**UNITED
      STATES**


**SECURITIES
      AND EXCHANGE COMMISSION**


**WASHINGTON,
      D.C. 20549**





**FORM
      10-K**





ý
            ANNUAL
                REPORT PURSUANT TO SECTION 13 OR 15(d) OF THESECURITIES
                EXCHANGE ACT OF 1934For
                the fiscal year ended December 31, 2005ORo
            TRANSITION
                REPORT PURSUANT TO SECTION 13 OR 15(d) OF THESECURITIES
                EXCHANGE ACT OF 1934








Commission
      file number: 0-22332





**INSITE
      VISION INCORPORATED**


(Exact
      name of registrant as specified in its charter)





**Delaware**
            
            **94-3015807**(State
                or other jurisdiction of
            
            (I.R.S.
                Employerincorporation
                or organization)
            
            Identification
                No.)**965
                Atlantic Avenue, Alameda CA**
            
            **94501**(Address
                of principal executive offices)
            
            (Zip
                Code)





**(510)-865-8800**


(Registrant’s
      telephone number, including area code)






Securities
      registered pursuant to Section 12(b) of the Act:




Title
                of each class
            
            Name
                of each exchange on which registeredCommon
                Stock, $0.01 par value per share
            
            American
                Stock Exchange




Securities
      registered pursuant to Section 12(g) of the Act: None








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 Exchange 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 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. x





Indicate
      by check mark whether the registrant is a large accelerated filer, an
      accelerated filer, or a non-accelerated filer. See definition of “accelerated
      filer and large accelerated filer” in Rule 12b-2 of the Exchange
      Act.


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








Indicate
      by check mark whether the registrant is a shell company (as defined in Rule
      12b-2 of the Exchange Act).


Yes o   No
x





The
      aggregate market value of registrant’s Common Stock, $0.01 par value, held by
      non-affiliates of the Registrant as of June 30, 2005: was approximately
      $42,950,850 (based upon the closing sale price of the Common Stock on the last
      business day of the registrant’s most recently completed second fiscal quarter).
      Shares of Common Stock held by each officer and director and by each person
      who
      owns 5% or more of the Common Stock have been excluded from such calculation
      as
      such persons may be deemed affiliates. This determination of affiliate status
      is
      not necessarily a conclusive determination for other purposes.





Number
      of
      shares of Common Stock, $0.01 par value, outstanding as of March 27, 2006:
      86,085,307.




















**ANNUAL
      REPORT ON FORM 10-K**


**FOR
      THE FISCAL YEAR ENDED DECEMBER 31, 2005**





**TABLE
      OF CONTENTS**








PagePART
                IItem
                1.
            Business
            1Item
                1A.
            Risk
                Factors
            14Item
                1B.
            Unresolved
                Staff Comments
            27Item
                2.
            Properties
            27Item
                3.
            Legal
                Proceedings
            27Item
                4.
            Submission
                of Matters to a Vote of Security Holders
            28PART
                IIItem
                5.
            Market
                for Registrant's Common Equity, Related Stockholder Matters and Issuer
                Purchases of Equity Securities
            28Item
                6.
            Selected
                Financial Data
            29Item
                7.
            Management's
                Discussion and Analysis of Financial Condition and Results of
                Operation
            30Item
                7A.
            Quantitative
                and Qualitative Disclosures About Market Risk
            37Item
                8.
            Financial
                Statements and Supplementary Data
            37Item
                9.
            Changes
                in and Disagreements with Accountants on Accounting and Financial
                Disclosure
            58Item
                9A.
            Controls
                and Procedures
            58Item
                9B.
            Other
                Information
            59PART
                IIIItem
                10.
            Directors
                and Executive Officers of the Registrant
            59Item
                11.
            Executive
                Compensation
            67Item
                12.
            Security
                Ownership of Certain Beneficial Owners and Management and Related
                Stockholder Matters
            73Item
                13.
            Certain
                Relationships and Related Transactions
            75Item
                14.
            Principal
                Accounting Fees and Services.
            75PART
                IVItem
                15.
            Exhibits,
                Financial Statement Schedules
            76Signatures
            
            
            77













**Cautionary
      Statement for purposes of the “Safe Harbor” provisions of Private Securities
      Litigation Reform Act of 1995:**





*Except
      for the historical information contained herein, the discussion in this Annual
      Report on Form 10-K contains certain forward-looking statements that
      involve risks and uncertainties, such as statements of our plans, beliefs,
      objectives, expectations and intentions. The cautionary statements made in
      this
      document should be read as applicable to all related forward-looking statements
      wherever they appear in this document. Our actual results could differ
      materially from those discussed herein. Factors that could cause or contribute
      to such differences include those discussed below in "Risk Factors," as well
      as
      those discussed elsewhere herein. Readers are cautioned not to place undue
      reliance on these forward-looking statements, which speak only as of the date
      hereof. We undertake no obligation to update any forward-looking statements
      to
      reflect events or circumstances after the date hereof or to reflect the
      occurrence of unanticipated events.*





**PART
      I**







**Item
      1. Business**





**THE
      COMPANY**








We
      are an
      ophthalmic product development company focused on ophthalmic pharmaceutical
      products based on our proprietary DuraSite® eyedrop-based drug delivery
      technology, as well as developing genetically-based technologies for the
      diagnosis, prognosis and management of glaucoma.





With
      our
      existing resources we are focusing our research and development and commercial
      efforts on the following:





·
            AzaSite’(ISV-401), a DuraSite formulation of azithromycin, a broad spectrum
                antibiotic; and


·
            AzaSite
                Plus’(ISV-502), a DuraSite formulation of azithromycin and a steroid for
                inflammation and pain.





*AzaSite
      (ISV-401).* To
      treat
      bacterial conjunctivitis and other infections of the outer eye we have developed
      a topical formulation (AzaSite) of the antibiotic azithromycin, an antibiotic
      with a broad spectrum of activity that is widely used to treat respiratory
      and
      other infections in its oral and parenteral forms. We believe that the key
      advantages of AzaSite may include a significantly reduced dosing regimen (9
      doses vs. 21-36 doses for comparable products), enabled by the high and
      persistent levels of azithromycin achieved by our formulation in the tissues
      of
      the eye and its wide spectrum of activity. Product safety and efficacy have
      been
      shown, respectively, in Phase 1 and Phase 2 clinical trials. The Phase 2 study
      compared an AzaSite formulation containing 1% azithromycin to a placebo. The
      results of this study showed that the AzaSite formulation was significantly
      more
      effective than the placebo in clinical resolution (p < 0.03), which includes
      reduction in inflammation and redness, and bacterial eradication (p < 0.001).





In
      July
      2004, we initiated two pivotal Phase 3 clinical trials for AzaSite which were
      conducted both in the United States and in select Latin American countries.
      One
      of the Phase 3 clinical trials was a multi-center study in which patients in
      one
      arm were dosed with a 1% AzaSite formulation and the patients in the second
      arm
      were dosed with a 0.3% formulation of the antibiotic tobramycin. In November
      2005, we announced that upon completion of enrollment this study included a
      total of 746 patients 1 year or older, of which 316 were confirmed positive
      for
      acute bacterial conjunctivitis in at least one eye. The results of this Phase
      3
      study indicated that AzaSite demonstrated a clinical resolution rate of 80%
      as
      compared to 78% for tobramycin. This result shows that the clinical resolution
      rate of AzaSite is equivalent to tobramycin, the primary efficacy endpoint
      of
      the study, according to statistical criteria which were previously agreed to
      by
      the FDA. The bacterial eradication rate was also equivalent for both
      groups .





1


The
      other
      Phase 3 clinical trial was a multi-center study in which patients in one arm
      were dosed with a 1% AzaSite formulation and the patients in the second arm
      were
      dosed with a placebo. In January 2006 we completed enrollment in this study
      of
      approximately 685 patients, of which approximately 277 were confirmed positive
      for acute bacterial conjunctivitis in at least one eye. In March 2006, we
      announced that the results of this study showed that the AzaSite formulation
      was
      more effective than the placebo in clinical resolution, which includes reduction
      in inflammation and redness, while also being superior in bacterial eradication
      over placebo.





In
      September 2005, we signed a manufacturing supply agreement with Cardinal Health
      for the manufacture of AzaSite commercial units. Cardinal Health has
      manufactured the clinical trial supplies used in our two Phase 3 bacterial
      conjunctivitis clinical trials, and also the registration batches to be used
      for
      the AzaSite New Drug Application. We anticipate that this contract manufacturing
      facility will be ready for inspection by the FDA soon after our NDA
      submission.




*AzaSite
      Plus (ISV-502).* Our
      first effort toward the expansion of our product candidate AzaSite into a larger
      franchise is the development of a combination of AzaSite with an
      anti-inflammatory steroid for the treatment of blepharitis, an infection of
      the
      eyelid and one of the most common eye problems in older adults. This combination
      product candidate is currently in preclinical development and will be more
      actively pursued as personnel and financial resources become available and
      as
      activities to support the AzaSite NDA are completed. We anticipate initiating
      Phase 1 clinical trials in 2006.





*Revenue.*  From
      our
      inception through the end of 2001, we did not receive any revenues from the
      sale
      of our products, other than a small amount of royalties from the sale of our
      AquaSite product by CIBA Vision and Global Damon. In the fourth quarter of
      2001,
      we commercially launched our Ocu G ene
      glaucoma genetic test and early in 2002 we began to receive a small amount
      of
      revenues from the sale of this test. With the exception of 1999 and the six
      month period ended June 30, 2004, we have been unprofitable since our inception
      due to continuing research and development efforts, including preclinical
      studies, clinical trials and manufacturing of our product candidates. We have
      financed our research and development activities and operations primarily
      through private and public placements of our equity securities, issuance of
      convertible debentures and, to a lesser extent, from collaborative agreements
      and bridge loans.





*Business
      Strategy* .
      Our
      business strategy is to license promising product candidates and technologies
      from academic institutions and other companies to which to apply our ophthalmic
      formulation expertise, to conduct preclinical and clinical testing, if
      necessary, and to partner with pharmaceutical companies to complete clinical
      development and regulatory filings as needed and to manufacture and market
      our
      products. We also have internally developed DuraSite-based product candidates
      using either non-proprietary drugs or compounds developed by others for
      non-ophthalmic indications. As with in-licensed product candidates, we either
      have or plan to partner with pharmaceutical companies to complete clinical
      development and commercialization of our own product candidates.





*Corporate
      Information.*  Our
      principle executive offices are located at 965 Atlantic Avenue, Alameda,
      California 94501. Our telephone number is (510) 865-8800. We were incorporated
      in 1986 as a California corporation and currently operate as a Delaware
      corporation. We make our periodic and current reports available, free of charge,
      through our website (http:///www.insitevision.com) under “Investor Relations -
      SEC Filings” as soon as reasonably practicable after such material is
      electronically filed with the Securities and Exchange Commission.








**Ophthalmic
      Pharmaceutical Market**





As
      the
      risk of most ophthalmic diseases increases with age, the U.S. ophthalmic market
      is projected to outpace the growth of the worldwide ophthalmic market due to
      the
      aging "baby-boomer" population. The prevalence of eye disease increases
      disproportionately with age and is ten times greater in persons over the age
      of
      65. The U.S. Census Bureau projects that the U.S. population over age 65 will
      increase from 34 million in 1997 to approximately 69 million by the year 2030.
      We believe that this aging of the U.S. population and similar trends in other
      developed countries will lead to increased demand for new ophthalmic
      products.





2


In
      addition to changing demographics, we believe that emerging medical
      technologies, such as genetics, will assist eye care physicians in understanding
      the patho-physiology of serious eye diseases like glaucoma, which will allow
      the
      identification and treatment of ocular disease at an earlier stage.





New
      drug
      formulations and delivery methods are also being developed to deliver lower
      concentrations of drugs over an extended period of time. Whether these enhanced
      delivery technologies are focused on age-related macular degeneration (AMD)
      or
      bacterial conjunctivitis (pink eye), the emergence of these products will lead
      to increased patient compliance and fewer complications due to inconsistent
      drug
      administration.





There
      are
      approximately 119 million Americans who are past the age of 40, which is the
      age
      at which serious eye diseases typically become a problem. Some 35 million are
      already affected by the four most prevalent: age-related macular degeneration,
      diabetic retinopathy, glaucoma, and cataracts. With the leading edge of the
      baby-boomer generation approaching 60, the number of eye-disease sufferers
      is
      expected to increase dramatically, topping 50 million or more over the next
      15
      years just in the United States.





We
      are a
      specialty pharmaceutical development company with our primary focus on the
      development of novel ophthalmic therapies that treat ocular infections, glaucoma
      and retinal diseases. Our main strategy is to utilize our patented drug-delivery
      vehicle, DuraSite, to develop enhanced drug therapies with reduced dosing
      frequencies.





Our
      lead
      product is AzaSite, which targets infections of the eye and is part of the
      ophthalmic anti-infective or antibiotic market. The global ophthalmic
      anti-infective market was approximately one billion dollars in 2005. The market
      is comprised of two separate product segments:





·
            Ocular
                antibiotic products


·
            Ocular
                antibiotic/steroid combination
                products





Both
      the
      antibiotic and combination antibiotic/steroid markets are expected to experience
      healthy growth in the future. New product developments, growth of
      less-industrialized nations, and an expanding elderly population are factors
      expected to support continued growth.





AzaSite,
      as an ocular antibiotic product, contains the drug azithromycin, a
      broad-spectrum antibiotic formulated with DuraSite, which offers the benefit
      of
      a low-dosing regimen, attractive to both the eye-care patient and physician.
      This product will initially be launched in the United States for the indication
      of bacterial conjunctivitis or "pink eye". We will then plan to expand this
      "technology platform" to include additional product candidates and indications
      for the worldwide market.





Bacterial
      conjunctivitis is a common ocular surface disease characterized by inflammation
      of the delicate skin and mucosa on the inside of the eyelids. These bacterial
      infections are contagious and are generally accompanied by irritation, itching,
      foreign body sensation watering, mucus discharge and redness. The bacterial
      form
      of the disease is generally more common in children than adults.





We
      are
      also developing AzaSite Plus, an ocular antibiotic/steroid combination product.
      This novel combination product would also contain the antibiotic azithromycin
      and the anti-inflammatory steroid dexamethasone. It would be indicated for
      the
      treatment of steroid-responsive inflammatory ocular conditions for which a
      cortiosteroid is indicated and where superficial bacterial ocular infection
      or
      risk of infection exists. This combination product profile is also being
      considered for other topical anti-infective markets such as the otic or ear
      infection market.








3


**Products
      and Product Candidates**





The
      following table summarizes the current status of our principal products and
      product candidates. A more detailed description of each product and product
      candidate follows the table. There can be no assurance that any of the listed
      products or product candidates will progress beyond its current state of
      development, receive necessary regulatory approval or be successfully
      marketed.





**Principal
      Products and Product Candidates**





**Product**
            **Indications**
            **Anticipated
                Benefits**
            **Status(1)****Active
                Programs****Ophthalmic
                Anti-infectives**AzaSite
            Bacterial
                infection including ophthalmia neonatorum
            Broad
                spectrum antibiotic with reduced dosing frequency
            Phase
                3 completedAzaSite
                Plus
            Blepharitis
                and other ophthalmic infections
            Broad
                spectrum antibiotic with reduced dosing frequency
            PreclinicalAzaSite
                Plus
            Otic
                infections
            Broad
                spectrum antibiotic with reduced dosing frequency
            Preclinical**Other
                Topical Product Candidates and Product**ISV
                - 205
            Inflammation
                and analgesia
            Reduced
                dosing frequency
            PreclinicalAquaSite
            Dry
                eye
            Reduced
                dosing frequency and extended duration of action
            Marketed
                (OTC)**Glaucoma
                Genetics**OcuGene-
                Glaucoma Genetic Test
            Glaucoma
                severity (TIGR gene)
            Determine
                disease severity among glaucoma patients
            Marketed**Inactive
                Programs****Glaucoma
                Product Candidates**ISV
                - 205
            Steroid-induced
                intraocular pressure elevation, glaucoma
            Treat/prevent
                disease progression
            Phase
                2(b) completed**Retinal
                Device**ISV
                - 014
            Retinal
                drug delivery device for potential treatment of diabetic retinopathy
                and
                macular degeneration
            Non-surgical
                delivery of drugs to the retina
            Research










1)
            All
                products except OcuGene, AquaSite and ISV-014 are expected to be
                prescription pharmaceuticals. As denoted in the table, “Preclinical”
                follows the research stage and indicates that a specific compound
                is being
                tested in preclinical studies in preparation for filing an investigational
                new drug application, or IND. For a description of preclinical trials,
                IND, Phase 1, Phase 2 and Phase 3 clinical trials and New Drug
                Application, or NDA, see “—Government
                Regulation.”






4


**Ophthalmic
      Anti-infectives**





*AzaSite.* We
      have
      developed a topical formulation of the antibiotic, azithromycin to treat
      bacterial conjunctivitis and other infections of the outer eye. Azithromycin
      has
      a broad spectrum of antibiotic activity and is widely used to treat respiratory
      and other infections in its oral and parenteral forms. The eye drop of 1%
      azithromycin (ISV-401) is formulated to deliver sufficient tissue concentrations
      over a 5-day dosing period using our proprietary DuraSite technology. The
      eyedrop is designed to enable superior bactericidal activity against common
      ocular pathogens and pseudomonas. We believe the key advantages of AzaSite
      may
      include a significantly reduced dosing regimen (9 doses vs. 36 doses for
      comparable products), the high and persistent levels of azithromycin achieved
      in
      the tissues of the eye and its wide spectrum of activity. Phase 1, 2 and 3
      studies have shown that AzaSite is well tolerated and effective.




AzaSite
      has been formulated to meet the regulatory requirements for both the United
      States and most other countries. Our marketing emphasis will focus on
      pediatricians, general practitioners, and ophthalmologists. Pediatricians and
      general practice physicians write more than 65% of total prescriptions for
      ophthalmic antibiotics. We expect that if and when it is approved and
      commercialized AzaSite will be positioned to compete favorably with the newer
      4 th generation fluoroquinolones for antibacterial coverage. Further, AzaSite
      possesses the advantage of reduced dosing frequency that we believe may
      ultimately increase patient compliance and reduce the likelihood of the
      development of bacterial resistance. Marketing of AzaSite will require us first
      to obtain additional funding either from a strategic partner or from
      investors.





Product
      safety and efficacy have been evidenced, respectively, in Phase 1, Phase 2
      and
      Phase 3 clinical trials. In November 2005, we announced the results of our
      first
      Phase 3 clinical trial which compared AzaSite to the antibiotic tobramycin.
      The
      results indicated that the clinical resolution rate of AzaSite is equivalent
      to
      tobramycin, the primary efficacy endpoint of the study, according to statistical
      criteria which were previously agreed to by the FDA. The bacterial eradication
      rate was also equivalent for both groups . In
      March 2006, we announced the results of a second Phase 3 clinical trial which
      compared AzaSite to a placebo. The results indicated that AzaSite is
      significantly superior to the placebo in both clinical resolution rates and
      bacterial eradication rates. B oth
      of
      the trials were conducted in the United States and Latin America and included
      both children and adults. The data from all of our clinical trials is currently
      being compiled along with results of our preclinical testing, chemistry and
      manufacturing and other required data into an NDA intended to be filed with
      the
      FDA in 2006.





We
      have
      secured a source for the active ingredient for AzaSite and have produced
      clinical trial supplies and registration batches at a contract-manufacturing
      site. These supplies were manufactured under the supervision of our personnel.
      We anticipate that this contract manufacturing facility will be ready for
      inspection by the FDA soon after our NDA submission. It should be noted that
      manufacturing plans are subject to delays and unanticipated interruptions and
      we
      have no experience in manufacturing products for commercialization.





*AzaSite
      Plus Ophthalmic (ISV-502).* Our
      first effort toward the expansion of our product candidate AzaSite into a larger
      franchise is the development of a combination of AzaSite with an
      anti-inflammatory steroid for the treatment of blepharitis, an infection of
      the
      eyelid and one of the most common eye problems in older adults, as well as
      other
      ophthalmic infections. This combination product candidate is currently in
      preclinical development and we anticipate filing an Investigational New Drug
      Applicaton (IND) with the FDA and initiating a Phase 1 study in 2006.





*AzaSite
      Plus Otic (ISV-016).* In
      a
      continued effort to expand the AzaSite franchise we have begun to evaluate
      the
      use of the AzaSite Plus combination as a treatment for ear infections. This
      product candidate is currently in preclinical development and we anticipate
      pursuing it more actively if and when personnel and financial resources become
      available.





**Inflammation
      and Glaucoma Product Candidates**





*ISV-205* .
      Our
      ISV-205 product candidate contains the drug diclofenac formulated in the
      DuraSite sustained-release delivery vehicle. Diclofenac is a non-steroidal
      anti-inflammatory drug or NSAID currently used to treat ocular inflammation.
      NSAIDs can block steroid-induced IOP elevation by inhibiting the production
      of
      the TIGR protein that appears to affect the fluid balance in the eye. Our
      ISV-205 product candidate delivers concentrations of diclofenac to the eye
      that
      have been shown in cell culture systems to inhibit the production of the TIGR
      protein.





5


We
      successfully completed a Phase 2a clinical study in 1999 that evaluated the
      efficacy of two concentrations of diclofenac. Analysis of the data from this
      study indicates that ISV-205 was safe and associated with a 75% reduction in
      the
      number of subjects with clinically significant IOP elevation following steroid
      use.





In
      2001
      we completed a Phase 2b clinical study that was conducted in 233 subjects with
      ocular hypertension. Genetic information was collected on the subjects using
      our
      ISV-900 technology and the subjects were dosed twice daily for six months with
      ISV-205. Our ISV-900 technology detected the TIGR mt-1 or mt-11 mutations in
      approximately 70% of the ocular hypertensives participating in the study. In
      patients with the TIGR mutations, a 0.1% formulation of our ISV-205 product
      candidate was statistically significantly more effective than placebo in
      lowering intraocular pressure (IOP) (p=0.008). These effects were not seen
      to
      the same extent in patients without the TIGR mutations. ISV-205 was similar
      to
      placebo in ocular safety and comfort in all patients. Only with the infusion
      of
      additional financial resources we will plan further clinical studies before
      filing for product approval with the U.S. Food and Drug Administration, or
      FDA.
      However, we cannot assure you that similar clinical results will be achieved.
      Also, initiation of such studies will require us to obtain additional funding
      either from a strategic partner or from investors.





Other
      potential indications for ISV-205 may include glaucoma prevention, analgesia
      and
      anti-inflammatory indications. Co-exclusive rights, in the U.S., to develop,
      manufacture, use and sell ISV-205 to treat non-glaucoma indications of
      inflammation and analgesia, were licensed to CIBA Vision in May 1996.





**Other
      Topical Product Candidates and Marketed Product**





*AquaSite* .
      The
      first product utilizing our DuraSite technology was introduced to the OTC market
      in the U.S. in October 1992 by CIBA Vision. We receive a royalty on sales of
      AquaSite by CIBA Vision. The product contains the DuraSite formulation and
      demulcents for the symptomatic treatment of dry eye. In March 1999, we licensed
      AquaSite to Global Damon Pharm, a Korean company. The license is
      royalty-bearing, has a term of 10 years and is exclusive in the Republic of
      Korea. In August 1999, we entered into a ten year royalty-bearing exclusive
      license with SSP for the sale and distribution of AquaSite in Japan.





**Glaucoma
      Genetics**





According
      to the Glaucoma Research Foundation, glaucoma is the leading cause of
      preventable blindness in the U.S., affecting an estimated two to three million
      people. The most prevalent form of glaucoma in adults is POAG.





Often
      called the “sneak thief of sight” because of its lack of symptoms, glaucoma is
      believed to result when the flow of fluid through the eye is impaired. This
      may
      lead to elevated intraocular pressure or IOP, which increases pressure on the
      optic nerve and can cause irreversible vision loss if left untreated. However,
      one form of glaucoma, normal or low-tension glaucoma, is associated with
      individuals who have normal eye pressure. It is estimated that one-third of
      U.S.
      glaucoma patients and three-quarters of glaucoma patients in Japan have this
      form of the disease, based on a study conducted by Dr. Kitazawa in Japan. These
      patients cannot be identified with standard glaucoma screening tests that only
      measure a patient's eye pressure and these patients usually incur visual field
      loss before they are diagnosed.





*Ocu* *G* *ene* .
      Current
      glaucoma tests are often unable to detect the disease before substantial damage
      to the optic nerve has occurred. Gene-based tests may make it possible to
      identify patients at risk and initiate treatment before permanent optic nerve
      damage and vision loss occurs. Ocu G ene,
      has
      been developed to help determine the potential severity of a patient’s glaucoma,
      and the product was commercially launched at the end of 2001. However,
      development of additional clinical data will be necessary to support the market
      utility of this product. We do not anticipate pursuing additional clinical
      studies and other marketing activities for this product until we obtain the
      necessary funding. We currently hold licenses to patents issued on the TIGR
      cDNA, TIGR antibodies, and methods for the diagnosis of glaucoma using the
      TIGR
      technology.





6


In
      December 2002, we entered into an agreement with Società Industria Farmaceutica
      Italiana (SIFI) that grants them the exclusive right to manufacture/perform,
      distribute and market Ocu G ene
      in
      Italy for eight years. SIFI introduced the Ocu G ene
      test
      at two Italian ophthalmic meetings in late 2003, and is currently conducting
      additional studies to evaluate the technology in the Italian
      population.





**Retinal
      Device**





Ophthalmic
      conditions that involve retinal damage include macular degeneration, which
      according to the American Macular Degeneration Foundation affects 10 million
      or
      more people in the U.S., and diabetic retinopathy, a common side effect of
      diabetes. According to the National Diabetes Education Foundation, approximately
      16 million people in the U.S. are diabetics. Both macular degeneration and
      diabetic retinopathy can lead to irreversible vision loss and blindness. Current
      treatment of retinal diseases, including diabetic retinopathy and macular
      degeneration, generally involves surgery, laser and photo-dynamic therapies,
      each of which can lead to loss of vision, retinal detachment, infection and
      may
      not slow the progression of the disease. Currently, there is no effective drug
      therapy for these conditions.





*Retinal
      Delivery Device* . *ISV-014* is one
      of our technology platforms and consists of a device for the controlled,
      non-surgical delivery of ophthalmic drugs to the retina and surrounding tissues.
      During 2002, we continued to enhance the device and performed in vivo
      experiments delivering products with a variety of molecular sizes to retinal
      tissues. The combination of this device technology with viral or small molecule
      drug platforms may permit long term delivery of therapeutic agents to treat
      several retinal diseases, including diabetic retinopathy and macular
      degeneration, most of which cannot be effectively treated at the present time.





The
      ISV-014 device consists of a handle with a distal platform that is placed
      against the surface of the eye. A small needle connected to a drug reservoir
      is
      extended from the platform into the tissues of the eye. Once in place, a
      metering mechanism controls the amount and rate that the drug is injected into
      the tissue. This produces a highly localized depot of drug inside the ocular
      tissues. By controlling both the distance and direction that the needle
      protrudes, the device greatly reduces the chance that the needle will penetrate
      through the sclera of the eye into the underlying tissues, which are easily
      damaged. We have filed two patent applications related to the device. In the
      U.S. two patents have been issued on the design and two patents have been issued
      on the method of use. We have placed further development of the device on hold
      and are pursuing the licensing of this technology to third
      parties.







**Collaborative,
      Licensing and Service Agreements**





As
      part
      of our business strategy, we have entered into, and will continue to pursue
      additional licensing agreements, corporate collaborations and service contracts.
      However, there can be no assurance that we will be able to negotiate acceptable
      collaborative, licensing or service agreements, or that our existing
      arrangements will be successful, will be renewed or will not be
      terminated.





*Cardinal
      Health PTS, L.L.C.* In
      September 2005, we entered into a commercial manufacturing supply agreement
      with
      Cardinal Health PTS, L.L.C. or Cardinal Health for the manufacture of AzaSite
      commercial units. The agreement has a term of four years subsequent to the
      approval by the FDA of Cardinal Health as a manufacturer of AzaSite. Payments
      under the contract will be dependent upon rolling production forecasts we will
      provide to Cardinal Health and are subject to certain minimum purchase
      commitments which escalate over the term of the contract.





*Bausch
      and Lomb Incorporated.*   On
      December 30, 2003, we completed the sale of our drug candidate ISV-403 for
      the
      treatment of ocular infections to Bausch & Lomb Incorporated or Bausch &
Lomb, pursuant to an ISV-403 Purchase Agreement dated December 19, 2003 (the
      “Purchase Agreement”) and a License Agreement dated December 30, 2003 (the
“License Agreement,” and collectively, the “Asset Sale”).





We
      are
      entitled to a percentage of future ISV-403 net product sales, if any, in all
      licensed countries, ending upon the later of the expiration of the patent rights
      underlying ISV-403 or ten years from the date of the first ISV-403 product
      sale
      by Bausch & Lomb. Bausch & Lomb has assumed all future ISV-403
      development and commercialization expenses and is responsible for all
      development activities.





7


The
      License Agreement provides Bausch & Lomb a license under certain of our
      patents related to our DuraSite delivery system for use with ISV-403 and under
      other non-patent intellectual property used in ISV-403. The License Agreement
      provides for Bausch & Lomb to complete development of the SS734
      fluoroquinolone products that combine certain compounds, we licensed from SSP,
      Co., Ltd., or SSP, with the DuraSite delivery system and to commercialize any
      such products. The patent license is exclusive (even as to us) in the particular
      field of developing, testing, manufacturing, obtaining regulatory approval
      of,
      marketing, selling and otherwise disposing of such products. The license of
      non-patented intellectual property granted to Bausch & Lomb is
      nonexclusive.





In
      connection with the Asset Sale, we also assigned to Bausch & Lomb a certain
      agreement between SSP and us under which we were licensed to commercialize
      SSP’s
      SS734 fluoroquinolone. Because that agreement also included a license from
      us to
      SSP under certain patents relating to DuraSite that we did not sell to Bausch
      & Lomb, the assignment of the agreement to Bausch & Lomb excluded the
      assignment of our obligations and rights as the licensor of such patents.
      Instead, we entered into a new license agreement with SSP reflecting our
      original rights and obligations as the licensor of the DuraSite patents to
      SSP.





*Societa
      Industria Farmaceutica Italiana - S.P.A. (SIFI)* In
      December 2002, we entered into an exclusive distribution agreement with SIFI
      for
      Ocu G ene
      in
      Italy. The distribution agreement grants SIFI the right to manufacture, directly
      or indirectly, distribute, perform, market, sell and promote our Ocu G ene
      glaucoma genetic test in Italy. Over the initial eight-year term of the
      agreement SIFI will pay us a fee for each test conducted. The agreement may
      be
      extended by SIFI for additional two year periods if certain sales targets are
      met during the initial and extension periods.





*Quest
      Diagnostics Incorporated.* In
      November 2002, we extended an exclusive laboratory service agreement with Quest
      Diagnostics Incorporated, or Quest, for our Ocu G ene
      test
      in the U.S. Under this agreement, we pay Quest for each Ocu G ene
      test
      that they perform.





*CIBA
      Vision Ophthalmics.* In
      October 1991, we entered into license agreements with CIBA Vision (the “CIBA
      Vision Agreements”), which granted CIBA Vision certain co-exclusive rights to
      manufacture, have manufactured, use and sell, in the U.S. and Canada:
      fluorometholone and tear replenishment products utilizing the DuraSite
      technology, ISV-205 for non-glaucoma indications, and ToPreSite Ò ,
      a
      product candidate for ocular inflammation/infection (the development of which
      is
      currently not being pursued by us or Ciba Vision).





*UC
      Regents* .
      In
      March 1993, we entered into a license agreement with the UC Regents granting
      us
      certain exclusive rights for the development of ISV-205 and, in August 1994,
      the
      parties entered into another license agreement granting us certain exclusive
      rights for the use of a nucleic acid sequence that codes for a protein
      associated with glaucoma. Under both agreements, we paid initial licensing
      fees,
      share sub-licensing fees we receive, if any, and will make royalty payments
      to
      the UC Regents on future product sales, if any.





*Columbia
      Laboratories, Inc* .
      In
      February 1992, we entered into a cross-license agreement (the “Columbia
      Agreement”) with Columbia Laboratories, Inc., or Columbia, in which Columbia
      licensed to us certain exclusive rights to a polymer technology upon which
      DuraSite is based. This license permits us to make, use and sell products using
      such polymer technology for non-veterinary ophthalmic indications in the
      over-the-counter and prescription markets in North America and East Asia (the
      “Columbia Territory”), and in the prescription market in countries outside the
      Columbia Territory. In exchange, we granted Columbia a license with certain
      exclusive rights to sublicense and use certain DuraSite technology in the
      over-the-counter market outside the Columbia Territory. In addition, we also
      granted Columbia a license with certain exclusive rights to DuraSite technology
      in the veterinary field. Under certain circumstances, certain of the licenses
      in
      the Columbia Agreement become non-exclusive. Subject to certain rights of early
      termination, the Columbia Agreement continues in effect until the expiration
      of
      all patents covered by the DuraSite technology to which Columbia has certain
      rights.





*Global
      Damon Pharm and Kukje Pharma Ind. Co., Ltd.* In
      March
      1999, we entered into a royalty-bearing license agreement with Global Damon
      Pharm, or Global Damon, a Korean company, for Global Damon to be the exclusive
      distributor of AquaSite in the Republic of Korea. Concurrently, we entered
      into
      a manufacturing agreement with Kukje Pharma Ind. Co., Ltd., or Kukje, a Korean
      company, to produce the AquaSite to be sold by Global Damon.





8


*SSP
      Co., Ltd.* In April
      2001, we entered into a royalty-bearing license agreement with SSP Co., Ltd,
      or
      SSP, for two fourth-generation fluoroquinolones, one of which is the active
      ingredient in ISV-403. We have worldwide development and marketing rights except
      for Japan, which were retained by SSP, and will share the rights with SSP in
      Asia. We subsequently assigned our rights under this agreement for the active
      ingredient in ISV-403 to Bausch & Lomb.





*Other.*  As
      part
      of our basic strategy, we continually pursue agreements with other companies,
      universities and research institutions concerning the licensing of additional
      therapeutic agents and drug delivery technologies to complement and expand
      our
      family of proprietary ophthalmic products as well as collaborative agreements
      for the further development and marketing of our current products and product
      candidates. We intend to continue exploring licensing and collaborative
      opportunities, though there is no certainty that we can successfully enter
      into,
      or maintain, any such agreements.





