating loss carryforwards will begin expiring at various dates between
2016 and 2029.
 
 Current
federal and California tax laws include substantial restrictions on the
utilization of net operating loss carryforwards in the event of an ownership
change of a corporation. Accordingly, our ability to utilize net operating loss
carryforwards may be limited as a result of such ownership changes. Such a
limitation could result in the expiration of carryforwards before they are
utilized
 
 Inflation
 
 We do not
believe that inflation has had a material impact on our business and operating
results during the periods presented, and we do not expect it to have a material
impact in the near future. There can be no assurances, however, that our
business will not be affected by inflation.
 
 Off-Balance
Sheet Arrangements
 
 We have
no off-balance sheet arrangements.
 
 35
 Contractual
Obligations
 
 Our
contractual cash commitments as of December 31, 2009 were as follows (in
thousands):
 
 Contractual
      Obligations
                
                Total
                
                
                Less
      Than 1year
                
                
                1
      - 3 Years
                
                
                3
      - 5 Years
                
                
                More
      Than 5 YearsOperating
      leases
                
                $
                5,410
                
                
                $
                901
                
                
                $
                1,914
                
                
                $
                2,007
                
                
                $
                588Captial
      lease
                
                
                7
                
                
                
                7
                
                
                
                -
                
                
                
                -
                
                
                
                -Equipment
      loan
                
                
                505
                
                
                
                396
                
                
                
                109
                
                
                
                -
                
                
                
                -$
                5,922
                
                
                $
                1,304
                
                
                $
                2,023
                
                
                $
                2,007
                
                
                $
                588
  Our
commitments under the operating leases shown above consist of payments relating
to our lease of laboratory and office space in one office building in
Emeryville, California.  This lease expires on October 31,
2015.
 
 Our
commitment under the capital lease shown above consists of the total payments
due under one lease of laboratory equipment. This amount includes an immaterial
amount of interest payments over the remaining term of the lease.
 
 Our
commitment under the equipment loan shown above consists of the total payments
due under the loan facility. This amount includes approximately $35,000 of
interest payments over the remaining term of the loan.
 
 We
believe our cash balance at December 31, 2009 is sufficient to fund our
projected operating requirements through at least the next twelve months.
However, we will need to raise additional capital or incur indebtedness to
continue to fund our operations in the future. Our future capital requirements
will depend on many factors, including:
 
 •
                the
      scope, rate of progress and cost of our pre-clinical studies and clinical
      trials and other research and development
  activities;
 
 •
                future
      clinical trial results;
 
 •
                the
      terms and timing of any collaborative, licensing and other arrangements
      that we may establish;
 
 •
                the
      cost and timing of regulatory
approvals;
 
 •
                the
      cost of establishing clinical and commercial supplies of our product
      candidates and any products that we may
develop;
 
 •
                the
      effect of competing technological and market
  developments;
 
 •
                the
      cost of filing, prosecuting, defending and enforcing any patent claims and
      other intellectual property rights;
and
 
 •
                the
      extent to which we acquire or invest in businesses, products and
      technologies, although we currently have no commitments or agreements
      relating to any of these types of
transactions.
 
 We do not
anticipate that we will generate significant product revenue for a number of
years. Until we can generate a sufficient amount of product revenue, if ever, we
expect to finance future cash needs through public or private equity offerings,
debt financings or corporate collaboration and licensing arrangements, as well
as through interest income earned on cash balances and short-term investments.
To the extent that we raise additional funds by issuing equity securities, our
shareholders may experience dilution. In addition, debt financing, if available,
may involve restrictive covenants. To the extent that we raise additional funds
through collaboration and licensing arrangements, it may be necessary to
relinquish some rights to our technologies or product candidates, or grant
licenses on terms that are not favorable to us. If adequate funds are not
available, we may be required to delay, reduce the scope of or eliminate one or
more of our research or development programs or to obtain funds through
collaborations for some of our technologies or product candidates that we would
otherwise seek to develop on our own. Such collaborations may not be on
favorable terms or they may require us to relinquish rights to our technologies
or product candidates.
 
 36
 
 ITEM 7A.
                QUANTITATIVE
      AND QUALITATIVE DISCLOSURES ABOUT MARKET
RISK
 
 Our
market risk consists principally of interest rate risk on our cash, cash
equivalents, and short-term investments. Our exposure to market risk is limited
primarily to interest income sensitivity, which is affected by changes in
interest rates, particularly because the majority of our investments are in
short-term debt securities.
 
 Our
investment policy restricts our investments to high-quality investments and
limits the amounts invested with any one issuer, industry, or geographic area.
The goals of our investment policy are as follows: preservation of capital;
assurance of liquidity needs; best available return on invested capital; and
minimization of capital taxation. Some of the securities in which we invest may
be subject to market risk. This means that a change in prevailing interest rates
may cause the principal amount of the investment to fluctuate. For example, if
we hold a security that was issued with an interest rate fixed at the
then-prevailing rate and the prevailing interest rate later rises, the principal
amount of our investment will probably decline. To minimize this risk, in
accordance with our investment policy, we maintain our cash and cash equivalents
in short-term marketable securities, including money market mutual funds,
Treasury bills, Treasury notes, commercial paper, and corporate and municipal
bonds. The risk associated with fluctuating interest rates is limited to our
investment portfolio. Due to the short term nature of our investment portfolio,
we believe we have minimal interest rate risk arising from our investments. As
of December 31, 2009 and 2008, a 10% change in interest rates would have had an
immaterial affect on the value of our short-term marketable
securities.    We do not use derivative financial
instruments in our investment portfolio. We do not hold any instruments for
trading purposes.
 
 To date,
we have operated exclusively in the United States and have not had any material
exposure to foreign currency rate fluctuations. We have recently formed a
wholly-owned subsidiary, which is incorporated under the laws of British
Columbia (Canada), which may conduct research and development activities in
Canada. To the extent we conduct operations in Canada, fluctuations in the
exchange rates of the U.S. and Canadian currencies may affect our operating
results.
   37
 ITEM 8.
                FINANCIAL
      STATEMENTS AND SUPPLEMENTARY DATA
 
 The
financial statements required by this Item 8 are set forth below. Our
quarterly financial information is set forth in Item 7 of this report and
is hereby incorporated into this Item 8 by reference.
  
 INDEX
      TO CONSOLIDATED FINANCIAL STATEMENTSPageReport
      of Independent Registered Public Accounting Firm
                
                39Consolidated
      Balance Sheets as of December 31, 2008 and 2009
                
                40Consolidated
      Statements of Operations for the Years Ended December 31, 2007, 2008 and
      2009 and for the cumulative period from July 1, 2002 ( date of development
      stage inception) to December 31, 2009
                
                41Consolidated
      Statements of Stockholders’ Equity for the cumulative period from July 1,
      2002 (date of development stage inception) to December 31,
      2009
                
                42Consolidated
      Statements of Cash Flows for the Years Ended December 31, 2007, 2008 and
      2009 and for the cumulative period from July 1, 2002 ( date of development
      stage inception) to December 31, 2009
                
                46
 
 
 
 38
 REPORT
OF INDEPENDENT REGISTERED
 PUBLIC
ACCOUNTING FIRM
 
 
 To the
Stockholders and the Board of Directors of
 NovaBay
Pharmaceuticals Inc. (a development stage company)
 
 We have
audited the accompanying consolidated balance sheets of NovaBay Pharmaceuticals
Inc. (a development stage company) as at December 31, 2009 and 2008 and the
related consolidated statements of operations, stockholders' equity and cash
flows for the years ended December 31, 2009, 2008, 2007, and for the period from
July 1, 2002 (date of development stage inception) to December 31,
2009.  These consolidated financial statements are the responsibility
of the Company's management.  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.  The
company is not required to have, nor were we engaged to perform, an audit of its
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 purpose 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, as well as evaluating the overall financial statement
presentation.  We believe that our audits provide a reasonable basis
for our opinion.
 
 In our
opinion, the consolidated financial statements referred to above present fairly,
in all material respects, the financial position of the Company as at December
31, 2009 and 2008 and the results of its operations and its cash flows for the
years ended December 31, 2009, 2008, 2007, and for the period from July 1, 2002
(date of development stage inception) to December 31, 2009 in conformity with
generally accepted accounting principles in the United States of
America.
 
 
 
 /s/
      Davidson & Company LLPChartered
      Accountants
 
 Vancouver,
Canada
 March 26,
2010
 
 39
 NOVABAY
PHARMACEUTICALS, INC.
 (a
development stage company)
 CONSOLIDATED
BALANCE SHEETS
 (in
thousands, except per share data)
 
 Decmber
      31,
                
                
                December
      31,2008
                
                
                2009ASSETSCurrent
      assets:Cash
      and cash equivalents
                
                $
                12,099
                
                
                $
                10,992Short-term
      investments
                
                
                -
                
                
                
                300Accounts
      receivable
                
                
                -
                
                
                
                3,801Prepaid
      expenses and other current assets
                
                
                414
                
                
                
                513Total
      current assets
                
                
                12,513
                
                
                
                15,606Other
      Assets
                
                
                -
                
                
                
                105Property
      and equipment, net
                
                
                1,456
                
                
                
                1,812TOTAL
      ASSETS
                
                $
                13,969
                
                
                $
                17,523LIABILITIES
      AND STOCKHOLDERS' EQUITYLiabilities:Current
      liabilities:Accounts
      payable
                
                $
                406
                
                
                $
                272Accrued
      liabilities
                
                
                1,166
                
                
                
                1,228Capital
      lease obligation
                
                
                42
                
                
                
                7Equipment
      loan
                
                
                366
                
                
                
                364Deferred
      revenue
                
                
                2,500
                
                
                
                2,167Total
      current liabilities
                
                
                4,480
                
                
                
                4,038Deferred
      Tax
                
                
                -
                
                
                
                34Capital
      lease obligation - non-current
                
                
                7
                
                
                
                -Equipment
      loan - non-current
                
                
                470
                
                
                
                106Deferred
      revenue - non-current
                
                
                1,667
                
                
                
                -Total
      liabilities
                
                
                6,624
                
                
                
                4,178Stockholders'
      Equity:Common
      stock, $0.01 par value; 65,000 shares authorized at December 31, 2009 and
      December 31, 2008; 23,254 and 21,471 shares issued and outstanding at
      December 31, 2009 and December 31, 2008, respectively
                
                
                215
                
                
                
                233Additional
      paid-in capital
                
                
                33,718
                
                
                
                37,003Accumulated
      other comprehensive income (loss)
                
                
                -
                
                
                
                -Accumulated
      deficit during development stage
                
                
                (26,588
                )
                
                
                (23,891
                )Total
      stockholders' equity
                
                
                7,345
                
                
                
                13,345TOTAL
      LIABILITIES AND STOCKHOLDERS' EQUITY
                
                $
                13,969
                
                
                $
                17,523
  The
accompanying notes are an integral part of these consolidated financial
statements.
 
 40
 NOVABAY
PHARMACEUTICALS, INC.
 (a
development stage company)
 CONSOLIDATED
STATEMENTS OF OPERATIONS
 (in
thousands, except per share data)
 
 
 Cumulative Periodfrom
      July 1, 2002(date
      ofdevelopment stageinception)
      toYear
      Ended December 31,
                
                
                December
      31,2007
                
                
                2008
                
                
                2009
                
                
                2009REVENUELicense
      and collaboration revenue
                
                $
                5,913
                
                
                $
                6,722
                
                
                $
                15,684
                
                
                $
                29,852Total
      revenue
                
                
                5,913
                
                
                
                6,722
                
                
                
                15,684
                
                
                
                29,852EXPENSESOperating
      Expenses:Research
      and development
                
                
                7,421
                
                
                
                9,595
                
                
                
                7,337
                
                
                
                32,344General
      and administrative
                
                
                4,368
                
                
                
                5,636
                
                
                
                5,607
                
                
                
                22,571Total
      operating expenses
                
                
                11,789
                
                
                
                15,231
                
                
                
                12,944
                
                
                
                54,915Other
      income (loss), net
                
                
                488
                
                
                
                397
                
                
                
                (36
                )
                
                
                1,193Net
      income (loss) before income taxes
                
                
                (5,388
                )
                
                
                (8,112
                )
                
                
                2,704
                
                
                
                (23,870
                )Provision
      for income taxes
                
                
                (12
                )
                
                
                (2
                )
                
                
                (7
                )
                
                
                (21
                )Net
      income (loss) before income taxes
                
                $
                (5,400
                )
                
                $
                (8,114
                )
                
                $
                2,697
                
                
                $
                (23,891
                )Net
      income (loss) per share:Basic
                
                $
                (0.60
                )
                
                $
                (0.38
                )
                
                $
                0.12Diluted
                
                $
                (0.60
                )
                
                $
                (0.38
                )
                
                $
                0.12Shares
      used in per share calculations:Basic
                
                
                8,974
                
                
                
                21,312
                
                
                
                22,404Diluted
                
                
                8,974
                
                
                
                21,312
                
                
                
                23,115
 
 The
accompanying notes are an integral part of these consolidated financial
statements.
 