**Patents
      and Proprietary Rights**





Patents
      and other proprietary rights are important to our business. Our policy is to
      file patent applications seeking to protect technology, inventions and
      improvements to our inventions that we consider important to the development
      of
      our business. Additionally, we assist UC Regents in filing patent applications
      seeking to protect inventions that are the subject of our agreements with those
      institutions. We also rely upon trade secrets, know-how, continuing
      technological innovations and licensing opportunities to develop and maintain
      our competitive position. Our DuraSite drug delivery products are made under
      patents and applications, including two U.S. patents, owned by Columbia and
      exclusively licensed to us in the field of human ophthalmic applications. In
      addition, we have filed a number of patent applications in the U.S. relating
      to
      our DuraSite technology. Of these applica-tions, six U.S. patents have been
      issued. Of the patent applications we have licensed from the UC Regents, twelve
      U.S. patents have been issued. We have four U.S. patents on our retinal drug
      delivery device that have been issued. Two U.S. patents have been issued related
      to our antibiotic programs with three applications pending,. Several other
      patent applications by us and by the UC Regents, relating to the foregoing
      and
      other aspects of our business and potential business are also pending. Foreign
      counterparts of the InSite patents as well as the licensed patents of certain
      of
      these applications exist in many countries.





The
      patent positions of pharmaceutical companies, including ours, are uncertain
      and
      involve complex legal and factual questions. In addition, the coverage claimed
      in a patent application can be significantly reduced before a patent is issued.
      Consequently, we do not know whether any of our pending patent applications
      will
      result in the issuance of patents or if any of our patents will provide
      significant proprietary protection. Since patent applications are maintained
      in
      secrecy until they are published, we cannot be certain that we or any licensor
      was the first to file patent applications for such inventions or that patents
      issued to our competitors will not block or limit our ability to exploit our
      technology. Moreover, we might have to participate in interference proceedings
      declared by the U.S. Patent and Trademark Office, or USPTO, to determine
      priority of invention, which could result in substantial cost to us, even if
      the
      eventual outcome were favorable. There can be no assurance that our patents
      will
      be held valid or enforceable by a court or that a competitor's technology or
      product would be found to infringe such patents.





A
      number
      of pharmaceutical companies and research and academic institutions have
      developed technologies, filed patent applications or received patents on various
      technologies that may be related to our business. Some of these technologies,
      applications or patents may conflict with our technologies or patent
      applications. This conflict could limit the scope of the patents, if any, that
      we may be able to obtain or result in the denial of our patent applications.
      In
      addition, if patents that cover our activities have been or are issued to other
      companies, there can be no assurance that we would be able to obtain licenses
      to
      these patents, at all, or at a reasonable cost, or be able to develop or obtain
      alternative technology. If we do not obtain such licenses, we could encounter
      delays in or be precluded altogether from introducing products to the market.
      For example, we are aware that Pfizer has been issued a U.S. patent, by the
      USPTO and the European Patent Office has issued a notice of allowance on a
      patent both of which cover the use of azithromycin in a topical formulation
      to
      treat bacterial infections in the eye. We may conclude that we require a license
      under these patents to develop or sell AzaSite in the U.S. and/or Europe, which
      may not be available on reasonable commercial terms if at all. If we are unable
      to obtain a license to these patents and our technology is deemed to infringe
      these patents, we could be enjoined from pursuing the commercialization of
      AzaSite in Europe and/or the U.S.





9


In
      addition to patent protection, we also rely upon trade secret protection for
      our
      confidential and proprietary information. There can be no assurance that others
      will not independently develop substantially equivalent proprietary information
      and techniques or otherwise gain access to our trade secrets, that such trade
      secrets will not be disclosed or that we can effectively protect our rights
      to
      unpatented trade secrets.





We
      believe our drug delivery technology may expand the ophthalmic pharmaceutical
      market by permitting the novel use of drugs for ophthalmic indications that
      are
      currently used or being developed for non-ophthalmic indications. However,
      we
      may be required to obtain licenses from third parties that have rights to these
      compounds in order to conduct research, to develop or to market products that
      contain such compounds. There can be no assurance that such licenses will be
      available on commercially reasonable terms, if at all.








**Research
      and Development**





On
      December 31, 2005, our research and development staff numbered 20 people, of
      whom 4 have Ph.D.s. In 2005, our research and development expenses were $11.3
      million. In 2004, our research and development expenses, including third-party
      research we sponsored, were $7.3 million, including the expenses related to
      contract research activities for which we received $537,000 from Bausch &
Lomb. In 2003, our research and development expenses, including third-party
      research we sponsored, were $4.4 million, including the expenses related to
      contract research activities for which we received $128,000 from Bausch &
Lomb.





**Manufacturing**





We
      have
      no experience or facilities for the manufacture of products for commercial
      purposes and we currently have no intention of developing such experience or
      implementing such facilities. We have a pilot facility, licensed by the State
      of
      California, to produce potential products for Phase 1 and some of our Phase
      2
      clinical trials. However, as stated above, we have no large-scale manufacturing
      capacity and we rely on third parties for supplies and materials necessary
      for
      all of our Phase 3 clinical trials. If we should encounter delays or
      difficulties in establishing and maintaining our relationship with qualified
      manufacturers to produce, package and distribute our finished products, then
      clinical trials, regulatory filings, market introduction and subsequent sales
      of
      such products would be adversely affected.





We
      have
      entered into a manufacturing supply agreement for commercial units of our
      AzaSite product candidate with Cardinal Health. Cardinal Health was the
      manufacturer of our AzaSite Phase 3 clinical trial supplies and registration
      batches to validate their production line for commercial scale batches and
      to
      manufacture the required validation batches for FDA review. Cardinal Health’s
      facility and the line that will be used to produce the AzaSite units will be
      subject to inspection by the FDA prior to the approval of the related NDA that
      we anticipate filing in 2006. While we believe Cardinal Health will be prepared
      for the inspections, they could encounter delays or difficulties in preparing
      for, or during, the inspection which would adversely impact our potential market
      introduction and subsequent sales of AzaSite.





**Marketing
      and Sales**





The
      cost
      to develop and maintain a marketing organization and sales force is significant
      and would result in the reallocation of resources needed for the development
      of
      our product candidates. We do not currently plan on establishing a dedicated
      sales force or a marketing organization for our AzaSite, AzaSite Plus or other
      product candidates.





We
      have
      entered into corporate collaborations, and we plan to enter into additional
      collaborations with one or more additional pharmaceutical companies, to market
      our products. We may not be able to conclude or maintain such arrangements
      on
      acceptable terms, if at all.





Our
      current collaborators include:





10


*CIBA
      Vision* .
      In
      1991, we entered into a co-exclusive rights agreement to market the AquaSite
      product in the U.S. and Canada. Additionally, in May 1996, we granted CIBA
      Vision a co-exclusive U.S. license for ISV-205 for non-glaucoma indications,
      and
      co-exclusive marketing rights within the U.S. to sell and use ToPreSite, a
      product candidate that currently is not being pursued. CIBA Vision is using
      our
      trademark, under license, for AquaSite dry eye treatment and our patents are
      identified on the AquaSite packaging. We received a one-time licensing fee
      and
      are entitled to royalties based on net sales of the products, if any.





*Global
      Damon and Kukje.* In
      March
      1999, we entered into a royalty-bearing licensing agreement with Global Damon,
      a
      Korean company, for Global Damon to be the exclusive distributor of AquaSite
      in
      the Republic of Korea. Concurrently, we entered into a manufacturing agreement
      with Kukje, a Korean company, to produce the AquaSite to be sold by Global
      Damon.





*SSP
      Co., Ltd.* In April
      2001, we entered into an exclusive licensing agreement with SSP for two
      fluoroquinolone compounds, one of which is incorporated into ISV-403. We have
      exclusive marketing rights for the world except for Japan, which SSP retained,
      and shared rights with SSP in the rest of Asia. In December 2003 we assigned
      our
      rights under this agreement to the compound incorporated into ISV-403 to Bausch
      & Lomb.





*Bausch
      & Lomb* .
      In
      December 2003, we sold our ISV-403 product candidate to Bausch & Lomb.
      Bausch & Lomb has the exclusive marketing rights for the world except for
      Japan, which were retained by SSP, and shared rights in the rest of Asia with
      SSP. **** Bausch
      & Lomb has also assumed the development and manufacturing responsibilities
      for the ISV-403 formulation for their sales and distribution.





*SIFI.* In
      December 2002, we entered into an exclusive licensing agreement with SIFI for
      Ocu G ene.
      SIFI
      has the exclusive right to manufacture/perform, distribute and market
      Ocu G ene
      in
      Italy. We provide SIFI with access to technical information related to
      Ocu G ene
      and
      provide them access to any marketing materials we develop with respect to
      Ocu G ene
      to
      aid them in their sales and distribution efforts.








**Competition**





The
      pharmaceutical industry is highly competitive and requires an ongoing commitment
      to the pursuit of technological innovation. Such commitment requires significant
      investment in the resources necessary to discover, develop, test and obtain
      regulatory approvals for products. It also involves the need to effectively
      commercialize, market and promote approved products, including communicating
      the
      effectiveness, safety and value of products to customers and medical
      professionals.





The
      global ophthalmic market will become even more competitive going forward as
      the
      prevalence of eye disease increases, which will lead to increased demand for
      new
      and novel ophthalmic products. The market segments that treat diseases and
      conditions of the eye are subject to ongoing technological change and evolution.





Many
      companies are engaged in activities similar to our own. Typically, these
      companies have substantially greater financial, technical, marketing and human
      resources available to them, which may allow them to succeed in developing
      technologies and products that are more effective, safer, and receive greater
      market acceptance than the therapies that we are developing or have developed.
      These competitors may also succeed in obtaining cost advantages or intellectual
      property rights that would limit our ability to develop and commercialize our
      product opportunities, in addition to obtaining a more timely and effective
      regulatory approval for the commercialization of their products in comparison
      to
      our products.





11


The
      global ophthalmic pharmaceutical market is currently dominated by a number
      of
      large and well-established companies which include Alcon Laboratories, Inc.,
      Allergan, Inc., Bausch & Lomb, Novartis Ophthalmics, Merck & Co., and
      Pfizer, Inc. While there are many other large and medium sized companies
      participating in the ophthalmic market, it continues to be very difficult for
      smaller companies such as our own to successfully develop and market products
      without entering into effective collaborations with the very companies we
      classify as our direct competitors.





Certain
      segments of the greater ophthalmic market, such as those for glaucoma,
      anti-infective, and anti-inflammatory agents, already have well-established
      competing products currently available and also many in development by prominent
      competitors. New products must exhibit improved efficacy and safety profiles,
      be
      supported by strong marketing and sales initiatives, and have the support of
      industry thought leaders in order to penetrate these competitive mature
      markets.





In
      summary, our competitive position will depend on our ability to develop enhanced
      and innovative products, maintain a proprietary position in our technology,
      obtain required government approvals for our products on a timely basis, attract
      and retain key personnel, and enter into effective collaborations for the
      manufacture, commercial marketing and distribution of our products
      worldwide.








**Government
      Regulation**





The
      manufacturing and marketing of our products and our research and development
      activities are subject to regulation by numerous governmental authorities in
      the
      U.S. and other countries. In the U.S., drugs are subject to rigorous FDA
      regulation. The Federal Food, Drug and Cosmetic Act and regulations promulgated
      thereunder govern the testing, manufacture, labeling, storage, record keeping,
      approval, advertising and promotion in the U.S. of our products. In addition
      to
      FDA regulations, we are also subject to other federal and state regulations
      such
      as the Occupational Safety and Health Act and the Environmental Protection
      Act.
      Product development and approval within this regulatory framework take a number
      of years and involve the expenditure of substantial resources.





While
      the
      FDA currently does not regulate genetic tests, it has stated that it has the
      right to do so, and there can be no assurance that the FDA will not seek to
      regulate such tests in the future. If the FDA should require that genetic tests
      receive FDA approval prior to their use, there can be no assurance such approval
      would be received on a timely basis, if at all. The failure to receive such
      approval could require us to develop alternative testing methods, which could
      result in the delay of such tests reaching the market, if at all. Such a delay
      could materially harm our business.





The
      steps
      required before a pharmaceutical agent may be marketed in the U.S.
      include:


·
            preclinical
                laboratory and animal tests;


·
            submission
                to the FDA of an IND;


·
            adequate
                and well-controlled human clinical trials to establish the safety
                and
                efficacy of the drug;


·
            the
                submission of an NDA or Product License Application (“PLA”) to the FDA;
                and


·
            the
                FDA approval of the NDA or PLA, prior to any commercial sale or shipment
                of the drug.





In
      addition to obtaining FDA approval for each product, each domestic drug
      manufacturer and facility must be registered with, and approved by, the FDA.
      Drug product manufacturing establishments located in California also must be
      licensed by the State of California in compliance with separate regulatory
      requirements.





Preclinical
      tests include laboratory evaluation of product chemistry and animal studies
      to
      assess the potential safety and efficacy of the product and its formulation.
      The
      results of the preclinical tests are submitted to the FDA as part of an IND
      and,
      unless the FDA objects, the IND will become effective 30 days following its
      receipt by the FDA.





Clinical
      trials involve the administration of the drug to healthy volunteers or to
      patients under the supervision of a qualified principal investigator. Clinical
      trials are conducted in accordance with protocols that detail the objectives
      of
      the study, the parameters to be used to monitor safety, and the efficacy
      criteria to be evaluated. Before any clinical trial can commence, each protocol
      is submitted to the FDA as part of the IND. Each clinical study is conducted
      under the auspices of an independent Institutional Review Board that considers,
      among other things, ethical factors and the rights, welfare and safety of human
      subjects.





12


Clinical
      trials are typically conducted in three sequential phases, but the phases may
      involve multiple studies and may overlap. In Phase 1, the initial introduction
      of the drug into human subjects, the drug is tested for safety (adverse
      effects), dosage tolerance, metabolism, distribution, excretion and clinical
      pharmacology. Phase 2 involves studies in a limited patient population to (i)
      determine the efficacy of the drug for specific targeted indications, (ii)
      determine dosage tolerance and optimal dosage and (iii) identify possible
      adverse effects and safety risks. When a compound is found to be effective
      and
      to have an acceptable safety profile in Phase 2 evaluations, Phase 3 trials
      are
      undertaken to further evaluate clinical efficacy and to further test for safety
      within an expanded patient population at multiple clinical study sites. The
      FDA
      reviews both the clinical plans and the results of the trials and may
      discontinue the trials at any time if there are significant safety
      issues.





The
      results of the preclinical studies and clinical studies are submitted to the
      FDA
      in the form of an NDA or PLA for marketing approval. The testing and approval
      process requires substantial time and effort and there can be no assurance
      that
      any approval will be granted on a timely basis, if at all. Additional animal
      studies or clinical trials may be requested during the FDA review period and
      may
      delay marketing approval. After FDA approval for the initial indications,
      further clinical trials are necessary to gain approval for the use of the
      product for additional indications. The FDA may also require post-marketing
      testing to monitor for adverse effects, which can involve significant
      expense.





Among
      the
      conditions for manufacture of clinical drug supplies and for NDA or PLA approval
      is the requirement that the prospective manufacturer's quality control and
      manufacturing procedures conform to GMP. Prior to approval, manufacturing
      facilities are subject to FDA and/or other regulatory agency inspection to
      ensure compliance with GMP. Manufacturing facilities are subject to periodic
      regulatory inspection to ensure ongoing compliance.





For
      marketing outside the U.S., we are also subject to foreign regulatory
      requirements governing human clinical trials and marketing approval for drugs.
      The requirements governing the conduct of clinical trials, product licensing,
      pricing and reimbursement vary widely from country to country and in some cases
      are even more rigorous than in the U.S.








**Scientific
      and Business Advisors**





We
      have
      access to a number of academic and industry advisors with expertise in clinical
      ophthalmology and pharmaceutical development, marketing and sales. Our advisors
      meet with our management and key scientific employees on an ad hoc basis to
      provide advice in their respective areas of expertise and further assist us
      by
      periodically reviewing with management our preclinical, clinical and marketing
      activities. We plan to make arrangements with other individuals to join as
      advisors as appropriate. Although we expect to receive guidance from our
      advisors, all of our advisors are employed on a full-time basis by other
      entities, or are primarily engaged in outside business activities, and may
      have
      other commitments to, or consulting or advisory contracts with, other entities
      that may conflict or compete with their obligations to us.





13


Our
      advisors are as follows:





Name
            
            PositionMark
                Abelson, M.D.
            
            Associate
                Clinical Professor of Ophthalmology, Department of Ophthalmology,
                Harvard
                Medical SchoolChandler
                R. Dawson, M.D.
            
            Emeritus
                Professor, Department of Ophthalmology, University of California,
                San
                FranciscoSyd
                Gilman, Ph.D.
            
            Partner,
                Trident Rx Consultant ServicePing
                H. Hsu, Ph.D.
            
            Consultant,
                BiostatisticsDavid
                G. Hwang, M.D.
            
            Professor
                of Clinical Ophthalmology, Co-Director, Cornea and Refractive Surgery
                Service, University of California, San Francisco School of
                MedicineHenrick
                K. Kulmala, Ph.D.
            
            Consultant,
                Pharmaceutical DevelopmentMichael
                Marmor, M.D.
            
            Professor,
                Department of Ophthalmology, Stanford University School of
                MedicineJames
                G. Shook, Ph.D.
            
            President,
                Jim Shook Research, Inc.Roger
                Vogel, M.D.
            
            Medical
                Director








**Employees**





As
      of
      December 31, 2005, we had 32 employees, 30 of whom were full time. None of
      our employees are covered by a collective bargaining agreement. We believe
      we
      have good employee relations. We also utilize independent consultants to provide
      services in certain areas of our scientific and business
      operations.








**Item
      1A. Risk Factors**








***Our
      current cash will only fund our business until approximately the end of June
      2006. We will need additional funding, either through equity or debt financings
      or partnering arrangements, that could be further dilutive to our stockholders
      and could negatively affect us and our stock price***





Our
      independent auditors included an explanatory paragraph in their audit report
      related to our consolidated financial statements for the fiscal year ended
      December 31, 2005 referring to our recurring operating losses and a
      substantial doubt about our ability to continue as a going concern.





We
      only
      expect our current cash (including cash received for warrant exercises after
      December 31, 2005 and from the January 2006 closing of our Senior Secured Notes
      financing) to enable
      us
      to continue our operations as currently planned until approximately the end
      of
      June 2006. At that point, or earlier if circumstances change from our current
      expectations, we will require additional funding. We cannot assure you that
      additional funding will be available on a timely basis, or on reasonable terms,
      or at all. The terms of any securities issued to future investors may be
      superior to the rights of our then current stockholders and could result in
      substantial dilution and could adversely affect the market price for our Common
      Stock. If we raise funds through the issuance of debt securities, such debt
      will
      likely be secured by a security interest or pledge of all of our assets, will
      require us to make principal and interest payments in cash, securities or a
      combination thereof, would likely include the issuance of warrants, and may
      subject us to restrictive covenants. If we do not obtain such additional
      financing when required, we would likely have to cease operations and liquidate
      our assets. In addition, the existence of the explanatory paragraph in the
      audit
      report may in and of itself harm our stock price as certain investors may be
      restricted or precluded from investing in companies that have received this
      notice in an audit report. Further, the factors leading to the explanatory
      paragraph in the audit report may harm our ability to obtain additional funding
      and could make the terms of any such funding, if available, less favorable
      than
      might otherwise be the case.





14


In
      addition, we expect to enter into partnering and collaborative arrangements
      in
      the future as part of our business plan, regardless of whether we require
      additional funding to continue our operations. Such arrangements could include
      the exclusive licensing or sale of certain assets or the issuance of securities,
      which may adversely affect our future financial performance and the market
      price
      of our Common Stock and we cannot assure you that such arrangements will be
      beneficial to us. It is difficult to precisely predict our future capital
      requirements as such requirements depend upon many factors,
      including:





·
            the
                progress and results of our preclinical and clinical testing, especially
                results of our ongoing Phase 3 clinical trials for our AzaSite product
                candidate;


·
            our
                ability to establish additional corporate partnerships to develop,
                manufacture and market our potential
                products;


·
            the
                progress of our research and development
                programs;


·
            the
                outcome of existing or possible future legal
                actions;


·
            the
                cost of maintaining or expanding a marketing organization for OcuGene
                and
                the related promotional activities;


·
            changes
                in, or termination of, our existing collaboration or licensing
                arrangements;


·
            whether
                we manufacture and market any of our other products
                ourselves;


·
            the
                time and cost involved in obtaining regulatory
                approvals;


·
            the
                cost of filing, prosecuting, defending and enforcing patent claims
                and
                other intellectual property rights;


·
            competing
                technological and market developments;
                and


·
            the
                purchase of additional capital
                equipment.








***If
      we do not receive additional funding when needed to continue our operations
      we
      will likely cease operations and liquidate our assets, which are secured by
      notes payable to the holders of our December 2005/January 2006 Senior Secured
      Notes and our chief executive officer***





In
      the
      event that we are unable to secure additional funding when required to continue
      our operations, we will likely be forced to wind down our operations, either
      through liquidation, voluntary or involuntary bankruptcy or a sale of our
      assets. As of January 31, 2006, we had outstanding secured indebtedness under
      our December 2005/January 2006 Senior Secured Notes (the “Senior Secured Notes”)
      and a note issued to our chief executive officer in an aggregate principal
      amount of $6,531,000, which is secured by a lien on all of our assets
      including our intellectual property. In the event that we wind down
      operations, whether voluntarily or involuntarily, while these secured notes
      are
      outstanding, this security interest enables the holders of our Senior Secured
      Notes to control the disposition of these assets. If we are unable to repay
      the
      amounts due under the secured notes when due, the holders of such notes could
      cause us to enter into involuntary liquidation proceedings in the event we
      default on our obligations and could take possession of our assets. If we wind
      down our operations for any reason, it is likely that our stockholders will
      lose
      their entire investment in us.





***Clinical
      trials are very expensive, time-consuming and difficult to design and implement
      and it is unclear whether the results of such clinical trials will be favorable***





We
      commenced two Phase 3 trials of our AzaSite product candidate in the third
      quarter of 2004. In October 2005 we announced the completion of enrollment
      in
      one of the two Phase 3 trials and in December 2005 announced preliminary results
      of that first trial. In January 2006 we announced the completion of enrollment
      in the second Phase 3 trial and in March 2006 announced the results of that
      trial. We expect our current cash will only be sufficient to enable us to
      continue our operations as currently planned until approximately the end of
      June 2006. Accordingly, we may require additional funds to prepare the related
      clinical reports, obtain the necessary FDA approvals and market the product.
      Any
      delay or failure in the filing of our NDA for AzaSite or in the FDA approval
      process will likely require us to obtain even further funding and such delay
      or
      failure could make it much more difficult or expensive for us to obtain funding.
      Human clinical trials for our product candidates are very expensive and
      difficult to design and implement, in part because they are subject to rigorous
      regulatory requirements. The clinical trial process is also time-consuming.
      We
      estimate that clinical trials of our other product candidates will take at
      least
      several years to complete once initiated. Furthermore, we could encounter
      problems that cause us to abandon or repeat clinical trials, further delaying
      or
      preventing the completion of such trials. The commencement and completion of
      clinical trials may be delayed by several factors, including:






15





·
            unforeseen
                safety issues;


·
            determination
                of dosing issues;


·
            lack
                of effectiveness during clinical
                trials;


·
            slower
                than expected rates of patient
                recruitment;


·
            inability
                to monitor patients adequately during or after treatment;
                and


·
            inability
                or unwillingness of medical investigators to follow our clinical
                protocols.





In
      addition, we or the FDA may suspend our clinical trials at any time if it
      appears that we are exposing participants to unacceptable health risks or if
      the
      FDA finds deficiencies in our submissions or the conduct of these trials.





***The
      results of our clinical trials may not support our product candidate claims***





Even
      if
      our clinical trials are completed as planned, we cannot be certain that their
      results will support our product candidate claims. Even if pre-clinical testing
      and early clinical trials for a product candidate are successful, this does
      not
      ensure that later clinical trials will be successful, and we cannot be sure
      that
      the results of later clinical trials will replicate the results of prior
      clinical trials and pre-clinical testing or meet our expectations. The clinical
      trial process may fail to demonstrate that our product candidates are safe
      for
      humans or effective for indicated uses. In addition, our clinical trials involve
      relatively small patient populations. Because of the small sample size, the
      results of these clinical trials may not be indicative of future results. Any
      such failure would likely cause us to abandon the product candidate and may
      delay development of other product candidates. Any delay in, or termination
      of,
      our clinical trials will delay or preclude the filing of our NDAs with the
      FDA
      and, ultimately, our ability to commercialize our product candidates and
      generate product revenues. For example, if the FDA determines that our current
      AzaSite Phase 3 trials did not produce sufficient evidence to obtain approval
      for the commercialization of AzaSite or the FDA refuses to grant our AzaSite
      NDA
      for any other reason, our business would be significantly harmed as we have
      devoted a significant portion of our resources to this product candidate, at
      the
      expense of our other product candidates.





***We
      may require additional licenses or be subject to expensive and uncertain patent
      litigation in order to sell AzaSite in the U.S. and/or Europe; We are aware
      that
      Pfizer has recently received patents in the U.S. and Europe which cover the
      use
      of azithromycin in a topical formulation to treat bacterial infections in the
      eye***





A
      number
      of pharmaceutical and biotechnology companies and research and academic
      institutions have developed technologies, filed patent applications or received
      patents on various technologies that may be related to our business. Some of
      these technologies, applications or patents may conflict with our technologies
      or patent applications. Such conflicts could invalidate our issued patents,
      limit the scope of the patents, if any, we may be able to obtain, result in
      the
      denial of our patent applications or block our rights to exploit our technology.
      In addition, if the USPTO or foreign patent agencies have issued or issue
      patents that cover our activities to other companies, we may not be able to
      obtain licenses to these patents at all, or at a reasonable cost, or be able
      to
      develop or obtain alternative technology. If we do not obtain such licenses,
      we
      could encounter delays in or be precluded altogether from introducing products
      to the market.





We
      are
      aware that Pfizer has been issued U.S. Patent No. 6,681,411 by the USPTO and
      the
      European Patent Office has granted its European counterpart EP 0925789, both
      of
      which cover the use of azithromycin in a topical formulation to treat ophthalmic
      infections. We may require a license under these patents to develop or sell
      AzaSite for ophthalmic indications in the U.S. and/or Europe, which may not
      be
      available on reasonable commercial terms, if at all. If we are unable to obtain
      a license to these patents, Pfizer brings suit to enforce them, these patents
      are held valid and enforceable and our technology is deemed to infringe these
      patents, Pfizer would be entitled to damages and we could be prevented from
      selling AzaSite in Europe and/or the U.S.





We
      may
      need to litigate in order to defend against claims of infringement by Pfizer
      or
      others, to enforce patents issued to us or to protect trade secrets or know-how
      owned or licensed by us. Litigation could result in substantial cost to and
      diversion of effort by us, which may harm our business, prospects, financial
      condition, and results of operations. Such costs can be particularly harmful
      to
      emerging companies such as ours without significant existing revenue streams
      or
      other cash resources. We have also agreed to indemnify our licensees against
      infringement claims by third parties related to our technology, which could
      result in additional litigation costs and liability for us. In addition, our
      efforts to protect or defend our proprietary rights may not be successful or,
      even if successful, may result in substantial cost to us, thereby utilizing
      our
      limited resources for purposes other than product development and
      commercialization.





16


If
      our
      products, methods, processes and other technologies infringe the proprietary
      rights of other parties, we could incur substantial costs and we may have to:





·
            obtain
                licenses, which may not be available on commercially reasonable terms,
                if
                at all;


·
            redesign
                our products or processes to avoid
                infringement;


·
            stop
                using the subject matter claimed in the patents held by others, which
                could preclude us from commercializing our
                products;


·
            pay
                damages; or


·
            defend
                litigation or administrative proceedings which may be costly whether
                we
                win or lose, and which could result in a substantial diversion of
                our
                valuable management resources.





***Our
      business depends upon our proprietary rights, and we may not be able to protect,
      enforce or secure our intellectual property rights adequately***





Our
      future success will depend in large part on our ability to obtain patents,
      protect trade secrets, obtain and maintain rights to technology developed by
      others, and operate without infringing upon the proprietary rights of others.
      A
      substantial number of patents in the field of ophthalmology and genetics have
      been issued to pharmaceutical, biotechnology and biopharmaceutical companies.
      Moreover, competitors may have filed patent applications, may have been issued
      patents or may obtain additional patents and proprietary rights relating to
      products or processes competitive with ours. Our patent applications may not
      be
      approved. We may not be able to develop additional proprietary products that
      are
      patentable. Even if we receive patent issuances, those issued patents may not
      be
      able to provide us with adequate protection for our inventions or may be
      challenged by others.





Furthermore,
      the patents of others may impair our ability to commercialize our products.
      The
      patent positions of firms in the pharmaceutical and genetic industries generally
      are highly uncertain, involve complex legal and factual questions, and have
      recently been the subject of much litigation. The USPTO and the courts have
      not
      developed, formulated, or presented a consistent policy regarding the breadth
      of
      claims allowed or the degree of protection afforded under pharmaceutical and
      genetic patents. Despite our efforts to protect our proprietary rights, others
      may independently develop similar products, duplicate any of our products or
      design around any of our patents. In addition, third parties from which we
      have
      licensed or otherwise obtained technology may attempt to terminate or scale
      back
      our rights.





We
      also
      depend upon unpatented trade secrets to maintain our competitive position.
      Others may independently develop substantially equivalent proprietary
      information and techniques or otherwise gain access to our trade secrets. Our
      trade secrets may also be disclosed, and we may not be able to protect our
      rights to unpatented trade secrets effectively. To the extent that we or our
      consultants or research collaborators use intellectual property owned by others,
      disputes also may arise as to the rights in related or resulting know-how and
      inventions.





***Our
      current financial situation may impede our ability to protect or enforce
      adequately our legal rights under agreements and to our intellectual property***





We
      expect
      our current cash to enable us to continue our operations as currently planned
      only until approximately the end of June 2006. Our limited financial
      resources make it more difficult for us to enforce our intellectual property
      rights, through the filing or maintenance of patents, taking legal action
      against those that may infringe on our proprietary rights, defending
      infringement claims against us, or otherwise. Our current financial situation
      may impede our ability to enforce our legal rights under various agreements
      we
      are currently a party to or may become a party to due to our inability to incur
      the costs associated with such enforcement. Our inability to adequately protect
      our legal and intellectual property rights may make us more vulnerable to
      infringement and could materially harm our business.





17


***We
      are dependent upon key employees and we may not be able to retain or attract
      key
      employees, and our ability to attract and retain key employees is likely to
      be
      harmed by our current financial situation***





We
      are
      highly dependent on Dr. Chandrasekaran, who is our chief executive officer,
      president and chief financial officer, and Dr. Lyle Bowman, our vice president,
      development and operations. The loss of services from either of these key
      personnel might significantly delay or prevent the achievement of planned
      development objectives. We carry a $1.0 million life insurance policy on Dr.
      Chandrasekaran under which we are the sole beneficiary, however in the event
      of
      the death of Dr. Chandrasekaran such policy would be unlikely to fully
      compensate us for the hardship and expense in finding a successor such a loss
      would cause us. We do not carry a life insurance policy on Dr. Bowman.
      Furthermore, a critical factor to our success will be recruiting and retaining
      qualified personnel. Competition for skilled individuals in the biotechnology
      business is highly intense, and we may not be able to continue to attract and
      retain personnel necessary for the development of our business. Our ability
      to
      attract and retain such individuals may be reduced by our recent and current
      difficult financial situation and our past reductions in force. The loss of
      key
      personnel or the failure to recruit additional personnel or to develop needed
      expertise would harm our business.





***We
      rely on third parties to develop, market and sell our products; we may not
      be
      able to continue or enter into third party arrangements, and these third
      parties’ efforts may not be successful***





We
      do not
      plan on establishing an internal, dedicated sales force or a marketing
      organization for our product candidates. We also rely on third parties for
      clinical testing and certain other product development activities especially
      in
      the area of our glaucoma programs. We are currently pursuing a licensing or
      collaborative agreement for the sale and marketing of our AzaSite product
      candidate. There can be no assurances that we will be successful in entering
      into such an agreement or that a partner would be successful in their efforts,
      either of which could significantly harm our business. In order to pursue our
      anti-inflammatory and glaucoma programs, ISV-205, we must enter into a third
      party collaboration agreement for the development, marketing and sale thereof
      or
      develop, market and sell the product ourselves. There can be no assurance that
      we will be successful in finding a corporate partner for our ISV-205 programs
      or
      that any collaboration will be successful, either of which could significantly
      harm our business. In addition, we have no experience in marketing and selling
      products and we cannot assure you that we would be successful in marketing
      ISV-205 ourselves. If we are to develop and commercialize our product candidates
      successfully, including ISV-205, we will be required to enter into arrangements
      with one or more third parties that will:





·
            provide
                for Phase 2 and/or Phase 3 clinical
                testing;


·
            obtain
                or assist us in other activities associated with obtaining regulatory
                approvals for our product candidates;
                and


·
            market
                and sell our products, if they are
                approved.





In
      December 2003, we completed the sale of our drug candidate ISV-403 for the
      treatment of ocular infections to Bausch & Lomb Incorporated. Bausch &
Lomb has assumed all future ISV-403 development and commercialization expenses
      and is responsible for all development activities, with our assistance, as
      appropriate. The Bausch & Lomb Purchase Agreement and License Agreement
      grants Bausch & Lomb rights to develop and market ISV-403, subject to
      payment of royalties, in all geographies except Japan (which were retained
      by
      SSP, in connection with a separate license agreement between us and SSP), with
      such rights being shared with SSP in Asia (except Japan) and exclusive
      elsewhere. This sale resulted in the termination of the August 2002 license
      agreement we entered into with Bausch & Lomb related to ISV-403. Our ability
      to generate royalties from this agreement will be dependent upon Bausch &
Lomb’s ability to complete the development of ISV-403, obtain regulatory
      approval for the product and successfully market it. In addition, under the
      Bausch & Lomb Purchase Agreement, we also have certain potential
      indemnification obligations to Bausch & Lomb in connection with the asset
      sale which, if triggered, could significantly harm our business and our
      financial position.





Our
      marketing and sales efforts related to our OcuGene glaucoma genetic test have
      been significantly curtailed. Any future activities would mainly pursued using
      external resources that included:





·
            a
                network of key ophthalmic clinicians;
                and


·
            other
                resources with ophthalmic
                expertise.






18


We
      may
      not be able to enter into or maintain arrangements with third parties with
      ophthalmic or diagnostic industry experience on acceptable terms or at all.
      If
      we are not successful in concluding such arrangements on acceptable terms,
      or at
      all, we may be required to establish our own sales force and expand our
      marketing organization significantly, despite the fact that we have no
      experience in sales, marketing or distribution. Even if we do enter into
      collaborative relationships these relationships can be terminated forcing us
      to
      seek alternatives. We may not be able to build a marketing staff or sales force
      and our sales and marketing efforts may not be cost-effective or successful.