 41
 
  NOVABAY
PHARMACEUTICALS, INC.
 (a
development stage company)
 CONSOLIDATED
STATEMENTS OF STOCKHOLDERS’ EQUITY
 (in
thousands)
 Preferred
      Stock
                      
                      
                      Common
      Stock
                      
                      
                      Additional
                        Paid-In
                      
                      
                      Stock
      Subscription
                      
                      
                      Accumulated
      Other Compre-hensive Income
                      
                      
                      Accumulated
      Deficit During Development
                      
                      
                      Total
      Stockholders'Shares
                      
                      
                      Amount
                      
                      
                      Shares
                      
                      
                      Amount
                      
                      
                      Capital
                      
                      
                      Receivable
                      
                      
                      (Loss)
                      
                      
                      Stage
                      
                      
                      EquityBalance
      at July 1, 2002
                      
                      
                      -
                      
                      
                      $
                      -
                      
                      
                      
                      -
                      
                      
                      $
                      -
                      
                      
                      $
                      -
                      
                      
                      $
                      -
                      
                      
                      $
                      -
                      
                      
                      $
                      -
                      
                      
                      $
                      -Comprehensive
      loss:Net
      loss
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      (544
                      )
                      
                      
                      (544
                      )Total
      comprehensiveloss
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      (544
                      )Issuance
      of Series Apreferred
      stock andcommon
      stock foracquisition
      of LLC
                      
                      
                      2,723
                      
                      
                      
                      27
                      
                      
                      
                      3,902
                      
                      
                      
                      39
                      
                      
                      
                      462
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      528Stock-basedcompensation
      expenserelated
      to non-employee
      stock options
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      15
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      15Sale
      of stock warrants
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      10
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      10Balance
      at December 31, 2002
                      
                      
                      2,723
                      
                      
                      
                      27
                      
                      
                      
                      3,902
                      
                      
                      
                      39
                      
                      
                      
                      487
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      (544
                      )
                      
                      
                      9Comprehensive
      loss:Net
      loss
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      (977
                      )
                      
                      
                      (977
                      )Total
      comprehensiveloss
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      (977
                      )Issuance
      of Series Apreferred
      stock
                      
                      
                      492
                      
                      
                      
                      5
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      192
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      197Issuance
      of Series Bpreferred
      stock net ofissuance
      costs of $86
                      
                      
                      3,258
                      
                      
                      
                      33
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      1,413
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      1,446Issuance
      of stock
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      25
                      
                      
                      
                      -
                      
                      
                      
                      7
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      7Issuance
      of stock foroption
      exercises
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      40
                      
                      
                      
                      1
                      
                      
                      
                      7
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      8Issuance
      of stock forwarrant
      exercises
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      137
                      
                      
                      
                      1
                      
                      
                      
                      109
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      110Stock-basedcompensation
      expenserelated
      to non-employeestock
      options
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      2
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      2Balance
      at December 31, 2003
                      
                      
                      6,473
                      
                      
                      
                      65
                      
                      
                      
                      4,104
                      
                      
                      
                      41
                      
                      
                      
                      2,217
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      (1,521
                      )
                      
                      
                      802Comprehensive
      loss:Net
      loss
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      (2,804
                      )
                      
                      
                      (2,804
                      )Total
      comprehensive loss
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      (2,804
                      )Issuance
      of Series Bpreferred
      stock net ofissuance
      costs of $127
                      
                      
                      2,694
                      
                      
                      
                      27
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      1,112
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      1,139Issuance
      of Series Bpreferred
      stock uponconversion
      of notes
                      
                      
                      913
                      
                      
                      
                      9
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      420
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      429Issuance
      of Series Cpreferred
      stock net ofissuance
      costs of $123
                      
                      
                      6,311
                      
                      
                      
                      63
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      5,178
                      
                      
                      
                      (873
                      )
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      4,368Issuance
      of stock foroption
      exercises
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      5
                      
                      
                      
                      -
                      
                      
                      
                      1
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      1Issuance
      of stock forwarrant
      exercises
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      31
                      
                      
                      
                      -
                      
                      
                      
                      37
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      37Issuance
      of stock forSeries
      B offering costs
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      368
                      
                      
                      
                      4
                      
                      
                      
                      106
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      110Issuance
      of stock forservices
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      15
                      
                      
                      
                      -
                      
                      
                      
                      4
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      4Stock-basedcompensation
      expenserelated
      to non-employee
      stock options
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      7
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      7Balance
      at December 31, 2004
                      
                      
                      16,391
                      
                      
                      
                      164
                      
                      
                      
                      4,523
                      
                      
                      
                      45
                      
                      
                      
                      9,082
                      
                      
                      
                      (873
                      )
                      
                      
                      -
                      
                      
                      
                      (4,325
                      )
                      
                      
                      4,093
   42
 NOVABAY
PHARMACEUTICALS, INC.
 (a
development stage company)
 CONSOLIDATED
STATEMENTS OF STOCKHOLDERS’ EQUITY – (Continued)
 (in
thousands)
  Preferred
      Stock
                      
                      
                      Common
      Stock
                      
                      
                      Additional
                        Paid-In
                      
                      
                      Stock
      Subscription
                      
                      
                      Accumulated
      Other Compre-hensive Income
                      
                      
                      Accumulated
      Deficit During Development
                      
                      
                      Total
      Stockholders'Shares
                      
                      
                      Amount
                      
                      
                      Shares
                      
                      
                      Amount
                      
                      
                      Capital
                      
                      
                      Receivable
                      
                      
                      (Loss)
                      
                      
                      Stage
                      
                      
                      EquityBalance
      at December 31, 2004
                      
                      
                      16,391
                      
                      
                      
                      164
                      
                      
                      
                      4,523
                      
                      
                      
                      45
                      
                      
                      
                      9,082
                      
                      
                      
                      (873
                      )
                      
                      
                      -
                      
                      
                      
                      (4,325
                      )
                      
                      
                      4,093Comprehensive
      loss:Net
      loss
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      (3,463
                      )
                      
                      
                      (3,463
                      )Change
      in unrealizedgains
      (losses) oninvestments
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      (4
                      )
                      
                      
                      -
                      
                      
                      
                      (4
                      )Total
      comprehensiveloss
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      (3,467
                      )Issuance
      of Series Cpreferred
      stock net ofissuance
      costs of $140
                      
                      
                      355
                      
                      
                      
                      4
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      158
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      162Issuance
      of Series Dpreferred
      stock net ofissuance
      costs of $36
                      
                      
                      742
                      
                      
                      
                      7
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      1,070
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      1,077Issuance
      of stock foroption
      exercises
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      50
                      
                      
                      
                      -
                      
                      
                      
                      12
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      12Issuance
      of stock forwarrant
      exercises
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      292
                      
                      
                      
                      3
                      
                      
                      
                      324
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      327Issuance
      of stock andoptions
      for Series Coffering
      costs
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      164
                      
                      
                      
                      2
                      
                      
                      
                      101
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      103Issuance
      of stock forservices
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      20
                      
                      
                      
                      -
                      
                      
                      
                      17
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      17Stock-basedcompensation
      expenserelated
      to non-employeestock
      options
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      55
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      55Proceeds
      from stocksubscription
      receivable
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      873
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      873Balance
      at December 31, 2005
                      
                      
                      17,488
                      
                      
                      
                      175
                      
                      
                      
                      5,049
                      
                      
                      
                      50
                      
                      
                      
                      10,819
                      
                      
                      
                      -
                      
                      
                      
                      (4
                      )
                      
                      
                      (7,788
                      )
                      
                      
                      3,252Comprehensive
      loss:Net
      loss
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      (5,286
                      )
                      
                      
                      (5,286
                      )Change
      in unrealizedgains
      (losses) oninvestments
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      16
                      
                      
                      
                      -
                      
                      
                      
                      16Total
      comprehensiveloss
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      (5,270
                      )Stock-basedcompensation
      expenseIssuance
      of Series Dpreferred
      stock net ofissuance
      costs of $114
                      
                      
                      1,739
                      
                      
                      
                      17
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      2,477
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      2,494Issuance
      of stock foroption
      exercises
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      80
                      
                      
                      
                      1
                      
                      
                      
                      22
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      23Issuance
      of stock forwarrant
      exercises
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      1,148
                      
                      
                      
                      12
                      
                      
                      
                      964
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      976Issuance
      of stock andoptions
      for Series Doffering
      costs
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      31
                      
                      
                      
                      -
                      
                      
                      
                      64
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      64Issuance
      of stock forservices
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      3
                      
                      
                      
                      -
                      
                      
                      
                      5
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      5Initial
      public offering costs
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      (93
                      )
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      (93
                      )Stock-basedcompensation
      expenserelated
      to employee anddirector
      stock options
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      313
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      313Stock-basedcompensation
      expenserelated
      to non-employeestock
      options
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      49
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      49Balance
      at December 31, 2006
                      
                      
                      19,227
                      
                      
                      
                      192
                      
                      
                      
                      6,311
                      
                      
                      
                      63
                      
                      
                      
                      14,620
                      
                      
                      
                      -
                      
                      
                      
                      12
                      
                      
                      
                      (13,074
                      )
                      
                      
                      1,813
    43
 NOVABAY
PHARMACEUTICALS, INC.
 (a
development stage company)
 CONSOLIDATED
STATEMENTS OF STOCKHOLDERS’ EQUITY – (Continued)
 (in
thousands)
  Preferred
      Stock
                      
                      
                      Common
      Stock
                      
                      
                      Additional
                        Paid-In
                      
                      
                      Stock
      Subscription
                      
                      
                      Accumulated
      Other Compre-hensive Income
                      
                      
                      Accumulated
      Deficit During Development
                      
                      
                      Total
      Stockholders'Shares
                      
                      
                      Amount
                      
                      
                      Shares
                      
                      
                      Amount
                      
                      
                      Capital
                      
                      
                      Receivable
                      
                      
                      (Loss)
                      
                      
                      Stage
                      
                      
                      EquityBalance
      at December 31, 2006
                      
                      
                      19,227
                      
                      
                      
                      192
                      
                      
                      
                      6,311
                      
                      
                      
                      63
                      
                      
                      
                      14,620
                      
                      
                      
                      -
                      
                      
                      
                      12
                      
                      
                      
                      (13,074
                      )
                      
                      
                      1,813Comprehensive
      loss:Net
      loss
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      (5,400
                      )
                      
                      
                      (5,400
                      )Change
      in unrealizedgains
      (losses) oninvestments
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      (15
                      )
                      
                      
                      -
                      
                      
                      
                      (15
                      )Total
      comprehensiveloss
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      (5,415
                      )Conversion
      of preferredstock
      to common stockin
      connection with IPO
                      
                      
                      (19,227
                      )
                      
                      
                      (192
                      )
                      
                      
                      9,614
                      
                      
                      
                      96
                      
                      
                      
                      96
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -Issuance
      of stock andwarrants
      in connectionwith
      IPO, net of offeringcosts
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      5,000
                      
                      
                      
                      50
                      
                      
                      
                      17,120
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      17,170Issuance
      of stock foroption
      exercises
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      298
                      
                      
                      
                      3
                      
                      
                      
                      111
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      114Issuance
      of stock forservices
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      38
                      
                      
                      
                      -
                      
                      
                      
                      92
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      92Issuance
      of stock fordirector
      compensation
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      8
                      
                      
                      
                      -
                      
                      
                      
                      29
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      29Stock-basedcompensation
      expenserelated
      to employee anddirector
      stock options
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      399
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      399Stock-basedcompensation
      expenserelated
      to non-employeestock
      options
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      118
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      118Balance
      at December 31, 2007
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      21,269
                      
                      
                      
                      212
                      
                      
                      
                      32,585
                      
                      
                      
                      -
                      
                      
                      
                      (3
                      )
                      
                      
                      (18,474
                      )
                      
                      
                      14,320Comprehensive
      loss:Net
      loss
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      (8,114
                      )
                      
                      
                      (8,114
                      )Realized
      gains
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      35
                      
                      
                      
                      -
                      
                      
                      
                      35Change
      in unrealizedgains
      (losses) oninvestments
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      (32
                      )
                      
                      
                      -
                      
                      
                      
                      (32
                      )Total
      comprehensiveloss
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      (8,111
                      )Issuance
      of warrants
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      67
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      67Issuance
      of stock foroption
      exercises
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      123
                      
                      
                      
                      1
                      
                      
                      
                      148
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      149Issuance
      of stock forservices
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      30
                      
                      
                      
                      1
                      
                      
                      
                      84
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      85Issuance
      of stock fordirector
      compensation
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      49
                      
                      
                      
                      1
                      
                      
                      
                      123
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      124Stock-basedcompensation
      expenserelated
      to employee anddirector
      stock options
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      721
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      721Stock-basedcompensation
      expenserelated
      to non-employeestock
      options
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      (11
                      )
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      (11
                      )Tax
      benefit from stockplans
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      1
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      1Balance
      at December 31, 2008
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      21,471
                      
                      
                      
                      215
                      
                      
                      
                      33,718
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      (26,588
                      )
                      
                      
                      7,345
  44
 NOVABAY
PHARMACEUTICALS, INC.
 (a
development stage company)
 CONSOLIDATED
STATEMENTS OF STOCKHOLDERS’ EQUITY – (Continued)
 (in
thousands)
 
  Preferred
      Stock
                      
                      
                      Common
      Stock
                      
                      
                      Additional
                        Paid-In
                      
                      
                      Stock
      Subscription
                      
                      
                      Accumulated
      Other Compre-hensive Income
                      
                      
                      Accumulated
      Deficit During Development
                      
                      
                      Total
      Stockholders'Shares
                      
                      
                      Amount
                      
                      
                      Shares
                      
                      
                      Amount
                      
                      
                      Capital
                      
                      
                      Receivable
                      
                      
                      (Loss)
                      
                      
                      Stage
                      
                      
                      EquityBalance
      at December 31, 2008
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      21,471
                      
                      
                      
                      215
                      
                      
                      
                      33,718
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      (26,588
                      )
                      
                      
                      7,345Comprehensive
      loss:Net
      income
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      2,697
                      
                      
                      
                      2,697Realized
      gains
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -Change
      in unrealizedgains
      (losses) oninvestments
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -Total
      comprehensiveloss
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      2,697Issuance
      of commonstock
      in connectionw/shelf
      offering, net ofoffering
      costs
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      1,225
                      
                      
                      
                      12
                      
                      
                      
                      1,932
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      1,944Issuance
      of stock foroption
      exercises
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      119
                      
                      
                      
                      1
                      
                      
                      
                      74
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      75Issuance
      of stock forservices
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      309
                      
                      
                      
                      4
                      
                      
                      
                      75
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      79Issuance
      of stock fordirector
      compensation
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      130
                      
                      
                      
                      1
                      
                      
                      
                      217
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      218Stock-basedcompensation
      expenserelated
      to employee anddirector
      stock options
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      702
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      702Stock-basedcompensation
      expenserelated
      to non-
                        employee
      stockoptions
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      285
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      285Tax
      benefit from stockplans
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -Balance
      at December 31, 2009
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      23,254
                      
                      
                      $
                      233
                      
                      
                      $
                      37,003
                      
                      
                      $
                      -
                      
                      
                      $
                      -
                      
                      
                      $
                      (23,891
                      )
                      
                      $
                      13,345
 The
accompanying notes are an integral part of these consolidated financial
statements.
 
 45
 NOVABAY
PHARMACEUTICALS, INC.
 (a
development stage company)
 CONSOLIDATED
STATEMENTS OF CASH FLOWS
 (in
thousands)
  Year
      Ended December 31,
                  
                  
                  Cumulative
      Period from July 1, 2002 (date of Development Stage inception) to December
      31,2007
                  
                  
                  2008
                  
                  
                  2009
                  
                  
                  2009Cash
      flows from operating activities:Net
      income (loss)
                  
                  $
                  (5,400
                  )
                  
                  $
                  (8,114
                  )
                  
                  $
                  2,697
                  
                  
                  $
                  (23,891
                  )Adjustments
      to reconcile net income (loss) to net cash used in operating
      activities:Depreciation
      and amortization
                  
                  
                  183
                  
                  
                  
                  304
                  
                  
                  
                  373
                  
                  
                  
                  1,077Accretion
      of discount on short-term investments
                  
                  
                  (246
                  )
                  
                  
                  (23
                  )
                  
                  
                  42
                  
                  
                  
                  (259
                  )Net
      realized gain on sales of short-term investments
                  
                  
                  -
                  
                  
                  
                  (35
                  )
                  
                  
                  -
                  
                  
                  
                  (3
                  )Loss
      on disposal of property and equipment
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  121Stock-based
      compensation expense for options issued to employeesand
      directors
                  
                  
                  428
                  
                  
                  
                  844
                  
                  
                  
                  920
                  
                  
                  
                  2,382Compensation
      expense for warrants issued for services
                  
                  
                  -
                  
                  
                  
                  67
                  
                  
                  
                  88
                  
                  
                  
                  188Stock-based
      compensation expense for options and stock issued tonon-employees
                  
                  
                  210
                  
                  
                  
                  (11
                  )
                  
                  
                  273
                  
                  
                  
                  798Taxes
      paid by LLC
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  1Changes
      in operating assets and liabilities:Increase
      in accounts receivable
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  (3,801
                  )
                  
                  
                  (3,801
                  )(Increase)
      decrease in prepaid expenses and other assets
                  
                  
                  (193
                  )
                  
                  
                  88
                  
                  
                  
                  (204
                  )
                  
                  
                  (613
                  )Increase
      (decrease) in accounts payable and accrued liabilities
                  
                  
                  397
                  
                  
                  
                  289
                  
                  
                  
                  (70
                  )
                  
                  
                  1,527Increase
      (decrease) in deferred revenue
                  
                  
                  (1,650
                  )
                  
                  
                  (3,351
                  )
                  
                  
                  (2,000
                  )
                  
                  
                  2,166Increase
      in deferred tax
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  34
                  
                  
                  
                  34Net
      cash used in operating activities
                  
                  
                  (6,271
                  )
                  
                  
                  (9,942
                  )
                  
                  
                  (1,648
                  )
                  
                  
                  (20,273
                  )Cash
      flows from investing activities:Purchases
      of property and equipment
                  
                  
                  (663
                  )
                  
                  
                  (610
                  )
                  
                  
                  (731
                  )
                  
                  
                  (2,891
                  )Proceeds
      from disposal of property and equipment
                  
                  
                  1
                  
                  
                  
                  -
                  
                  
                  
                  2
                  
                  
                  
                  46Purchases
      of short-term investments
                  
                  
                  (49,197
                  )
                  
                  
                  (32,097
                  )
                  
                  
                  (3,975
                  )
                  
                  
                  (98,519
                  )Proceeds
      from maturities and sales of short-term investments
                  
                  
                  44,199
                  
                  
                  
                  43,571
                  
                  
                  
                  3,635
                  
                  
                  
                  98,482Cash
      acquired in purchase of LLC
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  516Net
      cash provided by (used in) investing activities
                  
                  
                  (5,660
                  )
                  
                  
                  10,864
                  
                  
                  
                  (1,069
                  )
                  
                  
                  (2,366
                  )Cash
      flows from financing activities:Proceeds
      from preferred stock issuances, net
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  11,160Proceeds
      from common stock issuances
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  17Proceeds
      from exercise of options and warrants
                  
                  
                  114
                  
                  
                  
                  153
                  
                  
                  
                  74
                  
                  
                  
                  1,835Initial
      public offering costs, net of costs
                  
                  
                  17,170
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  17,077Proceeds
      from Shelf offering, net of costs
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  1,944
                  
                  
                  
                  1,944Proceeds
      from stock subscription receivable
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  873Proceeds
      from issuance of notes
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  405Principal
      payments on capital lease
                  
                  
                  (31
                  )
                  
                  
                  (37
                  )
                  
                  
                  (42
                  )
                  
                  
                  (150
                  )Proceeds
      from borrowings  under equipment loan
                  
                  
                  794
                  
                  
                  
                  422
                  
                  
                  
                  -
                  
                  
                  
                  1,216Principal
      payments on equipment loan
                  
                  
                  (78
                  )
                  
                  
                  (302
                  )
                  
                  
                  (366
                  )
                  
                  
                  (746
                  )Net
      cash provided by financing activities
                  
                  
                  17,969
                  
                  
                  
                  236
                  
                  
                  
                  1,610
                  
                  
                  
                  33,631Net
      increase (decrease) in cash and cash equivalents
                  
                  
                  6,038
                  
                  
                  
                  1,158
                  
                  
                  
                  (1,107
                  )
                  
                  
                  10,992Cash
      and cash equivalents, beginning of period
                  
                  
                  4,903
                  
                  
                  
                  10,941
                  
                  
                  
                  12,099
                  
                  
                  
                  -Cash
      and cash equivalents, end of period
                  
                  $
                  10,941
                  
                  
                  $
                  12,099
                  
                  
                  $
                  10,992
                  
                  
                  $
                  10,992
 
 The
accompanying notes are an integral part of these consolidated financial
statements.
 46
 NOVABAY
PHARMACEUTICALS, INC.
 (a
development stage company)
 CONSOLIDATED
STATEMENTS OF CASH FLOWS (continued)
 (in
thousands)
  Year
      Ended December 31,
                  
                  
                  Cumulative
      Period from July 1, 2002 (date of Development Stage inception) to December
      31,2007
                  
                  
                  2008
                  
                  
                  2009
                  
                  
                  2009Supplemental
      Disclosure of non cash informationInterest
      paid
                  
                  $
                  34
                  
                  
                  $
                  102
                  
                  
                  $
                  77
                  
                  
                  $
                  223Income
      taxes paid
                  
                  $
                  -
                  
                  
                  $
                  -
                  
                  
                  $
                  -
                  
                  
                  $
                  -Non-cash
      financing and investing activitiesIssuance
      of stock options and warrants for stock option costs
                  
                  $
                  524
                  
                  
                  $
                  -
                  
                  
                  $
                  1,086
                  
                  
                  $
                  1,887Property
      and equipment acquired under capital lease obligations
                  
                  $
                  117
                  
                  
                  $
                  62
                  
                  
                  $
                  -
                  
                  
                  $
                  219
 
 
 47
 
 NOVABAY
PHARMACEUTICALS, INC.
 (a
development stage company)
 
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 NOTE
1. ORGANIZATION
 
 NovaBay
Pharmaceuticals, Inc. (the “Company”) is a clinical stage specialty
pharmaceutical company engaged in the discovery and development of innovative
product candidates for the treatment or prevention of a wide range of infections
in hospital and non-hospital environments. Many of these infections have become
increasingly difficult to treat because of the rapid rise in drug resistance. We
have discovered and are developing a class of non-antibiotic anti-infective
compounds, which we have named Aganocide compounds. These compounds are based
upon small molecules that are naturally generated by white blood cells when
defending the body against invading pathogens. We believe that our Aganocide
compounds could form a platform on which to create a variety of products to
address differing needs in the treatment and prevention of bacterial and viral
infections. In laboratory testing, our Aganocide compounds have demonstrated the
ability to destroy all bacteria against which they have been tested.
Furthermore, because of their mechanism of action, we believe that bacteria are
unlikely to develop resistance to our Aganocide compounds.
 
 The
Company was incorporated under the laws of the State of California on
January 19, 2000 as NovaCal Pharmaceuticals, Inc. We had no operations
until July 1, 2002, on which date we acquired all of the operating assets
of NovaCal Pharmaceuticals, LLC, a California limited liability company. In
February 2007, we changed our name from NovaCal Pharmaceuticals, Inc. to NovaBay
Pharmaceuticals, Inc. In August 2007, we formed two subsidiaries––NovaBay
Pharmaceuticals Canada, Inc., a wholly-owned subsidiary incorporated under the
laws of British Columbia (Canada), which may conduct research and development in
Canada, and DermaBay, Inc., a wholly-owned U.S. subsidiary, which may explore
and pursue dermatological opportunities. We currently operate in one business
segment.
 
 In
October 2007, we completed an initial public offering of our common stock
(“IPO”) in which we sold and issued 5,000,000 shares of our common stock at a
price to the public of $4.00 per share. We raised a total of $20.0 million from
the IPO, or approximately $17.1 million in net cash proceeds after deducting
underwriting discounts and commissions of $1.4 million and other offering costs
of $1.5 million. Upon the closing of the IPO, all shares of convertible
preferred stock outstanding automatically converted into 9,613,554 shares of
common stock. In connection with the IPO, we also issued warrants to the
underwriters to purchase an aggregate of 350,000 shares of common stock at
an exercise price of $4.00 per share. The warrants were exercisable on or after
October 31, 2008 and expire on October 31, 2010.
 
 In August
2009, the Company completed a sale of equity securities from its shelf
registration statement (“Shelf Registration Offering”) in which the Company sold
and issued 1,225,000 units, with each unit consisting of one share of the
Company’s common stock and a warrant to purchase one share of the Company’s
common stock.  The purchase price for each unit was
$2.00.  Each warrant has an exercise price of $2.75 per share, and
will be exercisable 180 days after issuance and will expire five years from the
date of issuance.  The shares of common stock and the warrants were
immediately separable and were issued separately, but were purchased together in
the Shelf Registration Offering.  The Company raised a total of $2.5
million from the Shelf Registration Offering, or approximately $ 1.9 million in
net proceeds after deducting underwriting commissions of $156,000 and other
offering costs of $349,868.
 
 NOTE
2.  SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
 
 Basis
of Presentation
 
 The
consolidated financial statements include our accounts and the accounts of our
wholly owned subsidiaries. Intercompany transactions and balances have been
eliminated. The accompanying consolidated financial statements have been
prepared in accordance with accounting principles generally accepted in the
United States (“U.S. GAAP”) and are expressed in U.S. dollars. The financial
statements have been prepared under the guidelines for Development Stage
Entities.  A development stage enterprise is one in which planned
principal operations have not commenced, or if its operations have commenced,
there have been no significant revenues therefrom. As of December 31, 2009, we
were still in clinical trials and had not commenced our planned principal
operations.
 
 Certain
amounts for prior periods have been reclassified to conform to current period
presentation.
 
 Principles
of Consolidation
 
 The
accompanying consolidated financial statements include the accounts of the
Company and its wholly owned subsidiaries, NovaBay Pharmaceuticals Canada, Inc.
and DermaBay, Inc. All inter-company accounts and transactions have been
eliminated in consolidation.
 
 48
 
 NOVABAY
PHARMACEUTICALS, INC.
 (a
development stage company)
 
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
 
 Reverse
Stock Split
 
 On
August 10, 2007, we filed an amendment to our articles of incorporation to
effect a 1-for-2 reverse stock split of our common stock. All share and per
share amounts relating to the common stock, stock options and warrants and the
conversion ratios of preferred stock included in the financial statements and
footnotes have been restated to reflect the reverse stock split.
 
 Use
of Estimates
 
 The
preparation of financial statements in accordance with U.S. GAAP requires
management to make estimates and assumptions that affect the reported amounts of
assets and liabilities, the disclosure of contingent assets and liabilities at
the date of the financial statements, and the reported amounts of revenue and
expenses during the reporting period. Actual results could differ from those
estimates.
 
 Cash
and Cash Equivalents and Short-Term Investments
 
 We
consider all highly liquid instruments with a stated maturity of three months or
less to be cash and cash equivalents. Cash and cash equivalents are stated at
cost, which approximate their fair value. As of December 31, 2009, our cash
and cash equivalents were held in financial institutions in the United States
and include deposits in money market funds, which were unrestricted as to
withdrawal or use.
 
 We
classify all highly liquid investments with a stated maturity of greater than
three months as short-term investments. Short-term investments generally consist
of United States government, municipal and corporate debt securities. We have
classified our short-term investments as available-for-sale. We do not intend to
hold securities with stated maturities greater than twelve months until
maturity. In response to changes in the availability of and the yield on
alternative investments as well as liquidity requirements, we occasionally sell
these securities prior to their stated maturities. These securities are carried
at fair value, with the unrealized gains and losses reported as a component of
other comprehensive income (loss) until realized. Realized gains and losses from
the sale of available-for-sale securities, if any, are determined on a specific
identification basis. A decline in the market value below cost of any
available-for-sale security that is determined to be other than temporary
results in a revaluation of its carrying amount to fair value and an impairment
charge to earnings, resulting in a new cost basis for the security. No such
impairment charges were recorded for the periods presented.  The
interest income and realized gains and losses are included in other income, net
within the consolidated statements of operations. Interest income is recognized
when earned.
 
 Concentrations
of Credit Risk and Major Partners
 
 Financial
instruments which potentially subject us to significant concentrations of credit
risk consist primarily of cash and cash equivalents and short-term investments.
We maintain deposits of cash, cash equivalents and short-term investments with
three highly-rated, major financial institutions in the United
States.
 
 Deposits
in these banks may exceed the amount of federal insurance provided on such
deposits. We do not believe we are exposed to significant credit risk due to the
financial position of the financial institutions in which these deposits are
held. Additionally, we have established guidelines regarding diversification and
investment maturities, which are designed to maintain safety and
liquidity.
 
 During
the year ended December 31, 2009 100% of our operating revenues were made up by
two partners and 100% of our accounts receivables were made up by one
partner.  For the years ended December 31, 2007 and 2008 two partners
represent 100% of our operating revenues.
 
 Fair
Value of Financial Assets and Liabilities
 
 Financial
instruments, including cash and cash equivalents and short term investments,
accounts payable and accrued liabilities are carried at cost, which management
believes approximates fair value due to the short-term nature of these
instruments. The fair value of capital lease obligations and equipment loans
approximates their carrying amounts as a market rate of interest is attached to
their repayment.
 
 The
Company measures the fair value of financial assets and liabilities based on
GAAP guidance which defines fair value, establishes a framework for measuring
fair value, and expands disclosures about fair value measurements.
Effective January 1, 2008, the Company adopted the provisions for financial
assets and liabilities, as well as for any other assets and liabilities
that are carried at fair value on a recurring basis. Effective January 1, 2009,
the Company adopted the provisions for non-financial assets and liabilities that
are required to be measured at fair value. The adoption of these provisions did
not materially impact the Company’s consolidated financial position and
results of operations.
 