In
      addition, we currently contract with a third party to assemble the sample
      collection kits used in our OcuGene glaucoma genetic test. If our assembler
      should encounter significant delays or we have difficulty maintaining our
      existing relationship, or in establishing a new one, our sales of this product
      could be adversely affected.





***Our
      strategy for research, development and commercialization of our products
      requires us to enter into various arrangements with corporate and academic
      collaborators, licensors, licensees and others; furthermore, we are dependent
      on
      the diligent efforts and subsequent success of these outside parties in
      performing their responsibilities***





Because
      of our reliance on third parties for the development, marketing and sale of
      our
      products, any revenues that we receive will be dependent on the efforts of
      these
      third parties, such as our corporate collaborators. These partners may terminate
      their relationships with us and may not diligently or successfully market our
      products. In addition, marketing consultants and contract sales organizations,
      we may use in the future for OcuGene and potential future products such as
      AzaSite, may market products that compete with our products and we must rely
      on
      their efforts and ability to market and sell our products effectively. We may
      not be able to conclude arrangements with other companies to support the
      commercialization of our products on acceptable terms, or at all. Moreover,
      our
      current financial condition may make us a less attractive partner to potential
      collaborators. In addition, our collaborators may take the position that they
      are free to compete using our technology without compensating or entering into
      agreements with us. Furthermore, our collaborators may pursue alternative
      technologies or develop alternative products either on their own or in
      collaboration with others, including our competitors, as a means for developing
      treatments for the diseases or disorders targeted by these collaborative
      programs.





***Physicians
      and patients may not accept and use our products***





Even
      if
      the FDA approves our product candidates, physicians and patients may not accept
      and use them. Acceptance and use of our product will depend upon a number of
      factors including:





·
            perceptions
                by members of the health care community, including physicians, about
                the
                safety and effectiveness of our
                drugs;


·
            cost-effectiveness
                of our product relative to competing
                products;


·
            the
                perceived benefits of competing products or
                treatments;


·
            availability
                of reimbursement for our products from government or other healthcare
                payers; and


·
            effectiveness
                of marketing and distribution efforts by us and our licensees and
                distributors, if any.





Because
      we expect sales of our current product candidates, if approved, to generate
      substantially all of our product revenues for the foreseeable future, the
      failure of any of these drugs, particularly AzaSite, to find market acceptance
      would harm our business and could require us to seek additional financing.





***Questions
      concerning our financial condition may cause customers and current and potential
      partners to reduce or not conduct business with us***





Our
      recent and on-going financial difficulties, and concerns regarding our ability
      to continue operations, even if we are able to raise additional funding, may
      cause current and potential customers and partners to decide not to conduct
      business with us, to reduce or terminate the business they currently conduct
      with us, or to conduct business with us on terms that are less favorable than
      those customarily offered by them. In such event, our sales would likely
      decrease, our costs could increase, our product development and
      commercialization efforts would suffer and our business will be significantly
      harmed.





19


***It
      is difficult to evaluate our business because we are in an early stage of
      development and our technology is untested***





We
      are in
      an early stage of developing our business. We have only received an
      insignificant amount of royalties from the sale of one of our products, an
      over-the-counter dry eye treatment, and in 2002 we began to receive a small
      amount of revenues from the sale of our OcuGene glaucoma genetic test. Before
      regulatory authorities grant us marketing approval for additional products,
      we
      need to conduct significant additional research and development and preclinical
      and clinical testing, including with respect to our leading product candidate
      AzaSite. All of our products, including AzaSite, are subject to risks that
      are
      inherent to products based upon new technologies. These risks include the risks
      that our products:





·
            are
                found to be unsafe or ineffective;


·
            fail
                to receive necessary marketing clearance from regulatory
                authorities;


·
            even
                if safe and effective, are too difficult or expensive to manufacture
                or
                market;


·
            are
                unmarketable due to the proprietary rights of third parties;
                or


·
            are
                not able to compete with superior, equivalent, more cost-effective
                or more
                effectively promoted products offered by
                competitors.





Therefore,
      our research and development activities including with respect to AzaSite may
      not result in any commercially viable products.





***We
      have a history of operating losses and we expect to continue to have losses
      in
      the future***





We
      have
      incurred significant operating losses since our inception in 1986 and have
      pursued numerous drug development candidates that did not prove to have
      commercial potential. As of December 31, 2005, our accumulated deficit was
      approximately $136.5 million. We expect to incur net losses for the foreseeable
      future or until we are able to achieve significant royalties or other revenues
      from sales of our products. In addition, we recognize revenue when all services
      have been performed and collectibility is reasonably assured. Accordingly,
      revenue for the sales of OcuGene may be recognized in a later period than the
      associated recognition of costs of the services provided, especially during
      the
      initial launch of the product. In addition, due to this delay in revenue
      recognition, our revenues recognized in any given period may not be indicative
      of our then current viability and market acceptance of our OcuGene product.





Attaining
      significant revenue or profitability depends upon our ability, alone or with
      third parties, to develop our potential products successfully, conduct clinical
      trials, obtain required regulatory approvals and manufacture and market our
      products successfully. We may not ever achieve or be able to maintain
      significant revenue or profitability, including with respect to our leading
      product candidate AzaSite.





***We
      may not successfully manage our growth***





If
      we are
      able to raise additional funding and gain FDA approval for additional products,
      including AzaSite, our success will depend upon the expansion of our operations
      and the effective management of our growth, which will place a significant
      strain on our management and on our administrative, operational and financial
      resources. To manage this growth, we will have to expand our facilities, augment
      our operational, financial and management systems and hire and train additional
      qualified personnel. If we are unable to manage our growth effectively, our
      business would be harmed.





***Our
      products are subject to government regulations and approvals which may delay
      or
      prevent the marketing of potential products and impose costly procedures upon
      our activities***





The
      FDA
      and comparable agencies in state and local jurisdictions and in foreign
      countries impose substantial requirements upon preclinical and clinical testing,
      manufacturing and marketing of pharmaceutical products. Lengthy and detailed
      preclinical and clinical testing, validation of manufacturing and quality
      control processes, and other costly and time-consuming procedures are required.
      Satisfaction of these requirements typically takes several years and the time
      needed to satisfy them may vary substantially, based on the type, complexity
      and
      novelty of the pharmaceutical product. The effect of government regulation
      may
      be to delay or to prevent marketing of potential products for a considerable
      period of time and to impose costly procedures upon our activities. The FDA
      or
      any other regulatory agency may not grant approval on a timely basis, or at
      all,
      for any products we develop. Success in preclinical or early stage clinical
      trials does not assure success in later stage clinical trials. Data obtained
      from preclinical and clinical activities are susceptible to varying
      interpretations that could delay, limit or prevent regulatory approval. If
      regulatory approval of a product is granted, such approval may impose
      limitations on the indicated uses for which a product may be marketed. Further,
      even after we have obtained regulatory approval, later discovery of previously
      unknown problems with a product may result in restrictions on the product,
      including withdrawal of the product from the market. Moreover, the FDA has
      recently reduced previous restrictions on the marketing, sale and prescription
      of products for indications other than those specifically approved by the FDA.
      Accordingly, even if we receive FDA approval of a product for certain indicated
      uses, our competitors, including our collaborators, could market products for
      such indications even if such products have not been specifically approved
      for
      such indications. Additionally, the FDA recently issued an advisory that
      microarrays used for diagnostic and prognostic testing may need regulatory
      approval. The need for regulatory approval of multiple gene analysis is
      uncertain at this time. Delay in obtaining or failure to obtain regulatory
      approvals would make it difficult or impossible to market our products and
      would
      harm our business, prospects, financial condition, and results of operations.





20


The
      FDA’s
      policies may change and additional government regulations may be promulgated
      which could prevent or delay regulatory approval of our potential products.
      Moreover, increased attention to the containment of health care costs in the
      United States could result in new government regulations that could harm our
      business. Adverse governmental regulation might arise from future legislative
      or
      administrative action, either in the United States or abroad. See
“-Uncertainties regarding healthcare reform and third-party reimbursement may
      impair our ability to raise capital, form collaborations and sell our products”





***We
      have no experience in performing the analytical procedures related to genetic
      testing and have established an exclusive commercial agreement with a third
      party to perform these procedures for our OcuGene glaucoma genetic test; If
      we
      are unable to maintain this arrangement, and are unable to establish new
      arrangements with third parties, we will have to establish our own regulatory
      compliant analytical process for genetic testing and may not have the financial
      resources to do so***





We
      have
      no experience in the analytical procedures related to genetic testing. We have
      entered into an agreement with Quest Diagnostics Incorporated under which Quest
      exclusively performs OcuGene genetic analytical procedures at a commercial
      scale
      in the United States. Accordingly, we are reliant on Quest for all of our
      OcuGene analytical procedures. If we are unable to maintain this arrangement,
      we
      would have to contract with another clinical laboratory or would have to
      establish our own facilities. We cannot assure you that we will be able to
      contract with another laboratory to perform these services on a commercially
      reasonable basis, or at all.





Clinical
      laboratories must adhere to Good Laboratory Practice regulations that are
      strictly enforced by the FDA on an ongoing basis through the FDA’s facilities
      inspection program. Should we be required to perform the analytical procedures
      for genetic testing ourselves, we:





·
            will
                be required to expend significant amounts of capital to install an
                analytical capability;


·
            will
                be subject to the regulatory requirements described above;
                and


·
            will
                require substantially more additional capital than we otherwise may
                require.





We
      cannot
      assure you we will be able successfully to enter into another genetic testing
      arrangement or perform these analytical procedures ourselves on a cost-efficient
      basis, or at all.





***We
      rely on a sole source for some of the raw materials in our products, including
      AzaSite, and the raw materials we need may not be available to us***





We
      currently have a single supplier for azithromycin, the active drug incorporated
      into our AzaSite product candidate. The supplier has submitted a Drug Master
      File on the compound with the FDA and is subject to the FDA’s review and
      oversight. If this supplier failed or refused to continue to supply us, the
      FDA
      were to identify issues in the production of the drug that the supplier was
      unable to resolve quickly, or other issues were to arise that impact production,
      our ability to continue the development of AzaSite, and potentially the
      commercial sale if the product is approved, could be interrupted, which would
      harm our business prospects. Additional suppliers for this drug exist, but
      qualification of an alternative source could be time consuming, expensive and
      could harm our business and there is no guarantee that these additional
      suppliers can supply sufficient quantities at a reasonable price, or at all.





21


SSP
      is
      the sole source for the active drug incorporated into the ISV-403 product
      candidate we sold to Bausch & Lomb for further development and
      commercialization. SSP has submitted a Drug Master File on the compound with
      the
      FDA and is subject to the FDA’s review and oversight. If SSP is unable to obtain
      and maintain FDA approval for their production of the drug or is otherwise
      unable or unwilling to supply Bausch & Lomb with sufficient quantities of
      the drug, Bausch & Lomb’s ability to continue with the development, and
      potentially the commercial sale if the product is approved, of ISV-403 would
      be
      interrupted or impeded, and our royalties from commercial sales of the ISV-403
      product could be delayed or reduced and our business could be harmed.





In
      addition, certain of the raw materials we use in formulating our DuraSite drug
      delivery system are available only from Noveon Corporation. Although we do
      not
      have a current supply agreement with the Noveon Corporation, to date we have
      not
      encountered any difficulties obtaining necessary materials from them. Any
      significant interruption in the supply of these raw materials could delay our
      clinical trials, product development or product sales and could harm our
      business.





***We
      have no experience in commercial manufacturing and if contract manufacturing
      is
      not available to us or does not satisfy regulatory requirements, we will have
      to
      establish our own regulatory compliant manufacturing capability and may not
      have
      the financial resources to do so***





We
      have
      no experience manufacturing products for Phase 3 and commercial purposes. We
      have a pilot facility licensed by the State of California to manufacture a
      number of our products for Phase 1 and Phase 2 clinical trials but not for
      late
      stage clinical trials or commercial purposes. Any delays or difficulties that
      we
      may encounter in establishing and maintaining a relationship with qualified
      manufacturers to produce, package and distribute our finished products may
      harm
      our clinical trials, regulatory filings, market introduction and subsequent
      sales of our products.





We
      have a
      contract with Cardinal Health, the manufacturer of our AzaSite Phase 3 clinical
      trial supplies and registration batches, to validate their production line
      for
      commercial scale batches and to manufacture the required validation batches
      for
      FDA review. Additionally, we have entered into a commercial manufacturing
      agreement with Cardinal Health for an initial four year period. Other commercial
      manufacturers exist and we currently believe that we could obtain alternative
      commercial manufacturing services if required. However, qualification of another
      manufacturer, transfer of the manufacturing process and regulatory approval
      of
      such a site would be costly and time consuming and would adversely impact our
      potential market introduction and subsequent sales of AzaSite. Cardinal Health’s
      facility and the line that will be used to produce the AzaSite units will be
      subject to inspection by the FDA prior to the approval of the related NDA that
      we anticipate filing in 2006. While we believe Cardinal Health will be prepared
      for the inspections, they could encounter delays or difficulties in preparing
      for, or during, the inspection which would adversely impact our potential market
      introduction and subsequent sales of AzaSite.





We
      currently contract with a third party to assemble the sample collection kits
      used in our OcuGene glaucoma genetic test. If our assembler should encounter
      significant delays or we have difficulty maintaining our existing relationship,
      or in establishing a new one, our sales of this product could be adversely
      affected.





Contract
      manufacturers must adhere to Good Manufacturing Practices regulations that
      are
      strictly enforced by the FDA on an ongoing basis through the FDA’s facilities
      inspection program. Contract manufacturing facilities must pass a pre-approval
      plant inspection before the FDA will approve a new drug application. Some of
      the
      material manufacturing changes that occur after approval are also subject to
      FDA
      review and clearance or approval. The FDA or other regulatory agencies may
      not
      approve the process or the facilities by which any of our products may be
      manufactured. Our dependence on third parties to manufacture our products may
      harm our ability to develop and deliver products on a timely and competitive
      basis. Should we be required to manufacture products ourselves, we:




22




·
            will
                be required to expend significant amounts of capital to install a
                manufacturing capability;


·
            will
                be subject to the regulatory requirements described
                above;


·
            will
                be subject to similar risks regarding delays or difficulties encountered
                in manufacturing any such products;
                and


·
            will
                require substantially more additional capital than we otherwise may
                require.





Therefore,
      we may not be able to manufacture any products successfully or in a
      cost-effective manner.





***We
      compete in highly competitive markets and our competitors’ financial, technical,
      marketing, manufacturing and human resources may surpass ours and limit our
      ability to develop and/or market our products and technologies***





Our
      success depends upon developing and maintaining a competitive advantage in
      the
      development of products and technologies in our areas of focus. We have many
      competitors in the United States and abroad, including pharmaceutical,
      biotechnology and other companies with varying resources and degrees of
      concentration in the ophthalmic market. Our competitors may have existing
      products or products under development which may be technically superior to
      ours
      or which may be less costly or more acceptable to the market. Our competitors
      may obtain cost advantages, patent protection or other intellectual property
      rights that would block or limit our ability to develop our potential products.
      Competition from these companies is intense and is expected to increase as
      new
      products enter the market and new technologies become available. Many of our
      competitors have substantially greater financial, technical, marketing,
      manufacturing and human resources than we do, particularly in light of our
      current financial condition. In addition, they may succeed in developing
      technologies and products that are more effective, safer, less expensive or
      otherwise more commercially acceptable than any that we have or will develop.
      Our competitors may also obtain regulatory approval for commercialization of
      their products more effectively or rapidly than we will. If we decide to
      manufacture and market our products by ourselves, we will be competing in areas
      in which we have limited or no experience such as manufacturing efficiency
      and
      marketing capabilities. See “ - We may require additional licenses or be subject
      to expensive and uncertain patent litigation in order to sell AzaSite in the
      U.S. and/or Europe; We are aware that Pfizer has recently received patents
      in
      the U.S. and Europe which cover the use of azithromycin in a topical formulation
      to treat bacterial infections in the eye,” and “- We have no experience in
      commercial manufacturing and need to establish manufacturing relationships
      with
      third parties, and if contract manufacturing is not available to us or does
      not
      satisfy regulatory requirements, we will have to establish our own regulatory
      compliant manufacturing capability and may not have the financia1 resources
      to
      do so.”





***If
      we cannot compete successfully for market share against other drug 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,
      they will compete with a number of existing and future drugs 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 fail to capture and maintain market
      share, we may not achieve sufficient product revenues and our business will
      be
      harmed.





We
      will
      compete against fully integrated pharmaceutical companies and smaller companies
      that are collaborating with larger pharmaceutical companies, academic
      institutions, government agencies and other public and private research
      organizations. Many of these competitors have products competitive with AzaSite
      already approved or in development, including Zymar and Ocuflox by Allergan,
      Vigamox and Ciloxan by Alcon, and Quixin by Johnson & Johnson. In addition,
      many of these competitors, either alone or together with their collaborative
      partners, operate larger research and development programs and have
      substantially greater financial resources than we do, as well as significantly
      greater experience in:





·
            developing
                drugs;


·
            undertaking
                pre-clinical testing and human clinical
                trials;


·
            obtaining
                FDA and other regulatory approvals of
                drugs;






23




·
            formulating
                and manufacturing drugs;


·
            launching,
                marketing and selling drugs; and


·
            attracting
                qualified personnel, parties for acquisitions, joint ventures or
                other
                collaborations.








***Uncertainties
      regarding healthcare reform and third-party reimbursement may impair our ability
      to raise capital, form collaborations and sell our products***





The
      continuing efforts of governmental and third-party payers to contain or reduce
      the costs of healthcare through various means may harm our business. For
      example, in some foreign markets the pricing or profitability of health care
      products is subject to government control. In the United States, there have
      been, and we expect there will continue to be, a number of federal and state
      proposals to implement similar government control. The implementation or even
      the announcement of any of these legislative or regulatory proposals or reforms
      could harm our business by impeding our ability to achieve profitability, raise
      capital or form collaborations. In addition, the availability of reimbursement
      from third-party payers determines, in large part, the demand for healthcare
      products in the United States and elsewhere. Examples of such third-party payers
      are government and private insurance plans. Significant uncertainty exists
      as to
      the reimbursement status of newly approved healthcare products, and third-party
      payers are increasingly challenging the prices charged for medical products
      and
      services. If we succeed in bringing one or more products to the market,
      reimbursement from third-party payers may not be available or may not be
      sufficient to allow us to sell our products on a competitive or profitable
      basis.





***Our
      insurance coverage may not adequately cover our potential product liability
      exposure***





We
      are
      exposed to potential product liability risks inherent in the development,
      testing, manufacturing, marketing and sale of human therapeutic products.
      Product liability insurance for the pharmaceutical industry is extremely
      expensive. Although we believe our current insurance coverage is adequate to
      cover likely claims we may encounter given our current stage of development
      and
      activities, our present product liability insurance coverage may not be adequate
      to cover all potential claims we may encounter. In addition, our existing
      coverage will not be adequate as we further develop, manufacture and market
      our
      products, and we may not be able to obtain or afford adequate insurance coverage
      against potential claims in sufficient amounts or at a reasonable cost.





***Our
      use of hazardous materials may pose environmental risks and liabilities which
      may cause us to incur significant costs***





Our
      research, development and manufacturing processes involve the controlled use
      of
      small amounts of hazardous solvents used in pharmaceutical development and
      manufacturing, including acetic acid, acetone, acrylic acid, calcium chloride,
      chloroform, dimethyl sulfoxide, ethyl alcohol, hydrogen chloride, nitric acid,
      phosphoric acid and other similar solvents. We retain a licensed outside
      contractor that specializes in the disposal of hazardous materials used in
      the
      biotechnology industry to properly dispose of these materials, but we cannot
      completely eliminate the risk of accidental contamination or injury from these
      materials. Our cost for the disposal services rendered by our outside contractor
      was approximately $7,100 and $10,400 for the years ended 2005 and 2004,
      respectively. In the event of an accident involving these materials, we could
      be
      held liable for any damages that result, and any such liability could exceed
      our
      resources. Moreover, as our business develops we may be required to incur
      significant costs to comply with federal, state and local environmental laws,
      regulations and policies, especially to the extent that we manufacture our
      own
      products.





***If
      we engage in acquisitions, we will incur a variety of costs, and the anticipated
      benefits of the acquisition may never be realized***





We
      may
      pursue acquisitions of companies, product lines, technologies or businesses
      that
      our management believes are complementary or otherwise beneficial to us. Any
      of
      these acquisitions could have a negative effect on our business. Future
      acquisitions may result in substantial dilution to our stockholders, the
      incurrence of additional debt and amortization expenses related to goodwill,
      research and development and other intangible assets. In addition, acquisitions
      would involve several risks for us, including:






24




·
            assimilating
                employees, operations, technologies and products from the acquired
                companies with our existing employees, operations, technologies and
                products;


·
            diverting
                our management’s attention from day-to-day operation of our
                business;


·
            entering
                markets in which we have no or limited direct experience;
                and


·
            potentially
                losing key employees from the acquired
                companies.








***Management
      and principal stockholders may be able to exert significant control on matters
      requiring approval by our stockholders and security interests in our assets
      held
      by management may enable them to control the disposition of such assets***





As
      of
      December 31, 2005, our management and principal stockholders together
      beneficially owned approximately 19% of our outstanding shares of Common Stock.
      In addition, investors in our March/June 2004 and May 2005 private placements,
      as a group, owned approximately 42% of our outstanding shares of Common Stock
      as
      of December 31, 2005. If such investors were to exercise the warrants they
      currently hold, assuming no additional acquisitions or distributions, such
      investors would own approximately 54% of our outstanding shares of Common Stock
      based on their ownership percentages as of December 31, 2005. As a result,
      these
      two groups of stockholders, acting together or as individual groups, may be
      able
      to exert significant control on matters requiring approval by our stockholders,
      including the election of all or at least a majority of our Board of Directors,
      amendments to our charter, and the approval of business combinations and certain
      financing transactions.





In
      July
      2003, we issued a $400,000 short-term senior secured note payable to Dr.
      Chandrasekaran, our chief executive officer, chief financial officer and a
      member of our Board of Directors, for cash. As of December 31, 2005, $231,000
      in
      principal amount remained outstanding. This note bears an annual interest rate
      of five and one-half percent (5.5%) and is due on the earlier to occur of March
      31, 2007 and upon an event that triggers a Mandatory Redemption of the notes
      issued in the offering of our Senior Secured Notes, and is secured by a lien
      on
      all of our assets including our intellectual property. In addition, the
      Senior Secured Notes are secured by a lien on all of our assets and are on
      parity with the note issued to our chief executive officer.





These
      security interests will enable the holders of the Senior Secured Notes to
      control the disposition of all of our assets in the event of our liquidation.
      If
      we are unable to repay the amounts due under this indebtedness, such secured
      lenders could cause us to enter into involuntary liquidation proceedings in
      the
      event we default on our obligations and take possession of our assets.





***The
      market prices for securities of biopharmaceutical and biotechnology companies
      such as ours have been and are likely to continue to be highly volatile due
      to
      reasons that are related and unrelated to our operating performance and progress***





The
      market prices for securities of biopharmaceutical and biotechnology companies,
      including ours, have been highly volatile. The market has from time to time
      experienced significant price and volume fluctuations that are unrelated to
      the
      operating performance of particular companies. In addition, future announcements
      and circumstances, such as our current financial condition, the audit report
      included in our annual report on Form 10-K for the year ended December 31,
      2004
      that includes an explanatory paragraph referring to our recurring operating
      losses and a substantial doubt about our ability to continue as a going concern,
      our ability to obtain new financing, the terms of any financing we are able
      to
      raise, the results of testing and clinical trials, developments in patent or
      other proprietary rights of us or our competitors, litigation regarding the
      same, the status of our relationships with third-party collaborators,
      technological innovations or new therapeutic products, governmental regulation,
      or public concern as to the safety of products developed by us or others and
      general market conditions, concerning us, our competitors or other
      biopharmaceutical companies, may have a significant effect on the market price
      of our Common Stock.





In
      addition, terrorist attacks in the U.S. and abroad, U.S. retaliation for these
      attacks, the war in Iraq and continued worldwide economic weakness and the
      related decline in consumer confidence have had, and may continue to have,
      an
      adverse impact on the U.S. and world economy. These and similar events, as
      well
      as fluctuations in our operating results and market conditions for
      biopharmaceutical and biotechnology stocks in general, could have a significant
      effect on the volatility of the market price for our Common Stock and on the
      future price of our Common Stock.





25


The
      exercise of outstanding warrants and the sale of the shares of our Common Stock
      issuable upon exercise of those outstanding warrants could result in dilution
      to
      our current holders of Common Stock and cause a significant decline in the
      market price for our Common Stock. We have not paid any cash dividends on our
      Common Stock, and we do not anticipate paying any dividends on our Common Stock
      in the foreseeable future.





In
      connection with our December 2005/January 2006 Private Placement of Notes and
      Warrants, we issued Warrants to purchase 1,460,000 shares of our Common Stock.
      The issuance of these shares of Common Stock will be dilutive to our current
      stockholders and could adversely affect the market price for our Common Stock.





***We
      have adopted and are subject to anti-takeover provisions that could delay or
      prevent an acquisition of our Company and could prevent or make it more
      difficult to replace or remove current management***





Provisions
      of our certificate of incorporation and bylaws may constrain or discourage
      a
      third party from acquiring or attempting to acquire control of us. Such
      provisions could limit the price that investors might be willing to pay in
      the
      future for shares of our Common Stock. In addition, such provisions could also
      prevent or make it more difficult for our stockholders to replace or remove
      current management and could adversely affect the price of our Common Stock
      if
      they are viewed as discouraging takeover attempts, business combinations or
      management changes that stockholders consider in their best interest. Our Board
      of Directors has the authority to issue up to 5,000,000 shares of preferred
      stock (“Preferred Stock”), 15,000 of which have been designated as Series A-1
      Preferred Stock. Our Board of Directors has the authority to determine the
      price, rights, preferences, privileges and restrictions, including voting
      rights, of the remaining unissued shares of Preferred Stock without any further
      vote or action by the stockholders. The rights of the holders of Common Stock
      will be subject to, and may be adversely affected by, the rights of the holders
      of any Preferred Stock that may be issued in the future. The issuance of
      Preferred Stock, while providing desirable flexibility in connection with
      possible financings, acquisitions and other corporate purposes, could have
      the
      effect of making it more difficult for a third party to acquire a majority
      of
      our outstanding voting stock, even if the transaction might be desired by our
      stockholders. Provisions of Delaware law applicable to us could also delay
      or
      make more difficult a merger, tender offer or proxy contest involving us,
      including Section 203 of the Delaware General Corporation Law, which prohibits
      a
      Delaware corporation from engaging in any business combination with any
      interested stockholder for a period of three years unless conditions set forth
      in the Delaware General Corporation Law are met. The issuance of Preferred
      Stock
      or Section 203 of the Delaware General Corporation Law could also be deemed
      to
      benefit incumbent management to the extent these provisions deter offers by
      persons who would wish to make changes in management or exercise control over
      management. Other provisions of our certificate of incorporation and bylaws
      may
      also have the effect of delaying, deterring or preventing a takeover attempt
      or
      management changes that our stockholders might consider in their best interest.
      For example, our bylaws limit the ability of stockholders to remove directors
      and fill vacancies on our Board of Directors. Our bylaws also impose advance
      notice requirements for stockholder proposals and nominations of directors
      and
      prohibit stockholders from calling special meetings or acting by written
      consent.





***Legislative
      actions, higher insurance costs and potential new accounting pronouncements
      are
      likely to impact our future financial position and results of operations***





There
      have been regulatory changes, including the Sarbanes-Oxley Act of 2002, and
      there may be potential new accounting pronouncements or regulatory rulings,
      which will have an impact on our future financial position and results of
      operations. The Sarbanes-Oxley Act of 2002 and other rule changes and proposed
      legislative initiatives are likely to increase general and administrative costs.
      In addition, insurance costs, including health, workers’ compensation and
      directors and officers’ insurance costs, have been dramatically increasing and
      insurers are likely to increase rates as a result of high claims rates over
      the
      past year and our rates are likely to increase further in the future. Further,
      initiatives could result in changes in accounting rules, including legislative
      and other proposals to account for employee stock options as an expense. These
      and other potential changes could materially increase the expenses we report
      under generally accepted accounting principles, and adversely affect our
      operating results.





26


***We
      may not be able to make principal or interest payments on our Senior Secured
      Notes***





The
      Senior Secured Notes are secured by a lien on all of our assets, including
      our
      intellectual property. Under our Senior Secured Notes, $4.3 million in aggregate
      principal amount has an initial maturity date of June 30, 2006, which may be
      extended, at our option, until December 30, 2006. In addition, $2.0 million
      in
      aggregate principal amount under the Senior Secured Notes has an initial
      maturity date of July 11, 2006, which may be extended, at our option, until
      January 11, 2007. If we are unable to enter into additional corporate
      collaborations, close equity or debt financings or generate sufficient cash
      flow
      from our operations and are otherwise unable to obtain funds necessary to meet
      required payments of principal and interest on our Senior Secured Notes by
      December 30, 2006 and January 11, 2007, we would be in default under the terms
      of such notes. In the event of such a payment or other event of default, the
      holders of the Senior Secured Notes (as well as the holders of our other secured
      indebtedness) could elect to declare all the funds borrowed thereunder to be
      due
      and payable, together with accrued and unpaid interest, and institute
      foreclosure proceedings against our assets, and we could be forced into
      bankruptcy or insolvency proceedings. Because the holders of the Senior Secured
      Notes have a senior security interest in all of our assets, they will have
      the
      ability to control the liquidation of our assets and will have first priority
      on
      any funds generated therefrom. Our common stockholders will likely not receive
      any proceeds from such a liquidation. Even if we are successful in raising
      additional funds, we may be forced to curtail our operating activities in order
      to meet our obligations under the Senior Secured Notes which could harm our
      business and prospects.





In
      addition, the Senior Secured Notes contain various negative covenants, including
      covenants that prevent us from incurring indebtedness in excess of $100,000,
      granting liens on our assets or repurchasing or declaring dividends on our
      equity securities, any of which could harm our business. In addition to limiting
      our ability to operate our business, a failure to comply with these covenants
      would lead to a default under the notes and an acceleration of the outstanding
      amounts due under the notes. If this were to occur we can make no assurance
      that
      we would have sufficient funds to repay the notes, which could result in
      foreclosure proceedings against our assets or bankruptcy or insolvency
      proceedings.








**Item
      1B. Unresolved Staff Comments**





Not
      applicable.








**Item
      2. Properties**





We
      currently lease approximately 29,402 square feet of research laboratory and
      office space located in Alameda, California. The facility includes laboratories
      for formulation, analytical, microbiology, pharmacology, quality control and
      development as well as a pilot manufacturing plant. The lease expires on
      December 31, 2006, and may be renewed by us for an additional 5-year term.
      We
      believe our existing facilities will be suitable and adequate to meet our needs
      for the immediate future.





**Item
      3. Legal Proceedings**





On
      July
      8, 2004, Bristol Investment Group, or Bristol, filed with the American
      Arbitration Association (“AAA”) a demand for arbitration against us seeking cash
      compensation and warrants based on a letter agreement dated January 28, 2003
      pursuant to which Bristol was engaged as a non-exclusive placement agent of
      investment capital for us.  On October 6, 2005, the arbitrator issued the
      final award in favor of Bristol, ruling that Bristol is entitled to recover
      $249,925, plus interest, attorneys’ and other fees, plus Bristol has the right
      to purchase for $922.80 a five-year, net-exerciseable warrant to purchase
      922,800 shares of our common stock at an exercise price of $0.50 per share.
      Following the issuance of the final arbitration award, the cash arbitration
      award was paid to Bristol and the right to purchase the warrant for 922,800
      shares was exercised. We registered the shares of common stock underlying the
      warrant on a registration statement on Form S-3 that was filed with the SEC
      on
      December 9, 2005 and declared effective on December 23, 2005.





27


**Item
      4. Submission of Matters to a Vote of Security Holders** .





None.





**PART
      II**





**Item
      5. Market for Registrant's Common Equity, Related Stockholder Matters and Issuer
      Purchases of Equity Securities**





**Market
      Information**





Since
      June 10, 1998, our common stock has traded on The American Stock Exchange under
      the symbol “ISV.” From our initial public offering on October 18, 1993 until
      June 9, 1998, our common stock traded on The Nasdaq National Market under the
      symbol "INSV." Prior to our initial public offering, there was no public market
      for our common stock. The following table sets forth the high and low sales
      prices for our common stock as reported by The American Stock Exchange for
      the
      periods indicated. These prices do not include retail mark-ups, mark-downs
      or
      commissions.





**2005**
            **High**
            **Low**First
                Quarter
            $0.92
            $0.48Second
                Quarter
            $0.87
            $0.42Third
                Quarter
            $0.70
            $0.49Fourth
                Quarter
            $0.95
            $0.61**2004**
            **High**
            **Low**First
                Quarter
            $1.15
            $0.49Second
                Quarter
            $0.93
            $0.60Third
                Quarter
            $0.70
            $0.47Fourth
                Quarter
            $0.88
            $0.55








**Holders**





As
      of
      March 27, 2006, we had approximately 300 stockholders of record. On March 27,
      2006, the last sale price reported on The American Stock Exchange for our common
      stock was $2.00 per share.





**Dividends**





We
      have
      never declared or paid dividends on our common stock and do not anticipate
      paying any cash dividends in the foreseeable future. It is the present policy
      of
      our Board of Directors to retain our earnings, if any, for the development
      of
      our business.





**Recent
      Sales of Unregistered Securities**





None.








**Issuer
      Purchases of Securities**





None.







28





**Item 6.  Selected
      Financial Data**





The comparability
      of the following selected financial data is affected by a variety of factors,
      and this data is qualified by reference to and should be read in conjunction
      with the audited consolidated financial statements and notes thereto and the
      Management’s Discussion and Analysis of Financial Condition and Results of
      Operations contained elsewhere in this Annual Report on Form 10-K. The following
      table sets forth selected consolidated financial data for us for the five years
      ended December 31, 2005 (in thousands except per share amounts):





**Year
                Ended December
                31,********2005**
            
            ******2004**
            
            ******2003**
            
            **2002**
            
            ******2001****Consolidated
                Statements of Operations Data**Contract,
                product and other revenues
            
            $
            4
            
            $
            542
            
            $
            134
            
            $
            36
            
            $
            5Cost
                of goods
            
            
            14
            
            
            14
            
            
            20
            
            
            114
            
            
            --Operating
                expenses:Research
                and development, net
            
            
            11,321
            
            
            7,273
            
            
            4,436
            
            
            6,911
            
            
            6,610Selling,
                general and administrative
            
            
            3,879
            
            
            3,341
            
            
            3,021
            
            
            4,022
            
            
            3,523Total
                expenses
            
            
            15,200
            
            
            10,614
            
            
            7,457
            
            
            10,933
            
            
            10,133Gain
                on sale of assets
            
            
            --
            
            
            4,616
            
            
            1,153
            
            
            --
            
            
            --Interest
                (expense) and other income, net
            
            
            (5
            )
            
            (44
            )
            
            (561
            )
            
            62
            
            
            572Net
                income loss
            
            
            (15,215
            )
            
            (5,514
            )
            
            (6,751
            )
            
            (10,949
            )
            
            (9,556
            )Non
                cash preferred dividend
            
            
            --
            
            
            --
            
            
            221
            
            
            48
            
            
            --Net
                income loss applicable to common stockholders
            
            $
            (15,215
            )
            $
            (5,514
            )
            $
            (6,972
            )
            $
            (10,997
            )
            $
            (9,556
            )Basic
                and diluted loss per share applicable to common
                stockholders
            
            $
            (0.21
            )
            $
            (0.11
            )
            $
            (
                0.27
            )
            $
            (0.44
            )
            $
            (0.38
            )Shares
                used to calculate basic and diluted net loss per share
            
            
            72,647
            
            
            47,984
            
            
            25,767
            
            
            24,997
            
            
            24,897




**December
                31,****2005**
            
            
            **2004**
            
            
            **2003**
            
            
            **2002**
            
            
            **2001****Consolidated
              Balance Sheet Data**Cash
                and cash equivalents, unrestricted
            
            $
            4,027
            
            $
            5,351
            
            $
            1,045
            
            $
            1,179
            
            $
            10,095Working
                capital
            
            
            (3,424
            )
            
            3,515
            
            
            (6,434
            )
            
            353
            
            
            8,747Total
                assets
            
            
            5,079
            
            
            5,696
            
            
            1,405
            
            
            1,866
            
            
            11,051Long
                term notes payable
            
            
            --
            
            
            --
            
            
            16
            
            
            10
            
            
            45Convertible
                preferred stock
            
            
            --
            
            
            --
            
            
            --
            
            
            2,048
            
            
            --Accumulated
                deficit
            
            
            (136,451
            )
            
            (121,236
            )
            
            (115,722
            )
            
            (108,750
            )
            
            (97,753
            )Total
                stockholders’ equity (deficit)
            
            
            (2,545
            )
            
            3,601
            
            
            (6,200
            )
            
            887
            
            
            9,485





No
      cash
      dividends have been declared or paid by us since our inception.







29




**Item
      7. Management's Discussion and Analysis of Financial Condition and Results
      of
      Operation**





*Except
      for the historical information contained herein, the discussion in this Annual
      Report on Form 10-K contains certain forward-looking statements that
      involve risks and uncertainties, such as statements of our plans, objectives,
      beliefs, expectations and intentions. The cautionary statements made in this
      document should be read as applicable to all related forward-looking statements
      wherever they appear in this document. Our actual results could differ
      materially from those discussed herein. Factors that could cause or contribute
      to such differences include those discussed above in "Risk Factors," as well
      as
      those discussed elsewhere herein. Readers are cautioned not to place undue
      reliance on these forward-looking statements, which speak only as of the date
      hereof. We undertake no obligation to update any forward- looking statements
      to
      reflect events or circumstances after the date hereof or to reflect the
      occurrence of unanticipated events.*





The
      following discussion should be read in conjunction with the financial statements
      and notes thereto included in Item 8 of this Form 10-K.





**Overview**





We
      are an
      ophthalmic product development company focused on ophthalmic pharmaceutical
      products based on our proprietary DuraSite® eyedrop-based drug delivery
      technology, as well as developing genetically-based technologies for the
      diagnosis, prognosis and management of glaucoma.





We
      face
      significant challenges related to our lack of financial resources. We only
      expect our current cash to enable us to continue our operations as currently
      planned until approximately the end of June 2006. Our independent auditors
      included an explanatory paragraph in their audit report related to our
      consolidated financial statements for the fiscal year ended December 31,
      2005 referring to our recurring operating losses and a substantial doubt about
      our ability to continue as a going concern.





With
      our
      existing resources we are focusing our research and development and commercial
      efforts on the following:





·
            AzaSite’(ISV-401), a DuraSite formulation of azithromycin, a broad spectrum
                antibiotic; and


·
            AzaSite
                Plus’(ISV-502), a DuraSite formulation of azithromycin and a steroid for
                inflammation and pain.





*AzaSite
      (ISV-401).* To
      treat
      bacterial conjunctivitis and other infections of the outer eye we have developed
      a topical formulation (AzaSite) of the antibiotic azithromycin, an antibiotic
      with a broad spectrum of activity that is widely used to treat respiratory
      and
      other infections in its oral and parenteral forms. We believe that the key
      advantages of AzaSite may include a significantly reduced dosing regimen (9
      doses vs. 21-36 doses for comparable products), enabled by the high and
      persistent levels of azithromycin achieved by our formulation in the tissues
      of
      the eye and its wide spectrum of activity. Product safety and efficacy have
      been
      shown, respectively, in Phase 1 and Phase 2 clinical trials. The Phase 2 study
      compared an AzaSite formulation containing 1% azithromycin to a placebo. The
      results of this study showed that the AzaSite formulation was significantly
      more
      effective than the placebo in clinical resolution (p < 0.03), which includes
      reduction in inflammation and redness, and bacterial eradication (p < 0.001).





In
      July
      2004, we initiated two pivotal Phase 3 clinical trials for AzaSite which were
      conducted both in the United States and in select Latin American countries.
      One
      of the Phase 3 clinical trials was a multi-center study in which patients in
      one
      arm were dosed with a 1% AzaSite formulation and the patients in the second
      arm
      were dosed with a 0.3% formulation of the antibiotic tobramycin. In November
      2005, we announced that upon completion of enrollment this study included a
      total of 746 patients 1 year or older, of which 316 were confirmed positive
      for
      acute bacterial conjunctivitis in at least one eye. The results of this Phase
      3
      study indicated that AzaSite demonstrated a clinical resolution rate of 80%
      as
      compared to 78% for tobramycin. This result shows that the clinical resolution
      rate of AzaSite is equivalent to tobramycin, the primary efficacy endpoint
      of
      the study, according to statistical criteria which were previously agreed to
      by
      the FDA. The bacterial eradication rate was also equivalent for both
      groups .





30


The
      other
      Phase 3 clinical trial was a multi-center study in which patients in one arm
      were dosed with a 1% AzaSite formulation and the patients in the second arm
      were
      dosed with a placebo. In January 2006 we completed enrollment in this study
      of
      approximately 685 patients, of which approximately 277 were confirmed positive
      for acute bacterial conjunctivitis in at least one eye. In March 2006, we
      announced that the results of this study showed that the AzaSite formulation
      was
      more effective than the placebo in clinical resolution, which includes reduction
      in inflammation and redness, while also being superior in bacterial eradication
      over placebo.





In
      September 2005, we signed a manufacturing supply agreement with Cardinal Health
      for the manufacture of AzaSite commercial units. Cardinal Health has
      manufactured the clinical trial supplies used in our two Phase 3 bacterial
      conjunctivitis clinical trials, and also the registration batches to be used
      for
      the AzaSite New Drug Application. We anticipate that this contract manufacturing
      facility will be ready for inspection by the FDA soon after our NDA
      submission.




*AzaSite
      Plus (ISV-502).* Our
      first effort toward the expansion of our product candidate AzaSite into a larger
      franchise is the development of a combination of AzaSite with an
      anti-inflammatory steroid for the treatment of blepharitis, an infection of
      the
      eyelid and one of the most common eye problems in older adults. This combination
      product candidate is currently in preclinical development and will be more
      actively pursued as personnel and financial resources become available and
      as
      activities to support the AzaSite NDA are completed. We anticipate initiating
      Phase 1 clinical trials in 2006.





*Revenue.*  From
      our
      inception through the end of 2001, we did not receive any revenues from the
      sale
      of our products, other than a small amount of royalties from the sale of our
      AquaSite product by CIBA Vision and Global Damon. In the fourth quarter of
      2001,
      we commercially launched our Ocu G ene
      glaucoma genetic test and early in 2002 we began to receive a small amount
      of
      revenues from the sale of this test. With the exception of 1999 and the six
      month period ended June 30, 2004, we have been unprofitable since our inception
      due to continuing research and development efforts, including preclinical
      studies, clinical trials and manufacturing of our product candidates. We have
      financed our research and development activities and operations primarily
      through private and public placements of our equity securities, issuance of
      convertible debentures and, to a lesser extent, from collaborative agreements
      and bridge loans.








**Critical
      Accounting Policies and Use of Estimates**





The
      preparation of financial statements in conformity with generally accepted
      accounting principles in the U.S. requires us to make estimates and assumptions
      that affect the amounts reported in the financial statements and accompanying
      notes. Actual results could differ from those estimates.





We
      believe the following policies to be the most critical to an understanding
      of
      our financial condition and results of operations because they require us to
      make significant estimates, assumptions and judgments about matters that are
      uncertain:





Revenue
      Recognition. We
      recognize up-front fees from licensing and similar arrangements over the
      expected term of the related research and development services using the
      straight-line method. When changes in the expected term of ongoing services
      are
      identified, the amortization period for the remaining fees is appropriately
      modified.





Revenue
      related to performance milestones is recognized when the milestone is achieved
      based on the terms set forth in the related agreements.





Revenue
      related to contract research services is recognized when the services are
      provided and collectibility is reasonable assured.





During
      the years ended 2004 and 2003, we recognized cost reimbursements as contract
      and
      other revenue in accordance with EITF 01-14, “Income Statement Characterization
      of Reimbursement for Out of Pocket Expenses Incurred.” We recognize the received
      cost sharing payments when persuasive evidence of an arrangement exists, the
      services have been rendered, the fee is fixed or determinable and collectibility
      is reasonably assured.





31


We
      receive royalties from licensees based on third-party sales and the royalties
      are recorded as earned in accordance with the contract terms, when third-party
      results are reliably measured and collectibility is reasonably
      assured.





Revenue
      related to sales of our product, the Ocu G ene
      glaucoma genetic test, is recognized when all related services have been
      rendered and collectibility is reasonably assured. Accordingly, revenue for
      sales of Ocu G ene
      may
      be recognized in a later period than the associated recognition of costs of
      the
      services provided, especially during the initial launch of the product. The
      revenue in connection with the sale of ISV-403 to B&L was recognized over
      the contract period.





Research
      and Development (R&D) Expenses .
      R&D
      expenses include salaries, benefits, facility costs, services provided by
      outside consultants and contractors, administrative costs and materials for
      our
      research and development activities. We also fund research at a variety of
      academic institutions based on agreements that are generally cancelable. We
      recognize such costs as they are incurred.





Cost
      of goods. We
      recognize the cost of inventory shipped and other costs related to our
      Ocu G ene
      glaucoma genetic test when they are incurred.





Inventory .
      Our
      inventories are stated at the lower of cost or market. The cost of the inventory
      is based on the first-in first-out method. If the cost of the inventory exceeds
      the expected market value a provision is recorded for the difference between
      cost and market. At December 31, 2005 and 2004, our inventory solely consisted
      of Ocu G ene
      kits
      which are considered finished goods.








**Results
      of Operations**





*Revenues.*


We
      had
      total net revenues of $4,000, $542,000, and $134,000 for the years ended
      December 31, 2005, 2004 and 2003, respectively, from contract research
      activities and sales of Ocu G ene.
      The
      increase in revenue in 2004 was due to contract research activities conducted
      for Bausch & Lomb in 2004 and 2003 under the ISV-403 Asset Purchase
      Agreement. We are no longer providing services to B&L and we do not expect
      to derive revenue from these activities in 2006 or future years.





*Cost
      of goods.*


Cost
      of
      goods of $14,000, $14,000 and $20,000 for 2005, 2004 and 2003, respectively,
      reflect the cost of Ocu G ene
      tests
      performed as well as the cost of sample collection kits distributed for use.





*Research
      and development.*


Research
      and development expenses increased to $11.3 million in 2005 from $7.3 million
      in
      2004. The majority of this increase represents increases in the cost of the
      clinical research organizations and microbiological testing related to our
      AzaSite Phase 3 clinical trials. The remainder of the increase mainly reflects
      costs related to consultants and temporary labor to assist with the preparation
      of the AzaSite New Drug Application (NDA).





Research
      and development expenses increased to $7.3 million in 2004 from $4.4 million
      in
      2003. The majority of this increase is due to the initiation of our AzaSite
      Phase 3 clinical trials and production of the related clinical supplies and
      registration batches. The remainder of the increase reflects salary increases
      for our research staff to return such salaries to the same level they were
      prior
      to the voluntary salary reductions instituted in 2003 and costs related to
      increased research activities in support of our AzaSite program.





Our
      R&D activities can be separated into two major segments, research and
      clinical development. Research includes activities involved in evaluating a
      potential product, related pre-clinical testing and manufacturing. Clinical
      development includes activities related to filings with the FDA and the related
      human clinical testing required to obtain marketing approval for a potential
      product. We estimate that the following represents the approximate cost of
      these
      activities for 2005, 2004 and 2003 (in thousands):





32








2005
            
            2004
            
            2003Research
            
            $
            2,763
            
            $
            2,874
            
            $
            2,707Clinical
                development
            
            
            8,558
            
            
            4,398
            
            
            1,729Total
                research and development
            
            $
            11,321
            
            $
            7,273
            
            $
            4,436





Although
      the majority of our personnel were focused on our AzaSite program in 2005,
      due
      to our limited personnel and the number of projects that we are developing,
      our
      personnel are involved in a number of projects at the same time. Accordingly,
      the majority of our R&D expenses are not linked to a specific project but
      are allocated across projects, based on personnel time expended on each project.
      Accordingly, the allocated costs may not reflect the actual costs of each
      project.





The
      decrease in research activities in 2005 compared to 2004 mainly reflected the
      decrease in manufacturing activities as expenses related to the production
      of
      clinical supplies for the Phase 3 AzaSite trials were incurred mainly in 2004.
      The increase in research activities in 2004 compared to 2003 reflected salary
      increases for our research staff to return such salaries to the same level
      they
      were prior to the voluntary salary reductions instituted in 2003 and costs
      related to increased patent and research activities in support of the AzaSite
      program.





Clinical
      development expenses were $8.6 million in 2005, $4.4 million in 2004 and $1.7
      million in 2003. The majority of the increase is related to our AzaSite Phase
      3
      clinical trials which were initiated in 2004. The remainder of the increase
      reflects increased staffing to support our AzaSite clinical trials and
      preparation for the filing of the AzaSite NDA.





Most
      of
      our projects are in the early stages of the product development cycle and may
      not result in commercial products. Projects in development may not proceed
      into
      clinical trials due to a number of reasons even though the project looks
      promising early in the process. Once a project reaches clinical trials it may
      be
      found to be ineffective or there may be harmful side effects. Additionally,
      during the development cycle, other companies may develop new treatments that
      decrease the market potential for our project or be issued patents that require
      us to negotiate a license or cease pursuing one of our products and we may
      decide not to proceed. Other factors including the cost of manufacturing at
      a
      commercial scale and the availability of quality manufacturing capabilities
      could negatively impact our ability to bring the project to the market. Also,
      our business strategy is to license projects to third parties to complete the
      development cycle and to market and sell the product. If we are unable to enter
      into collaborative arrangements for any product candidate, our ability to
      commercialize the product may be slowed or we may decide not to proceed with
      that candidate. These collaborative arrangements may either speed the
      development or they may extend the anticipated time to market. Because of these
      factors, as well as others, we cannot be certain if, or when, our projects
      in
      development will complete the development cycle and be commercialized.





*Selling,
      general and administrative.*


Selling,
      general and administrative expenses increased to $3.9 million in 2005 from
      $3.3
      million in 2004. Legal expenses increased in 2005 mainly due to costs associated
      with the Bristol arbitration which was settled in 2005. Additionally, in 2005
      costs were incurred for marketing studies related to the AzaSite and AzaSite
      Plus product candidates.





Selling,
      general and administrative expenses increased to $3.3 million in 2004 from
      $3.0
      in 2003. Personnel-related expenses increased in 2004 due to the payment of
      performance bonuses to our selling, general and administrative personnel in
      June
      2004 and salary increases to these staff members to return such salaries to
      the
      same level they were prior to the salary reduction in 2003. This increase was
      partially offset by a reduction in our legal and financial service activities
      as
      expenses incurred in the second half of 2003 towards raising funds were not
      incurred in the second half of 2004.





33


*Interest,
      other income (expenses).*


Net
      interest, other income (expense) was an expense of $5,000, $44,000 and $561,000
      in 2005, 2004 and 2003, respectively. The decreased expense in 2005 mainly
      reflects the lower average balance of debt outstanding during 2005 compared
      to
      2004 as we did not close the December tranche of the Senior Secured Notes until
      December 30, 2005. The change from 2004 to 2003 principally reflects the
      $545,000 of interest expense related to the debt discount of the convertible
      debentures recorded in 2003, and interest expense related to the short-term
      notes payable in 2003 and 2004. Any interest earned or paid in the future will
      be dependent on our ability to raise additional funding and prevailing interest
      rates.








**Liquidity
      and Capital Resources**





We
      have
      financed our operations since inception primarily through private placements
      and
      public offerings of debt and equity securities, equipment and leasehold
      improvement financing, other debt financing and payments from corporate
      collaborations. At
      December 31, 2005, our unrestricted cash and cash equivalents were $4.0 million.
      It is our policy to invest our cash and cash equivalents in highly liquid
      securities, such as interest-bearing money market funds, Treasury and federal
      agency notes and corporate debt.





Our
      auditors have included an explanatory paragraph in their audit report referring
      to our recurring operating losses and a substantial doubt about our ability
      to
      continue as a going concern. Absent additional funding from private or public
      equity or debt financings, collaborative or other partnering arrangements,
      asset
      sales, or other sources, we expect that our cash on hand (including cash
      received for warrant exercises after December 31, 2005 and from the January
      2006
      closing of our Senior Secured Notes financing), anticipated cash flow from
      operations and current cash commitments to us will only be adequate to fund
      our
      operations until approximately the end of June 2006. If we are unable to secure
      sufficient additional funding prior to that time, we will need to cease
      operations and liquidate our assets, which are secured by the 2005 Senior
      Secured Notes. Our financial statements were prepared on the assumption that
      we
      will continue as a going concern and do not include any adjustments that might
      result should we be unable to continue as a going concern.





Even
      if
      we are able to obtain additional financing in order to continue long-term
      operations beyond approximately the end of June 2006, we will require and will
      seek additional funding through collaborative or other partnering arrangements,
      public or private equity or debt financings, asset sales and from other sources.
      However, there can be no assurance that we will obtain interim or longer-term
      financing or that such funding, if obtained, will be sufficient to continue
      our
      operations as currently conducted or in a manner necessary for the continued
      development of our products or the long-term success of our company. If we
      raise
      funds through the issuance of debt securities, such debt will be secured by
      a
      security interest or pledge of all of our assets, will require us to make
      principal and interest payments, would likely include the issuance of warrants
      and may subject us to restrictive covenants. In addition, our stockholders
      may
      suffer substantial dilution if we raise additional funds by issuing equity
      securities.





For
      the
      years ended December 31, 2005, 2004 and 2003, cash used for operating activities
      was $13.4
      million, $10.0 million and $5.6 million, respectively. Cash used in investing
      activities were $137,000 and $183,000 primarily related to cash outlays for
      additions to laboratory and other equipment and a change in restricted cash
      during 2005 and 2004, respectively. In 2003 proceeds received from investing
      activities of $1,477,000 were related primarily to the sale of assets. ****





Cash
      provided by financing activities was $12.2 million, $14.5 million and $4.0
      million for the years ending December 31, 2005, 2004 and 2003, respectively.
      We
      received net proceeds of $3.8 million from the issuance of short-term senior
      secured notes in December 2005 and net proceeds of $1.9 million from the final
      closing of the sale of notes in January 2006. The notes issued in December
      2005
      bear interest at a rate of 10% and are due on June 30, 2006, but the maturity
      date may be extended at our option to December 30, 2006 and would bear a 12%
      interest rate during that period. The notes issued in January 2006 also bear
      interest at a rate of 10% and are due July 11, 2006, but the maturity date
      may
      be extended at our option to January 11, 2007 and would bear a 12% interest
      rate
      during that period. We received net proceeds of $8.1 million from the issuance
      of an aggregate of approximately 16.4 million shares of common stock in a May
      2005 private placement. We received net proceeds of $15.1 million from the
      issuance of an aggregate of 33.0 million shares of common stock in the initial
      and final closings of the March 2004 private placement. We received $2.0 million
      in the first quarter of 2003 from the issuance of 2,000 shares of our Series
      A-1
      preferred stock to B&L under the ISV-403 license agreement. We issued $1.0
      million of short-term notes payable in 2003 to directors, members of senior
      management and other stockholders. These notes bear interest at rates from
      2% to
      12% and are due from January 15, 2003 through March 31, 2007. In 2005 and 2004
      we repaid $73,000 and $621,000, respectively, of these notes in cash. In the
      year ended December 2003, we received $845,000, net of debt issuance costs
      of
      approximately $154,000, from the issuance of convertible debentures. These
      debentures were later converted into 3,763,651 shares of common stock in 2003.
      In 2005, we received $536,000 from the issuance of our common stock from the
      exercise of stock options by employees, purchases under the employee stock
      purchase plan and exercises of warrants to purchase common stock compared to
      $12,000 in 2004 and $3,000 in 2003. During 2003 we also received $134,000 in
      connection with private placements of our common stock. We received payments
      on
      a note to a stockholder of $19,000, $21,000, and $23,000 in 2005, 2004 and
      2003,
      respectively. We also made $13,000 of payments on capital leases for certain
      laboratory equipment in 2004 compared to $18,000 in 2003.





34


Assuming
      we are able to obtain additional financing and continue our operations, our
      future capital expenditures and requirements will depend on numerous factors,
      including the progress of our clinical testing, research and development
      programs and preclinical testing, the time and costs involved in obtaining
      regulatory approvals, our ability to **** successfully
      commercialize AzaSite, Ocu G ene and any
      other products that we may launch in the future, our ability to establish collaborative arrangements, the cost of filing, prosecuting, defending
      and enforcing patent claims and other intellectual property rights, competing
      technological and market developments, changes in our existing collaborative
      and
      licensing relationships, acquisition of new businesses, products and
      technologies, the completion of commercialization activities and arrangements,
      and the purchase of additional property and equipment.





We
      anticipate no material capital expenditures to be incurred for environmental
      compliance in fiscal year 2006. Based on our environmental compliance record
      to
      date, and our belief that we are current in compliance with applicable
      environmental laws and regulations, environmental compliance is not expected
      to
      have a material adverse effect on our operations.





**Off-Balance
      Sheet Arrangements**





We
      have
      no off-balance sheet arrangements that have or are reasonably likely to have
      a
      current or future material effect.





**Contractual
      Obligations**





The
      following table summarizes our significant contractual obligations as of
      December 31, 2005 and the effect such obligations are expected to have on our
      liquidity and cash flows in the future periods. Some of these amounts are based
      on management’s estimate and assumptions about these obligations including their
      duration, the possibility of renewal and other factors. Because these estimates
      are necessarily subjective, our actual payments in the future may vary from
      those listed in this table.




Payments
                due by period
              (in
                thousands)Total
            
            Less
                than
              1
                year
            
            1
                -
                3
              years
            
            3
                -
                5
              Years
            
            More
                than
              5
                yearsOperating
                lease obligations (1)
            
            $
            769
            
            $
            769
            
            $
            -
            
            $
            -
            
            $
            -Purchase
                obligations (2)
            
            
            2,215
            
            
            2,215
            
            
            -
            
            
            -
            
            
            -Licensing
                agreement obligations (3)
            
            
            240
            
            
            20
            
            
            40
            
            
            40
            
            
            140Notes
              payable (4)
            
            
            4,566
            
            
            4,566
            
            
            -
            
            
            -
            
            
            -Total
                commitments
            
            $
            7,790
            
            $
            7,570
            
            $
            40
            
            $
            40
            
            $
            140





(1) We
      lease
      our facilities under a non-cancelable operating lease that expires in
      2006.


(2) Purchase
      obligations include commitments related to clinical development, consulting
      contracts, equipment maintenance, and other significant purchase commitments.


(3) We
      have
      entered into certain license agreements that require us to make minimum royalty
      payments for the life of the licensed patents. The life of the patents which
      may
      be issued and covered by the license agreements cannot be determined at this
      time, but the minimum royalties due under such agreements are as noted for
      2006
      through 2017 and are approximately $20,000 per year.


(4)  
      See further discussion of our debt issuance above in “Liquidity.”





35


**Recent
      Accounting Pronouncements**





In
      November 2004, the Financial Accounting Standards Board (“FASB”) issued
      Statement of Financial Accounting Standards No. 151, “Inventory Costs - An
      Amendment of ARB No. 43, Chapter 4” (“SFAS 151”). SFAS 151 amends the guidance
      in ARB No. 43, Chapter 4, “Inventory Pricing,” to clarify the accounting for
      abnormal amounts of idle facility expense, freight, handling costs, and wasted
      material (spoilage). Among other provisions, the new rule requires that items
      such as idle facility expense, excessive spoilage, double freight and
      re-handling costs must be recognized as current-period charges regardless of
      whether they meet the criterion of “so abnormal” as stated in ARB No. 43.
      Additionally, SFAS 151 requires that the allocation of fixed production
      overheads to the costs of conversion be based on the normal capacity of the
      production facilities. SFAS 151 is effective for fiscal years beginning after
      June 15, 2005 and is required to be adopted by us in the first quarter of 2006,
      beginning on January 1, 2006. We do not expect SFAS 151 to have a material
      financial statement impact.





In
      December 2004, the FASB issued Statement of Financial Accounting Standards
      No.
      153, “Exchanges of Non-monetary Assets - An Amendment of APB Opinion No. 29”
(“SFAS 153”). SFAS 153 eliminates the exception from fair value measurement for
      non-monetary exchanges of similar productive assets in paragraph 21(b) of APB
      Opinion No. 29, “Accounting for Non-monetary Transactions,” and replaces it with
      the exception for exchanges that do not have commercial substance. SFAS 153
      specifies that a non-monetary exchange has commercial substance if the future
      cash flows of the entity are expected to change significantly as a result of
      the
      exchange. SFAS 153 is effective for fiscal periods beginning after June 15,
      2005
      and is required to be adopted by us in the first quarter of fiscal 2006,
      beginning on January 1, 2006. We do not expect it to have a material financial
      statement impact.





In
      December 2004, the FASB issued Statement of Financial Accounting Standards
      No. 123 (revised 2004), “Share-Based Payment” (“SFAS 123(R)”), which
      requires the measurement of all share-based payments to employees, including
      grants of stock options, using a fair-value-based method and the recording
      of
      such expense in the consolidated statements of operations. The accounting
      provisions of SFAS 123(R) were originally effective for all reporting
      periods beginning after June 15, 2005. The pro forma disclosures previously
      permitted under SFAS 123 no longer will be an alternative to financial
      statement recognition. See “Stock-Based Compensation” above for the pro forma
      net income (loss) and net income (loss) per share amounts, as if we had used
      a
      fair-value-based method similar to the methods required under SFAS 123(R)
      to measure compensation expense for employee stock incentive awards.





In
      March
      2005, the Securities and Exchange Commission (“SEC”) issued Staff Accounting
      Bulletin (“SAB”) No. 107, providing supplemental implementation guidance
      for SFAS 123R. In April 2005, the SEC approved a rule that delayed the effective
      date of SFAS 123(R) to the first annual reporting period beginning after June
      15, 2005. The adoption of SFAS 123(R) and SAB No. 107 is expected to result
      in a material increase in expense in 2006 based on unvested options outstanding
      as of December 31, 2005 and current compensation plans. SFAS123(R) will be
      effective for us beginning with the first quarter of 2006.





In
      May
      2005, the FASB issued Statement of Financial Accounting Standards 154,
“Accounting Changes and Error Corrections—a replacement of APB Opinion
      No. 20 and FASB Statement No. 3” (“SFAS 154”). SFAS 154 changes the
      requirements for the accounting for and reporting of a change in accounting
      principle, and applies to all voluntary changes in accounting principle. It
      also
      applies to changes required by an accounting pronouncement in the unusual
      instance that the pronouncement does not include specific transition provisions.
      This statement requires retrospective application to prior periods’ financial
      statements of changes in accounting principle, unless it is impracticable to
      determine either the period-specific effects or the cumulative effect of the
      change. SFAS 154 is effective for accounting changes made in fiscal years
      beginning after December 15, 2005. The Company does not expect the adoption
      of this statement will have a material impact on our results of operations
      or
      financial condition.








36





**Item
      7A. Quantitative and Qualitative Disclosures About Market
      Risk**





The
      following discusses our exposure to market risk related to changes in interest
      rates.





We
      invest
      our excess cash in investment grade, interest-bearing securities. At December
      31, 2005, we had $4.0 million invested in interest bearing operating accounts.
      While a hypothetical decrease in market interest rates by 10 percent from the
      December 31, 2005 levels would cause a decrease in interest income, it would
      not
      result in a loss of the principal. Additionally, the decrease in interest income
      would not be material.








**Item
      8. Financial Statements and Supplementary Data**





The
      following Consolidated Financial Statements and Report of Independent Auditors
      are included on the pages that follow:




PageReport
                of Independent Registered Public Accounting Firm
            38Consolidated
                Balance Sheets - December 31, 2005 and 2004
            39Consolidated
                Statements of OperationsYears
                Ended December 31, 2005, 2004 and 2003
            40Consolidated
                Statements of Stockholders' Equity (Deficit)Years
                ended December 31, 2005, 2004 and 2003
            41Consolidated
                Statements of Cash FlowsYears
                Ended December 31, 2005, 2004 and 2003
            42
                - 43Notes
                to Consolidated Financial Statements
            44
                - 58







37





**REPORT
      OF INDEPENDENT REGISTERED****PUBLIC ACCOUNTING FIRM**










To
      the
      Board of Directors and Stockholders of


InSite
      Vision Incorporated




We
      have
      audited the accompanying consolidated balance sheets of InSite Vision
      Incorporated (the “Company”) as of December 31, 2005 and 2004 and the related
      consolidated statements of operations, stockholders’ equity, and cash flows for
      each of the three years in the period ended December 31, 2005. The consolidated
      financial statements are the responsibility of the Company’s management. Our
      responsibility is to express an opinion on these consolidated 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. An audit includes examining,
      on a
      test basis, evidence supporting the amounts and disclosures in the financial
      statements. An audit also includes 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 InSite Vision, Incorporated
      as of December 31, 2005 and 2004 and the results of their operations and their
      cash flows for each of the three years in the period ended December 31, 2005,
      in
      conformity with accounting principles generally accepted in the United States
      of
      America.







As
      discussed in Note 1 to the financial statements, the Company’s recurring losses
      from operations raise substantial doubt about its ability to continue as a
      going
      concern. Management’s plans as to these matters are also described in Note 1.
      The 2005 financial statements do not include any adjustments that might result
      from the outcome of this uncertainty.