 49
 
 NOVABAY
PHARMACEUTICALS, INC.
 (a
development stage company)
 
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
 Under
GAAP, fair value is defined as the exchange price that would be received for an
asset or paid to transfer a liability (an exit price) in the principal or most
advantageous market for the asset or liability in an orderly transaction between
market participants on the measurement date.  A fair value hierarchy
is also established, which requires an entity to maximize the use of observable
inputs and minimize the use of unobservable inputs when measuring fair
value.   There are three levels of inputs that may be used to
measure fair value:
 
 Level 1 –
quoted prices in active markets for identical assets or liabilities
 Level 2 –
quoted prices for similar assets and liabilities in active markets or inputs
that are observable
 Level 3 –
inputs that are unobservable (for example cash flow modeling inputs based on
assumptions)
 
 At
December 31, 2009 our cash and short term investments were measured using level
one inputs.
 
 Property
and Equipment
 
 Property
and equipment are stated at cost, less accumulated depreciation and
amortization. Depreciation is calculated using the straight-line method over the
estimated useful lives of the related assets of five to seven years for office
and laboratory equipment, three years for software and seven years for furniture
and fixtures. Leasehold improvements are depreciated on the shorter of seven
years or the life of the lease term. Depreciation of assets recorded under
capital leases is included in depreciation expense.
 
 The costs
of normal maintenance, repairs, and minor replacements are charged to operations
when incurred.
 
 Impairment
of Long-Lived Assets
 
 The
Company accounts for long-lived assets in accordance with GAAP, which requires
that companies consider whether events or changes in facts and circumstances,
both internally and externally, may indicate that an impairment of long-lived
assets held for use are present. Management periodically evaluates the carrying
value of long-lived assets and has determined that there was no impairment as of
all periods presented. Should there be impairment in the future, the Company
would recognize the amount of the impairment based on the discounted expected
future cash flows from the impaired assets. The cash flow estimates would be
based on management’s best estimates, using appropriate and customary
assumptions and projections at the time.
 
 Accumulated
Other Comprehensive Income
 
 Accumulated
other comprehensive income consists of unrealized gains and losses on short-term
investments classified as available-for-sale.
 
 Revenue
Recognition
 
 License
and collaboration revenue is primarily generated through agreements with
strategic partners for the development and commercialization of the Company’s
product candidates. The terms of the agreements typically include non-refundable
upfront fees, funding of research and development activities, payments based
upon achievement of certain milestones and royalties on net product sales. In
accordance with revenue recognition under GAAP,  the Company analyzes
its multiple element arrangements to determine whether the element can be
separated. The Company performs its analysis at the inception of the arrangement
and as each product or service is delivered. If a product or service is not
separable, the combined deliverables are
 accounted
for as a single unit of accounting and recognized over the
performance obligation period.  Revenue is recognized when the
following criteria have been met: persuasive evidence of an arrangement exists;
delivery has occurred and risk of loss has passed; the seller’s price to the
buyer is fixed or determinable; and collectability is reasonably
assured.
 
 Assuming
the elements meet the revenue recognition guidelines the revenue recognition
methodology prescribed for each unit of accounting is summarized
below:
 
 Upfront Fees—We defer
recognition of non-refundable upfront fees if we have continuing performance
obligations without which the technology licensed has no utility to the
licensee. If we have continuing involvement through research and development
services that are required because our know-how and expertise related to the
technology is proprietary to us, or can only be performed by us, then such
up-front fees are deferred and recognized over the period of continuing
involvement.
 
 50
 Funded Research and
Development— Revenue from research and development services is recognized
during the period in which the services are performed and is based upon the
number of full-time-equivalent personnel working on the specific project at the
agreed-upon rate. Reimbursements from collaborative partners for agreed upon
direct costs including direct materials and outsourced, or subcontracted,
pre-clinical studies are classified as revenue and recognized in the period the
reimbursable expenses are incurred. Payments received in advance are recorded as
deferred revenue until the research and development services are performed or
costs are incurred.
 
 Milestones—Substantive
milestone payments are considered to be performance bonuses that are recognized
upon achievement of the milestone only if all of the following conditions are
met: the milestone payments are non-refundable; achievement of the milestone
involves a degree of risk and was not reasonably assured at the inception of the
arrangement; substantive effort is involved in achieving the milestone; the
amount of the milestone is reasonable in relation to the effort expended or the
risk associated with achievement of the milestone; and a reasonable amount of
time passes between the up-front license payment and the first milestone payment
as well as between each subsequent milestone payment. If any of these conditions
are not met, the milestone payments are deferred and recognized as revenue over
the term of the arrangement as we complete our performance
obligations.
 
 Royalties—We recognize
royalty revenues from licensed products upon the sale of the related
products.
 
 Advertising
Costs
 
 There
were no advertising costs incurred for any of the periods
presented.
 
 Research
and Development Costs
 
 We charge
research and development costs to expense as incurred. These costs include
salaries and benefits for research and development personnel, costs associated
with clinical trials managed by contract research organizations, and other costs
associated with research, development and regulatory activities. We use external
service providers to conduct clinical trials, to manufacture supplies of product
candidates and to provide various other research and development-related
products and services.
 
 Patent
Costs
 
 We
expense patent costs, including legal expenses, in the period in which they are
incurred. Patent expenses are included as general and administrative expenses in
our statements of operations.
 
 Stock-Based
Compensation
 
 The
Company accounts for share-based compensation under the provisions of ASC 718,
“Compensation-Stock Compensation”. Under the fair value recognition provisions,
stock-based compensation expense is measured at the grant date for all
stock-based awards to employees and directors and is recognized as expense over
the requisite service period, which is generally the vesting period. The Company
was required to utilize the prospective application method, under which prior
periods are not revised for comparative purposes. Under the prospective
application transition method, non-public entities that previously used the
minimum value method of the provisions continue to account for non-vested equity
awards outstanding at the date of adoption of the provisions in the same manner
as they had been accounted for prior to adoption. The provision specifically
prohibits pro forma disclosures for those awards valued using the minimum value
method. The valuation and recognition provisions apply to new awards and to
awards outstanding as of the adoption date that are subsequently modified. The
adoption of these provisions had a material effect on the Company’s financial
position and results of operations. See Note 10 for further information
regarding stock-based compensation expense and the assumptions used in
estimating that expense.
 
 Prior to
the adoption of ASC 718, the Company valued its stock-based awards using the
minimum value method and provided pro-forma information regarding stock-based
compensation and net income required. The Company did not recognize stock-based
compensation expense in its consolidated statements of operations for option
grants to its employees or directors for the periods prior to its adoption
of  ASC 718 because the exercise price of options granted was
generally equal to the fair market value of the underlying common stock on the
date of grant.
 
 The
Company accounts for stock compensation arrangements with non-employees in
accordance with ASC 718 which require that such equity instruments are recorded
at their fair value on the measurement date. The measurement of stock-based
compensation is subject to periodic adjustment as the underlying equity
instruments vest.
 
 Non-employee
stock-based compensation charges are amortized over the vesting period on a
straight-line basis. For stock options granted to non-employees, the fair value
of the stock options is estimated using a Black-Scholes-Merton valuation
model.
 
 51
 
 NOVABAY
PHARMACEUTICALS, INC.
 (a
development stage company)
 
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
 Income
Taxes
 
 We
account for income taxes under the asset and liability method. Deferred tax
assets and liabilities are recognized for the future tax consequences
attributable to differences between the financial statement carrying amounts of
existing assets and liabilities and their respective tax bases and operating
loss and tax credit carryforwards. Deferred tax assets and liabilities are
measured using enacted tax rates expected to apply to taxable income in the
years in which those temporary differences are expected to be recovered or
settled. The effect on deferred tax assets and liabilities of a change in tax
rates is recognized in income in the period that includes the enactment date. A
valuation allowance is recognized if it is more likely than not that some
portion or all of the deferred tax asset will not be recognized.
 
 Net
Income (Loss) per Share
 
 The
Company computes net income (loss) per share by presenting both basic and
diluted earnings (loss) per share (“EPS”).
 
 Basic EPS
is computed by dividing net income (loss) available to common shareholders
(numerator) by the weighted average number of common shares outstanding
(denominator) during the period. Diluted EPS gives effect to all dilutive
potential common shares outstanding during the period including stock options
and stock warrants, using the treasury stock method, and convertible preferred
stock, using the if-converted method. In computing diluted EPS, the average
stock price for the period is used in determining the number of shares assumed
to be purchased from the exercise of stock options or warrants. Potentially
dilutive common share equivalents are excluded from the diluted EPS computation
in net loss periods if their effect would be anti-dilutive. During 2007 and
2008, there is no difference between basic and diluted net loss per share due to
the Company’s net losses.  The following table sets forth the
reconciliation between basic EPS and diluted EPS:
 
 
 Year
      Ended December 31,(in
      thousands)
                
                2007
                
                
                2008
                
                
                2009Net
      income (loss)
                
                $
                (5,400
                )
                
                $
                (8,114
                )
                
                $
                2,697Basic
      shares
                
                
                8,974
                
                
                
                21,312
                
                
                
                22,404Add:
      shares issued upon assumed exercise of stock options
                
                
                -
                
                
                
                -
                
                
                
                711Diluted
      shares
                
                
                8,974
                
                
                
                21,312
                
                
                
                23,115Basic
      EPS
                
                $
                (0.60
                )
                
                $
                (0.38
                )
                
                $
                0.12Diluted
      EPS
                
                $
                (0.60
                )
                
                $
                (0.38
                )
                
                $
                0.12
  The
following outstanding preferred stock, stock options and stock warrants were
excluded from the diluted EPS computation as their effect would have been
anti-dilutive:
 
 Year
      Ended December 31,(in
      thousands)
                
                2007
                
                
                2008
                
                
                2009Stock
      options
                
                
                2,896
                
                
                
                3,371
                
                
                
                711Stock
      warrants
                
                
                350
                
                
                
                650
                
                
                
                1,875
  Recent
Accounting Pronouncements
 
 During
the third quarter of 2009, the Company adopted the FASB Accounting Standards
Codification and the Hierarchy of Generally Accepted Accounting Principles in
accordance with FASB ASC Topic 105,”Generally Accepted Accounting
Principles”(the Codification).  The Codification has become the source
of authoritative U.S. generally accepted accounting principles (GAAP) recognized
by the FASB to be applied by nongovernmental entities.  Rules and
interpretive releases of the Securities and Exchange Commission (SEC) under
authority of federal securities laws are also sources of authoritative GAAP for
SEC registrants.  Effective with the Company’s adoption on July 1,
2009, the Codification has superseded all prior non-SEC accounting and reporting
standards.  All other non-grandfathered non-SEC accounting literature
not included in the Codification has become non-authoritative.  As the
adoption of the Codification only affected how specific references to GAAP
literature have been disclosed in the notes to our condensed consolidated
financial statements, it did not result in any impact on the Company’s results
of operations, financial condition, or cash flows.
 
 52
 
 NOVABAY
PHARMACEUTICALS, INC.
 (a
development stage company)
 
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
 In
September 2009, the FASB issued authoritative guidance regarding
multiple-deliverable revenue arrangements.  This guidance addresses
how to separate deliverables and how to measure and allocate consideration to
one or more units of accounting.  Specifically, the guidance requires
that consideration be allocated among multiple deliverables based on relative
selling prices.  The guidance establishes a selling price hierarchy of
(1) vendor-specific objective evidence, (2) third-party evidence and (3)
estimated selling price.  This guidance is effective for annual
periods beginning after June 15, 2010 but may be early adopted as of the
beginning of an annual period.  The Company is currently evaluating
the effect that this guidance will have on consolidated financial position and
results of operations.
 
 ASC
855-10-20, “Subsequent Events” establishes accounting and reporting standards
for events that occur after the balance sheet date but before financial
statements are issued or are available to be issued.  This statement
is effective for our third quarter ended September 30, 2009 and the adoption did
not have an impact on the condensed consolidated financial
statements.
 
 In April
2009, the FASB issued ASC 820-10-65 formerly FASB Staff Position FAS 157-4,
“Determining Fair Value When the Volume and Level of Activity for the Asset or
Liability Have Significantly Decreased and Identifying Transactions That Are Not
Orderly” (“FSP 157-4”). This provides significant guidance for determining when
a market has become inactive as well as guidance for determining whether
transactions are not orderly. It also provides guidance on the use of valuation
techniques and the use of broker quotes and pricing services. It reiterates that
fair value is based on an exit price and also that fair value is market-driven
and not entity-specific. The accounting standard of codification applies to all
assets and liabilities within the scope of ASC 820 and is effective for all
interim and annual periods ending after June 15, 2009. The adoption of ASC
820-10-65 did not have a material effect on the Company’s results of operations,
financial position, and cash flows.
 
 In April
2009, the FASB issued ASC 320-10-65, formerly FASB Staff Position FAS 115-2, FAS
124-2 and EITF 99-20-2, “Recognition and Presentation of Other-Than-Temporary
Impairments” (“FSP 115-2”). This accounting standard provides guidance related
to determining the amount of an other-than-temporary impairment (OTTI) of debt
securities and prescribes the method to be used to present information about an
OTTI in the financial statements.  It is effective for all interim and
annual periods ending after June 15, 2009. The adoption of FSP 115-2 did not
have a material effect on the Company’s results of operations, financial
position, and cash flows.
 
 In April
2009, the FASB issued ASC 825-10-65, formerly FASB Staff Position FAS 107-1 and
APB 28-1, “Interim Disclosures about Fair Value of Financial Instruments” (“FSP
107-1”), which increases the frequency of fair value disclosures to a quarterly
basis instead of an annual basis. The guidance relates to fair value disclosures
for any financial instruments that are not currently reflected on the balance
sheet at fair value. This ASC is effective for interim and annual periods ending
after June 15, 2009. The adoption did not have a material effect on the
Company’s results of operations, financial position, and cash
flows.
 