/s/
      Burr,
      Pilger & Mayer LLP





Palo
      Alto, California


February
      28, 2006







38




**InSite
        Vision Incorporated**
 **Consolidated
        Balance Sheets**







December
                31,(in
                thousands, except share and per share amounts)
            
            2005
            
            2004**Assets**Current
                assets:Cash
                and cash equivalents
            
            $
            4,027
            
            $
            5,351Restricted
                cash and cash equivalents
            
            
            75
            
            
            170Inventory
            
            
            17
            
            
            18Prepaid
                expenses and other current assets
            
            
            81
            
            
            71Total
                current assets
            
            
            4,200
            
            
            5,610Property
                and equipment, at cost:Laboratory
                and other equipment
            
            
            313
            
            
            288Leasehold
                improvements
            
            
            73
            
            
            73Furniture
                and fixtures
            
            
            10
            
            
            -396
            
            
            361Accumulated
                depreciation
            
            
            131
            
            
            275265
            
            
            86Deferred
                debt issuance cost
            
            
            614
            
            
            -Total
                assets
            
            $
            5,079
            
            $
            5,696**Liabilities
                and stockholders’ equity (deficit)**Current
                liabilities:Short-term
                notes payable to related parties, unsecured
            
            $
            36
            
            $
            91Short-term
                notes payable to related parties, secured
            
            
            233
            
            
            251Short-term
                notes payable, secured, (net of debt discount of $491 atDecember
                31, 2005 and $0 at December 31, 2004)
            
            
            3,809
            
            
            -Accounts
                payable
            
            
            1,941
            
            
            574Accrued
                liabilities
            
            
            1,167
            
            
            787Accrued
                compensation and related expense
            
            
            388
            
            
            317Deferred
                rent
            
            
            50
            
            
            75Total
                current liabilities
            
            
            7,624
            
            
            2,095Commitments
                (Note 7)**Stockholders
                equity (deficit)**Preferred
                stock, $0.01 par value, 5,000,000 shares authorized, noneissued
                and outstanding at December 31, 2005 and 2004
            
            
            -
            
            
            -Common
                stockholders’ equity:Common
                stock, $0.01 par value, 120,000,000 shares authorized;79,614,806
                issued and outstanding at December 31, 2005;62,381,808
                issued and outstanding at December 31, 2004
            
            
            796
            
            
            624Additional
                paid-in capital
            
            
            133,278
            
            
            124,400Notes
                receivable from stockholder
            
            
            (168
            )
            
            (187
            )Accumulated
                deficit
            
            
            (136,451
            )
            
            (121,236
            )Common
                stockholders’ equity (deficit)
            
            
            (2,545
            )
            
            3,601Total
                liabilities and stockholders’ equity (deficit)
            
            $
            5,079
            
            $
            5,696*See
                accompanying notes to consolidated financial
                statements.*







39


**InSite
        Vision Incorporated**
 **Consolidated
        Statements of Operations**




Year
                Ended December 31,(in
                thousands, except per share amounts)
            
            
            2005
            
            
            2004
            
            
            2003Contract,
                product and other revenues
            
            $
            4
            
            $
            542
            
            $
            134Cost
                of goods
            
            
            14
            
            
            14
            
            
            20Gross
                profit (loss)
            
            
            (10
            )
            
            528
            
            
            114Operating
                expenses:Research
                and development
            
            
            11,321
            
            
            7,273
            
            
            4,436Selling,
                general and administrative
            
            
            3,879
            
            
            3,341
            
            
            3,021Total
            
            
            15,200
            
            
            10,614
            
            
            7,457Loss
                from operations
            
            
            (15,210
            )
            
            (10,086
            )
            
            (7,343
            )Gain
                on sale of assets
            
            
            -
            
            
            4,616
            
            
            1,153Interest
                (expense) and other income, net
            
            
            (5
            )
            
            (44
            )
            
            (561
            )Net
                loss
            
            
            (15,215
            )
            
            (5,514
            )
            
            (6,751
            )Non-cash
                preferred stock dividend
            
            
            -
            
            
            -
            
            
            221Net
                loss applicable to common stockholders
            
            $
            (15,215
            )
            $
            (5,514
            )
            $
            (6,972
            )Net
                loss per share applicable to common stockholders, basic and
                diluted
            
            $
            (0.21
            )
            $
            (0.11
            )
            $
            (0.27
            )Shares
                used to calculate basic and diluted net loss per share applicable
                to
                common stockholders
            
            
            72,647
            
            
            47,984
            
            
            25,767*See
                accompanying notes to consolidated financial
                statements.*








40


**Consolidated
        Statements of Stockholders’ Equity (Deficit)**




**Note**
            
            
            
            **Total****Additional**
            
            **Receivable**
            
            
            
            **Stockholders’****Preferred**
            
            **Common**
            
            **Paid
                In**
            
            **From**
            
            **Accumulated**
            
            **Equity**(dollars
                in thousands)
            
            **Stock**
            
            **Stock**
            
            **Capital**
            
            **Stockholder**
            
            **Deficit**
            
            **(deficit)****Balances,
                January 1, 2003**
            
            **$**
            **2,048**
            
            **$**
            **251**
            
            **$**
            **107,569**
            
            **$**
            **(231**
            **)**
            **$**
            **(108,750**
            **)**
            **$**
            **887****Issuance
                of 5,000 shares of common stock**
              from
                exercise of options
            
            
            -
            
            
            -
            
            
            3
            
            
            -
            
            
            -
            
            
            3Issuance
                of 2,000 shares of Series A-1preferred
                stock
            
            
            2,000
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            2,000Issuance
                of 352,857 shares of commonstock
                from private placements
            
            
            -
            
            
            4
            
            
            130
            
            
            -
            
            
            -
            
            
            134Issuance
                of convertible notes payable with beneficial conversion
                feature
            
            
            -
            
            
            -
            
            
            547
            
            
            -
            
            
            -
            
            
            547Issuance
                of 3,763,651 share of commonstock
                from conversion of debentures
            
            
            -
            
            
            38
            
            
            946
            
            
            -
            
            
            -
            
            
            984Surrender
                of Series A-1 preferred stock aspart
                of sale of assets
            
            
            (4,269
            )
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            (4,269
            )Loan
                payment from stockholder
            
            
            -
            
            
            -
            
            
            -
            
            
            23
            
            
            -
            
            
            23Non-employee
                stock compensation
            
            
            -
            
            
            -
            
            
            242
            
            
            -
            
            
            -
            
            
            242Net
                loss and comprehensive loss
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            (6,751
            )
            
            (6,751
            )Non-cash
                preferred dividend
            
            
            221
            
            
            -
            
            
            -
            
            
            -
            
            
            (221
            )
            
            -Net
                loss applicable to common stockholders
            
            
            221
            
            
            -
            
            
            -
            
            
            -
            
            
            (6,972
            )
            
            (6,751
            )**Balances,
                December 31, 2003**
            
            **$**
            **-**
            
            **$**
            **293**
            
            **$**
            **109,437**
            
            **$**
            **(208**
            **)**
            **$**
            **(115,722**
            **)**
            **$**
            **(6,200**
            **)**Issuance
                of 19,623 shares of common stockfrom
                exercise of options and employeestock
                purchase plan
            
            
            -
            
            
            -
            
            
            12
            
            
            -
            
            
            -
            
            
            12Issuance
                of 33,000,000 shares of commonstock
                from private placement
            
            
            -
            
            
            330
            
            
            14,781
            
            
            -
            
            
            -
            
            
            15,111Non-employee
                stock compensation
            
            
            -
            
            
            -
            
            
            96
            
            
            -
            
            
            -
            
            
            96Issuance
                of 2,940 shares of common stockfrom
                exercise of warrants
            
            
            -
            
            
            **-**
            
            
            2
            
            
            -
            
            
            -
            
            
            2Loan
                payment from stockholder
            
            
            **-**
            
            
            **-**
            
            
            **-**
            
            
            21
            
            
            **-**
            
            
            21Issuance
                of 105,951 shares of commonstock
                from conversion of notes payable
            
            
            -
            
            
            1
            
            
            72
            
            
            -
            
            
            -
            
            
            73Net
                loss applicable to common stockholders
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            (5,514
            )
            
            (5,514
            )**Balances,
                December 31, 2004**
            
            **$**
            **-**
            
            **$**
            **624**
            
            **$**
            **124,400**
            
            **$**
            **(187**
            **)**
            **$**
            **(121,236**
            **)**
            **$**
            **3,601**Issuance
                costs related to 2004 private
              placement
            
            
            -
            
            
            -
            
            
            (262
            )
            
            -
            
            
            -
            
            
            (262
            )Issuance
                of 65,647 shares of common stockfrom
                exercise of options and employeestock
                purchase plan
            
            
            -
            
            
            -
            
            
            33
            
            
            -
            
            
            -
            
            
            33Issuance
                of 803,725 shares of common stockfrom
                exercise of warrants
            
            
            -
            
            
            8
            
            
            495
            
            
            -
            
            
            -
            
            
            503Issuance
                of 16,363,626 shares of commonstock
                from private placement
            
            
            -
            
            
            164
            
            
            7,978
            
            
            -
            
            
            -
            
            
            8,142Non-employee
                stock compensation
            
            
            -
            
            
            -
            
            
            14
            
            
            -
            
            
            -
            
            
            14Loan
                payment from stockholder
            
            
            -
            
            
            -
            
            
            -
            
            
            19
            
            
            -
            
            
            19Issuance
                of warrants in connection withprivate
                placement of notes payable
            
            
            -
            
            
            -
            
            
            620
            
            
            -
            
            
            -
            
            
            620Net
                loss applicable to common stockholders
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            (15,215
            )
            
            (15,215
            )**Balances,
                December 31, 2005**
            
            **$**
            **-**
            
            **$**
            **796**
            
            **$**
            **133,278**
            
            **$**
            **(168**
            **)**
            **$**
            **(136,451**
            **)**
            **$**
            **(2,545**
            **)**


*See
        accompanying notes to consolidated financial statements.*
  41


**InSite
        Vision Incorporated**


**Consolidated
        Statements of Cash Flows**




Year
                Ended December 31,(in
              thousands)
            
            2005
            
            2004
            
            2003**Operating
                activities:**Net
                loss
            
            $
            (15,215
            )
            $
            (5,514
            )
            $
            (6,751
            )Adjustments
                to reconcile net loss to net cash used in operating
                activities:Depreciation
                and amortization
            
            
            57
            
            
            176
            
            
            275Stock-based
                compensation
            
            
            14
            
            
            96
            
            
            242Loss
                on disposal of capital lease asset
            
            
            -
            
            
            -
            
            
            27Non-cash
                interest expense
            
            
            
            
            
            20
            
            
            -Gain
                on sale of asset
            
            
            (4
            )
            
            (4,616
            )
            
            (1,153
            )Amortization
                of beneficial conversion feature
            
            
            -
            
            
            -
            
            
            546Debt
                issuance cost amortization
            
            
            -
            
            
            1
            
            
            153Accrued
                interest on convertible notes payable
            
            
            -
            
            
            -
            
            
            2Changes
                in:Inventories,
                prepaid expenses and other current assets
            
            
            (9
            )
            
            21
            
            
            33Accounts
                payable, accrued liabilities, accrued compensation and related expense,
                and deferred rent
            
            
            1,793
            
            
            (207
            )
            
            1,031Net
                cash used in operating activities
            
            
            (13,364
            )
            
            (10,023
            )
            
            (5,595
            )**Investing
                activities:**Purchases
                of property and equipment
            
            
            (236
            )
            
            (13
            )
            
            (23
            )Proceeds
                from sale of asset
            
            
            4
            
            
            -
            
            
            1,500Restricted
                cash decrease (increase)
            
            
            95
            
            
            (170
            )
            
            -Net
                cash provided by (used in) investing activities
            
            
            (137
            )
            
            (183
            )
            
            1,477**Financing
                activities:**Payment
                of capital lease obligation
            
            
            -
            
            
            (13
            )
            
            (18
            )Note
                payment received from stockholder
            
            
            19
            
            
            21
            
            
            23Payments
                of notes payable to related parties
            
            
            (73
            )
            
            (604
            )
            
            -Payment
                of convertible note payable
            
            
            -
            
            
            (17
            )
            
            -Issuance
                costs related to 2004 equity private placement
            
            
            (262
            )
            
            -
            
            
            -Issuance
                of short-term notes payable, net of issuance costs
            
            
            3,815
            
            
            -
            
            
            997Issuance
                of convertible notes payable, net of issuance costs
            
            
            -
            
            
            -
            
            
            845Issuance
                of preferred stock
            
            
            -
            
            
            -
            
            
            2,000Issuance
                of common stock from exercise of options, employee stockpurchase
                plan and warrants
            
            
            536
            
            
            14
            
            
            3Issuance
                of common stock, net of issuance costs
            
            
            8,142
            
            
            15,111
            
            
            134Net
                cash provided by financing activities
            
            
            12,177
            
            
            14,512
            
            
            3,984Net
                decrease in cash andcashequivalents
            
            
            (1,324
            )
            
            4,306
            
            
            (134
            )Cash
                and cash equivalents, beginning of year
            
            
            5,351
            
            
            1,045
            
            
            1,179Unrestricted
                cash and cash equivalents, end of year
            
            $
            4,027
            
            $
            5,351
            
            $
            1,045




See accompanying notes to consolidated financial
      statements.




42


**InSite
        Vision Incorporated**
 **Consolidated
        Statements of Cash Flows**




Year
                Ended December 31,(continued,
                in thousands)
            
            2005
            
            2004
            
            2003Supplemental
                cash flow information:Cash
                paid for interest
            
            $
            2
            
            $
            11
            
            $
            -Taxes
                paid
            
            $
            1
            
            $
            1
            
            $
            1Non
                cash investing and financing activities:Surrender
                of preferred stock in connection with sale of asset
            
            $
            -
            
            $
            -
            
            $
            4,269Preferred
                stock dividends
            
            $
            -
            
            $
            -
            
            $
            221Conversion
                of debentures and interest payable to common stock
            
            $
            -
            
            $
            73
            
            $
            984Beneficial
                conversion feature on convertible notes payable
            
            $
            -
            
            $
            -
            
            $
            547Issuance
                of warrants to lenders in connection with note payable
            
            $
            491
            
            $
            -
            
            $
            -Issuance
                of warrants to placement agent in connection with notes
                payable
            
            $
            129
            
            $
            -
            
            $
            -


*See
        accompanying notes to consolidated financial
        statements.*




43





**InSite
      Vision Incorporated**





Notes
      to
      Consolidated Financial Statements


December
      31, 2005











**1.**  **Summary
      of Significant Accounting Policies**




Basis
      of Presentation .
      The
      accompanying consolidated financial statements include the accounts of InSite
      Vision, Ophthalmic Solutions, Inc., its wholly-owned subsidiary and its
      wholly-owned United Kingdom subsidiary, InSite Vision Limited. InSite Vision
      Incorporated (the “Company” or “InSite Vision”) operated in one segment and is
      focused on ophthalmic genetics and developing ophthalmic drugs and ophthalmic
      drug delivery systems. All intercompany accounts and transactions have been
      eliminated.





The
      Company’s consolidated financial statements have been presented on a basis that
      contemplates the realization of assets and the satisfaction of liabilities
      in
      the normal course of business and assumes the Company will continue as a going
      concern. Except for 1999, the Company has incurred losses since its inception,
      including a net loss of $15.2 million for the year ended December 31, 2005,
      and
      the Company expects to incur substantial additional losses, including additional
      development costs, costs related to clinical trials and manufacturing expenses.
      The Company has incurred negative cash flows from operations since inception,
      including net cash used in operations of $13.4 million for the year ended
      December 31, 2005. As of December 31, 2005, the Company had an accumulated
      deficit of $136.5 million and a cash and cash equivalents balance of $4.0
      million. In these circumstances the Company believes it may not have enough
      cash
      to meet its various cash needs for fiscal 2006 unless the Company is able to
      obtain additional cash from activities it is actively pursuing such as
      placements of debt or equity securities, new license or collaborative agreements
      or exercise of outstanding warrants.  There is no assurance that additional
      funds or license or collaborative agreements will be available for the Company
      to finance its operations on acceptable terms, if at all. If the Company cannot
      obtain such additional financing when required, management would likely have
      to
      cease operations and liquidate the Company’s assets. These conditions raise
      substantial doubt about the Company’s ability to continue as a going concern.
      The financial statements do not include any adjustments to reflect the possible
      future effects on the recoverability and classification of assets or the amounts
      and classification of liabilities that may result from the outcome of this
      uncertainty.





Any
      person considering an investment in the Company's securities is urged to
      consider both the risk that the Company will cease operations at or around
      the
      end of June 2006 if an additional source of funds is not obtained. All of the
      statements set forth in this report are qualified by reference to those facts.





**Accounting
      Policies and Use of Estimates**





The
      preparation of financial statements in conformity with generally accepted
      accounting principles in the United States of America requires us to make
      estimates and assumptions that affect the amounts reported in the financial
      statements and accompanying notes. Actual results could differ from those
      estimates.





The
      following are items in our financial statements that require significant
      estimates and judgments:





Cash
      and cash equivalents.   The
      Company considers all highly liquid investments with maturities of 90 days
      or
      less from the date of purchase to be cash equivalents.





Inventory .
      The
      Company’s inventories are stated at the lower of cost or market. The cost of the
      inventory is based on the first-in first-out method. If the cost of the
      inventory exceeds the expected market value a provision is recorded for the
      difference between cost and market. At December 31, 2005 and 2004, the Company’s
      inventories solely consisted of Ocu G ene
      kits
      which are considered finished goods.





Property
      and Equipment .
      Property and equipment is stated at cost, less accumulated depreciation and
      amortization. Depreciation of property and equipment is provided over the
      estimated useful lives of the respective assets, which range from three to
      five
      years, using the straight-line method. Leasehold improvements are amortized
      over
      the lives of the related leases or their estimated useful lives, whichever
      is
      shorter, using the straight-line method. It is our policy to write-off our
      fully
      depreciated assets.





44


Additionally,
      the Company records impairment losses on long-lived assets used in operations
      when events and circumstances indicate that the assets might be impaired and
      the
      undiscounted cash flows estimated to be generated by those assets are less
      than
      the carrying amounts of those assets.





The
      costs
      of repairs and maintenance are expensed as incurred.





Revenue
      Recognition. The
      Company recognizes up-front fees over the expected term of the related research
      and development services using the straight-line method. When changes in the
      expected term of ongoing services are identified, the amortization period for
      the remaining fees is appropriately modified.





Revenue
      related to performance milestones is recognized when the milestone is achieved
      based on the terms set forth in the related agreements.





Revenue
      related to contract research services is recognized when the services are
      provided and collectibility is reasonable assured.





The
      Company recognizes cost reimbursements as contract and other revenue in
      accordance with EITF 01-14, Income Statement Characterization of Reimbursement
      for “Out of Pocket” Expenses Incurred. Such cost reimbursements are recognized
      when the fee is fixed or determinable and collectibility is reasonably
      assured.





The
      Company receives royalties from licensees based on third-party sales and the
      royalties are recorded as earned in accordance with contract terms, when third
      party results are reliably measured and collectibility is reasonably
      assured.





Revenue
      related to the sales of the Company product, the Ocu G ene
      glaucoma genetic test, is recognized when all related services have been
      rendered and collectibility is reasonably assured. The revenue in connection
      with the asset purchase agreement with Bausch & Lomb will be recognized over
      the contract period.





Cost
      of goods. The
      Company recognizes the cost of inventory shipped and other costs related to
      our
      Ocu G ene
      glaucoma genetic test when they are incurred.





Research
      and Development (R&D) Expenses .
      R&D
      expenses include salaries, benefits, facility costs, services provided by
      outside consultants and contractors, administrative costs and materials for
      the
      Company research and development activities. The Company also funds research
      at
      a variety of academic institutions based on agreements that are generally
      cancelable. The Company recognizes such costs as they are incurred.





Selling,
      General and Administrative (SG&A) Expenses .
      SG&A expenses include salaries, benefits, facility costs, services provided
      by outside consultants and contractors, advertising and marketing, investor
      relations, financial reporting, materials and other expenses related to general
      corporate and sales and marketing activities.





Advertising. Advertising costs are expensed as incurred. Advertising expenses for the period
      ended December 31, 2005 and 2004 were not significant.





Stock-Based
      Compensation. The
      Company has elected to continue to follow the intrinsic value method of
      accounting as prescribed by Accounting Principles Board Opinion No. 25 (or
      APB
      25), “Accounting for Stock Issued to Employees,” to account for employee and
      director stock options. Accordingly, the Company does not recognize compensation
      expense for options granted to employees and directors at an exercise price
      equal to the fair value of the underlying common stock.





Pro
      forma
      information regarding net loss and loss per share is required by Statement
      of
      Financial Accounting Standards (SFAS) No. 123, “Accounting for Stock Based
      Compensation,” as amended by SFAS No. 148, and has been determined as if we had
      accounted for our employee stock options under the fair value method of that
      Statement. The fair value for these options was estimated at the date of grant
      using a Black-Scholes option pricing model with the following weighted-average
      assumptions for 2005, 2004 and 2003, respectively: risk-free interest rates
      ranging from 0.89% to 4.44%; volatility factors for the expected market price
      of
      our common stock of 1.03, 1.05 and 1.06; and a weighted-average expected life
      for the options of 4 years.





45





The
      following table illustrates the effect on net loss and net loss per share as
      if
      the Company had applied the fair value recognition provisions of SFAS 123 as
      amended by SFAS 148 to stock based employee compensation (in thousands, except
      per share amounts):





Year
                Ended December 31,2005
            
            2004
            
            2003Net
                loss applicable to common stockholders-as reported
            
            $
            (15,215
            )
            $
            (5,514
            )
            $
            (6,972
            )Deduct:
                Total stock-based employee compensation expense determined
              under
                fair value method for all awards
            
            
            (524
            )
            
            (372
            )
            
            (473
            )Net
                loss applicable to common stockholders-pro forma
            
            $
            (15,739
            )
            $
            (5,886
            )
            $
            (7,445
            )Loss
                applicable to common stockholders per share:Basic
                and diluted-as reported
            
            $
            (0.21
            )
            $
            (0.11
            )
            $
            (0.27
            )Basic
                and diluted-pro forma
            
            $
            (0.22
            )
            $
            (0.12
            )
            $
            (0.29
            )







For
      purposes of pro forma disclosures pursuant to SFAS 123 as amended by SFAS 148,
      the estimated fair value of options is amortized to expense over the options’
vesting period.





The
      pro
      forma impact of options on the net loss for 2005, 2004 and 2003 is not
      necessarily representative of the effects on net income (loss) for future years,
      as future years will include the effects of additional stock
      grants.





Accounting
      for Stock Options and Warrants Exchanged for Services. The
      Company issues stock options and warrants to consultants of the Company in
      exchange for services. The Company has valued these options and warrants using
      the Black-Scholes option pricing model in accordance with the Emerging Issues
      Task Force (EITF) Consensus No. 96-18, “Accounting for Equity Investments that
      are Issued to Other Than Employees for Acquiring or in Conjunction with Selling
      Goods, or Services,” at each reporting period and has recorded charges to
      operations over the vesting periods of the individual stock options or warrant.
      Such charges amounted to approximately $14,000, $96,000 and $242,000 in 2005,
      2004 and 2003, respectively.





Income
      (Loss) per Share .
      Basic
      and diluted net income (loss) per share information for all periods is presented
      under the requirement of SFAS No. 128, “Earnings per Share.” Basic earnings per
      share has been computed using the weighted-average number of common shares
      outstanding during the period. Dilutive earnings per share is computed using
      the
      sum of the weighted-average number of common shares outstanding and the
      potential number of dilutive common shares outstanding during the period.
      Potential common shares consist of the shares issuable upon exercise of stock
      options, warrants and convertible securities. Potentially dilutive securities
      have been excluded from the computation of diluted net loss per share in 2005,
      2004 and 2003 as their inclusion would be antidilutive.





46


The
      following table sets forth the computation of basic and diluted earnings (loss)
      per share:





(in
                thousands, except per share amounts)
            
            2005
            
            2004
            
            2003Numerator:Net
                loss
            
            $
            (15,215
            )
            $
            (5,514
            )
            $
            (6,751
            )Non-cash
                preferred stock dividend
            
            
            -
            
            
            -
            
            
            (221
            )Net
                loss applicable to common stockholders
            
            $
            (15,215
            )
            $
            (5,514
            )
            $
            (6,972
            )Denominator:Denominator
                for basic and diluted loss per share -weighted-average
                common shares outstanding
            
            
            72,647
            
            
            47,984
            
            
            25,767Basic
                and diluted net loss per share
            
            $
            (0.21
            )
            $
            (0.11
            )
            $
            (0.27
            )





Due
      to
      the loss applicable to common stockholders, loss per share for 2005, 2004 and
      2003 is based on the weighted average number of common shares only, as the
      effect of including equivalent shares from stock options would be anti-dilutive.
      If the Company had recorded net income, the calculation of earnings per share
      would have been impacted by the dilutive effect of the convertible notes payable
      in 2003, but would not have been effected by the minimal number of outstanding
      stock options and warrants priced below the market price of the common shares
      at
      December 31, 2003. At December 31, 2005, 2004 and 2003, 30,253,869,
      21,646,284 and 5,223,651 options and warrants were excluded from the calculation
      of diluted earnings per share because the effect was anti-dilutive.





Accounting
      for Materials Purchased for Research and Development .
      The
      Company expenses materials for research and development activities when the
      obligation for the items is incurred.





Key
      Suppliers. The
      Company is dependent on single or limited source suppliers for certain materials
      used in its research and development activities. The Company has generally
      been
      able to obtain adequate supplies of these components. However, an extended
      interruption in the supply of these components currently obtained from single
      or
      limited source suppliers could adversely affect the Company's research and
      development efforts.





Income
      Taxes The
      Company accounts for income taxes under an asset and liability approach that
      requires the recognition of deferred tax assets and liabilities for the expected
      future tax consequences of events that have been recognized in the Company’s
      financial statements or the Company’s tax returns. In estimating future tax
      consequences, the Company generally considers all expected future events other
      than enactments and changes in the tax law or rates. A deferred tax valuation
      allowance is provided for deferred tax assets when it is determined that it
      is
      more likely than not that amounts will not be recovered.





Concentration
      of Risk. Financial instruments that potentially subject the Company to significant
      concentrations of credit risk consist principally of cash and cash equivalents.
      The Company’s cash and cash equivalents are primarily deposited in demand
      accounts with one financial institution.




Recent
      Accounting Pronouncements. In November 2004, the Financial Accounting Standards
      Board (“FASB”) issued Statement of Financial Accounting Standards No. 151,
“Inventory Costs - An Amendment of ARB No. 43, Chapter 4” (“SFAS 151”). SFAS 151
      amends the guidance in ARB No. 43, Chapter 4, “Inventory Pricing,” to clarify
      the accounting for abnormal amounts of idle facility expense, freight, handling
      costs, and wasted material (spoilage). Among other provisions, the new rule
      requires that items such as idle facility expense, excessive spoilage, double
      freight and re-handling costs must be recognized as current-period charges
      regardless of whether they meet the criterion of “so abnormal” as stated in ARB
      No. 43. Additionally, SFAS 151 requires that the allocation of fixed production
      overheads to the costs of conversion be based on the normal capacity of the
      production facilities. SFAS 151 is effective for fiscal years beginning after
      June 15, 2005 and is required to be adopted by the Company in the first quarter
      of 2006, beginning on January 1, 2006. The Company does not expect SFAS 151
      to
      have a material financial statement impact.





47


In
      December 2004, the FASB issued Statement of Financial Accounting Standards
      No.
      153, “Exchanges of Non-monetary Assets - An Amendment of APB Opinion No. 29”
(“SFAS 153”). SFAS 153 eliminates the exception from fair value measurement for
      non-monetary exchanges of similar productive assets in paragraph 21(b) of APB
      Opinion No. 29, “Accounting for Non-monetary Transactions,” and replaces it with
      the exception for exchanges that do not have commercial substance. SFAS 153
      specifies that a non-monetary exchange has commercial substance if the future
      cash flows of the entity are expected to change significantly as a result of
      the
      exchange. SFAS 153 is effective for fiscal periods beginning after June 15,
      2005
      and is required to be adopted by the Company in the first quarter of fiscal
      2006, beginning on January 1, 2006. The Company does not expect it to have
      a
      material financial statement impact.





In
      December 2004, the FASB issued Statement of Financial Accounting Standards
      No. 123 (revised 2004), “Share-Based Payment” (“SFAS 123(R)”), which
      requires the measurement of all share-based payments to employees, including
      grants of stock options, using a fair-value-based method and the recording
      of
      such expense in the consolidated statements of operations. The accounting
      provisions of SFAS 123(R) were originally effective for all reporting
      periods beginning after June 15, 2005. The pro forma disclosures previously
      permitted under SFAS 123 no longer will be an alternative to financial
      statement recognition. See “Stock-Based Compensation” above for the pro forma
      net income (loss) and net income (loss) per share amounts, as if the Company
      had
      used a fair-value-based method similar to the methods required under
      SFAS 123(R) to measure compensation expense for employee stock incentive
      awards.





In
      March
      2005, the Securities and Exchange Commission (“SEC”) issued Staff Accounting
      Bulletin (“SAB”) No. 107, providing supplemental implementation guidance
      for SFAS 123R. In April 2005, the SEC approved a rule that delayed the effective
      date of SFAS 123(R) to the first annual reporting period beginning after June
      15, 2005. The adoption of SFAS 123(R) and SAV No. 107 is expected to result
      in a material increase in expense in 2006 based on unvested options outstanding
      as of December 31, 2005 and current compensation plans. SFAS123(R) will be
      effective for the Company beginning with the first quarter of 2006.





In
      May
      2005, the FASB issued Statement of Financial Accounting Standards 154,
“Accounting Changes and Error Corrections—a replacement of APB Opinion
      No. 20 and FASB Statement No. 3” (“SFAS 154”). SFAS 154 changes the
      requirements for the accounting for and reporting of a change in accounting
      principle, and applies to all voluntary changes in accounting principle. It
      also
      applies to changes required by an accounting pronouncement in the unusual
      instance that the pronouncement does not include specific transition provisions.
      This statement requires retrospective application to prior periods’ financial
      statements of changes in accounting principle, unless it is impracticable to
      determine either the period-specific effects or the cumulative effect of the
      change. SFAS 154 is effective for accounting changes made in fiscal years
      beginning after December 15, 2005. The Company does not expect the adoption
      of this statement will have a material impact on our results of operations
      or
      financial condition.





**2.**  **Sale
      of Assets and Licenses**





In
      December 2003, the Company entered into agreements with Bausch & Lomb
      Incorporated, or Bausch & Lomb, in which the Company sold the assets related
      to its ISV-403 product candidate, for the treatment of ocular bacterial
      infections, and licensed certain DuraSite patents for use in the ISV-403 product
      candidate. Bausch & Lomb made a payment to the Company of $1.5 million,
      surrendered 4,000 shares of Series A-1 Preferred Stock (See Note 10) and the
      related accumulated dividends, and will pay the Company royalties on future
      sales, if any. The Company had no carrying value related to the ISV-403 assets
      as all costs of development were expensed as incurred. Additionally, the Company
      agreed to provide certain contracted services to Bausch & Lomb for a period
      beginning in November 2003 through June 2004, for which the Company was paid
      an
      additional amount. The license and stock purchase agreements the Company entered
      into with Bausch & Lomb in August 2002 related to the ISV-403 product
      candidate were terminated.





In
      accordance with Staff Accounting Bulletin No. 104, *Revenue
      Recognition in Financial Statements,* the
      Company recognized $5.8 million of gain on sale of assets, representing the
      cash
      received of $1.5 million and the value of the Series A-1 Preferred Stock
      surrendered of $4.3 million, on a straight-line basis over the seven month
      period for which contract services were provided. Correspondingly, in 2003
      the
      Company recognized $1.2 million of gain from the sale of assets and recognized
      the remaining gain from the sale of assets of $4.6 million in 2004.





48





**3.**  **Restricted
      Cash**





In
      December 2005 the Company reserved approximately $75,000 related to a letter
      of
      credit issued as collateral for a capital lease for a telephone system which
      was
      to be installed and initiated in the first quarter of 2006.





In
      2004
      the Company received proceeds totaling $170,000 from the sale of shares obtained
      from the demutualization of an insurance company, which had provided health
      benefits to the Company’s employees. During 2005 these proceeds were used for
      the payment of health insurance benefits for the employees, no amounts remained
      outstanding as of December 31, 2005.








**4.**  **Short-term
      Notes Payable to Related Parties, Unsecured**





In
      August, September and November 2003, the Company issued a total of $188,000
      in a
      series of short-term unsecured notes payable to members of the Board of
      Directors, senior management and other employees of the Company for cash. As
      of
      December 31, 2005, $36,000 remains outstanding. These notes bear interest at
      a
      rate of two percent (2%) and are due the earlier of March 31, 2007 or the
      successful completion of the AzaSite Phase 3 clinical trials.





**5.**  **Short-term
      Notes Payable to Related Parties, Secured**





In
      July
      and August 2003, the Company issued $500,000 in short-term Senior Secured Notes
      payable to an officer who is also a member of the Board of Directors and an
      affiliate of a member of senior management for cash. In November 2003, the
      Company increased one of the short-term Senior Secured Notes by $20,000 after
      receipt of cash. These notes bear interest at a rate of between five and
      one-half percent (5.5%) and twelve percent (12%), were due between September
      30,
      2003 and October 15, 2003 and, in combination with the notes described in Note
      6, are secured by a lien on substantially all of the assets of the Company,
      including the Company’s intellectual property, other than certain other
      equipment secured by the lessor of such equipment. Prior to September 30, 2003
      the due dates of these notes were extended to between November 15, 2003 and
      December 31, 2003. Subsequently, the due dates were further extended to January
      15, 2004 and March 31, 2004. In January 2004, the Company repaid $120,000 of
      these Senior Secured Notes and the related accrued interest. The Company had
      $233,000 of these short-term secured notes payable to related parties
      outstanding at December 31, 2005 and the due date has been extended to the
      sooner of March 31, 2007 or the successful completion of the AzaSite Phase
      3
      clinical trials.





**6.**  **Short-term
      Notes Payable, Secured**





In
      December 2005, the Company issued a total of $4,300,000 of short-term Senior
      Secured Notes payable and warrants to purchase 860,000 shares of Common Stock
      at
      an exercise price of $0.82 per share. The Company also issued warrants to
      purchase 200,000 shares of Common Stock at an exercise price of $0.82 per share
      to the placement agent. These warrants were valued using a Black-Scholes option
      pricing model, assuming no dividend yield, with the following assumptions:
      risk-free interest rate of 4.30%, volatility of 1.0285 and an expected life
      of 5
      years. The relative fair value model was then applied to the Black-Scholes
      valuation of the warrants issued to the note holders resulting in the recording
      of a debt discount of $491,000 which will be amortized over the term of the
      notes. The Black-Scholes model resulted in a deferred debt issue cost of
      $129,000 for the warrants issued to the placement agent which will be amortized
      over the term of the notes.





These
      notes, and the Senior Secured Note described in Note 5, are secured by a lien
      on
      all of the assets of the Company, including the Company’s intellectual property.
      These notes bear interest at a rate of ten percent (10%) and have an original
      maturity date of June 30, 2006, but may be extended for an additional six months
      at an interest rate of twelve percent (12%). Payments of principal and interest
      under the Notes are due in one lump sum upon the earlier of the applicable
      maturity date and an “Event of Acceleration” under the Notes.





49


The
      following events, among others, constitute an “Event of Acceleration” under the
      Notes: (i) the Company fails to make a payment under the Notes when due; (ii)
      the Company fails to perform, in any material respect, any term or provision
      of
      the Notes; (iii) the Company fails to perform in any material respect, any
      material agreement or covenant in the Subscription Agreement or the Security
      Agreement (collectively, the “Reference Agreements”); (iv) any of the
      representations and warranties in the Reference Agreements are untrue and the
      effect of which has a material adverse effect on the business or operations
      of
      the Company or the ability of the Company to repay the Notes; (v) the Company
      enters into bankruptcy or receivership proceedings or otherwise admits in
      writing its inability to pay its debts as they become due; or (vi) an order
      or
      judgment in excess of $500,000 is entered into against the Company.





The
      Notes
      also contain a mandatory redemption provision which requires the Company to
      redeem the Notes in full (including a “make-whole” premium of all interest due
      to the end of the relevant maturity date) within 10 days following the
      consummation of a (i) Sale of the Company, (ii) Qualified Financing or (iii)
      Corporate Collaboration.





For
      purposes of the Notes, (i) “Qualified Financing” shall mean the closing of an
      equity financing or series of equity financings by the Company resulting in
      aggregate gross cash proceeds (before commissions or other expenses) to the
      Company of at least $12,500,000; (ii) “Sale of the Company” shall mean a
      transaction (or series of related transactions) between the Company and one
      or
      more non-affiliates, pursuant to which such party or parties acquire (A) capital
      stock of the Company possessing the voting power to elect a majority of the
      board of directors of the Company (whether by merger, consolidation, sale or
      transfer of the Company’s capital stock or otherwise); or (B) all or
      substantially all of the Company’s assets determined on a consolidated basis; *provided* , *however* ,
      that a
      transaction (or series of related transactions) pursuant to which the
      then-existing holders of the Company’s capital stock immediately prior to such
      transaction (or series of related transactions) continue to own, directly or
      indirectly, a majority of the outstanding shares of the capital stock of the
      Company or such other resulting, surviving or combined company resulting from
      such transaction (or series of related transactions) shall not be deemed to
      be a
      Sale of the Company; and (iii) “Corporate Collaboration” shall mean the closing
      by the Company of a transaction in which any rights to AzaSite are licensed
      to a
      third party.





The
      Notes
      also contain certain negative covenants that restrict or prohibit the Company
      from incurring additional indebtedness in excess of $100,000; creating or
      granting liens on its assets; engaging in certain transactions with officers,
      directors or 5% or greater stockholders; repurchasing equity securities or
      declaring dividends on its capital stock; or changing its primary line of
      business without the written consent of the holders of a majority of the
      aggregate principal amount of the Company’s senior secured notes.




The
      weighted average interest rate for the unsecured and secured notes payable
      was
      9.7% and 4.6% at December 31, 2005 and 2004, respectively.





**7.**  **Commitments
      and Contingencies**




At
        December 31, 2005, the Company had purchase commitments and contractual
        obligations of approximately $1.7 million, primarily related to its clinical
        trial activities and minimum license fees. These purchase commitments and
        contractual obligations are reflected in the Company’s financial statements once
        the related goods or services have been received or payments related to the
        obligations become due.





The
      Company leases its facilities under non-cancelable operating lease agreements
      that expire in 2006. Rent expense was $719,000, $719,000, and $697,000 for
      2005,
      2004 and 2003, respectively.





Future
      minimum payments under operating leases are as follows:





Year
                ending December 31,
            
            Operating
              Leases2006
            
            
            769,248Total
                minimum lease payments
            
            $
            769,248








50


**8.**  **Convertible
      Notes Payable**





On
      September 22, 2003, the Company, Arrow Acquisition, Inc., a wholly-owned
      subsidiary of the Company, and Ophthalmic Solutions, Inc. (“Ophthalmic
      Solutions”) entered into an Agreement and Plan of Merger (the “Merger
      Agreement”). The merger contemplated by the Merger Agreement (the “Merger”) was
      also completed on September 22, 2003. As a result of the Merger, Ophthalmic
      Solutions became a wholly-owned subsidiary of the Company and all outstanding
      shares of Ophthalmic Solutions’ capital stock held by its sole stockholder were
      converted into 100 shares of the Company’s common stock. Ophthalmic Solutions is
      a private, development stage company with a business plan to pursue
      opportunities for over-the-counter products in the area of ophthalmology and
      had
      immaterial assets and liabilities as of September 22, 2003, other than its
      obligations under and the proceeds from the debentures described below.





Immediately
      prior to the Merger, Ophthalmic Solutions entered into a Convertible Debenture
      Purchase Agreement (the “Purchase Agreement”) dated as of September 22, 2003,
      with HEM Mutual Assurance LLC, pursuant to which it sold and issued convertible
      debentures to HEM in an aggregate principal amount of up to $1,000,000 in a
      private placement pursuant to Rule 504 of Regulation D under the Securities
      Act
      of 1933, as amended. Two debentures in the aggregate principal amount of
      $500,000 were issued for gross proceeds of $500,000 in cash (the “Initial
      Debentures”) and an additional debenture in the aggregate principal amount of
      $500,000 (the “Contingent Debenture” and collectively with the Initial
      Debentures, the “Debentures”) was issued in exchange for a promissory note from
      HEM in the principal amount of $500,000 (the “Note”). Each of the Debentures had
      a maturity date of September 21, 2008, subject to earlier conversion or
      redemption pursuant to its terms, and bears interest at the rate of 1% per
      year,
      payable in cash or shares of common stock at the option of the holder of the
      Debentures. As a result of the Merger, the Company assumed the rights and
      obligations of Ophthalmic Solutions in the private placement, including the
      gross proceeds raised through the sale of the Debentures, the Note issued by
      HEM
      to Ophthalmic Solutions, and Ophthalmic Solutions’ obligations under the
      Debentures and the Purchase Agreement.





As
      a
      result of the Merger at September 22, 2003, $492,750 and $3,625 in principal
      amount of the Initial Debentures was convertible into unrestricted shares of
      the
      Company’s common stock at a conversion price that is the lower of $0.30 or the
      average of the three lowest closing per share bid prices for the common stock
      during the 40 trading days prior to conversion and $0.01 per share,
      respectively. On November 12, 2003 the $500,000 Contingent Debenture and an
      additional $3,625 of Initial Debentures became convertible and subject to
      repayment when the related Note from HEM was paid in full to the Company in
      cash. The Contingent Debenture is convertible into unrestricted shares of the
      Company’s common stock at a conversion price that is the lower of $0.375 or the
      average of the three lowest closing per share bid prices for the common stock
      during the 40 trading days prior to conversion and the additional Initial
      Debentures have a conversion price of $0.01 per share.





The
      merger has been accounted for as an acquisition of assets. The assets acquired
      and liabilities assumed include: convertible debentures, cash and the related
      promissory note(s). Ophthalmic Solutions had no other assets or liabilities
      at
      the time of the merger. This asset acquisition has been, in substance, reflected
      as a financing transaction in the accompanying financial statements, including
      the receipt of cash and the issuance of debentures.





The
      Initial Debenture conversion prices of $0.30 and $0.01 per share, respectively
      were lower than the per share price of the Company’s common stock on the
      issuance date of September 22, 2003. The conversion prices of the Contingent
      Debenture and remaining Initial Debentures of $0.375 and $0.01 per share,
      respectively were lower than the per share price of the Company’s common stock
      on November 12, 2003 when the related Note from HEM was paid in full to the
      Company in cash. In accordance with the provisions of EITF 00-27, *Accounting
      for Convertible Securities with Beneficial Conversion Features or Contingently
      Adjustable Conversion Ratios to Certain Convertible Instruments* ,
      the
      Company recorded a beneficial conversion feature of $547,000 related to the
      debentures. The Company accretes the $547,000 discount recorded from the
      beneficial conversion feature from the dates the debentures became convertible,
      September 22, 2003 and November 12, 2003, to the stated redemption date of
      September 21, 2008. The accretion has been reported as interest expense with
      a
      corresponding increase to convertible debentures. Further, as amounts are
      converted into common stock, prior to the redemption date, all of the remaining
      unamortized discount associated with those shares will be immediately recognized
      as interest expense. As of December 31, 2003 approximately $546,000 of the
      beneficial conversion feature had been expensed as interest. As of December
      31,
      2003, the $16,000 convertible debentures reported on the face of the balance
      sheet are net of related unamortized debt discount of $1,000. In connection
      with
      the convertible debt financing, the Company capitalized approximately $154,000
      of debt issuance costs, which were included in prepaid expenses and other
      current assets and other assets. These costs were being amortized over the
      life
      of the convertible debentures. For the years ended December 31, 2004 and 2003,
      $1,000 and $153,000, resepectively, of the debt financing costs were amortized
      to expenses.





51


On
      December 19, 2003, $482,329 in debenture principal and the related interest
      was
      converted into 1,393,011 shares of the Company’s common stock. On December 11,
      2003, $3,625 in debenture principal and the related interest was converted
      into
      363,284 shares of the Company’s common stock. On November 26, 2003, $92,750 in
      debenture principal and the related interest was converted into 309,717 shares
      of the Company’s common stock. On November 10, 2003, $200,000 in debenture
      principal and the related interest was converted into 667,561 shares of the
      Company’s common stock. On October 30, 2003, $200,000 in debenture principal and
      the related interest was converted into 667,360 shares of the Company’s common
      stock. On October 15, 2003, $3,625 debenture principal and the related interest
      was converted into 362,718 shares of the Company’s common stock.





On
      May 3,
      2004, the Company redeemed approximately $17,000 of convertible notes payable
      assumed by the Company as part of its acquisition of Ophthalmic Solutions,
      Inc.,
      for approximately $25,000, which included a 40% redemption premium. After this
      redemption, all of the convertible notes payable have been paid in cash or
      converted into the Company’s common stock.





To
      satisfy its conversion obligations under the Debentures, the Company placed
      5,000,000 shares of its common stock into escrow for potential issuance to
      HEM
      upon conversion of the Debentures. As of December 31, 2003, 1,236,348 shares
      of
      common stock were in escrow. Upon the repayment of the outstanding convertible
      notes payable in May 2004, the common stock remaining in escrow was returned
      to
      the Company.





**9.**  **Income
      Taxes**





Due
      to
      the company’s history of net operating losses, there is no provision for income
      taxes for the years ended December 31, 2005, 2004 and 2003.





Significant
      components of the Company’s deferred tax assets for federal and state income
      taxes as of December 31, 2005 and 2004 are as follows (in
      thousands):





2005
            
            2004Deferred
                tax assets:Net
                operating loss carryforwards
            
            $
            35,503
            
            $
            33,441Tax
                credit carryforwards
            
            
            6,038
            
            
            6,066Capitalized
                research and development
            
            
            11,016
            
            
            8,700Depreciation
            
            
            453
            
            
            463Other
            
            
            192
            
            
            98Total
                deferred tax assets
            
            
            53,202
            
            
            48,768Valuation
                allowance
            
            
            (53,202
            )
            
            (48,768
            )Net
                deferred tax assets
            
            $
            -
            
            $
            -





The
      valuation allowance increased by $4.4 million, $857,000, and $2.1 million during
      the years ended December 31, 2005, 2004 and 2003, respectively.





At
      December 31, 2005, the Company has net operating loss carryforwards for federal
      income tax purposes of approximately $94.2 million, which expire in the years
      2005 through 2024 and federal tax credits of approximately $3.2 million, which
      expire in the years 2005 through 2024. The Company also has net operating loss
      carryforwards for state income tax purposes of approximately $58.1 million
      which
      expire in the years 2005 through 2014, and state research and development tax
      credits of approximately and $2.7 million which carryforward
      indefinitely.





52


Utilization
      of the Company’s federal and state net operating loss carryforwards and research
      and development tax credits are subject to an annual limitation against taxable
      income in future periods due to the ownership change limitations provided by
      the
      Internal Revenue Code of 1986. As a result of this annual limitation, a
      significant portion of these carryforwards will expire before ultimately
      becoming available for offset against taxable income. Additional losses and
      credits will be subject to limitation if the Company incurs another change
      in
      ownership in the future.





**10.**  **Preferred
      Stock**





Series
      A-1 Preferred Stock





In
      August
      2002, the Company entered into a Preferred Stock Purchase Agreement with Bausch
      & Lomb contemporaneously with the execution of the Bausch & Lomb License
      Agreement for the ISV-403 product candidate. The Stock Purchase Agreement
      provided for Bausch & Lomb to purchase up to 15,000 shares of Series A-1
      Preferred Stock for a purchase price equal to $1,000 per share for an aggregate
      investment of up to $15.0 million. The initial investment, which was made in
      August 2002, was for 2,000 shares of Series A-1 Preferred Stock, for a total
      investment equal to $2.0 million. In February 2003, the first milestone was
      reached and Bausch & Lomb invested an additional $2.0 million and received
      2,000 more shares of Series A-1 Preferred Stock. In December 2003, the ISV-403
      product candidate was sold to Bausch & Lomb and the Preferred Stock Purchase
      Agreement was terminated and the 4,000 outstanding shares, and the related
      accumulated dividends, were surrendered to the Company. The Series A-1 Preferred
      Stock did not contain voting rights, except as otherwise provided by the
      Delaware General Corporation law and each share of Series A-1 Preferred Stock
      was entitled to a 6% per annum cumulative dividend.





For
      the
      year ended December 31, 2003, the Company reported non-cash preferred dividends
      of $221,000. The dividends are related to the 6% per annum premium earned on
      the
      outstanding Series A-1 Preferred Stock and are taken into consideration to
      determine the net loss per share applicable to common
      stockholders.





**11.**  **Common
      Stockholders’ Equity (Deficit)**





On
      May
      26, 2005, the Company received, net of placement fees, approximately $8.1
      million from a private placement. The Company issued 16,363,626 shares of Common
      Stock and warrants to purchase 4,909,077 shares of Common Stock at an exercise
      price of $0.6325 per share. The Company also issued warrants to purchase 818,181
      shares of Common Stock at an exercise price of $0.6325 per share to the
      placement agent. These warrants were valued using a Black-Scholes option pricing
      model, assuming no dividend yield, with the following assumptions: risk-free
      interest rate of 2.32%, volatility of 1.0435 and an expected life of 5 years,
      resulting in the recording of a stock issue cost of approximately $2.4 million
      for the warrants issued to the investors in the private placement and $0.4
      million for the warrants issued to the placement agent.





In
      2005 a
      final award was issued by the arbitrator of a legal action brought against
      the
      Company by Bristol Investment Group in regards to placement agent fees related
      to a 2004 private placement. As a result of the award the Company recorded
      a
      placement agent fee, including interest, of $262,000. Bristol also received
      the
      right to purchase for $922.80 a five-year, net-exerciseable warrant to purchase
      922,800 shares of our common stock at an exercise price of $0.50 per share.
      The
      warrants were valued using a Black-Scholes option pricing model, assuming no
      dividend yield, with the following assumptions: risk-free interest rate of
      4.18%, volatility of 1.04 and an expected life of 5 years, resulting in the
      recording of a stock issue cost of approximately $467,000. In January 2006,
      the
      warrants were exercised using the non-cash exercise provision in the warrant
      for
      a total of 565,125 shares of Common Stock.





53


In
      2005
      the Company received approximately $298,000, net of approximately $9,000 of
      fees, from the exercise of warrants to purchase 410,206 shares of Common Stock
      issued as part of the March 2004 private placement. In December 2005, the
      Company received approximately $145,000 from the exercise of warrants to
      purchase 268,519 shares of Common Stock issued in December 2003. Additionally,
      in January 2005, the Company received approximately $50,000 from the exercise
      of
      warrants to purchase 125,000 shares of Common Stock issued in November 2003.
      In
      August 2005, the Company received approximately $10,000 from the exercise of
      an
      employee stock option to purchase 25,000 shares of Common Stock.





On
      June
      28, 2004, the Company converted a $50,000 short-term note payable issued June
      30, 2003, and the related accumulated interest payable, by issuing 105,951
      shares of Common Stock at a price of $0.50 per share.





On
      March
      26, 2004, the Company received, net of issuance costs of $0.3 million,
      approximately $1.7 million from the initial closing of a private placement
      totaling $16.5 million. At the initial closing the Company issued 3,880,000
      shares of Common Stock and warrants to purchase 1,940,000 shares of Common
      Stock
      at an exercise price of $0.75 per share. These warrants were valued using a
      Black-Scholes option pricing model, assuming no dividend yield, with the
      following assumptions: risk-free interest rate of 2.64%, volatility of 1.0679
      and an expected life of 5 years, resulting in the recording of a stock issue
      cost of $1.5 million. In April 2004, 2,940 of the warrants were
      exercised.





On
      June
      14, 2004, the Company received, net of issuance costs of $1.1 million,
      approximately $13.4 million from the final closing of the March 2004 private
      placement. At the final closing the Company issued 29,120,000 shares of Common
      Stock and warrants to purchase 14,560,000 shares of Common Stock at an exercise
      price of $0.75 per share. The Company also issued warrants to purchase 750,000
      shares of Common Stock at an exercise price of $0.55 per share to the placement
      agent. These warrants were valued using a Black-Scholes option pricing model,
      assuming no dividend yield, with the following assumptions: risk-free interest
      rate of 3.92%, volatility of 1.0662 and an expected life of 5 years, resulting
      in the recording of a stock issue cost of $8.0 million for the warrants issued
      to the investors in the private placement and $427,000 for the warrants issued
      to the placement agent.





Stock
      Option Plan





At
      December 31, 2005, a total of 5,773,445 shares of common stock were reserved
      under the 1994 Stock Plan for issuance upon the exercise of options or by direct
      sale to employees, including officers, directors and consultants. Options
      granted under the plan expire 10 years from the date of grant and become
      exercisable at such times and under such conditions as determined by the
      Company’s Board of Directors (generally ratably over four years, with the first
      25% vesting after one year). Under the terms of the 1994 Stock Plan on automatic
      share increase feature pursuant to which the number of shares available for
      issuance is automatically increased on the first trading day in January each
      calendar year, beginning with calendar year 2002 and continuing over the term
      of
      the Plan by an amount equal to 0.2% of the total number of shares of common
      stock outstanding on the last trading day in December in the immediately
      proceeding calendar year. Activity under the 1994 Stock Plan is as
      follows:




54





SharesOptions
                Availablefor
                Grant
            
            OptionsOutstanding
            
            OptionPrice
            
            Weighted
                Average Exercise Price ofShares
                Under PlanBalances
                at December 31, 2002
            
            
            999,864
            
            
            2,477,213
            
            $
            0.60
                - 9.25
            
            $
            2.26Additional
                shares reserved
            
            
            502,574Granted
            
            
            (925,500
            )
            
            925,500
            
            
            0.41-0.85
            
            
            0.60Exercised
            
            
            -
            
            
            (5,000
            )
            
            0.70-0.70
            
            
            0.70Forfeited
            
            
            346,384
            
            
            (346,384
            )
            $
            0.41-9.25
            
            
            1.48Balances
                at December 31, 2003
            
            
            923,322
            
            
            3,051,329
            
            
            0.41-6.38
            
            
            1.85Additional
                shares reserved
            
            
            585,004Granted
            
            
            (968,000
            )
            
            968,000
            
            $
            0.56-0.88
            
            
            0.77Exercised
            
            
            -
            
            
            (8,784
            )
            
            0.63-0.93
            
            
            0.70Forfeited
            
            
            174,809
            
            
            (174,809
            )
            
            0.63-6.23
            
            
            1.86Balances
                at December 31, 2004
            
            
            715,135
            
            
            3,835,736
            
            $
            0.41-6.38
            
            
            1.58Additional
                shares reserved
            
            
            1,247,574Granted
            
            
            (2,175,000
            )
            
            2,175,000
            
            $
            0.60-0.90
            
            
            0.65Exercised
            
            
            -
            
            
            (25,000
            )
            
            0.41-0.41
            
            
            0.41Forfeited
            
            
            430,746
            
            
            (430,746
            )
            
            0.56-5.69
            
            
            2.40Balances
                at December 31, 2005
            
            
            218,455
            
            
            5,554,990
            
            $
            0.41-6.38
            
            $
            1.15





The
      following table summarizes information concerning currently outstanding and
      exercisable options:




Options
                Outstanding
            
            
            
            
            
            Options
                ExercisableWeighted
                AverageRange
                of Exercise Prices
            
            
            Number
                Number outstanding
            
            
            Contractual
                Life
            
            
            Exercise
                Price
            
            
            Number
                Exercisable
            
            
            Weighted
                Average Exercise
                Price$0.41
                - $0.60
            
            
            282,500
            
            
            7.97
            
            $
            0.41
            
            
            229,643
            
            $
            0.41$0.63
                - $0.63
            
            
            2,151,000
            
            
            9.27
            
            
            0.63
            
            
            481,185
            
            
            0.63$0.64
                - $0.93
            
            
            1,619,126
            
            
            8.06
            
            
            0.80
            
            
            960,559
            
            
            0.80$1.02
                - $6.38
            
            
            1,502,364
            
            
            3.28
            
            
            2.42
            
            
            1,502,220
            
            
            2.425,554,990
            
            
            7.23
            
            $
            1.15
            
            
            3,173,607
            
            $
            1.51







The
      weighted average grant date fair value of options granted during 2005, 2004
      and
      2003 was $0.65, $0.77 and $0.56 per share, respectively.




Pursuant
      to the terms of the 1994 Stock Plan, generally each non-employee director who
      is
      newly elected or appointed after October 25, 1993, is granted an
      option to purchase 10,000 shares of common stock at a price per share equal
      to
      the fair market value of the common stock on the grant date. Each continuing
      non-employee director also receives an annual grant of an option to purchase
      10,000 shares. Such options vest one year after the grant date.





55


In
      June
      2002, the Company’s stockholders approved a series of amendments to the
      Company’s 1994 Stock Option Plan, or the 1994 Plan, including (i) increasing the
      maximum number of shares of common stock issuable to any one person under the
      1994 Plan over the term of the 1994 Plan by 400,000 shares so that the limit
      is
      increased from 850,000 shares to 1,250,000 shares and (ii) extending the term
      of
      the 1994 Plan by an additional 5 years so that the expiration date is extended
      from July 27, 2003 to July 27, 2008.





The
      Company granted stock options to non-employees which resulted in compensation
      expense of $14,000, $65,000 and $62,000 in 2005, 2004 and 2003,
      respectively.





Employee
      Stock Purchase Plan





On
      April
      1, 1994, employees of the Company began participating in the 1994 Employee
      Stock
      Purchase Plan, or the Purchase Plan, which provides the opportunity to purchase
      common stock at prices not more than 85% of market value at the time of
      purchase. In June 2000, the Company’s stockholders approved an additional 85,000
      shares of common stock be reserved for issuance under the Purchase Plan. In
      June
      2002, the Company’s stockholders approved a series of amendments to the
      Company’s Purchase Plan, including (i) increasing by 100,000 the total number of
      shares of the Company’s common stock authorized for issuance under the Purchase
      Plan, (ii) extending the term of the Purchase Plan by an additional 5 years
      so
      that the expiration date is extended from December 31, 2003 to December 31,
      2008, and (iii) implementing an automatic share increase feature pursuant to
      which the number of shares available for issuance under the Purchase Plan is
      automatically increased on the first trading day in January each calendar year,
      beginning with calendar year 2003 and continuing over the remaining term of
      the
      Purchase Plan, as extended, by an amount equal to 0.5% of the total number
      of
      shares of common stock outstanding on the last trading day in December in the
      immediately preceding calendar year, but in no event will any such annual
      increase exceed 125,000 shares.





During
      the years ended December 31, 2005, 2004 and 2003, respectively, 40,647, 10,739,
      and 0 shares of common stock were issued pursuant to this plan. At December
      31,
      2005, 125,000 additional shares were reserved for issuance under this plan.
      The
      effects of this plan on the pro forma disclosures described in Note 1 are not
      material.





The
      weighted average grant date fair value of the Purchase Plan shares issued during
      2005 was $0.55.





**12.**  **Notes
      Receivable from Stockholder**





In
      May
      2000, the Company issued loans to Dr. Chandrasekaran, the Company’s President,
      Chief Executive Officer (CEO), Chief Financial Officer (CFO) and Chairman of
      the
      Board, related to his exercise of 126,667 options to acquire common stock.
      In
      May 2001, the terms on the loans were extended from 4 years to 5 years. In
      2005
      and 2004, Dr. Chandrasekaran made principal and interest payments of
      approximately $19,000 and $21,000, respectively. The loans are full recourse
      and
      bear interest at 7% per annum. Interest payments are due semi-annually and
      principal payments are due annually. While the 126,667 shares of common stock
      issued secure the loans, the Company is not limited to these shares to satisfy
      the loan. In January 2006, these notes were repaid in full.





**13.**  **Legal
      Proceedings**





On
      July
      8, 2004, Bristol Investment Group, or Bristol, filed with the American
      Arbitration Association (“AAA”) a demand for arbitration against us seeking cash
      compensation and warrants based on a letter agreement dated January 28, 2003
      pursuant to which Bristol was engaged as a non-exclusive placement agent of
      investment capital for the Company.  On October 6, 2005 the arbitrator
      issued the final award in favor of Bristol, ruling that Bristol is entitled
      to
      recover $249,925, plus interest, attorneys’ and other fees, plus Bristol has the
      right to purchase for $922.80 a five-year, net-exerciseable warrant to purchase
      922,800 shares of our common stock at an exercise price of $0.50 per share.
      The
      Company recorded the attorneys’ and other fees in selling, general and
      administrative expenses and the remainder of which was recorded as a stock
      issuance cost in additional paid-in-capital. The warrants were valued using
      a
      Black-Scholes option pricing model, assuming no dividend yield, with the
      following assumptions: risk-free interest rate of 4.18%, volatility of 1.04
      and
      an expected life of 5 years, resulting in the recording of a stock issue cost
      of
      approximately $467,000. In January 2006, the warrants were exercised using
      the
      non-cash exercise provision in the warrant for a total of 565,125 shares of
      Common Stock.





56


On
      or
      about October 8, 2003, a former consultant filed a complaint in the Superior
      Court of California, County of San Francisco, against the Company, our chief
      executive officer, Kumar Chandrasekaran, the Regents of the University of
      California or “Regents,” and two individuals associated with Regents. The former
      consultant alleged that the Company breached an obligation to continue
      supporting his research; he has also made a variety of other related claims
      and
      allegations against the Company and the other defendants. In December 2004,
      the
      parties reached a settlement resulting in a total payment owed to the consultant
      of $250,000, of which $100,000 was reimbursed by the Company’s insurance
      carrier, and issuance of 30,000 stock options valued at $23,253. At December
      31,
      2004 the Company had paid $75,000 of the settlement payment owed and accrued
      the
      remainder, which was paid in 2005.





From
      time
      to time, the Company may be subject to legal proceedings and claims in the
      ordinary course of business, including claims of alleged infringement of
      trademarks and other intellectual property rights. The Company currently is
      not
      aware of any other legal proceedings or claims that it believes will have,
      individually or in the aggregate, a material adverse effect on its business,
      prospects, financial condition and operating results.





**14.**  **Related
      Party**





Included
      in accounts payable on the balance sheet at December 31, 2005 and 2004 is
      $27,000 and $8,000, respectively, due to related parties for expenses incurred
      on behalf of the Company. See Notes 4 and 5 for discussion of related party
      notes payable transactions.








**15.**  **Subsequent
      Events**


In
      the
      first quarter of 2006 the Company received approximately $3,711,000, net of
      approximately $115,000 of fees, from the exercise of warrants to purchase
      5,100,994 shares of Common Stock issued as part of the March 2004 private
      placement. The Company also issued 10,088 shares of Common Stock from the
      cashless exercise of 18,088 warrants issued to the placement agent as part
      of
      the March 2004 private placement. Additionally, the Company received
      approximately $345,000 from the exercise of warrants to purchase 545,451 shares
      of Common Stock as part of the May 2005 private placement. The Company also
      issued 172,490 shares of Common Stock from the cashless exercise of 299,998
      warrants issued as part of the May 2005 private placement. The Company also
      received $25,000 from the exercise of warrants to purchase 50,000 shares of
      Common Stock issued in 2003.





In
      January 2006, the Company issued an additional $2,000,000 short-term Senior
      Secured Notes payable and warrants to purchase 400,000 shares of Common Stock
      at
      an exercise price of $0.82 per share. These warrants were valued using a
      Black-Scholes option pricing model, assuming no dividend yield, with the
      following assumptions: risk-free interest rate of 4.30%, volatility of 1.0285
      and an expected life of 5 years. The relative fair value model was then applied
      to the Black-Scholes valuation of the warrants issued to the note holders
      resulting in the recording of a debt discount of $307,000 which will be
      amortized over the term of the notes. The remaining terms of these Notes are
      consistent with the Senior Secured Notes described in Note 6.





57





**16.**  **Quarterly
      Results (Unaudited)**





The
      following table is a summary of the quarterly results of operations for the
      years ended December 31, 2005 and 2004. The Company believes that the following
      information reflects all normal recurring adjustments necessary for a fair
      presentation of the information for the periods presented. The operating results
      for any quarter are not necessarily indicative of results for any future period.


2005(in
                thousands, except per share amounts)
            
            First
                Quarter
            
            Second
                Quarter
            
            Third
                Quarter
            
            FourthQuarter
            
            TotalYearRevenues
            
            $
            1
            
            $
            1
            
            $
            1
            
            $
            1
            
            $
            4Cost
                of goods
            
            
            5
            
            
            3
            
            
            3
            
            
            3
            
            
            14Loss
                from operations
            
            
            (3,435
            )
            
            (4,216
            )
            
            (3,488
            )
            
            (4,071
            )
            
            (15,210
            )Net
                loss applicable to common stockholder
            
            
            (3,438
            )
            
            (4,217
            )
            
            (3,488
            )
            
            (4,072
            )
            
            (15,215
            )Basic
                and diluted net loss per shareapplicable
                to common stockholders
            
            $
            (0.06
            )
            $
            (0.06
            )
            $
            (0.04
            )
            $
            (0.05
            )
            $
            (0.21
            )Shares
                used to calculate basic and dilutednet
                loss per share applicable tocommon
                stockholders
            
            
            62,493
            
            
            70,699
            
            
            78,903
            
            
            79,092
            
            
            72,6472004First
                Quarter
            
            
            Second
                Quarter
            
            
            Third
                Quarter
            
            
            FourthQuarter
            
            
            TotalYearRevenues
            
            $
            374
            
            $
            118
            
            $
            49
            
            $
            1
            
            $
            542Cost
                of goods
            
            
            5
            
            
            3
            
            
            3
            
            
            3
            
            
            14Loss
                from operations
            
            
            (1,093
            )
            
            (2,579
            )
            
            (3,340
            )
            
            (3,074
            )
            
            (10,086
            )Net
                income (loss) applicable to commonstockholders
            
            
            2,361
            
            
            (1,460
            )
            
            (3,340
            )
            
            (3,075
            )
            
            (5,514
            )Basic
                and diluted net loss per share
              Applicable
                to common stockholders
            
            $
            0.08
            
            $
            (0.04
            )
            $
            (0.05
            )
            $
            (0.05
            )
            $
            (0.11
            )Shares
                used to calculate basic net income(loss)
                per share applicable to commonstockholders
            
            
            30,548
            
            
            40,450
            
            
            62,371
            
            
            62,374
            
            
            47,984Shares
                used to calculate diluted net income (loss) per share applicable
                to common
                stockholders
            
            
            30,987
            
            
            40,450
            
            
            62,371
            
            
            62,374
            
            
            47,984





**Item
      9. Changes in and Disagreements with Accountants on Accounting and Financial
      Disclosure**





None





**Item** **9A.** **Controls
      and Procedures**





Under
      the
      supervision and with the participation of our management, including our
      principal executive officer and principal financial officer, we conducted an
      evaluation of the effectiveness of the design and operation of our disclosure
      controls and procedures, as defined in Rules 13a-15(e) and 15d-15(e) under
      the
      Securities Exchange Act of 1934, as amended (the “Exchange Act”), as of the end
      of the period covered by this report (the “Evaluation Date”). Based upon the
      evaluation, our principal executive officer and principal financial officer
      concluded as of the Evaluation Date that our disclosure controls and procedures
      were effective to ensure that information required to be disclosed by us in
      reports that we file or submit under the Exchange Act (i) is recorded,
      processed, summarized and reported within the time periods specified in
      Securities and Exchange Commission rules and forms, and (ii) is accumulated
      and
      communicated to our management, including our principal executive officer and
      principal financial officer, as appropriate to allow timely decisions regarding
      required disclosure.





58


**Item** **9B.** **Other
      Information**





Not
      applicable.








**PART
      III**





**Item
      10. Directors and Executive Officers of the Company**





As
      of
      March 31, 2006, our executive officers and other senior management were as
      follows:





**Name**
            **Age**
            **Title**S.
                Kumar Chandrasekaran, Ph.D.
            63
            Chairman
                of the Board, President, Chief Executive Officer and Chief Financial
                OfficerLyle
                M. Bowman, Ph.D.
            57
            Vice
                President, Development and OperationsDavid
                F. Heniges
            62
            Vice
                President and General Manager, CommercialOpportunitiesSandra
                C. Heine
            44
            Vice
                President, Finance and AdministrationErwin
                C. Si, Ph.D.
            52
            Senior
                Director, Preclinical Research




S.
      Kumar
      Chandrasekaran joined us in September 1987 as Vice President, Development.
      From
      1988 to 1989, Dr. Chandrasekaran served as Vice President, Research and
      Development. From 1989 to 1993, he served as President and Chief Operating
      Officer. Since August 1993, Dr. Chandrasekaran has served as Chairman of
      the Board of Directors, President, Chief Executive Officer and, since January
      1999, as Chief Financial Officer, a position he also held from December 1995
      to
      December 1997. Dr. Chandrasekaran holds a Ph.D. in Chemical Engineering
      from the University of California, Berkeley.





Lyle
      M.
      Bowman joined us in October 1988 as Director of Drug Delivery Systems. From
      1989
      to 1991, Dr. Bowman served as Vice President, Science and Technology. From
      1991
      to 1995, he served as Vice President, Development, and since 1995 has served
      as
      Vice President Development and Operations. Dr. Bowman holds a Ph.D. in Physical
      Chemistry from the University of Utah.





David
      Heniges joined us in July 2002 as Vice President and General Manager, Commercial
      Opportunities. From 1998 to 2001, Mr. Heniges served as General
      Manager-Europe/Africa/Middle East for Kera Vision, Inc., a manufacturer of
      implantable ophthalmic devices and equipment. From 1996 to 1998 he was Vice
      President, Global Marketing for the cardiovascular group at Baxter Healthcare
      Corporation. From 1982 to 1995 he served in various managerial positions,
      including Director, Product Management and International Marketing, Vice
      President, Marketing, and Vice President, Worldwide Business Development, at
      IOLAB Corporation, a Johnson & Johnson company, which manufactured
      ophthalmic devices, equipment and pharmaceuticals. Mr. Heniges holds a B.S.
      in
      Sociology with a minor in science from Oregon State University.





Sandra
      C.
      Heine joined us in March 1997 as Controller. From October 1999 to January 2005,
      Ms. Heine served as Senior Director of Finance and Administration and since
      January 2005 has served as Vice President, Finance and Administration. Ms.
      Heine
      holds a B.S. in Business Administration from Colorado State
      University.





Erwin
      C.
      Si joined us in April 1989 as Manager of Pharmacology and Toxicology. From
      1992
      to 1996, he served as Manager of Drug Discovery. From 1996 to 1999, he served
      as
      Principal Scientist. Since October 1999, he has served as Senior Director of
      Preclinical Research. Dr. Si holds a Ph.D. in Pharmacology and Toxicology from
      Purdue University.





59


Officers
      are appointed to serve, at the discretion of the Board of Directors, until
      their
      successors are appointed. There are no family relationships between any members
      of our Board of Directors and our executive officers.





We
      currently have five directors. Certain information regarding the members of
      the
      Board of Directors as of March 31, 2006 is set forth below:





**Name**
            **Position(s)
                with the Company**
            **Age**
            **Director
                Since**S.
                Kumar Chandrasekaran, Ph.D.
            Chairman
                of the Board,
              President,
                Chief Executive Officer and Chief Financial Officer
            63
            1989Mitchell
                H. Friedlaender, M.D.
            Director
            60
            1996John
                L. Mattana
            Director
            76
            1997Jon
                S. Saxe, Esq.
            Director
            69
            2000Anders
                P. Wiklund
            Director
            66
            1996




**Business
      Experience of Board Members**




**S.
      Kumar Chandrasekaran, Ph.D.** has been
      a Director of the Company since 1989. Dr. Chandrasekaran joined the Company
      in
      September 1987 as Vice President, Development. From 1988 to 1989, Dr.
      Chandrasekaran served as Vice President, Research and Development. From 1989
      to
      1993, Dr. Chandrasekaran served as President and Chief Operating Officer. Since
      August 1993, he has served as Chairman of the Board of Directors, President
      and
      Chief Executive Officer and since December 1999, he has served as Chief
      Financial Officer, a position he also held from December 1995 to December 1997.
      Dr. Chandrasekaran holds a Ph.D. in Chemical Engineering from the University
      of
      California at Berkeley.