 NOTE
3. SHORT-TERM INVESTMENTS
 
 Short-term
investments at December 31, 2008 and 2009 consisted of the
following:
 
 53
 
 NOVABAY
PHARMACEUTICALS, INC.
 (a
development stage company)
 
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
 
 December
      31, 2008Gross
                  
                  
                  GrossAmortized
                  
                  
                  Unrealized/Realized
                  
                  
                  Unrealized/Realized
                  
                  
                  Market(in
      thousands)
                  
                  Cost
                  
                  
                  Gains
                  
                  
                  Losses
                  
                  
                  ValueCorporate
      bonds
                  
                  $
                  -
                  
                  
                  $
                  -
                  
                  
                  $
                  -
                  
                  
                  $
                  -U.S.
      Agencies
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -Municipal
      Bonds
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -Certificates
      of Deposit
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -Other
      Fixed Income
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -$
                  -
                  
                  
                  $
                  -
                  
                  
                  $
                  -
                  
                  
                  $
                  -
  December
      31, 2009Gross
                  
                  
                  GrossAmortized
                  
                  
                  Unrealized/Realized
                  
                  
                  Unrealized/Realized
                  
                  
                  Market(in
      thousands)
                  
                  Cost
                  
                  
                  Gains
                  
                  
                  Losses
                  
                  
                  ValueCorporate
      bonds
                  
                  $
                  -
                  
                  
                  $
                  -
                  
                  
                  $
                  -
                  
                  
                  $
                  -U.S.
      Agencies
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -Municipal
      Bonds
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -Certificates
      of Deposit
                  
                  
                  300
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  300Other
      Fixed Income
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -$
                  300
                  
                  
                  $
                  -
                  
                  
                  $
                  -
                  
                  
                  $
                  300
  Contractual
maturities of short-term investments as of December 31, 2008 and 2009 were
as follows:
 
 December
      31, 2008Amortized
                  
                  
                  Market(in
      thousands)
                  
                  Cost
                  
                  
                  ValueDue
      in one year or less
                  
                  $
                  -
                  
                  
                  $
                  -Due
      after 10 years
                  
                  
                  -
                  
                  
                  
                  -Total
                  
                  $
                  -
                  
                  
                  $
                  -
  December
      31, 2009Amortized
                  
                  
                  Market(in
      thousands)
                  
                  Cost
                  
                  
                  ValueDue
      in one year or less
                  
                  $
                  300
                  
                  
                  $
                  300Due
      after 10 years
                  
                  
                  -
                  
                  
                  
                  -Total
                  
                  $
                  300
                  
                  
                  $
                  300
  During
the years ended December 31, 2007, 2008, and 2009 we recognized a net
realized gain of $0, $35,000 and $0 respectively. For the cumulative period from
July 1, 2002 (date of development stage inception) to December 31,
2009, we recognized a net realized gain of $3,000.
 
 54
 
 NOVABAY
PHARMACEUTICALS, INC.
 (a
development stage company)
 
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
 NOTE
4. PROPERTY AND EQUIPMENT
 
 Property
and equipment consisted of the following:
 
 (in
      thousands)
                
                December 31,
      2008
                
                
                December 31,
      2009Office
      and laboratory equipment
                
                $
                1,728
                
                
                $
                2,430Furniture
      and fixtures
                
                
                113
                
                
                
                113Software
                
                
                110
                
                
                
                133Leasehold
      improvement
                
                
                143
                
                
                
                147Total
      property and equipment, at cost
                
                
                2,094
                
                
                
                2,823Less:
      accumulated depreciation
                
                
                (638
                )
                
                
                (1,011
                )Total
      property and equipment, net
                
                $
                1,456
                
                
                $
                1,812
  Depreciation
expense was $373,000, $304,000 and $183,000 for the years ended December 31,
2009, 2008 and 2007, respectively and $1,077,000 for the cumulative period from
July 1, 2002 (date of development stage inception) to December 31,
2009.
 
 NOTE
5. ACCRUED LIABILITIES
 
 Accrued
liabilities consisted of the following:
 
 (in
      thousands)
                
                December 31,
      2008
                
                
                December 31,
      2009Research
      and development
                
                $
                509
                
                
                $
                118Employee
      payroll and benefits
                
                
                423
                
                
                
                744Professional
      fees
                
                
                182
                
                
                
                58Other
                
                
                52
                
                
                
                308Total
      accrued liabilities
                
                $
                1,166
                
                
                $
                1,228
  NOTE
6. CAPITAL LEASE OBLIGATION
 
 During
the first quarter of 2007, we commenced a lease for a portion of our laboratory
equipment. This arrangement is being accounted for as a capital lease. Assets
under capital leases that are included in property and equipment are as
follows:
 
 December
      31,
                
                
                December
      31,(in
      thousands)
                
                2008
                
                
                2009Office
      and laboratory equipment
                
                $
                229
                
                
                $
                147Less:
      accumulated depreciation
                
                
                (47
                )
                
                
                (80
                )Capital
      lease assets, net
                
                $
                182
                
                
                $
                67
  Future
minimum lease payments under capital leases were as follows at December 31,
2009:
 
 Lease(in
      thousands)
                
                CommitmentYear
      ending December 31,2010
                
                $
                7Total
      minimum lease payments
                
                
                7Less:
      amount representing interest
                
                
                -Present
      value of minimum lease payments
                
                $
                7
  NOTE
7. EQUIPMENT LOAN
 
 During
April 2007, we entered into a master security agreement to establish a $1.0
million equipment loan facility with a financial institution. The purpose of
this loan is to finance equipment purchases, principally in the build-out of our
laboratory facilities. Borrowings under the loan are secured by eligible
equipment purchased from January 2006 through April 2008 and will be repaid over
40 months at an interest rate equal to the greater of 5.94% over the three year
Treasury rate in effect at the time of funding or 10.45%. There are no loan
covenants specified in the agreement.
 
 55
 
 NOVABAY
PHARMACEUTICALS, INC.
 (a
development stage company)
 
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
 As of
December 31, 2009, we had an outstanding equipment loan balance of $470,000
carrying a weighted-average interest rate of 10.99%. At December 31, 2009, there
was $216,000 available for borrowing under this equipment loan
facility.
 
 Future
minimum loan payments under equipment loans were as follows at December 31,
2009:
 
 Loan(in
      thousands)
                
                CommitmentYear
      ending December 31:2010
                
                $
                3962011
                
                
                109Total
      minimum loan payments
                
                
                505Less:
      amount representing interest
                
                
                (35
                )Present
      value of minimum loan payments
                
                $
                470
  NOTE
8. COMMITMENTS AND CONTINGENCIES
 
 Operating
Leases
 
 We lease
laboratory facilities and office space under an operating lease, portions of
which expire at various dates through 2015. Rent expense was $526,000, $620,000,
and $878,000 for the years ended December 31, 2007, 2008 and 2009, respectively,
and $2,820,000 for the cumulative period from July 1, 2002 (date of
development stage inception) to December 31, 2009.  The future minimum
lease payments under non-cancellable operating leases were as follows as of
December 31, 2009:
 
 Lease(in
      thousands)
                
                CommitmentYear
      ending December 31:2010
                
                $
                9012011
                
                
                9382012
                
                
                9762013
                
                
                1,0152014
                
                
                992thereafter
                
                
                588Total
      lease commitment
                
                $
                5,410
 
 Legal
Matters
 
 From time
to time, the Company may be involved in various legal proceedings arising in the
ordinary course of business. There are no matters at December 31, 2009 that, in
the opinion of management, would have a material adverse effect on our financial
position, results of operations or cash flows.
 
 NOTE
9. STOCKHOLDERS’ EQUITY
 
 Preferred
Stock
 
 In 2002
and 2003, the Company issued 3.2 million shares of Series A Convertible
Preferred Stock for net proceeds of $647,000. In 2003 and 2004, the Company
issued 6.9 million shares of Series B Convertible Preferred Stock for net
proceeds of $3.0 million. In 2004 and 2005, the Company issued 6.7 million
shares of Series C Convertible Preferred Stock for net proceeds of $5.4 million.
In 2005 and 2006, the Company issued 2.5 million shares of Series D Convertible
Preferred Stock for net proceeds of $3.6 million. All outstanding shares of
convertible preferred stock automatically converted into 9.6 million shares of
common stock upon the closing of the Company’s IPO in October 2007. In
connection with the IPO, the Company amended its articles of incorporation to
provide for the issuance of up to 5,000,000 shares of preferred stock in such
series and with such rights and preferences as may be approved by the board of
directors. As of December 31, 2009, there were no shares of preferred stock
outstanding.
 
 56
 
 NOVABAY
PHARMACEUTICALS, INC.
 (a
development stage company)
 
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
 Common
Stock
 
 Under the
Company’s amended articles of incorporation, the Company is authorized to issue
65,000,000 shares of $0.01 par value common stock. Each holder of common stock
has the right to one vote but does not have cumulative voting rights. Shares of
common stock are not subject to any redemption or sinking fund provisions, nor
do they have any preemptive, subscription or conversion rights. Holders of
common stock are entitled to receive dividends whenever funds are legally
available and when declared by the board of directors, subject to the prior
rights of holders of all classes of stock outstanding having priority rights as
to dividends. No dividends have been declared or paid as of December 31,
2009.
 
 In
August 2007, the Company filed an amendment to its articles of incorporation to
effect a 1-for-2 reverse stock split of its common stock. All share and per
share amounts relating to the common stock, stock options and warrants and the
conversion ratios of preferred stock included in the financial statements and
footnotes have been restated to reflect the reverse stock split.
 
 In
October 2007, the Company completed an initial public offering of its common
stock in which it sold and issued 5,000,000 shares of its common stock at a
price to the public of $4.00 per share. The Company raised a total of $20.0
million from the IPO, or approximately $17.1 million in net cash proceeds after
deducting underwriting discounts and commissions of $1.4 million and other
offering costs of $1.5 million.
 
 In August
2009, the Company sold and issued 1,225,000 units of its common stock at a price
of $2.00 per unit from a Shelf Registration Offering.  Each unit
consisted of one share of the Company’s common stock and a warrant to purchase
one share of the Company’s common stock.  The Company raised a total
of $2.5 million from the Shelf Registration Offering, or approximately $1.9
million in net proceeds after deducting underwriting commissions of $156,000 and
other offering costs of $349,868.
 
 Stock
Warrants
 
 Warrants
to acquire shares of common stock were issued in connection with the sales of
the Series A and Series B Convertible Preferred Stock and certain convertible
notes. Additionally, in October 2007, warrants were issued to the underwriters
in connection with the IPO. In 2009 warrants were issued to investors as part of
our Shelf Registration Offering.  The significant terms of the Series
A, Series B, Note, Underwriter and Investor warrants were as
follows:
 
 Series A Warrants—The
warrants issued with the sale of Series A Preferred Stock were issued on the
basis of 0.20 of a warrant for every share of Series A Preferred Stock
purchased. The exercise price of these warrants was $1.20 per share. We extended
a limited-time offer to holders of the warrants to exercise them at a price of
$0.80 per share. Any unexercised warrants expired on July 1, 2005,
except for warrants issued in connection with later purchases of the Series A
Preferred Stock for which the expiration date was extended to July 1,
2006.
 
 Series B Warrants—The
warrants issued with the sale of Series B Preferred Stock were issued on the
basis of 0.175 of a warrant for every share of Series B Preferred Stock
purchased. The exercise price of these warrants was $0.80 per share. Any
unexercised warrants expired on June 30, 2006.
 
 Note Warrants—Warrants were
granted in connection with promissory notes issued to certain of our
shareholders in 2002 and 2003. The warrants issued to these shareholders had an
exercise price of $1.20 per share. Any unexercised warrants expired on June
30, 2006.
 
 Underwriter Warrants—In
connection with the IPO, the Company issued warrants to the underwriters to
purchase an aggregate of 350,000 shares of common stock at an exercise price of
$4.00 per share. The warrants were exercisable on or after October 31, 2008 and
expire on October 31, 2010. The warrants were valued at approximately $524,000
using the Black-Scholes-Merton option-pricing model based upon the following
assumptions: (1) expected price volatility of 50.0%, (2) a risk-free interest
rate of 3.94% and (3) a contractual life of 3 years. The Company accounted for
the fair value of the Underwriter Warrants as an expense of the IPO resulting in
a charge to stockholders’ equity.
 
 Advisory Services Warrants -
In April 2008, the Company issued a two year warrant and a four year warrant to
purchase an aggregate of 300,000 shares of common stock to PM Holdings Ltd. as
part of our consideration for the revision of the agreement dated February 13,
2007 with PM Holdings.  Under the terms of the original agreement, the
Company agreed to pay PM Holdings $28,000 per month through February 2010 for
financial and investor relations advisory services. The amendment to this
agreement eliminated the monthly cash payment obligation and instead provided
for a one-time, upfront cash payment of $264,000 and the issuance of warrants to
purchase 300,000 shares of common stock at an exercise price of $4.00 per share.
The warrants were valued at approximately $162,000 using the
Black-Scholes-Merton option-pricing model based upon the following assumptions:
(1) expected price volatility of 50.0%, (2) a risk-free interest rate of 3.94%
and (3) a contractual life of 2 years.   The Company accounts for
the fair value of the Advisory Services Warrants as an expense amortized over
the life of the warrants.
 
 57
 
 NOVABAY
PHARMACEUTICALS, INC.
 (a
development stage company)
 
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
 
 Investor Warrants—In August
2009, in connection with the Shelf Registration Offering, the Company issued
warrants to the investors to purchase an aggregate of 1,225,000 shares of common
stock at an exercise price of $2.75 per share. The warrants are exercisable on
or after February 17, 2010 and expire on August 21, 2014.
 
 At
December 31, 2009, there were outstanding warrants to purchase 650,000 shares of
common stock at a weighted-average exercise price of $4.00 per
share.  Additionally, there were outstanding warrants to purchase
1,225,000 shares of common stock from the Shelf Registration Offering at the
exercise price of $2.75 per share. None of the warrants were exercisable at
December 31, 2009.
  The
following table summarizes information about the Company’s warrants outstanding
at December 31, 2009, 2008 and 2007 and activity during the three years then
ended.
 
 (in
      thousands, except per share data)
                
                Warrants
                
                
                Weighted-Average
                  Exercise
      PriceOutstanding
      at December 31, 2006
                
                
                -
                
                
                $
                -Warrants
      granted
                
                
                350
                
                
                $
                4.00Outstanding
      at December 31, 2007
                
                
                350
                
                
                $
                4.00Warrants
      granted
                
                
                300
                
                
                $
                4.00Outstanding
      at December 31, 2008
                
                
                650
                
                
                $
                4.00Warrants
      granted
                
                
                1,225
                
                
                $
                2.75Outstanding
      at December 31, 2009
                
                
                1,875
                
                
                $
                3.18
  NOTE
10. EQUITY-BASED COMPENSATION
 
 Equity
Compensation Plans
 
 Prior to
the IPO, the Company had two equity plans in place: the 2002 Stock Option Plan
and the 2005 Stock Option Plan. Upon the closing of the IPO in October 2007, the
Company adopted the 2007 Omnibus Incentive Plan (the “2007 Plan”) to provide for
the granting of stock awards, such as stock options, unrestricted and restricted
common stock, stock units, dividend equivalent rights, and stock appreciation
rights to employees, directors and outside consultants as determined by the
board of directors. In conjunction with the adoption of the 2007 Plan, no
further option awards may be granted from the 2002 or 2005 Stock Option Plans
and any option cancellations or expirations from the 2002 or 2005 Stock Option
Plans may not be reissued. At the inception of the 2007 Plan, 2,000,000 shares
were reserved for issuance under the Plan.  Beginning in January 2009,
the number of shares of common stock authorized for issuance under the 2007 Plan
increases annually in an amount equal to the lesser of (a) 1,000,000 shares or
(b) 4% of the number of shares of the Company’s common stock outstanding on the
last day of the preceding year or (c) such lesser number as determined by the
board of directors.  Accordingly, an additional 858,766 shares of
common stock were authorized for issuance under the 2007 Plan in January 2009.
As of December 31, 2009, there were 550,995 shares available for future
grant under the 2007 Plan.
 
 Under the
terms of the 2007 Plan, the exercise price of incentive stock options may not be
less than 100% of the fair market value of the common stock on the date of grant
and, if granted to an owner of more than 10% of the Company’s stock, then not
less than 110%. Stock options granted under the 2007 Plan expire no later than
ten years from the date of grant. Stock options granted to employees generally
vest over four years while options granted to directors and consultants
typically vest over a shorter period, subject to continued service. All of the
options granted prior to October 2007 include early exercise provisions that
allow for full exercise of the option prior to the option vesting, subject to
certain repurchase provisions. The Company issues new shares to satisfy option
exercises under the plans.
 
 58
 
 NOVABAY
PHARMACEUTICALS, INC.
 (a
development stage company)
 
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
 Stock
Options Summary
  The
following table summarizes information about the Company’s stock options
outstanding at December 31, 2009, 2008 and 2007 and activity during the three
years then ended.
 
 (in
      thousands, except per share data)
                
                Options
                
                
                Weighted-Average
      Exercise Price
                
                
                Weighted-Average
      Remaining Contractual Life (years)
                
                
                Aggregate
      Intrinsic ValueOutstanding
      at December 31, 2006
                
                
                2,401
                
                
                $
                0.83Options
      granted
                
                
                814
                
                
                $
                3.30Options
      exercised
                
                
                (298
                )
                
                $
                0.38Options
      forfeited/cancelled
                
                
                (21
                )
                
                $
                1.52Outstanding
      at December 31, 2007
                
                
                2,896
                
                
                $
                1.57Options
      granted
                
                
                903
                
                
                $
                2.39Options
      exercised
                
                
                (122
                )
                
                $
                1.18Options
      forfeited/cancelled
                
                
                (306
                )
                
                $
                2.66Outstanding
      at December 31, 2008
                
                
                3,371
                
                
                $
                1.70Options
      granted
                
                
                1,196
                
                
                $
                1.80Options
      exercised
                
                
                (119
                )
                
                $
                0.62Options
      forfeited/cancelled
                
                
                (301
                )
                
                $
                2.42Outstanding
      at December 31, 2009
                
                
                4,147
                
                
                $
                1.71
                
                
                
                7.0
                
                
                $
                2,456Vested
      and expected to vest at December 31, 2009
                
                
                3,973
                
                
                $
                1.69
                
                
                
                6.9
                
                
                $
                2,427Vested
      at December 31, 2009
                
                
                2,360
                
                
                $
                1.41
                
                
                
                5.5
                
                
                $
                2,084Exercisable
      at December 31, 2009
                
                
                2,532
                
                
                $
                1.53
                
                
                
                5.6
                
                
                $
                2,099
 
 The
aggregate intrinsic value is calculated as the difference between the exercise
price of the underlying stock option awards and the closing market price of the
Company’s common stock as quoted on the NYSE Amex as of December 31, 2009. The
Company received cash payments for the exercise of stock options in the amount
of $114,000, $149,000 and $74,000 during the years ended December 31, 2007, 2008
and 2009, respectively. The aggregate intrinsic value of stock option awards
exercised was $571,000, $108,000 and $148,000 for the years ended December 31,
2007, 2008 and 2009, respectively, as determined at the date of option
exercise.
  The
options outstanding and vested by exercise price at December 31, 2009 were as
follows (number of options in thousands):
 
 Options
      Outstanding
                  
                  
                  Options
      VestedRange
      of Exercise Prices
                  
                  Number
      Outstanding
                  
                  
                  Weighted-Average
                    Remaining
                    Contractual
      Life (years)
                  
                  
                  Weighted-Average
                    Exercise
      Price
                  
                  
                  Number
      Vested
                  
                  
                  Weighted-Average
                    Exercise
      Price$0.20
                  
                  
                  494
                  
                  
                  
                  2.1
                  
                  
                  $
                  0.20
                  
                  
                  
                  494
                  
                  
                  $
                  0.20$0.30
                  
                  
                  318
                  
                  
                  
                  4.0
                  
                  
                  $
                  0.30
                  
                  
                  
                  318
                  
                  
                  $
                  0.30$0.56
                  
                  
                  162
                  
                  
                  
                  4.5
                  
                  
                  $
                  0.56
                  
                  
                  
                  154
                  
                  
                  $
                  0.56$1.20
      - $1.56
                  
                  
                  503
                  
                  
                  
                  8.3
                  
                  
                  $
                  1.39
                  
                  
                  
                  180
                  
                  
                  $
                  1.24$1.70
      - $1.99
                  
                  
                  1,686
                  
                  
                  
                  8.2
                  
                  
                  $
                  1.82
                  
                  
                  
                  742
                  
                  
                  $
                  1.75$2.00
      - $2.41
                  
                  
                  407
                  
                  
                  
                  8.1
                  
                  
                  $
                  2.25
                  
                  
                  
                  158
                  
                  
                  $
                  2.26$3.56
      - $4.00
                  
                  
                  577
                  
                  
                  
                  8.0
                  
                  
                  $
                  3.69
                  
                  
                  
                  314
                  
                  
                  $
                  3.694,147
                  
                  
                  
                  7.0
                  
                  
                  $
                  1.71
                  
                  
                  
                  2,360
                  
                  
                  $
                  1.41
  Stock
Option Awards to Employees and Directors
  The
Company grants options to purchase common stock to some of its employees and
directors at prices equal to or greater than the market value of the stock on
the dates the options are granted. The Company has estimated the value of
certain stock option awards as of the date of the grant by applying the
Black-Scholes-Merton option pricing valuation model using the single-option
valuation approach. The application of this valuation model involves assumptions
that are judgmental and subjective in nature. See Note 2 for a description of
the accounting policies that the Company applied to value its stock-based
awards.
 
 59
 
 NOVABAY
PHARMACEUTICALS, INC.
 (a
development stage company)
 
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
 The
weighted average assumptions used in determining the value of options granted
and a summary of the methodology applied to develop each assumption are as
follows:
 
 Year
      Ended December 31,Assumption
                2007
                
                2008
                
                2009Expected
      price volatility
                68.9%
                
                70.3%
                
                87.1%Expected
      term (in years)
                6.0
                
                6.1
                
                6.1Risk-free
      interest rate
                4.1%
                
                3.1%
                
                2.4%Dividend
      yield
                0.0%
                
                0.0%
                
                0.0%Weighted-average
      fair value of options granted during the period
                $2.17
                
                $1.56
                
                $1.31
  Expected Price
Volatility—This is a measure of the amount by which the stock price has
fluctuated or is expected to fluctuate. The computation of expected volatility
was based on the historical volatility of comparable companies from a
representative peer group selected based on industry and market capitalization
data. An increase in the expected price volatility will increase the value of
the option granted and the related compensation expense.
  Expected Term—This is the
period of time over which the options granted are expected to remain
outstanding. Because there is insufficient historical information available to
estimate the expected term of the stock-based awards, we adopted the simplified
method for estimating the expected term pursuant to SAB No. 107. On this
basis, we estimated the expected term of options granted by taking the average
of the vesting term and the contractual term of the option. An increase in the
expected life will increase the value of the option granted and the related
compensation expense.
  Risk-Free Interest Rate—This
is the U.S. Treasury rate for the week of the grant having a term approximating
the expected life of the option. An increase in the risk-free interest rate will
increase the value of the option granted and the related compensation
expense.
  Dividend Yield—We have not
made any dividend payments nor do we have plans to pay dividends in the
foreseeable future. An increase in the dividend yield will decrease the value of
the option granted and the related compensation expense.
  Forfeitures
are estimated at the time of grant and reduce compensation expense ratably over
the vesting period. This estimate is adjusted periodically based on the extent
to which actual forfeitures differ, or are expected to differ, from the previous
estimate. For the years ended December 31, 2007 and 2009, we applied an
estimated forfeiture rate of 5% to employee grants and 0% to director grants.
Due to employee turnover in 2008, we applied an estimated forfeiture rate of 20%
to employee grants and 0% to director grants.
  For the
years ended December 31, 2007, 2008 and 2009, we recognized stock-based
compensation expense of $399,000 $721,000 and $702,000, respectively, for option
awards to employees and directors. As of December 31, 2009, total unrecognized
compensation cost related to unvested stock options granted or modified on or
after January 1, 2006 was $2.0 million. This amount is expected to be
recognized as stock-based compensation expense in our statements of operations
over the remaining weighted average vesting period of 2.8 years.
 
 Common
Stock Awards to Directors
  In
connection with the close of the IPO in October 2007, in December 2009 the
Company adopted a new plan to compensate the independent members of the Board of
Directors for their services. Under the terms of the
Director Compensation Plan, each independent member is entitled to a
combination of cash and stock options, at their discretion, for their
participation in the board and various committees.  If the director
elects to receive stock options these are issued to the director at the
beginning of the year and vest over the term of the year.  Cash
payments are made quarterly at the beginning of each quarter.
 
 In
accordance with these provisions, the Company issued 51,000 and 130,000 shares
of common stock to independent directors during the years ended December 31,
2008 and 2009, respectively. These shares were issued out of the 2007 Plan. The
fair market value of the stock issued to directors was recorded as an operating
expense in the period in which the meeting occurred, resulting in total
compensation expense of $124,000 and $218,000 for common stock awards to
directors during the years ended December 31, 2008 and 2009,
respectively.
 
 Summary
of Stock-Based Compensation Expense
  Stock-based
compensation expense is classified in the statements of operations in the same
expense line items as cash compensation. Since the Company has operated at a
loss and has considerable net operating loss carryforwards, it does not expect
to realize any current tax benefits related to stock options.
 
 60
 
 NOVABAY
PHARMACEUTICALS, INC.
 (a
development stage company)
 
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
 A summary
of the stock-based compensation expense included in results of operations for
the option and stock awards to employees and directors discussed above is as
follows:
 
 Year
      ended December 31,(in
      thousands)
                
                2007
                
                
                2008
                
                
                2009Research
      and development
                
                $
                206
                
                
                $
                412
                
                
                $
                548General
      and administrative
                
                
                222
                
                
                
                432
                
                
                
                372Total
      stock-based compensation expense
                
                $
                428
                
                
                $
                844
                
                
                $
                920
  Stock-Based
Awards to Non-Employees
  During
the years ended December 31, 2007, 2008 and 2009, the Company granted options to
purchase an aggregate of 69,000, 16,000 and 273,000 shares of common stock,
respectively, to non-employees in exchange for advisory and consulting services.
The stock options are recorded at their fair value on the measurement date and
recognized over the respective service or vesting period. The fair value of the
stock options granted was calculated using the Black-Scholes-Merton option
pricing model based upon the following assumptions:
 
 Year
      Ended December 31,Assumption
                
                2007
                
                2008
                
                2009Expected
      price volatility
                
                71.0%
                
                70.0%
                
                87.2%Expected
      term (in years)
                
                5.3
                
                6.1
                
                5.6Risk-free
      interest rate
                
                4.7%
                
                3.1%
                
                1.9%Dividend
      yield
                
                0.0%
                
                0.0%
                
                0.0%Weighted-average
      fair value of options granted during the period
                
                $1.70
                
                $1.26
                
                $1.41
 
 For the
years ended December 31, 2007 and 2009, the Company recognized stock-based
compensation expense of $118,000 and $273,000, respectively, related to
non-employee option grants. For the year ended December 31, 2008 the Company
reversed previously recognized expense of $13,000 due to the required
revaluation of unvested non-employee grants.
 
 NOTE
11. COLLABORATION AND LICENSE AGREEMENTS
 
 Alcon
Manufacturing, Ltd.
 
 In August
2006, we entered into a collaboration and license agreement with Alcon
Manufacturing, Ltd. (“Alcon”) to license to Alcon the exclusive rights to
develop, manufacture and commercialize products incorporating the Aganocide
compounds for application in connection with the eye, ear and sinus and for use
in contact lens solution. Under the terms of the agreement, Alcon agreed to pay
an up-front, non-refundable, non-creditable technology access fee of $10.0
million upon the effective date of the agreement. This up-front fee was recorded
as deferred revenue and is being amortized into revenue on a straight-line basis
over the four-year funding term of the agreement, through August 2010.
Additionally, we will receive semi-annual payments to support on-going research
and development activities over the four year funding term of the agreement. The
research and development support payments include amounts to fund a specified
number of personnel engaged in collaboration activities and to reimburse for
qualified equipment, materials and contract study costs. Our obligation to
perform research and development activities under the agreement expires at the
end of the four year funding term. As product candidates are developed and
proceed through clinical trials and approval, we will receive milestone
payments. If the products are commercialized, we will also receive royalties on
any sales of products containing the Aganocide compound. Alcon has the right to
terminate the agreement in its entirety upon nine months’ notice, or terminate
portions of the agreement upon 135 days’ notice, subject to certain provisions.
Both parties have the right to terminate the agreement for breach upon 60 days’
notice.
 
 Revenue
has been recognized as follows:
 
 Year
      Ended December 31,(in
      thousands)
                
                2007
                
                
                2008
                
                
                2009Amortization
      of Upfront Technology Access Fee
                
                $
                2,500
                
                
                $
                2,500
                
                
                $
                2,500On-going
      Research and Development
                
                
                2,700
                
                
                
                2,700
                
                
                
                4,322Materials,
      Equipment, and Contract Study Costs
                
                
                611
                
                
                
                1,386
                
                
                
                1,349Milestone
      Payment
                
                
                -
                
                
                
                -
                
                
                
                1,000$
                5,811
                
                
                $
                6,586
                
                
                $
                9,171
  At
December 31, 2007, 2008 and 2009, we had deferred revenue balances of $7.4
million, $4.2 million and $1.7 million, respectively, related to the Alcon
agreement which was comprised of $6.7 million, $4.2 million and $1.7 million,
respectively, for the upfront technology access fee and $0.7 million, $0 and $0,
respectively, for other prepaid reimbursements.
 