**Mitchell
      H. Friedlaender, M.D.** has
      been
      a Director of the Company since May 1996. He has served as an ophthalmologist
      at
      Scripps Clinic and Research Foundation (“Scripps”) since 1986 and currently
      serves as Head of Division of Ophthalmology and Director, LaserVision Center,
      Scripps Clinic. Prior to joining Scripps, Dr. Friedlaender served as a full-time
      faculty member at the University of California, San Francisco for 10 years.
      He
      is the founder of the Aspen Corneal Society and the Pacific Ophthalmic Forum,
      co-editor in chief of International Ophthalmology Clinics, a member of four
      scientific editorial boards, a member of the Sjogren’s Syndrome Foundation
      Medical Advisory Board, and former president of the Ocular Microbiology and
      Immunology Group. He also serves as a consultant for several pharmaceutical
      companies and performs clinical studies on new ophthalmic drugs. Dr.
      Friedlaender holds an M.B.A. from the University of Phoenix and an M.D. from
      the
      University of Michigan.





**John
      L. Mattana** has
      been
      a Director of the Company since September 1997. From 1992 to 1997, Mr. Mattana
      served as an Investment Vice President at New York Life Insurance Company,
      where
      he was a Director of Venture Capital Investments. From October 1997 through
      February 2004 he served as a Vice President at Ceptor Corporation. Mr. Mattana
      holds an M.B.A. from New York University.





**Jon
      S. Saxe, Esq.** has
      been
      a Director of the Company since December 1999. Mr. Saxe was also a Director
      of
      the Company from 1992 through 1997, when he resigned as a member of the Board
      of
      Directors and became Director Emeritus until December 1999. Mr. Saxe is a
      Director of Protein Design Labs, Inc., a biotechnology company for which he
      served as President from January 1995 to May 1999. Mr. Saxe served as President
      of Saxe Associates, a biotechnology consulting firm, from May 1993 to December
      1994, President, Chief Executive Officer and a Director of Synergen, Inc.,
      from
      October 1989 to April 1993, and Vice President, Licensing & Corporate
      Development for Hoffmann-LaRoche from August 1984 through September 1989. Mr.
      Saxe serves on the board of directors of Questcor Pharmaceuticals, Inc., First
      Horizon Pharmaceutical Corporation, Protein Design Labs, Inc., SciClone
      Pharmaceuticals, Inc. and Durect, Inc. Mr. Saxe also serves on the board of
      directors of several private companies. Mr. Saxe holds a B.S. in Chemical
      Engineering from Carnegie-Mellon University, a J.D. from George Washington
      University School of Law, and an L.L.M. from New York University School of
      Law.





60


**Anders
      P. Wiklund** has
      been
      a Director of the Company since November 1996. Since January 1997 he has served
      as Principal at Wiklund International Inc., an advisory firm to the
      biotechnology and pharmaceutical industries, and from 1997 through 2002 served
      as Senior Vice President at Biacore Holding Inc., a life science technology
      company. He served as Vice President, Corporate Business Development of
      Pharmacia & Upjohn from January 1996 to December 1996, as Executive Vice
      President of Pharmacia U.S. Inc. from 1994 to 1996 and as President and Director
      of Pharmacia Development Corp. from 1993 to 1994. Mr. Wiklund served as Chief
      Executive Officer, President and Director of KABI Pharmacia Inc. from 1990
      to
      1993. Mr. Wiklund serves on the board of directors of Medivir AB. Mr. Wiklund
      also serves on the board of directors of several private companies. Mr. Wiklund
      holds a Master of Pharmacy from the Pharmaceutical Institute, Stockholm,
      Sweden.





**Board
      Committees and Meetings**




During
      the fiscal year ended December 31, 2005, the Board of Directors held four
      regular meetings and numerous special meetings. The Board of Directors has
      an
      Audit Committee, a Stock Plan and Compensation Committee, a Nominating and
      Corporate Governance Committee, a Financing Committee, a Mergers and
      Acquisitions Committee, a New Ophthalmic Opportunities Committee and a Clinical
      Oversight Committee. During the 2005 fiscal year each individual currently
      serving as a director attended at least 75% of the aggregate number of meetings
      of the Board of Directors and meetings of the Committees of the Board of
      Directors on which he served.





*Communications
      with the Board*





The
      Company encourages stockholder communications with its Board of Directors.
      Any
      stockholder wishing to communicate with the Board of Directors or any individual
      director of the Company regarding matters concerning the Company should submit
      such communications in writing to the Company’s corporate secretary via postal
      mail at the following address:





InSite
      Vision Incorporated


965
      Atlantic Avenue


Alameda,
      CA 94501


Attention:
      Corporate Secretary





The
      Company’s corporate secretary will review all such correspondence and distribute
      the correspondence to such members of the Board of Directors as the corporate
      secretary deems appropriate or advisable.





*Company
      Policy Regarding Board Member Attendance at Annual Meetings*





The
      Company strongly encourages each director to attend its Annual Meeting of
      Stockholders. All of the Company’s directors attended the Company’s 2005 Annual
      Meeting of Stockholders.





*Audit
      Committee*





During
      the 2005 fiscal year, the Audit Committee was composed of three non-employee
      directors: John L. Mattana, Jon S. Saxe and Anders P. Wiklund.





The
      Audit
      Committee appoints the Company's independent accountants; pre-approves all
      audit
      and non-audit services to be provided to the Company by the independent
      accountants; oversees the independence of the independent accountants; evaluates
      the independent accountants’ performance; receives and considers the independent
      accountants’ comments as to accounting and financial controls; monitors the
      effectiveness of the internal and external audit controls, oversees the
      Company’s financial and accounting organization and financial reporting,
      discusses with management and the independent auditors the results of the annual
      audit and the Company's annual financial statements; and discusses with
      management and the independent auditors, as applicable, the results of the
      independent auditors' interim review of the Company's quarterly financial
      statements, as well as the Company's earnings press releases. The Audit
      Committee met five times in 2005. The Board of Directors adopted and approved
      a
      revised written charter for the Audit Committee in April 2004. A current copy
      of
      the Company’s Audit Committee charter is available on the Company’s website
      located at www.InSiteVision.com under
“Investor Relations.” A copy of the Company’s Code of Conduct and Code of Ethics
      is available to investors free of charge by writing to InSite Vision,
      Incorporated, Investor Relations, 965 Atlantic Avenue, Alameda, CA
      94501.





61


Among
      other things, under the revised charter of the Audit Committee, the Audit
      Committee is responsible for reviewing and approving all related party
      transactions, approving and monitoring the Company’s code of ethics for senior
      finance personnel and code of conduct for all employees and directors (including
      approving any waivers of such codes for directors, executive officers and senior
      financial personnel), and establishing procedures for the receipt, retention
      and
      treatment of complaints received by the Company regarding accounting, internal
      accounting controls, or auditing matters, and the confidential, anonymous
      submission by Company employees of concerns regarding questionable accounting,
      auditing or legal matters. The Company’s Code of Conduct and Code of Ethics can
      be found on the Company’s website located at www.InSiteVision.com under
“Investor Relations.” A copy of the Company’s Audit Committee
      charter is available to investors free of charge by writing to InSite
      Vision Incorporated, Investor Relations, 965 Atlantic Avenue, Alameda, CA 94501. The
      Company will disclose any waivers under its Code of Conduct or Code of Ethics
      which are granted to its directors or executive officers in a current report
      on
      Form 8-K filed with the Securities and Exchange Commission within 4 business
      days of any such waiver. No such waivers were granted during 2005.





The
      Board
      of Directors has determined that each of the members of the Audit Committee
      is
“independent” as that term is defined in Section 121(A) of the American
      Stock Exchange’s listing standards and also meets the additional criteria for
      independence of Audit Committee members set forth in Rule 10A-3(b)(1) under
      the
      Securities Exchange Act of 1934, as amended. In addition, the Board of Directors
      has determined that each member of its Audit Committee is “financially
      sophisticated” and that therefore the Audit Committee meets the requirement
      under the rules of the American Stock Exchange that at least one member of
      the
      audit committee be “financially sophisticated.” Although the Board of Directors
      does not believe any member of the Audit Committee currently qualifies as an
      "audit committee financial expert" as defined by the Securities and Exchange
      Commission, the Company believes that the experience and financial acumen of
      the
      members of its Audit Committee is sufficient given the Company’s current needs
      and financial position. The Board of Directors will continue to assess the
      qualifications of the members of its Audit Committee, including the need to
      appoint a financial expert, in light of the Company’s financial complexity,
      position and requirements in order to serve the best interests of the Company
      and its stockholders.





*Stock
      Plan and Compensation Committee*





The
      Stock
      Plan and Compensation Committee (the “Compensation Committee”) currently
      consists of two directors: John L. Mattana and Anders P. Wiklund. The
      Compensation Committee met two times in the 2005 fiscal year. The Compensation
      Committee determines and reviews the compensation to be paid to the Company’s
      officers and directors and administers the Company’s 1994 Stock Option Plan (the
“1994 Plan”) and the Company’s 1994 Employee Stock Purchase Plan (the “Purchase
      Plan”). The Board of Directors has determined that each of the members of the
      Compensation Committee is “independent” as that term is defined in
      Section 121(A) of the American Stock Exchange’s listing standards. The
      Board of Directors adopted a revised written charter for the Compensation
      Committee in April 2004.





*Nominating
      and Corporate Governance*  *Committee*





The
      Nominating and Corporate Governance Committee (the “Nominating Committee”)
      currently consists of two directors, John L. Mattana and Mitchell H.
      Friedlaender, M.D. The Nominating Committee held one meeting during the 2005
      fiscal year to recommend to the Board the nomination of directors standing
      for
      election at the Company’s 2005 Annual Meeting. The Board of Directors has
      determined that each of the members of the Nominating Committee is “independent”
as that term is defined in Section 121(A) of the American Stock Exchange’s
      listing standards. The Board of Directors adopted a revised written charter
      for
      the Nominating Committee in April 2004. A current copy of the Company’s
      Nominating Committee charter is available on the Company’s website located at www.InSiteVision.com under
“Investor Relations.” A copy of the Company’s Nominating Committee
      charter is available to investors free of charge by writing to InSite
      Vision Incorporated, Investor Relations, 965 Atlantic Avenue, Alameda, CA 94501. The
      Nominating Committee, identifies and recommends director nominees to be selected
      by the Board of Directors for submission to vote at the Company’s annual
      stockholder meetings or to fill vacancies between such meetings, implements
      the
      Board’s criteria for selecting new directors, develops or reviews and recommends
      corporate governance policies for the Board, and oversees the Board’s annual
      evaluation process.





62


**Consideration
      of Director Nominees**




***Stockholder
      Nominees***




The
      policy of the Nominating Committee is to consider properly submitted stockholder
      nominations for candidates for membership on the Board as described below under
      "Identifying and Evaluating Nominees for Directors." In evaluating such
      nominations, the Nominating Committee seeks to achieve a balance of knowledge,
      experience and capability on the Board and to address the membership criteria
      set forth under "Director Qualifications."





The
      Nominating Committee will consider timely suggestions of nominees from
      stockholders. Stockholders may recommend individuals for consideration by
      submitting the materials set forth below to the Company addressed to the
      Chairman of the Nominating Committee at the Company’s address. To be timely, the
      written materials must be submitted within the time permitted for submission
      of
      a stockholder proposal for inclusion in the Company’s proxy statement for the
      subject annual meeting and in accordance with the Company’s Bylaw provisions
      regarding stockholder proposals.





The
      written materials must include: (1) all information to relating the individual
      recommended that is required to be disclosed pursuant to Regulation 14A under
      the Securities Exchange Act of 1934 (including such person’s written consent to
      being named in the proxy statement as a nominee and to serving as a director
      if
      elected); (2) the name(s) and address(es) of the stockholders making the
      nomination and the amount of the Company’s securities which are owned
      beneficially and of record by such Stockholder(s); (3) appropriate biographical
      information (including a business address and a telephone number) and a
      statement as to the individual’s qualifications, with a focus on the criteria
      described below; (4) a representation that the stockholder of record is a holder
      of stock of the Company entitled to vote on the date of submission of such
      written materials and (5) any material interest of the stockholder in the
      nomination.





Any
      stockholder nominations proposed for consideration by the Nominating Committee
      should be addressed to:





Chairman
      of the Nominating and Corporate Governance Committee


InSite
      Vision Incorporated


965
      Atlantic Avenue


Alameda,
      CA 94501





***Director
      Qualifications***




The
      Nominating Committee has established the following minimum criteria for
      evaluating prospective board candidates:





·
            Reputation
                for integrity, strong moral character and adherence to high ethical
                standards.


·
            Holds
                or has held a generally recognized position of leadership in the
                community
                and/or chosen field of endeavor, and has demonstrated high levels
                of
                accomplishment.


·
            Demonstrated
                business acumen and experience, and ability to exercise sound business
                judgment and common sense in matters that relate to the current and
                long-term objectives of the
                Company.


·
            Ability
                to read and understand basic financial statements and other financial
                information pertaining to the
                Company.


·
            Commitment
                to understand the Company and its business, industry and strategic
                objectives.


·
            Commitment
                and ability to regularly attend and participate in meetings of the
                Board
                of Directors, Board Committees and stockholders; number of other
                company
                Boards on which the candidate serves; and ability to generally fulfill
                all
                responsibilities as a director of the
                Company.


·
            Willingness
                to represent and act in the interests of all stockholders of the
                Company
                rather than the interests of a particular
                group.


·
            Good
                health, and ability to serve.








63




·
            For
                prospective non-employee directors, independence under SEC and applicable
                stock exchange rules, and the absence of any conflict of interest
                (whether
                due to a business or personal relationship) or legal impediment to,
                or
                restriction on, the nominee serving as a
                director.


·
            Willingness
                to accept the nomination to serve as a director of the
                Company.





Other
      Factors for Potential Consideration




The
      Nominating Committee will also consider the following factors in connection
      with
      its evaluation of each prospective nominee:





·
            Whether
                the prospective nominee will foster a diversity of skills and
                experiences.


·
            For
                potential Audit Committee members, whether the nominee possesses
                the
                requisite education, training and experience to qualify as “financially
                sophisticated” or as an audit committee “financial expert” under
                applicable SEC and stock exchange
                rules.


·
            For
                incumbent directors standing for re-election, the Nominating Committee
                will assess the incumbent director’s performance during his or her term,
                including the number of meetings attended, level of participation,
                and
                overall contribution to the
                Company.


·
            Composition
                of Board and whether the prospective nominee will add to or complement
                the
                Board’s existing strengths





***Identifying
      and Evaluating Nominees for Directors***




The
      Nominating Committee initiates the process by preparing a slate of potential
      candidates who, based on their biographical information and other information
      available to the Nominating Committee, appear to meet the criteria specified
      above and/or who have specific qualities, skills or experience being sought
      (based on input from the full Board).





·
            Outside
                Advisors. The Nominating Committee may engage a third-party search
                firm or
                other advisors to assist in identifying prospective
                nominees.


·
            Nomination
                of Incumbent Directors. The re-nomination of existing directors is
                not
                automatic, but is based on continuing qualification under the criteria
                set
                forth above.


o
            For
                incumbent directors standing for re-election, the Nominating Committee
                will assess the incumbent director’s performance during his or her term,
                including the number of meetings attended, level of participation,
                and
                overall contribution to the Company; the number of other company
                boards on
                which the individual serves, composition of the Board at that time,
                and
                any changed circumstances affecting the individual director which
                may bear
                on his or her ability to continue to serve on the
                Board.


·
            Management
                Directors. The number of officers or employees of the Company serving
                at
                any time on the Board should be limited such that, at all times,
                a
                majority of the directors is “independent” under applicable SEC and
                American Stock Exchange rules.





After
      reviewing appropriate biographical information and qualifications, first-time
      candidates will be interviewed by at least one member of the Nominating
      Committee and by the Chief Executive Officer. Upon completion of the above
      procedures, the Nominating Committee shall determine the list of potential
      candidates to be recommended to the full Board for nomination at the annual
      meeting. The Board of Directors will select the slate of nominees only from
      candidates identified, screened and approved by the Nominating
      Committee.





64


*Financing*  *Committee*





The
      Financing Committee currently consists of two directors: John L. Mattana and
      Jon
      S. Saxe. The Financing Committee reviews and evaluates potential financing
      opportunities for the Company and communicates with and advises management
      and
      the Board of Directors with respect to such opportunities. The Board of
      Directors has determined that each of the members of the Financing Committee
      is
“independent” as that term is defined in Section 121(A) of the American
      Stock Exchange’s listing standards. The Board of Directors adopted a written
      charter for the Financing Committee in April 2004.





*Mergers
      and Acquisitions*  *Committee*





The
      Mergers and Acquisitions Committee currently consists of two directors: Jon
      S.
      Saxe and Anders P. Wiklund. The Mergers and Acquisitions Committee reviews
      and
      evaluates potential strategic business combination opportunities for the Company
      and communicates with and advises management and the Board of Directors with
      respect to such opportunities. The Board of Directors has determined that each
      of the members of the Mergers and Acquisitions Committee is “independent” as
      that term is defined in Section 121(A) of the American Stock Exchange’s
      listing standards. The Board of Directors adopted a written charter for the
      Mergers and Acquisitions Committee in April 2004.





*New
      Ophthalmic Opportunities* *Committee*





The
      New
      Ophthalmic Opportunities Committee currently consists of two directors: Mitchell
      H. Friedlaender and Anders P. Wiklund. The New Ophthalmic Opportunities
      Committee reviews and evaluates potential partnering and other collaborative
      arrangements for the Company and communicates with and advises management and
      the Board of Directors with respect to such opportunities. The Board of
      Directors has determined that each of the members of the New Ophthalmic
      Opportunities Committee is “independent” as that term is defined in
      Section 121(A) of the American Stock Exchange’s listing standards. The
      Board of Directors adopted a written charter for the New Ophthalmic
      Opportunities Committee in April 2004.





*Clinical
      Oversight Committee*





The
      Clinical Oversight Committee currently consists of one director: Mitchell H.
      Friedlander. The Clinical Oversight Committee oversees, evaluates and analyzes
      the structure and implementation of the Company’s clinical trials and the
      results of such trials and clinical programs and communicates with and advises
      management and the Board of Directors with respect to such activities. The
      Board
      of Directors has determined that the member of the Clinical Oversight Committee
      is “independent” as that term is defined in Section 121(A) of the American Stock
      Exchange’s listing standards. The Board of Directors adopted a written charter
      for the Clinical Oversight Committee in June 2004.




**Compensation
      of Directors**




During
      the 2005 fiscal year, each non-employee Board member was entitled to
      receive:





·
            $2,000
                for each Board meeting attended in person or by telephone, up to
                a maximum
                of $8,000 per year;


·
            an
                additional $500 for each Audit Committee Meeting attended in person
                or by
                telephone, up to a maximum of $3,500 per
                year;


·
            an
                additional $500 for each Compensation Committee Meeting attended
                in person
                or by telephone, up to a maximum of $2,000 per
                year;


·
            an
                additional $12,000 per year for serving on each of the Financing
                Committee, the Mergers and Acquisitions Committee, the New Ophthalmic
                Opportunities Committee; and the Clinical Oversight
                Committee.


·
            reimbursement
                of reasonable expenses for attending any Board or committee
                meetings.






65




Under
      the
      Automatic Option Grant Program in effect under the 1994 Plan, each individual
      who first joins the Board as a non-employee Board member will receive, at the
      time of his or her initial election or appointment to the Board, an option
      grant
      to purchase 10,000 shares of Common Stock at an exercise price per share equal
      to the fair market value per share of Common Stock on the grant date. Each
      such
      option will have a maximum term of 10 years measured from the grant date,
      subject to earlier termination following the optionee’s cessation of Board
      service, and will vest and become exercisable for all of the option shares
      upon
      the optionee’s completion of one year of Board service measured from the grant
      date. However, the option will immediately vest and become exercisable for
      all
      the option shares upon certain changes in control of the Company.





Continuing
      non-employee Board members will each receive an automatic option grant for
      an
      additional 10,000 shares of Common Stock on the date of the first Board meeting
      held in December each year. In the event there is no December Board meeting
      in
      any year, then the annual option grant for that year will be made on December
      15th or if December 15th is not a day on which the New York Stock Exchange
      is
      open for business such grant will be made on the immediately succeeding trading
      day. The option will have an exercise price per share equal to the fair market
      value per share of Common Stock on the grant date and will have a maximum term
      of 10 years measured from the grant date, subject to earlier termination
      following the optionee’s cessation of Board service. The option will vest and
      become exercisable for all the option shares upon the optionee’s completion of
      one year of Board service measured from the grant date. However, the option
      will
      immediately vest and become exercisable for all the option shares upon certain
      changes in control of the Company.





Accordingly,
      on December 9, 2005, the date of the Company’s first December Board meeting in
      2005, each of the following non-employee Board members received an automatic
      option grant to purchase 10,000 shares of Common Stock at an exercise price
      of
      $0.90 per share, the fair market value per share of Common Stock on such grant
      date: Messrs. Friedlaender, Mattana, Saxe and Wiklund. In addition, on December
      9, 2005, each of these non-employee Board members received an additional
      discretionary option grant in recognition of their service to the Company on
      the
      Board of Directors to purchase 20,000 shares of Common Stock at an exercise
      price of $0.90 per share, the fair market value per share of Common Stock on
      such grant date. Each of the foregoing options to purchase Common Stock will
      vest and become exercisable for all the option shares on the date that is one
      year from the date of grant.





The
      information required by this item with respect to the identification of
      Executive Officers is contained in Item 1 of Part I of this report under the
      caption “Executive Officers.”







**Section
      16(a) beneficial ownership reporting compliance**




Section
      16(a) of the Securities Exchange Act of 1934 requires the Company’s directors
      and executive officers, and persons who beneficially own more than 10% of a
      registered class of the Company’s equity securities, to file with the United
      States Securities and Exchange Commission initial reports of beneficial
      ownership and reports of changes in beneficial ownership of Common Stock and
      other equity securities of the Company. Officers, directors and greater than
      10%
      stockholders are required by the Securities Exchange Act of 1934, as amended,
      to
      furnish the Company with copies of all Section 16(a) reports they
      file.





Based
      solely upon review of the copies of such reports furnished to the Company and
      written representations that no other reports were required, the Company
      believes that during the fiscal year ended December 31, 2005, its officers,
      directors and holders of more than 10% of the Common Stock complied with all
      Section 16(a) filing requirements.





66





**Item
      11. Executive Compensation**





**Stock
      Plan and Compensation Committee Report on Executive
      Compensation**




The
      Stock
      Plan and Compensation Committee (the “Compensation Committee”) of the Board is
      responsible for establishing the cash and equity compensation of the Company’s
      Chief Executive Officer, President and Chief Financial Officer, Dr.
      Chandrasekaran, and the Company’s other executive officers. All decisions by the
      Compensation Committee with respect to cash compensation are reviewed by the
      full Board of Directors. However, the Compensation Committee has the sole and
      exclusive authority to administer the 1994 Plan and to make option grants to
      the
      Company’s executive officers under the 1994 Plan. The Compensation Committee has
      furnished the following report with respect to the 2005 compensation of Dr.
      Chandrasekaran and the Company’s other executive officers.





*Compensation
      Policy*




The
      Compensation Committee’s principal goals in making its executive compensation
      recommendations are (i) to ensure that there exists an appropriate relationship
      between executive pay and both the performance of the Company and stockholder
      value, particularly, but not exclusively, as reflected in the price of the
      Company’s Common Stock, and (ii) to attract, motivate and retain key executives
      in the face of competition within the biopharmaceutical industry for qualified
      personnel. To achieve these objectives, the Compensation Committee’s executive
      compensation policies generally integrate annual base salaries and other
      guaranteed payments for Dr. Chandrasekaran and the Company’s other executive
      officers with variable incentive bonuses and stock options primarily based
      upon
      corporate and individual performance. Performance is measured primarily by
      comparison with specific objectives. In addition to linking executive
      compensation directly to stockholder value, the Compensation Committee believes
      that stock options, through staged vesting provisions, perform an important
      role
      in motivating and retaining key executives.





*Base
      Salary*




The
      base
      salary levels for the executive officers were established for the 2005 fiscal
      year on the basis of the following factors: personal performance, the estimated
      salary levels in effect for similar positions at a select group of companies
      with which the Company competes for executive talent, and internal comparability
      considerations. The Compensation Committee, however, did not rely upon any
      specific compensation surveys for comparative compensation purposes. Instead,
      the Compensation Committee made its decisions as to the appropriate market
      level
      of base salary for each executive officer on the basis of its understanding
      of
      the salary levels in effect for similar positions at those companies with which
      the Company competes for executive talent. During the 2003 fiscal year and
      the
      first six months of 2004, the Company’s executive officers other than the Chief
      Executive Officer agreed with the Company to reduce their salaries in light
      of
      the Company’s financial condition by a total of $242,928 and $115,753,
      respectively. The salary reductions agreed to by the Company’s Chief Executive
      Officer are described below. On June 1, 2004, the Compensation Committee
      determined based on the factors identified above and the Company’s then improved
      financial condition that it was appropriate to increase the executive officers’
base salaries back to the levels as of December 31, 2002, effective June 15,
      2004. The Compensation Committee will continue to review base salaries on an
      annual basis and consider whether any increase in executive officer salaries
      and/or other forms of compensation is advisable. See “CEO Compensation” in this
      report.





*Performance
      Measures*




Due
      to
      the current stage of the Company’s development, the Compensation Committee
      believes that corporate performance is not appropriately measured in terms
      of
      traditional financial performance criteria such as profitability and earnings
      per share. Rather, the Compensation Committee believes that corporate
      performance is appropriately measured by analyzing the degree to which the
      Company has achieved certain goals established by the Compensation Committee
      and
      approved by the Board. Accordingly, annual incentive compensation is awarded
      on
      the basis of these factors.





67


The
      incentive compensation paid to the executive officers for the 2005 fiscal year
      was based primarily upon the Company’s attainment of performance milestones tied
      to clinical and regulatory developments and the pursuit and formation of
      third-party collaborative relationships with respect to the Company’s
      technology. As of March 28, 2006, the bonuses for the 2005 fiscal year on the
      basis of the Company’s achievement of those milestones have not been approved or
      awarded to the executive officers.





*Stock
      Option Grants*




Stock
      option grants under the 1994 Plan are designed to align the interests of each
      executive officer with those of the stockholders and provide each individual
      with a significant incentive to manage the Company from the perspective of
      an
      owner with an equity stake in the business. Each grant allows the individual
      to
      acquire shares of Common Stock at a fixed price per share (the market price
      on
      the grant date) over a specified period of time (up to 10 years). Each option
      generally becomes exercisable in installments over a period of years, contingent
      upon the executive officer’s continued employment with the Company. Accordingly,
      the option will provide a return to the executive officer only if the executive
      officer remains employed by the Company during the applicable vesting period,
      and then only if the market price of the underlying shares appreciates over
      the
      option term.





The
      number of shares subject to each option grant will be set at a level intended
      to
      create a meaningful opportunity for stock ownership based on the officer’s
      current position with the Company, the base salary associated with that
      position, the size of comparable awards made to individuals in similar positions
      within the industry, the individual’s potential for increased responsibility and
      promotion over the option term, and the individual’s personal performance in
      recent periods. The Compensation Committee will also take into account the
      executive officer’s existing holdings of Common Stock and the number of vested
      and unvested options held by that individual in order to maintain an appropriate
      level of equity incentive. However, the Compensation Committee does not intend
      to adhere to any specific guidelines as to the relative option holdings of
      the
      Company’s executive officers.





During
      the 2005 fiscal year, stock options in the aggregate amount of 1,450,000 shares
      of Common Stock were granted to the executive officers named in the Summary
      Compensation Table. Please refer to the “Summary Compensation Table” and the
      section entitled “Option Grants in Last Fiscal Year.”





*CEO
      Compensation*




In
      setting the total compensation payable to Dr. Chandrasekaran, the Company’s
      Chief Executive Officer, President and Chief Financial Officer, for the 2005
      fiscal year, the Compensation Committee sought to make such compensation
      competitive with that provided by other companies with which the Company
      competes for executive talent.





The
      incentive portion of Dr. Chandrasekaran’s cash compensation earned for the 2005
      fiscal year was based primarily upon the Company’s attainment of performance
      milestones tied to clinical and regulatory developments, results of fundraising
      efforts, and recognition of certain additional performance milestones achieved
      after the $400,000 bonus was paid to Dr. Chandrasekaran in the second quarter
      of
      the 2004 fiscal year. Dr. Chandrasekaran agreed with the Company to forego
      the
      payout of the $200,000 bonus awarded to him in 2005 until the Company completed
      at least one of its Phase 3 clinical trials and Company’s financial position
      improves to a sufficient degree that the Compensation Committee determines
      that
      such bonus can be paid without undue negative impact on the Company’s financial
      position. This bonus was paid during the first quarter of 2006.





Additionally,
      the Compensation Committee awarded a stock option grant to Dr. Chandrasekaran
      in
      the 2005 fiscal year in order to provide him with an equity incentive tied
      to
      the financial success of the Company. The option will have value for Dr.
      Chandrasekaran only if the market price of the underlying option shares
      appreciates over the market price in effect on the date the grant was made.





68


*Compliance
      with Internal Revenue Code Section 162(m)*




Section
      162(m) of the Internal Revenue Code generally disallows a tax deduction to
      publicly held companies for compensation exceeding $1 million paid to certain
      of
      the Company’s executive officers, to the extent that compensation is not deemed
      to be performance-based pursuant to the criteria established under a
      stockholder-approved plan. The cash-based compensation paid to the Company’s
      executive officers for the 2005 fiscal year did not exceed the $1 million limit
      per officer, and the Compensation Committee does not anticipate that the total
      cash compensation to be paid to any of the Company’s executive officers for
      fiscal 2006 will exceed that limit. Accordingly, the Compensation Committee
      has
      decided not to submit any of the Company’s cash incentive bonus plans for
      stockholder approval at the Annual Meeting or to take any other action to limit
      or restructure the elements of cash compensation payable to the Company
      executive officers. The Compensation Committee will reconsider this decision
      should the individual cash compensation of any executive officer be expected
      to
      exceed the $1 million level on a recurring basis as a result of their
      participation in one or more of the Company’s non-stockholder approved incentive
      bonus plans.







Submitted
      by the Compensation Committee


of
      the
      Board of Directors




John
      L.
      Mattana


Anders
      P.
      Wiklund





69





**Compensation
      Committee Interlocks and Insider Participation**




During
      the 2005 fiscal year, the Compensation Committee consisted of John L. Mattana
      and Anders P. Wiklund. No member of the Compensation Committee was at any time
      during the 2005 fiscal year, or at any other time, an officer or employee of
      the
      Company or had any relationships requiring disclosure by the Company under
      the
      SEC’s rules requiring disclosure of certain relationships and related party
      transactions.





During
      the 2005 fiscal year, no executive officer of the Company served as a member
      of
      the board of directors or compensation committee of any entity which has one
      or
      more executive officers serving as a member of the Company’s Board of Directors
      or Compensation Committee.





**Employment
      Contracts, Termination of Employment Arrangements and Change of Control
      Arrangements**




On
      May
      30, 1995, the Company amended the 1994 Plan to implement a special change in
      control feature designed to protect the economic benefit of the outstanding
      options in the event the Company were to be acquired. As a result of this
      special feature, should any optionee’s service be involuntarily terminated
      within twelve (12) months following a Corporate Transaction in which his or
      her
      options are assumed by the successor corporation and do not otherwise accelerate
      at that time, then those options will accelerate and become fully exercisable
      for all of the option shares as fully-vested shares of Common Stock upon such
      involuntary termination. A “Corporate Transaction” under the 1994 Plan is
      defined as a merger or consolidation in which securities possessing more than
      50% of the total combined voting power of the Company’s outstanding securities
      are transferred to a person or persons different from those who held those
      securities immediately prior to such transaction, or the sale, transfer or
      other
      disposition of all or substantially all of the Company’s assets in complete
      liquidation of the Company.





**Summary
      of Cash and Certain Other Compensation**




The
      following table sets forth the compensation earned by the Company’s Chief
      Executive Officer and each of the Company’s other executive officers whose
      salary and bonus for fiscal year 2005 was in excess of $100,000, for services
      rendered in all capacities to the Company for the 2005, 2004 and 2003 fiscal
      years (the “Named Executive Officers”). No executive officer who would have
      otherwise been included in such table on the basis of salary and bonus earned
      for the 2005 fiscal year resigned or terminated employment during that fiscal
      year.





**SUMMARY
      COMPENSATION TABLE**




**Annual
                Compensation**
            **Long-Term
                Compensation**
              **Awards****Name
                and Principal Position(1)**
            **Year**
            **Salary
                ($)(2)**
            **Bonus
                ($)(3)**
            **Other
                Annual Compensation ($)(4)**
            **Securities**
              **Underlying
                Options (#)**S.
                Kumar Chandrasekaran, Ph. D.
            2005
            390,000
            200,000
            5,782
            1,000,000Chairman
                of the Board,
            2004
            222,632
            400,000
            2,772
            180,000President,
                Chief Executive
            2003
            104,085
            ---
            730
            295,000Officer
                and Chief Financial OfficerLyle
                M. Bowman, Ph. D.
            2005
            220,000
            ---
            2,012
            175,000Vice
                President, Development
            2004
            156,065
            140,000
            1,806
            60,000and
                Operations
            2003
            103,443
            ---
            491
            65,000David
                Heniges
            2005
            235,000
            ---
            3,326
            125,000Vice
                President and General
            2004
            143,882
            120,000
            2,772
            45,000Manager,
                Commercial
            2003
            69,329
            ---
            730
            40,000OpportunitiesSandra
                C. Heine
            2005
            147,250
            ---
            288
            150,000Vice
                President, Finance andAdministration






70





(1)
      Principal Position determined as of December 31, 2005.


(2)
      During 2003, the executive officers agreed to reduce their annual salaries
      by
      the following amounts: Dr. Chandrasekaran $245,915, Dr. Bowman $97,257 and
      Mr.
      Heniges $145,671. This agreement continued until June 15, 2004 and resulted
      in
      2004 salary reductions of the following amounts: Dr. Chandrasekaran $127,368,
      Dr. Bowman $44,635 and Mr. Heniges $71,118.


(3)
      The
      amounts shown under the Bonus column include cash bonuses earned for the
      indicated fiscal years.


(4)
      Represents amounts for excess life insurance coverage.





Option
      Grants in Last Fiscal Year





The
      following table sets forth information concerning the stock options granted
      during the 2005 fiscal year to the executive officers named in the Summary
      Compensation Table. Except for the limited right described in footnote (1),
      no
      stock appreciation rights were granted to those individuals during such fiscal
      year.