 61
 
 NOVABAY
PHARMACEUTICALS, INC.
 (a
development stage company)
 
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
 Galderma
 
 On March 25, 2009, the Company
announced that it entered into an agreement with Galderma S.A. to develop and
commercialize the Company’s Aganocide compounds, which covers acne and impetigo
and potentially other major dermatological conditions, excluding onychomycosis
(nail fungus) and orphan drug indications. The Company amended this agreement on
December 17, 2009.  This agreement is exclusive and worldwide in
scope, with the exception of Asian markets where the Company has
commercialization rights, and North America, where the Company has an option to
exercise co-promotion rights.   Galderma will be responsible for
the development costs of the acne and other indications, except in Japan, in
which Galderma has the option to request that we share such development costs,
and for the ongoing development program for impetigo, upon the achievement of a
specified milestone. Galderma will also reimburse NovaBay for the use of its
personnel in support of the collaboration. NovaBay retains the right to
co-market products resulting from the agreement in Japan. In addition, NovaBay
has retained all rights in other Asian markets outside Japan, and has the right
to co-promote the products developed under the agreement in the hospital and
other healthcare institutions in North America. Upon the termination of the
agreement under certain circumstances, Galderma will grant NovaBay certain
technology licenses which would require NovaBay to make royalty payments to
Galderma for such licenses with royalty rates in the low- to mid-single
digits.
 
 Galderma
will pay to NovaBay certain upfront fees, ongoing fees, reimbursements, and
milestone payments related to achieving development and commercialization of its
Aganocide compounds.  If products are commercialized under the
agreement, NovaBay’s royalties will escalate as sales increase.  The
Company received a $1.0 million upfront technology access fee payment in the
first quarter of 2009.  Upon the termination of the agreement under
certain circumstances, Galderma will grant NovaBay certain technology licenses
which would require NovaBay to make royalty payments to Galderma for such
licenses with royalty rates in the low-to- mid single digits.
 
 Revenue
has been recognized under the Galderma agreement as follows:
 
 Year
      Ended December 31,(in
      thousands)
                
                2007
                
                
                2008
                
                
                2009Amortization
      of Upfront Technology Access Fee
                
                $
                -
                
                
                $
                -
                
                
                $
                500On-going
      Research and Development
                
                
                -
                
                
                
                -
                
                
                
                1,200Materials,
      Equipment, and Contract Study Costs
                
                
                -
                
                
                
                -
                
                
                
                1,063Milestone
      Payments
                
                
                -
                
                
                
                -
                
                
                
                3,750$
                -
                
                
                $
                -
                
                
                $
                6,513
  The
Company had deferred revenue balances of $0 and $500,000 respectively, at
December 31, 2008 and December 31, 2009, related to the Galderma agreement,
which consisted of the remaining amount to be amortized for the upfront
technology access fee.  As of December 31, 2009, the Company has
earned $3.75 million in milestone payments.  This balance was included
in accounts receivable as of December 31, 2009.  As of December 31,
2009, the Company has not earned or received any royalty payments under the
Galderma agreement.
 
 KCI
International VOF GP
 
 In June
2007, we entered into a license agreement with an affiliate of Kinetic Concepts,
Inc. (“KCI”), under which we granted KCI the exclusive rights to develop,
manufacture and commercialize NVC-101, or NeutroPhase, as well as other products
containing hypochlorous acid as the principal active ingredient, worldwide for
use in wound care in humans, other than products or uses intended for the eye,
ear or nose. Under the terms of the agreement, KCI paid to us a non-refundable
technology access fee of $200,000. The up-front technology access fee was
recorded as deferred revenue and has been amortized into revenue on a
straight-line basis over the 18-month performance obligation period, through
December 2008. Under the agreement, we are also entitled to receive
reimbursements for qualified consulting, materials and contract study costs. In
addition, we are entitled to receive payments of up to $1.25 million if certain
milestones are met. If products covered by the license are commercially
launched, we will also receive royalty payments based on net revenues from sales
by KCI of such products. KCI has the right to terminate the agreement without
penalty upon 60 days’ notice. We have the right to terminate the agreement if
KCI has not commercially launched a product incorporating NVC-101, or any other
product containing hypochlorous acid, within 18 months of the date of the
agreement. Both parties have the right to terminate the agreement for breach
upon 60 days’ notice.  On November 19, 2009, the agreement between KCI
and NovaBay was mutually terminated.
 
 62
 
 NOVABAY
PHARMACEUTICALS, INC.
 (a
development stage company)
 
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
 Revenue
has been recognized as follows:
 
 Year
      Ended December 31,(in
      thousands)
                
                2007
                
                
                2008
                
                
                2009Amortization
      of Upfront Technology Access Fee
                
                $
                72
                
                
                $
                128
                
                
                $
                -On-going
      Research and Development
                
                
                30
                
                
                
                8
                
                
                
                -Materials,
      Equipment, and Contract Study Costs
                
                
                -
                
                
                
                -
                
                
                
                -$
                102
                
                
                $
                136
                
                
                $
                -
  As of
December 31, 2009, we had no deferred revenue related to the KCI agreement
and we had not earned or received any milestone or royalty payments under the
KCI agreement.
 
 NOTE
12. EMPLOYEE BENEFIT PLAN
 
 We have a
401(k) plan covering all eligible employees. We are not required to contribute
to the plan and have made no contributions through December 31,
2009.
 
 NOTE
13. INCOME TAXES
 
 Net
income (loss) before provision for income taxes consisted of the following (in
thousands):
 
 Year
      Ending December 312007
                
                
                2008
                
                
                2009United
      States
                
                
                (5,388
                )
                
                
                (8,112
                )
                
                
                2,704International
                
                
                -
                
                
                
                -
                
                
                
                -(5,388
                )
                
                
                (8,112
                )
                
                
                2,704
  The
federal and state income tax provision (benefit) is summarized as follows (in
thousands):
 
 Year
      Ending December 31(in
      thousands)
                
                2007
                
                
                2008
                
                
                2009CurrentFederal
                
                $
                -
                
                
                $
                -
                
                
                $
                -State
                
                
                12
                
                
                
                2
                
                
                
                7Other
                
                
                -
                
                
                
                -
                
                
                
                -Total
      Current Tax Expense
                
                
                12
                
                
                
                2
                
                
                
                7DeferredFederal
                
                
                -
                
                
                
                -
                
                
                
                -State
                
                
                -
                
                
                
                -
                
                
                
                -Other
                
                
                -
                
                
                
                -
                
                
                
                -Total
      Deferred Tax Expense
                
                
                -
                
                
                
                -
                
                
                
                -Total
      Tax Expense
                
                $
                12
                
                
                $
                2
                
                
                $
                7
  Deferred
income taxes reflect the net tax effects of (a) temporary differences between
the carrying amounts of assets and liabilities for financial reporting purposes
and the amounts used for income tax purposes, and (b) operating losses and tax
credit carryforwards.
 
 63
 
 NOVABAY
PHARMACEUTICALS, INC.
 (a
development stage company)
 
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
 The tax
effects of significant items comprising the Company's deferred taxes as of
December 31 are as follows:
  Year
      Ending December 31(in
      thousands)
                  
                  2008
                  
                  
                  2009Deferred
      Tax Assets:Accruals
                  
                  $
                  409
                  
                  
                  $
                  296Deferred
      Revenue
                  
                  
                  1,660
                  
                  
                  
                  664Net
      Operating Losses
                  
                  
                  7,946
                  
                  
                  
                  7,780Stock
      Options
                  
                  
                  176
                  
                  
                  
                  406Other
      Deferred Tax Assets
                  
                  
                  45
                  
                  
                  
                  54Total
      Deferred Tax Assets
                  
                  
                  10,236
                  
                  
                  
                  9,200Deferred
      Tax Liabilities:Property,
      Plant & Equipment
                  
                  
                  (228
                  )
                  
                  
                  (322
                  )Total
      Deferred Tax Liabilities
                  
                  
                  (228
                  )
                  
                  
                  (322
                  )Valuation
      Allowance
                  
                  $
                  (10,008
                  )
                  
                  $
                  (8,878
                  )Net
      Deferred Taxes
                  
                  $
                  -
                  
                  
                  $
                  -
  ASC 740
requires that the tax benefit of net operating losses, temporary differences and
credit carryforwards be recorded as an asset to the extent that management
assesses that realization is "more likely than not." Realization of the future
tax benefits is dependent on the Company's ability to generate sufficient
taxable income within the carryforward period. Because of the Company's recent
history of operating losses, management believes that recognition of the
deferred tax assets arising from the above-mentioned future tax benefits is
currently not likely to be realized and, accordingly, has provided a valuation
allowance.
 
 The
valuation allowance increased by the following amounts (in
thousands):
 
 2007
                
                2008
                
                2009$1,997
                
                $2,978
                
                $(1,130)
  We track
the portion of our federal and state net operating loss carryforwards
attributable to stock option benefits in a
separate memo account. Therefore, these amounts are not included in gross or net
deferred tax assets.
  The
benefit of these net operating loss carryforwards will only be recorded to
equity when they
reduce cash taxes payable.
 
 Net
operating losses and tax credit carryforwards as of December 31, 2009 are as
follows (in thousands):
 
 ExpirationAmount
                
                
                YearsNet
      operating losses, federal
                
                $
                20,025
                
                
                
                2024
      - 2029Net
      operating losses, state
                
                $
                20,012
                
                
                
                2016
      - 2029Tax
      credits, state
                
                $
                15
                
                
                
                N/A
 
 64
 NOVABAY
PHARMACEUTICALS, INC.
 (a
development stage company)
 
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
 The
effective tax rate of the Company's provision (benefit) for income taxes differs
from the federal statutory rate as follows:
 
 Year
      Ending December 31(in
      thousands)
                
                2007
                
                
                2008
                
                
                2009Statutory
      Rate
                
                $
                (1,832
                )
                
                $
                (2,758
                )
                
                $
                950State
      Tax
                
                
                (274
                )
                
                
                (435
                )
                
                
                152ISO
      Related Expense for GAAP
                
                
                81
                
                
                
                207
                
                
                
                196Change
      in Valuation Allowance
                
                
                1,997
                
                
                
                2,978
                
                
                
                (1,130
                )Other
                
                
                40
                
                
                
                10
                
                
                
                (161
                )Total
                
                $
                12
                
                
                $
                2
                
                
                $
                7
  Uncertain
Income Tax Positions
 
 We
adopted the provisions of ASC 740-10 on January 1, 2007. There was no impact on
our consolidated financial position, results of operations and cash flows as a
result of adoption. We have no unrecognized tax benefit as of December 31, 2009,
including no accrued amounts for interest and penalties.
 
 Our policy will be to recognize
interest and penalties related to income taxes as a component of income tax
expense. We are subject to income tax examinations for U.S. incomes taxes and
state income taxes from 2004 forward. We do not anticipate that total
unrecognized tax benefits will significantly change prior to December 31,
2010.
 
 NOTE
14. SUBSEQUENT EVENTS
 
 We
evaluated subsequent events through March 26, 2010 when these financial
statements were issued.  We are not aware of any significant events
that occurred subsequent to the balance sheet date but prior to the filing of
this Annual Report on Form 10-K that would have a material impact on our
Consolidated Financial Statements
  65
 ITEM 9.
                CHANGES
      IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL
      DISCLOSURE
 
 None.
 
 ITEM
      9A.
                CONTROLS
      AND PROCEDURES
 
 Not
applicable.
 
 ITEM 9A(T).
                CONTROLS
      AND PROCEDURES
 
 Evaluation
of Disclosure Controls and Procedures
 
 As of the
end of the period covered by this report, we carried out an evaluation, under
the supervision and with the participation of our management, including our
Chief Executive Officer and Chief Financial Officer, of the effectiveness of our
disclosure controls and procedures pursuant to Rule 13a-15 and 15d-15 of the
Securities Exchange Act of 1934, as amended (the “Exchange Act”). Based upon
that evaluation, our Chief Executive Officer and our Chief Financial Officer
concluded that our disclosure controls and procedures were effective to ensure
that information required to be disclosed by us in the reports that we file or
submit under the Exchange Act is recorded, processed, summarized and reported
within the time periods specified in the SEC’s rules and forms and were
effective in ensuring that information required to be disclosed by us in the
reports that we file or submit under the Exchange Act was accumulated and
communicated to our management, including our Chief Executive Officer and Chief
Financial Officer, as appropriate, to allow timely decisions regarding required
disclosure.
 
 A control
system, no matter how well conceived and operated, can provide only reasonable,
not absolute, assurance that the objectives of the control system are met.
Further, the design of a control system must reflect the fact that there are
resource constraints, and the benefits of controls must be considered relative
to their costs. Assessing the costs and benefits of such controls and procedures
necessarily involves the exercise of judgment by management. Because of the
inherent limitations in all control systems, no evaluation of controls can
provide absolute assurance that all control issues and instances of fraud, if
any, have been detected.   Our Chief Executive Officer and our
Chief Financial Officer concluded that our disclosure controls and procedures
were effective at the reasonable assurance level.
 
 Management’s Report on Internal
Control over Financial Reporting.
 
 Our
management is responsible for establishing and maintaining adequate internal
control over financial reporting, as such term is defined in Exchange Act Rules
13a-15(f) and 15d-15(f). Under the supervision and with the participation of our
management, including our principal executive officer and our principal
financial officer, we conducted an evaluation of the effectiveness of our
internal control over financial reporting as of December 31, 2009.  In
making this assessment, our management used the criteria set forth by the
Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control— Integrated Framework.Our
management has concluded that, as of December 31, 2009, our internal control
over financial reporting was effective based on these criteria.
 
 This
annual report does not include an attestation report of the company's registered
public accounting firm regarding internal control over financial reporting.
Management's report was not subject to attestation by the company's registered
public accounting firm pursuant to temporary rules of the Securities and
Exchange Commission that permit the company to provide only management's report
in this annual report.
 
 This
report shall not be deemed to be filed for purposes of Section 18 of the
Exchange Act or otherwise subject to the liabilities of that section, unless the
registrant specifically states that the report is to be considered "filed" under
the Exchange Act or incorporates it by reference into a filing under the
Securities Act or the Exchange Act.
 