**Individual
                Grants****Number
                of**
              **Securities**
              **Underlying**
              **Options**
              **Granted**
            **%
                of Total**
              **Options**
              **Granted
                to**
              **Employees**
              **in
                Fiscal**
            **Exercise
                or Base Price ($/Share)**
            **Expiration**
            **Potential
                Realizable Value**
              **at
                Assumed Annual Rates**
              **of
                Stock Price Appreciation**
              **for
                Option Term****Name**
            **(#)****(1)**
            **Year****(2)**
            ******(3)**
            **Date**
            **5%****(4)**
            **10%****(4)**





S.
                Kumar Chandrasekaran, Ph.D.
            (a)
                1,000,00
            46.0%
            $0.63
            6/1/15
            396,204
            1,004,058Lyle
                M. Bowman
            (a)
                175,000
            8.1%
            $0.75
            6/1/14
            69,336
            175,710David
                Heniges
            (a)
                125,000
            5.7%
            $0.88
            3/30/14
            49,525
            125,507Sandra
                C. Heine
            (a)
                150,000
            6.9%
            $0.75
            6/1/14
            59,431
            150,609





______________________


(1)  Each
      option has a maximum term of 10 years, subject to earlier termination in the
      event of the optionee's cessation of service with the Company. The option
      granted will vest and become exercisable:





(a)  for
      twenty five percent (25%) of the option shares upon the completion of one (1)
      year of service measured from the grant date and will vest and become
      exercisable for the balance of the option shares on a daily basis over the
      next
      three years of service thereafter (the “Normal Vesting Schedule”).





However,
      each option will become immediately exercisable for all the option shares upon
      an acquisition of the Company by merger or asset sale, unless the option is
      assumed by the successor entity. The option, to the extent so assumed, will
      subsequently vest in full should the optionee's employment be terminated
      (whether involuntarily or through a resignation following a material change
      in
      the optionee's duties and responsibilities, level of compensation or principal
      place of employment) within twelve (12) months following the acquisition in
      which that option does not otherwise vest on an accelerated basis. The option
      includes a limited stock appreciation right which will result in the
      cancellation of that option, to the extent exercisable for vested shares, upon
      the successful completion of a hostile tender offer for securities possessing
      more than 50% of the combined voting power of the Company's outstanding voting
      securities. In return for the cancelled option, the optionee will receive a
      cash
      distribution per cancelled option share equal to the excess of (i) the highest
      price paid per share of the Company's Common Stock in such hostile tender offer
      over (ii) the exercise price payable per share under the cancelled option.
      The
      exercise price may be paid in cash or in shares of Common Stock (valued at
      fair
      market value on the exercise date) or through a cashless exercise procedure
      involving a same-day sale of the purchased shares. For additional information
      on
      option acceleration provisions, please see “Employment Contracts, Termination of
      Employment Arrangements and Change in Control Arrangements” above.





71


(2)  Represents
      the individual’s percentage (%) of the total options granted to all employees in
      the 2005 Fiscal Year as determined with respect to each individual grant in
      the
      2005 Fiscal Year to the particular individual.





(3)  The
      exercise price may be paid in cash, in shares of the Company’s common stock
      valued at the fair market value on the exercise date or through a cashless
      exercise procedure involving the same-day sale of the purchased
      shares.





(4)  There
      is
      no assurance provided to any executive officer or any other holder of the
      Company’s securities that the actual stock price appreciation over the 10-year
      option term will be at the five percent (5%) or ten percent (10%) assumed annual
      rates of compounded stock price appreciation or at any other defined level.
      Unless the market price of the Common Stock appreciates over the option term,
      no
      value will be realized from the option grants made to the executive
      officers.





**Aggregate
      Option Exercises and Fiscal Year-End Holdings**




The
      following table sets forth information concerning the exercise of options during
      the 2005 fiscal year by the Company’s Chief Executive Officer and each of the
      Company’s other Named Executive Officers and the unexercised options held by
      such individuals at the end of such fiscal year. Except for the limited rights
      described in footnote (1) to the Summary Option Grant Table above, no stock
      appreciation rights were exercised by such individuals during the 2005 fiscal
      year, and no outstanding stock appreciation rights remain outstanding at the
      end
      of such fiscal year.




**AGGREGATE
      OPTION EXERCISES IN LAST FISCAL YEAR**






**AND
      FISCAL YEAR-END OPTION VALUES**




**Number
                of**
              **Shares
                Acquired**
            **Aggregate**
              **Value**
            **Number
                of**
              **Securities
                Underlying**
              **Unexercised
                Options at**
              **December
                31, 2005**
            **Value
                of Unexercised**
              **In-the-Money**
              **Options
                at**
              **December
                31, 2005 (2)****Name**
            **On
                Exercise (#)**
            **Realized
                (1)**
            **Exercisable**
            **Unexercisable**
            **Exercisable**
            **Unexercisable**S.
                Kumar Chandrasekaran, Ph. D
            None
            $0
            1,075,372
            1,014,628
            $370,739
            $969,261Lyle
                M. Bowman
            None
            $0
            183,158
            186,842
            $20,017
            $31,683David
                Heniges
            None
            $0
            141,068
            143,932
            $9,900
            $22,700Sandra
                C. Heine
            25,000
            $2,250
            154,407
            165,593
            $13,016
            $27,434


__________


(1)
      Based
      on the market value of the shares on the date of exercise less the exercise
      price paid for those shares.


(2)
      Calculated on the basis of the closing sale price per share of the Common Stock
      on the American Stock Exchange of $0.83 on December 31, 2005 less the exercise
      price.




**EQUITY
      COMPENSATION PLAN INFORMATION**


The
      Company currently maintains the following compensation plans under which the
      Company’s equity securities are authorized for issuance:





·
            InSite
                Vision Incorporated 1994 Stock Option Plan (the “1994
                Plan”)


·
            InSite
                Vision Incorporated 1994 Employee Stock Purchase Plan (the “Purchase
                Plan”)







72


Each
      of
      these plans has been approved by the Company’s stockholders. The following table
      sets forth the number of shares of the Company’s Common Stock subject to
      outstanding options, warrants, and rights, the weighted-average exercise price
      of outstanding options, warrants, and rights, and the number of shares remaining
      available for future grants under these plans as of December 31,
      2005.





**A**
            
            **B**
            
            **C****Plan
                Category**
            
            **Number
                of Shares of the Company’s Common Stock to be Issued Upon Exercise of
                Outstanding Options, Warrants and Rights**
            
            **Weighted-Average
                Exercise Price of Outstanding Options, Warrants and
                Rights**
            
            **Number
                of Shares of the Company’s Common Stock Remaining Available for Future
                Issuance Under Equity Compensation Plans (Excluding Securities Reflected
                in Column A)****Equity
                Compensation Plans Approved by Stockholders**
            
            5,554,990
            
            $1.15
            
            624,077
                (1)**Equity
                Compensation Plans Not Approved by Stockholders**
            
            0
            
            0
            
            0**Total**
            
            5,554,990
            
            $1.15
            
            624,077




(1)  Of the
      total number of shares available, 218,455 were available for additional stock
      option grants under the 1994 Plan and 423,622 were available for purchases
      under
      our Purchase Plan. In addition, the number of shares of the Company’s Common
      Stock available for issuance under the 1994 Plan will automatically increase
      on
      the first day of January each year during the term of the 1994 Plan (which
      is
      currently scheduled to expire in 2008) by an amount equal to two percent (2%)
      of
      the total number of shares of the Company’s Common Stock issued and outstanding
      on the last day of December in the immediately preceding year. In addition,
      the
      number of shares of the Company’s Common Stock available for issuance under the
      Purchase Plan will automatically increase on the first trading day in January
      each year during the term of the Purchase Plan (which is currently scheduled
      to
      expire in 2008) by an amount equal to one-half-percent (0.5%) of the total
      number of shares of the Company’s Common Stock issued and outstanding as of the
      last trading day in December in the immediately preceding calendar year, but
      in
      no event will any such annual increase exceed 125,000 shares.








**Item
      12. Security Ownership of Certain Beneficial Owners and Management and Related
      Stockholder Matters**





The
      following table sets forth certain information known to the Company regarding
      beneficial ownership of the Company’s Common Stock, as of March 15, 2006 unless
      otherwise noted by (i) each person who is known by the Company to beneficially
      own more than five percent of the Company’s Common Stock, (ii) the Chief
      Executive Officer and each of the other Named Executive Officers of the Company,
      (iii) each director and nominee for director at the Annual Meeting, and (iv)
      all
      current executive officers and directors as a group. Unless otherwise indicated,
      the principal address of each of the stockholders below is: c/o InSite Vision
      Incorporated, 965 Atlantic Avenue, Alameda, California 94501. Except as
      otherwise indicated, the Company believes that each of the beneficial owners
      of
      the Common Stock listed below has sole voting and investment power with respect
      to such shares, subject to community property laws, where applicable.
      Information for Eli Jacobson is based upon the most recent 13G or 13G/A filed
      by
      such person with the Securities and Exchange Commission.





73


The
      percentage of beneficial ownership is calculated based on the 85,532,857 shares
      of Common Stock that were outstanding on March 15, 2006. This percentage also
      includes Common Stock of which such individual or entity had the right to
      acquire beneficial ownership of as of March 15, 2006 or within 60 days after
      March 15, 2006, including but not limited to upon the exercise of options;
      however, such Common Stock shall not be deemed outstanding for the purpose
      of
      computing the percentage owned by any other individual or entity.





**Beneficially
                Owned****Name
                of Beneficial Owner**
            
            **Number
                of Shares**
            
            **Percent
                of Class**Eli
                Jacobson
            
            
            5,858,528(1
            )
            
            6.82
            %125
                Broad Street, 32nd Floor
              New
                York, NY 10004Pinto
                Technology Ventures, LLP
            
            
            7,490,908(2
            )
            
            8.55
            %S.
                Kumar Chandrasekaran, Ph.D.
            
            
            1,431,674(3
            )
            
            1.65
            %Lyle
                M. Bowman, Ph.D.
            
            
            254,923(4
            )
            
            *David
                F. Heniges.
            
            
            152,072(5
            )
            
            *Sandra
                C. Heine
            
            
            222,432(6
            )
            
            *Mitchell
                H. Friedlaender, M.D
            
            
            150,000(7
            )
            
            *John
                L. Mattana
            
            
            175,000(8
            )
            
            *Jon
                S. Saxe
            
            
            152,000(9
            )
            
            *Anders
                P. Wiklund
            
            
            150,000(10
            )
            
            *All
                current executive officers and directors as a group (8
                persons)
            
            
            2,688,101
                (11
            )
            
            3.07
            %


__________


*  Less
      than
      one percent of the outstanding Common Stock.







(1)  Pursuant
      to a Schedule 13G dated and filed with the Securities and Exchange Commission
      on
      February 17, 2006, Eli Jacobson reported that as of February 17, 2006 he had
      sole voting power and sole dispositive power over 5,434,665 shares. The amount
      noted above also includes 423,863 shares issuable upon the exercise of warrants,
      purchased in the March 26, 2004, June 14, 2004 and May 26, 2005 private
      placements.





(2)
      Pinto
      Technology Ventures, LLP. Includes 2,036,363 shares issuable upon the exercise
      of warrants purchased in the May 26, 2005 and December 30, 2005 private
      placements.





(3)  Includes
      1,106,649 shares issuable upon the exercise of stock options exercisable on
      March 15, 2006 or within 60 days thereafter.





(4)  Includes
      190,035 shares issuable upon the exercise of stock options exercisable on
      March 15, 2006 or within 60 days thereafter.





(5)  Comprised
      of 152,072 shares issuable upon the exercise of stock options exercisable on
      March 15, 2006 or within 60 days thereafter.





(6)  Includes
      161,284 shares issuable upon the exercise of stock options exercisable on
      March 15, 2006 or within 60 days thereafter.





(7)  Includes
      130,000 shares issuable upon the exercise of stock options exercisable on
      March 16, 2006 or within 60 days thereafter.





(8)  Includes
      125,000 shares issuable upon the exercise of stock options exercisable on
      March 16, 2006 or within 60 days thereafter.





(9)  Includes
      130,000 shares issuable upon the exercise of stock options exercisable on
      March 16, 2006 or within 60 days thereafter.







74


(10)  Includes
      130,000 shares issuable upon the exercise of stock options exercisable on
      March 16, 2006 or within 60 days thereafter.





(11)  Includes
      2,125,040 shares issuable upon the exercise of stock options exercisable on
      March 16, 2006 or within 60 days thereafter.





**Item
      13. Certain Relationships and Related Transactions**





The
      Company’s Restated Certificate of Incorporation (the “Certificate”) provides for
      indemnification of directors and officers of the Company to the fullest extent
      permitted by the Delaware General Corporation Law. Each of the current directors
      and executive officers of the Company has entered into separate indemnification
      agreements with the Company. In addition, the Certificate limits the liability
      of directors to the Company or its stockholders to the fullest extent permitted
      by the Delaware General Corporation Law.





*Interested
      Transactions*





In
      July
      2003, we issued a $400,000 short-term senior secured note payable to Dr.
      Chandrasekaran, our chief executive officer, chief financial officer and a
      member of our board of directors, for cash. As of March 31, 2006, $231,000
      of
      this note remained outstanding. This note bears an interest rate of five and
      one-half percent (5.5%) and is due on the earlier to occur of March 31, 2007
      or
      upon an event that triggers a Mandatory Redemption of the notes issued in the
      offering of our Senior Secured Notes, and is secured by a lien on all of our
      assets including our intellectual property. In addition the Senior Secured
      Notes
      are secured by a lien on all our assets and are on parity with the note issued
      to Dr. Chandrasekaran.





In
      addition to the note issued to Dr. Chandrasekaran referenced above, from June
      2003 through November 2003, the Company issued a series of unsecured short
      term
      notes payable with a total principal amount of $178,500 in respect of loans
      made
      to the Company by other members of the Board of Directors and Named Executive
      Officers, including the issuance of a note in principal amount of $55,000 issued
      to Dr. Friedlaender. As of March 31, 2006, an aggregate principal amount of
      $35,000 plus accrued interest remains outstanding under such notes. These notes
      bear an interest rate of 2% and are due on the earlier to occur of March 31,
      2007 or upon an event that triggers a Mandatory Redemption of the notes issued
      in the offering of our Senior Secured Notes.





In
      May
      2000, the Company issued loans to Dr. Chandrasekaran related to his exercise
      of
      126,667 options to acquire common stock. In May 2001, the terms on the loans
      were extended from 4 years to 5 years. In 2005 and 2004, Dr. Chandrasekaran
      made
      principal and interest payments of approximately $19,000 and $21,000,
      respectively. The loans are full recourse and bear interest at 7% per annum.
      Interest payments are due semi-annually and principal payments are due annually.
      While the 126,667 shares of common stock issued secure the loans, the Company
      is
      not limited to these shares to satisfy the loan. In January 2006, these loans
      were paid in full.





Each
      of
      the transactions set forth above were approved by the Board of Directors and
      the
      Company believes that each such transaction was made on terms no less favorable
      to the Company than could have been obtained from unaffiliated third parties.
      Pursuant to recently adopted American Stock Exchange regulations, the Company’s
      corporate governance policies and its revised Audit Committee charter, all
      future related-party transactions will be reviewed and approved by the Audit
      Committee.





**Item
      14. Principal Accounting Fees and Services**





**Audit
      Fees**





Audit
      fees billed to the Company by Burr, Pilger & Mayer LLP for review of the
      Company’s financial statements included in the Company’s quarterly reports on
      Form 10-Q and annual report on Form 10-K for the fiscal year ended December
      31,
      2005 totaled $114,157. Audit fees billed to the Company by Burr, Pilger &
Mayer LLP for review of the Company’s financial statements included in the
      Company’s quarterly reports on Form 10-Q and annual report on Form 10-K for the
      fiscal year ended December 31, 2003 totaled $87,143.





75


**Audit-Related
      Fees**





Burr,
      Pilger & Mayer LLP billed the Company amounts during the 2005 and 2004
      fiscal years for assurance and related services reasonably related to the
      performance of the audit or review of the Company’s financial statements that
      were not reported in the paragraph above under the caption “Audit Fees.” These
      audit-related fees were $6,795 and $18,369 for 2005 and 2004, respectively.





**Tax
      Fees**





Burr,
      Pilger & Mayer LLP did not bill the Company any amounts during the 2005 or
      2004 fiscal years for tax compliance, tax advice or tax planning.





**All
      Other Fees**





Burr,
      Pilger & Mayer LLP did not bill the Company any amounts during the 2005 or
      2004 fiscal years for any other products or services.





All
      of
      the audit fees, audit-related fees and tax fees, and all other fees, were
      pre-approved by the Audit Committee of the Company’s Board of Directors. The
      Audit Committee has delegated to Mr. Jon Saxe the ability to pre-approve
      audit-related fees and services on behalf of the Audit Committee in accordance
      with Rule 10A-3 under the Securities Exchange Act of 1934.





The
      Audit
      Committee considered whether the provision of audit-related services, tax
      services and other non-audit services is compatible with the principal
      accountants’ independence.











**PART
      IV**





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





(a)(1)  Financial
      Statements





The
      Financial Statements and Report of Independent Auditors are included in a
      separate section of this Annual Report on Form 10-K. See index to consolidated
      financial statements at Item 8 of this Annual Report on Form 10-K.





(2)  Financial
      Statement Schedules





All
      financial statement schedules have been omitted because they are not applicable
      or are not required or the required information to be set forth therein is
      included in the Financial Statements or notes thereto included in a separate
      section of this Annual Report on Form 10-K. See index to consolidated
      financial statements at Item 8 of this Annual Report on Form 10-K.





(3)  Exhibits





See
      Exhibit Index on page 78 of this Annual Report on Form 10-K.





76







**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 to be signed on its behalf
      by
      the undersigned, thereunto duly authorized.




Dated:
        March 31, 2006


INSITE
                VISION INCORPORATEDBy:
            /s/
                S. Kumar ChandrasekaranS.
                Kumar Chandrasekaran, Ph.D.
              Chairman
                of the Board, President,
              Chief
                Executive Officer and Chief Financial Officer





**POWER
      OF ATTORNEY**





KNOW
      ALL
      PEOPLE BY THESE PRESENTS, that each person whose signature appears below
      constitutes and appoints S. Kumar Chandrasekaran, his or her attorneys in fact,
      each with the power of substitution, for him or her in any and all capacities,
      to sign any amendments to this Report on Form 10-K, and to file the same, with
      exhibits thereto and other documents in connection therewith, with the
      Securities and Exchange Commission, hereby ratifying and confirming all that
      each of said attorneys in fact, or his or her substitutes, may do or cause
      to be
      done by virtue thereof.





Pursuant
      to the requirements of the Securities Exchange Act of 1934, this report has
      been
      signed by the following persons on behalf of the Registrant and in the
      capacities and on the dates indicated.





Name  Capacity  Date











/s/
                S. Kumar Chandrasekaran
            Chairman
                of the Board, President,
            March
                31, 2006S.
                Kumar Chandrasekaran, Ph.D.
            Chief
                Executive Officer and Chief Financial Officer/s/Mitchell
                H. Friedlaender
            Director
            March
                31, 2006Mitchell
                H. Friedlaender, M. D./s/John
                L. Mattana
            Director
            March
                31, 2006John
                L. Mattana/s/Jon
                S. Saxe
            Director
            March
                31, 2006Jon
                S. Saxe/s/Anders
                P. Wiklund
            Director
            March
                31, 2006


Anders
      P.
      Wiklund







77


**EXHIBIT
      INDEX**





Number
            
            Exhibit
                Table2.1
            
            Agreement
                and Plan of Merger, dated as of September 22, 2003, by and among
                InSite
                Vision Incorporated, a Delaware corporation, Arrow Acquisition, Inc.,
                a
                Delaware corporation, and Ophthalmic Solutions, Inc., a Delaware
                corporation.3.11
            
            Restated
                Certificate of Incorporation.3.29
            
            Certificate
                of Designations, Preferences and Rights of Series A Convertible Preferred
                Stock as filed with the Delaware Secretary of State on September
                11,
                1997.3.39
            
            Certificate
                of Correction of the Certificate of Designations, Preferences and
                Rights
                of Series A Convertible Preferred Stock as filed with the Delaware
                Secretary of State on September 26, 1997.3.415
            
            Certificate
                of Designations, Preferences and Rights of Series A-1 Preferred Stock
                as
                filed with the Delaware Secretary of State on July 3,
                2002.3.521
            
            Certificate
                of Amendment to Restated Certificate of Incorporation as filed with
                the
                Delaware Secretary of State on June 3, 1994.3.56
            
            Amended
                and Restated Bylaws.4.1
            
            Reference
                is made to Exhibits 3.1, 3.2, 3.3 and 3.4.4.217
            
            Convertible
                Debenture Purchase Agreement, dated as of September 22, 2003, by
                and
                between Ophthalmic Solutions, Inc. and HEM Mutual Assurance
                LLC.4.317
            
            $492,750
                1% Convertible Debenture Due September 21, 2008, originally issued
                by
                Ophthalmic Solutions, Inc., a Delaware corporation to HEM Mutual
                Assurance
                LLC on September 22, 3003.4.417
            
            $7,250
                1% Convertible Debenture Due September 21, 2008, originally issued
                by
                Ophthalmic Solutions, Inc., a Delaware corporation to HEM Mutual
                Assurance
                LLC on September 22, 3003.4.517
            
            $500,000
                1% Convertible Debenture Due September 21, 2008, originally issued
                by
                Ophthalmic Solutions, Inc., a Delaware corporation to HEM Mutual
                Assurance
                LLC on September 22, 3003.10.110
            
            InSite
                Vision Incorporated 1994 Employee Stock Purchase Plan (As amended
                and
                restated through April 17, 2000).10.28HH
            
            InSite
                Vision Incorporated 1994 Stock Option Plan (Amended and Restated
                as of
                June 8, 1998).10.31HH
            
            Form
                of InSite Vision Incorporated Notice of Grant of Stock Option and
                Stock
                Option Agreement, with Addenda.10.48HH
            
            Form
                of InSite Vision Incorporated Notice of Automatic Option Grant and
                Non-Employee Director Option Agreement.10.51
            
            InSite
                Vision Incorporated 1994 Employee Stock Purchase Plan.10.61
            
            Form
                of InSite Vision Incorporated Stock Purchase Agreement.10.71
            
            Form
                of InSite Vision Incorporated Employee Stock Purchase Plan
                Enrollment/Change Form.10.82
            
            Form
                of Indemnity Agreement Between the Registrant and its directors and
                officers.10.92
            
            Form
                of Employee's Proprietary Information and Inventions
                Agreement.10.103H
            
            License
                Agreement dated as of October 9, 1991 by and between the Company and
                CIBA Vision Corporation, as amended October 9,
                1991.10.113H
            
            Letter
                Agreement dated February 27, 1992 by and among the Company, Columbia
                Laboratories, Inc. and Joseph R. Robinson, as amended
                October 23, 1992.10.127
            
            Facilities
                Lease, dated September 1, 1996, between the Registrant and Alameda
                Real Estate Investments.10.134
            
            Common
                Stock Purchase Agreement dated January 19, 1996 between the
                Registrant and the Investors listed on Schedule 1
                thereto.10.145H
            
            ISV-205
                License Agreement dated May 28, 1996 by and between the Company and
                CIBA Vision Ophthalmics.






78




10.155H
            
            ToPreSite
                License Agreement dated May 28, 1996 by and between the Company and
                CIBA Vision Ophthalmics.10.165H
            
            Timolol
                Development Agreement dated July 18, 1996 by and between the Company
                and Bausch & Lomb Pharmaceuticals, Inc.10.175H
            
            Stock
                Purchase Agreement dated July 18, 1996 by and between the Company and
                Bausch & Lomb Pharmaceuticals, Inc.10.189H
            
            License
                Agreement, dated July 1, 1997, by and between the University of
                Connecticut Health Center and the Company.10.199H
            
            License
                Agreement, dated August 19, 1997, by and between the University of
                Rochester and the Company.10.2011
            
            Form
                of Stock and Warrant Purchase Agreement, dated May 1, 2000 by and
                among
                the Company and the purchasers thereto.10.2112
            
            Placement
                Agent Agreement with Ladenburg Thalmann & Co., Inc. dated January 9,
                2001.10.2213
            
            Amendment
                No. 1 to Marina Village Office Tech Lease, dated July 20, 2001 and
                effective January 1, 2002.10.2314H
            
            License
                Agreement, dated December 21, 2001 by and between the Company and
                The
                University of Connecticut Health Center.10.2416
            
            Form
                of Senior Secured Notes in the aggregate principal amount of $100,000,
                each dated May 28, 2003, issued by the Company to the holders listed
                on
                the signature pages to the Equipment Lien Agreement included as Exhibit
                10.25 hereto.10.2516
            
            Form
                of Equipment Lien Agreement, dated as of May 28, 2003, between the
                Company
                and the holders listed on the signature pages thereto.10.2616
            
            Form
                of Promissory Notes in the aggregate principal amount of $188,500,
                dated
                between June 13, 2003 and June 30, 2003, issued by the Company to
                certain
                members of the Company’s Board of Directors, senior management, and
                stockholders.10.2716
            
            Form
                of Waiver and Amendment to Promissory Notes to Promissory Notes by
                and
                between the Company and the holders of the promissory Notes included
                as
                Exhibit 10.26 hereto.10.2816
            
            Form
                of Senior Secured Note in the principal amount of $400,000, dated
                July 15,
                2003, issued by the Company to S. Kumar Chandrasekaran,
                Ph.D.10.2916
            
            Form
                of Senior Secured Note in the principal amount of $50,000, dated
                July 30,
                2003, issued by the Company to MHU Ventures, Inc.10.3016
            
            Form
                of Security Agreement, dated as of July 15, 2003, between the Company
                and
                the holders listed on the signature pages thereto.10.3116
            
            Form
                of Amendment to July 15, 2003 Security Agreement, dated as of July
                30,
                2003, by and among the Company and the parties listed on the signature
                page thereto.10.3219H
            
            ISV-403
                Asset Purchase Agreement, dated December 19, 2003, between the Company
                and
                Bausch & Lomb, Inc.10.3320
            
            Form
                of Subscription Agreement, dated as of March 26, 2004, by and between
                the
                Company and the Subscribers named on the signature pages
                thereto.10.3420
            
            Form
                of Class A Warrants.10.3520
            
            Form
                of Class B Warrants.10.3620
            
            Form
                of Placement Warrant.10.3720
            
            Placement
                Agent Agreement, dated as of February 12, 2004, by and between the
                Company
                and Paramount Capital, Inc.10.3821
            
            Form
                of Subscription Agreement, dated on or about May 26, 2005 by and
                between
                the Company and the Subscribers named on the signature pages
                thereto.10.3922
            
            Form
                of Warrant for the purchase of shares of Common Stock of the
                Company.10.4023
            
            Form
                of Warrant for the purchase of shares of Common Stock of the
                Company.10.4124
            
            Form
                of Placement Agent Warrant, dated as of May 9, 2005.10.4225
            
            Placement
                Agent Agreement, dated as of February 24, 2005, by and between the
                Company
                and Paramount BioCapital, Inc.10.4326
            
            Warrant,
                dated as of October 10, 2005, for the purchase of 922,800 shares
                of Common
                Stock of the Company.






79




10.4427
            
            Form
                of Subscription Agreement, dated as of December 30, 2005 by and between
                the Company and the Subscribers named on the signature pages
                thereto.10.4528
            
            Form
                of Warrant, dated as of January 11, 2006.10.4629
            
            Form
                of Placement Agent Warrant, dated as of January 11,
                2006.10.4730
            
            Form
                of Consent to Expand Size of Offering of Notes and Warrants, dated
                as of
                January 6, 2006.10.48
            
            Placement
              Agency Agreement, dated as of December 16, 2005, by and between the
              Company and Paramount BioCapital, Inc.10.49
            
            Amended
                and Restated Security Agreement, dated as of December 30, 2005, by
                and
                between the Company and The Bank of New York.10.50
            
            Collateral
                Agency and Intercreditor  Agreement, dated as of December 30,
                2005, by and among the Company, S. Kumar Chandrasekaran, Ph.D. and
                The
                Bank of New York as the Collateral Agent for the holders of the Company’s
                2003 Senior Secured Notes and 2005 Senior Secured
                Notes.10.51
            
            Form
                of Senior Secured Note, dated as of December 30, 2005, issued to
                certain
                investors in an aggregate principal amount of
                $4,300,000.10.52
            
            Form
                of Senior Secured Note, dated as of January 11, 2006, issued to certain
                investors in an aggregate principal amount of
                $2,000,000.10.53
            
            Amended
              and Restated Senior Secured Note in aggregate principal amount of
              $231,000, dated as of December 30, 1005, issued by the Company to
              S. Kumar Chandrasekaran, Ph.D.16.118
            
            Letter
                of Ernst & Young, LLP regarding change in certifying accountants,
                dated October 28, 2003.23.1
            
            Consent
                of Burr, Pilger & Mayer LLP, Independent Registered Public Accounting
                Firm.31.1
            
            Certification
                of Chief Executive Officer pursuant to Rules 13a-14(a) and 15d-14(a)
                promulgated under the Securities Exchange Act of 1934, as
                amended.31.2
            
            Certification
                of Chief Financial Officer pursuant to Rules 13a-14(a) and 15d-14(a)
                promulgated under the Securities Exchange Act of 1934, as
                amended.32.1
            
            Certification
                of Chief Executive Officer and Chief Financial Officer pursuant to
                18
                U.S.C. Section 1350, as adopted pursuant to Section 906 of the
                Sarbanes-Oxley Act of 2002.











1
            Incorporated
                by reference to an exhibit in the Company's Annual Report on Form
                10-K for
                the year ended December 31, 1993.2
            Incorporated
                by reference to an exhibit in the Company's Registration Statement
                on Form
                S-1 (Registration No. 33-68024) as filed with the Securities and
                Exchange
                Commission on August 27, 1993.3
            Incorporated
                by reference to an exhibit in Amendment No. 1 the Company's
                Registration Statement on Form S-1 (Registration No. 33-68024) as
                filed
                with the Securities and Exchange Commission on September 16,
                1993.4
            Incorporated
                by reference to an exhibit in the Company's Annual Report on Form
                10-K for
                the year ended December 31, 1995.5
            Incorporated
                by reference to an exhibit in the Company's Quarterly Report on Form
                10-Q
                for the quarter ended June 30, 1996.6
            Incorporated
                by reference to an exhibit in the Company's Quarterly Report on Form
                10-Q
                for the quarter ended March 31, 1997.7
            Incorporated
                by reference to an exhibit in the Company's Annual Report on Form
                10-K for
                the year ended December 31, 1996.8
            Incorporated
                by reference to exhibits in the Company's Registration Statement
                on Form
                S-8 (Registration No. 333-60057) as filed with the Securities and
                Exchange
                Commission on July 28, 1998.






80




9
            Incorporated
                by reference to exhibits in the Company's Registration Statement
                on Form
                S-3 (Registration No. 333-36673) as filed with the Securities and
                Exchange
                Commission on September 29, 1997.10
            Incorporated
                by reference to an exhibit to the Company’s Registration Statement on Form
                S-8 (Registration No. 333-43504) as filed with the Securities and
                Exchange
                Commission on August 11, 2000.11
            Incorporated
                by reference to an exhibit to the Company’s Registration Statement on Form
                S-3 (Registration No. 333-38266) as filed with the Securities and
                Exchange
                Commission on June 1, 2000.12
            Incorporated
                by reference to an exhibit to the Company’s Registration Statement on Form
                S-3 (Registration No. 333-54912) as filed with the Securities and
                Exchange
                Commission on February 2, 2001.13
            Incorporated
                by reference to an exhibit to the Company’s Quarterly Report on Form 10-Q
                for the quarter ended September 30, 2001.14
            Incorporated
                by reference to an exhibit to the Company’s Annual Report of Form 10-K for
                the year ended December 31, 2001.15
            Incorporated
                by reference to an exhibit to the Company’s Quarterly Report on Form 10-Q
                for the quarter ended September 30, 2002.16
            Incorporated
                by reference to an exhibit to the Company’s Quarterly Report on Form
                10-Q/A for the quarter ended June 30, 2003.17
            Incorporated
                by reference to an exhibit to the Company’s Current Report on Form 8-K
                filed with the Securities and Exchange Commission on September 23,
                2003.18
            Incorporated
                by reference to an exhibit to the Company’s Current Report on Form 8-K
                filed with the Securities and Exchange Commission on October 28,
                2003.19
            Incorporated
                by reference to an exhibit to the Company’s Current Report on Form 8-K
                filed with the Securities and Exchange Commission on January 14,
                2004.20
            Incorporated
                by reference to an exhibit to the Company’s Current Report on Form 8-K
                filed with the Securities and Exchange Commission on March 29,
                2004.21
            Incorporated
                by reference to Exhibit 4.2 to the Company’s Registration Statement on
                Form S-3 filed with the Securities and Exchange Commission on June
                23,
                2005 (File Number 333-126084).22
            Incorporated
                by reference to Exhibit 4.7 to the Company’s Registration Statement on
                Form S-3 filed with the Securities and Exchange Commission on June
                23,
                2005 (File Number 333-126084).23
            Incorporated
                by reference to Exhibit 4.8 to the Company’s Registration Statement on
                Form S-3 filed with the Securities and Exchange Commission on June
                23,
                2005 (File Number 333-126084).24
            Incorporated
                by reference to Exhibit 4.9 to the Company’s Registration Statement on
                Form S-3 filed with the Securities and Exchange Commission on June
                23,
                2005 (File Number 333-126084).25
            Incorporated
                by reference to Exhibit 4.10 to the Company’s Registration Statement on
                Form S-3 filed with the Securities and Exchange Commission on June
                23,
                2005 (File Number 333-126084).26
            Incorporated
                by reference to Exhibit 4.1 to the Company’s Current Report on Form 8-K
                filed with the Securities and Exchange Commission on October 11,
                2005
                (File Number 001-14207).






81




27
            Incorporated
                by reference to Exhibit 4.7 to the Company’s Registration Statement on
                Form S-3 filed with the Securities and Exchange Commission on February
                10,
                2006 (File Number 333-131774).28
            Incorporated
                by reference to Exhibit 4.8 to the Company’s Registration Statement on
                Form S-3 filed with the Securities and Exchange Commission on February
                10,
                2006 (File Number 333-131774).29
            Incorporated
                by reference to Exhibit 4.9 to the Company’s Registration Statement on
                Form S-3 filed with the Securities and Exchange Commission on February
                10,
                2006 (File Number 333-131774).30
            Incorporated
                by reference to Exhibit 4.10 to the Company’s Registration Statement on
                Form S-3 filed with the Securities and Exchange Commission on February
                10,
                2006 (File Number 333-131774).H
            Confidential
                treatment has been granted with respect to certain portions of this
                agreement.HH
            Management
                contract or compensatory plan.










82