 Changes
in Internal Control Over Financial Reporting
 
 During
the fourth quarter of 2009, there were no changes in our internal control over
financial reporting which has materially affected, or is reasonably likely to
materially affect, our internal control over financial reporting.
 
 ITEM 9B.
                OTHER
      INFORMATION
 
 On March
25, 2010 the board of directors approved a new employee cash bonus
plan.  The plan provides for a target bonus award opportunity for each
employee, set as a percent of base salary.  Actual awards may be
modified upward or downward based on the achievement of individual and corporate
performance objectives established at the beginning of the year or due to other
factors solely at the discretion of the board and management.  The
bonus will also be weighted between individual and corporate performance factors
which will vary based on reporting levels and responsibility.  The
employee cash bonus plan is filed as Exhibit 10.7 to this Annual Report on Form
10-K.
 
 66
 
 PART
III
 
 ITEM 10.
                DIRECTORS,
      EXECUTIVE OFFICERS AND CORPORATE
GOVERNANCE
 
 The
information required by this Item with respect to Executive Officers may be
found under the caption, “Executive Compensation and Other Information”
appearing in the definitive Proxy Statement to be delivered to NovaBay’s
stockholders in connection with the solicitation of proxies for NovaBay’s 2010
Annual Meeting of Stockholders (the “Proxy Statement”).  The
information required by this Item with respect to Directors, including
information with respect to our audit committee, audit committee financial
experts, risk management and procedures for Board nominations, is incorporated
herein by reference from the information under the caption, “Proposal One:
Election of Directors” and  “Corporate Governance” appearing in the
Proxy Statement.
 
 Section
16(a) Beneficial Ownership Reporting Compliance
 
 The
information required by this Item with respect to compliance with Section 16(a)
of the Exchange Act is incorporated herein by reference from the section
captioned “Section 16(a) Beneficial Ownership Reporting Compliance” contained in
the Proxy Statement.
 
 Code
of Ethics and Business Conduct
 
 The
information required by this Item with respect to our code of ethics and
business conduct is incorporated herein by reference from the section captioned
“Corporate Governance” contained in the Proxy Statement.
 
 ITEM 11.
                EXECUTIVE
      COMPENSATION
 
 The
information required by this Item is set forth in the Proxy Statement under the
caption, “Executive Compensation and Other Information.” Such information is
incorporated herein by reference.
 
 ITEM 12.
                SECURITY
      OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED
      STOCKHOLDER MATTERS
 
 The
information required by this Item with respect to security ownership of certain
beneficial owners and management is set forth in the Proxy Statement under the
caption, “Security Ownership of Certain Beneficial Owners and Management” and
“Equity Compensation Plan Information.”   Such information is
incorporated herein by reference.
 
 ITEM 13.
                CERTAIN
      RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR
      INDEPENDENCE
 
 The
information required by this Item is set forth in the Proxy Statement under the
headings “Proposal 1:  Election of Directors” and “Certain
Relationships and Related Transactions.” Such information is incorporated herein
by reference.
 
 ITEM 14.
                PRINCIPAL
      ACCOUNTING FEES AND SERVICES
 
 The
information required by this Item is set forth in the Proxy Statement under the
heading “Fees Paid to Independent Registered Public Accounting
Firm.”  Such information is incorporated herein by
reference.
 
 Consistent
with Section 10A(i)(2) of the Securities Exchange Act of 1934, as added by
Section 202 of the Sarbanes-Oxley Act of 2002, we are responsible for listing
the non-audit services approved by our Audit Committee to be performed by
Davidson & Company LLP, our external auditor. Non-audit services are defined
as services other than those provided in connection with an audit or a review of
our financial statements. Our Audit Committee has approved our recurring
engagements of non-audit services of Moss Adams, LLP for the preparation of tax
returns, and tax advice in preparing for and in connection with such
filings.
 
 67
 PART
IV
 
 ITEM 15.
                EXHIBITS,
      FINANCIAL STATEMENT SCHEDULES
 
 (a)
Documents filed as part of this report:
 
 (1)Financial Statements. The
following financial statements of NovaBay Pharmaceuticals, Inc. are included in
Item 8 of this Annual Report on Form 10-K commencing on the pages
referenced below:
 
 INDEX
      TO CONSOLIDATED FINANCIAL STATEMENTSPageReport
      of Independent Registered Public Accounting Firm
                
                39Consolidated
      Balance Sheets as of December 31, 2008 and 2009
                
                40Consolidated
      Statements of Operations for the Years Ended December 31, 2007, 2008 and
      2009 and for the cumulative period from July 1, 2002 (date of development
      stage inception) to December 31, 2009
                
                41Consolidated
      Statements of Stockholder's Equity for the cumulative period from July 1,
      2002 (date of development stage inception) to December 31,
      2009
                
                42Consolidated
      Statements of Cash Flows for the Years Ended December 31, 2007,2008 and
      2009 and for the cumulative period from July 1, 2002 (date of development
      stage inception) to December 31, 2009
                
                46
 
 (2)Financial Statement
Schedules.
 
 All
schedules have been omitted because they are not required or the required
information is included in our consolidated financial statements and notes
thereto.
 
 (3)Exhibits.
 
 See the
Exhibit Index which follows the signature page of this Annual Report on Form
10-K, which is incorporated herein by reference.
 
 
 68
 SIGNATURES
 
 Pursuant
to the requirements of Section 13 or 15(d) of the Securities Exchange Act
of 1934, the registrant has duly caused this report on Form 10-K to be
signed on its behalf by the undersigned, thereunto duly authorized.
 
 Date:
      March 26, 2010
                NOVABAY
      PHARMACEUTICALS, INC.By:
                /S/    RAMIN NAJAFIRamin
      (“Ron”) NajafiChief
      Executive Officer and President
 
 POWER
OF ATTORNEY
 
 We, the
undersigned officers and directors of NovaBay Pharmaceuticals, Inc., do hereby
constitute and appoint Ramin (“Ron”) Najafi and Thomas J. Paulson, and each of
them, our true and lawful attorneys-in-fact and agents, each with full power of
substitution and resubstitution, for him and in his name, place and stead, in
any and all capacities, to sign any and all amendments to this report, and to
file the same, with exhibits thereto, and other documents in connection
therewith, with the Securities and Exchange Commission, granting unto said
attorneys-in-fact and agents, and each of them, full power and authority to do
and perform each and every act and thing requisite or necessary to be done in
and about the premises, as fully to all intents and purposes as he might or
could do in person, hereby, ratifying and confirming all that each of said
attorneys-in-fact and agents, or his substitute or substitutes, may lawfully do
or cause to be done by virtue hereof.
 
 Pursuant
to the requirements of the Securities Exchange Act of 1934, this report on
Form 10-K has been signed below by the following persons on behalf of the
registrant in the capacities and on the dates indicated:
 
 Signature
                
                Title
                Date/S/    RAMIN
      NAJAFI
                
                Chairman
      of the Board, Chief Executive Officer andPresident
      (principal executive officer)
                March
      25, 2010Ramin
      (“Ron”) Najafi/S/    THOMAS PAULSON
                
                Chief
      Financial Officer and Treasurer (principalfinancial
      and accounting officer)
                March
      25, 2010Thomas J. Paulson/S/    CHARLES J. CASHION
                
                Director
                March
      23, 2010Charles J. Cashion/S/    ANTHONY DAILLEY
                
                Director
                March
      24, 2010Anthony Dailley,
      DDS/S/    PAUL FREIMAN
                
                Director
                March
      24, 2010Paul E. Freiman/S/    ALEX MCPHERSON
                
                Director
                March
      23, 2010Alex McPherson,
      MD, Ph.D./S/    ROBERT R. TUFTS
                
                Director
                March
      24, 2010Robert R. Tufts/S/    TONY
      WICKS
                
                Director
                March
      23, 2010Tony
      Wicks/S/    HARRY
      F. HIXSON, JR., PhD
                
                Director
                March
      26, 2010Harry F. Hixson
  69
 EXHIBIT
INDEX
 
 Exhibit
                  No.
                
                Description3.1
                
                Amended
      and Restated Articles of Incorporation of the
      Company  (Incorporated by reference to the exhibit of the same
      number from the Company’s quarterly report on Form 10-Q for the
      quarter ended September 30, 2007 as filed with the SEC on November 15,
      2007 (SEC File No. 001-33678).)3.2
                
                Amended
      and Restated Bylaws of the Company  (Incorporated by reference
      to the exhibit of the same number from the Company’s quarterly report on
      Form 8-K as filed with the SEC on January 26, 2010 (SEC File No.
      001-33678).)4.1*
                
                Specimen
      common stock certificate4.2
                
                Form
      of Form of Common Stock Purchase Warrant issued in August 2009.
      (Incorporated by reference to Exhibit 4.3 to the Company’s current report
      on Form 8-K as filed with the SEC on August 21, 2009 (SEC File No.
      001-33678).)10.1*+
                
                2002
      Stock Option Plan, and forms of agreements thereto10.2*+
                
                2005
      Stock Option Plan, and forms of agreements thereto10.3*+
                
                2007
      Omnibus Incentive Plan, and forms of agreements thereto ((the Plan is
      incorporated by reference to Exhibit 10.1 from the Company’s quarterly
      report on Form 10-Q for the quarter ended June 30, 2008 as filed with
      the SEC on August 14, 2008 (SEC File No. 001-33678), and the forms of
      agreements thereto are incorporated by reference to the exhibit
      referencing the Plan from the Company’s amendment to registration
      statement of Form S-1 (File No. 333-140714) filed with the Securities
      and Exchange Commission on May 29, 2007, as amended.)10.4*+
                
                Employment
      Agreement dated January 1, 2007 by and between the Company and Ramin
      (“Ron”) Najafi10.5*+
                
                Employment
      Agreement dated January 1, 2007 by and between the Company and John
      (“Jack”) O’Reilly10.6*+
                
                Employment
      Agreement dated January 1, 2007 by and between the Company and
      Behzad Khosrovi10.7+
                
                NovaBay
      Pharmaceuticals, Inc. Employee Incentive Cash Compensation
      Plan.10.8*+
                
                Employment
      Agreement dated January 9, 2008 by and between the Company and
      Thomas J. Paulson (Incorporated by reference to Exhibit 10.18
      from the Company’s annual report on Form 10-K for the year end
      December 31, 2007 as filed with the SEC on March 14, 2008 (SEC File No.
      001-33678).)10.9+
                
                Retirement
      and Consulting Agreement dated January 1, 2009 by and Between the Company
      and John (“Jack”) O’Reilly (Incorporated by reference to Exhibit 10.9 from
      the Company’s annual report on Form 10-K for the year end December
      31, 2008, as filed with the SEC on March 31, 2009 (SEC File No.
      001-33678).)10.10*
                
                Office
      Lease dated June 3, 2004 by and between the Company and Emery Station
      Associates II, LLC, as amended10.11
                
                Fifth
      Amendment dated November 20, 2007 to Office Lease dated June 3,
      2004 by and between the Company and Emery Station Associates II, LLC, as
      amended (Incorporated by reference to Exhibit 10.20 from the
      Company’s annual report on Form 10-K for the year ended December 31,
      2007 as filed with the SEC on March 14, 2008 (SEC File No.
      001-33678).)10.12
                
                Sixth
      Amendment to Lease between Emery Station Office II, LLC and Novacal
      Pharmaceuticals, Inc., effective September 1,
      2008.  (Incorporated by reference to Exhibit 10.1 from the
      Company’s quarterly report on Form 10-Q/A for the quarter ended
      September 30, 2008 as filed with the SEC on November 14, 2008 (SEC File
      No. 001-33678).)10.13†
                
                Collaboration
      and License Agreement, by and between the Company and Galderma S.A., dated
      as of March 20, 2009 (Incorporated by reference to Exhibit 10.2 from
      the Company’s quarterly report on Form 10-Q/A for the quarter ended
      March 31, 2009, as filed with the SEC on August 4, 2009 (SEC File No.
      001-33678).)10.14+
                
                Director Compensation Plan10.15*†
                
                Collaboration
      and License Agreement dated August 29, 2006 by and between the Company and
      Alcon Manufacturing, Ltd.  70
 10.16*
                
                Master
      Security Agreement dated April 23, 2007 by and between the Company and
      General Electric Capital Corporation10.17*
                
                Form
      of Common Stock Purchase Warrant by and between the Company and the
      underwriters10.18††
                
                Amendment
      No. 1 to the Collaboration and License Agreement, dated as of December 1,
      2009, between the Company and Galderma S.A.10.19+
                
                Named
      Executive Officer Cash Compensation Arrangements10.20+
                
                Employment
      Agreement, dated July 28, 2009, between the Company and Roy
      Wu.10.21
                
                Placement
      Agent Agreement, dated August 21, 2009, by and between the Company and
      Maxim Group LLC (Incorporated by reference to Exhibit 1.1 from the
      Company’s quarterly report on Form 8-K as filed with the SEC on
      August 21, 2009 (SEC File No. 001-33678)).10.22+
                
                Employment
      Agreement, dated October 15, 2009, between the Company and Mark
      Anderson.23.1
                
                Consent
      of Davidson & Company LLP24.1
                
                Power
      of Attorney (included on the signature pages
  hereto)31.1
                
                Certification
      of the principal executive officer pursuant to Section 302 of the
      Sarbanes-Oxley Act of 200231.2
                
                Certification
      of the principal financial officer pursuant to Section 302 of the
      Sarbanes-Oxley Act of 200232.1
                
                Certification
      of the chief executive officer pursuant to Section 906 of the
      Sarbanes-Oxley Act of 200232.2
                
                Certification
      of the chief financial officer pursuant to Section 906 of the
      Sarbanes-Oxley Act of 2002
 
 *
                Incorporated
      by reference to the exhibit of the same description  from the
      Company’s registration statement of Form S-1 (File No. 333-140714)
      initially filed with the Securities and Exchange Commission on February
      14, 2007, as amended.
 
 +
                Indicates
      a management contract or compensatory plan or
  arrangement
 
 †
                NovaBay
      Pharmaceuticals, Inc. has been granted confidential treatment with respect
      to certain portions of this exhibit (indicated by asterisks), which have
      been separately filed with the Securities and Exchange
      Commission.
 
 ††
                NovaBay
      Pharmaceuticals, Inc. has requested confidential treatment with respect to
      certain portions of this exhibit (indicated by asterisks), which have been
      separately filed with the Securities and Exchange
    Commission.
 
 
 71