**UNITED
      STATES**


**SECURITIES
      AND EXCHANGE COMMISSION**


**WASHINGTON,
      D.C. 20549**





**FORM
      10-K**




x
              ANNUAL
                  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
                  EXCHANGE ACT OF
                  1934
  For
          the
          fiscal year ended December 31, 2006
 OR
 o
                  TRANSITION
                        REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
                        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 x   Non-accelerated
      filer o









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, 2006 was approximately
      $124,602,189 (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 15, 2007:
      93,472,187.




DOCUMENTS
      INCORPORATED BY
      REFERENCE




Portions
      of the Registrant's Proxy Statement in
      connection with the 2007 Annual Meeting of Stockholders are incorporated herein
      by reference in Part III of this Annual Report on Form 10-K to the extent stated
      herein.











**ANNUAL
      REPORT ON FORM 10-K**


**FOR
      THE FISCAL YEAR ENDED DECEMBER 31, 2006**





**TABLE
      OF CONTENTS**





PagePART
                IItem
                1.
            
            Business
            
            1Item
                1A.
            
            Risk
                Factors
            
            16Item
                1B.
            
            Unresolved
                Staff Comments
            
            31Item
                2.
            
            Properties
            
            31Item
                3.
            
            Legal
                Proceedings
            
            31Item
                4.
            
            Submission
                of Matters to a Vote of Security Holders
            
            31PART
                IIItem
                5.
            
            Market
                for Registrant's Common Equity, Related Stockholder
                Mattersand
                Issuer Purchases of Equity Securities
            
            33Item
                6.
            
            Selected
                Financial Data
            
            34Item
                7.
            
            Management's
                Discussion and Analysis of Financial Condition and Resultsof
                Operation
            
            35Item
                7A.
            
            Quantitative
                and Qualitative Disclosures About Market Risk
            
            43Item
                8.
            
            Financial
                Statements and Supplementary Data
            
            44Item
                9.
            
            Changes
                in and Disagreements with Accountants on Accounting and Financial
                Disclosure
            
            67Item
                9A.
            
            Controls
                and Procedures
            
            67Item
                9B.
            
            Other
                Information
            
            69PART
                IIIItem
                10.
            
            Directors
                and Executive Officers of the Company
            
            69Item
                11.
            
            Executive
                Compensation
            
            70Item
                12.
            
            Security
                Ownership of Certain Beneficial Owners and Management and Related
                Stockholder Matters
            
            70Item
                13.
            
            Certain
                Relationships and Related Transactions
            
            70Item
                14.
            
            Principal
                Accounting Fees and Services
            
            70PART
                IVItem
                15.
            
            Exhibits,
                Financial Statement Schedules
            
            70Signatures
            
            
            
            71











*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. 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. The cautionary statements made in this
      document should be read as applicable to all related forward-looking statements
      wherever they appear in this document. 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 the development of genetically-based technologies for
      the
      diagnosis, prognosis and management of glaucoma.





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





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





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





*AzaSite
      (ISV-401).* To
      treat
      bacterial conjunctivitis and other infections of the outer eye we have developed
      a topical ophthalmic 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 significantly fewer doses per
      day, 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, Phase 2 and
      Phase
      3 clinical trials.





In
      July
      2004, we initiated two pivotal Phase 3 clinical trials for AzaSite which were
      conducted both in the United States and in selected 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 747 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 U.S. Food and Drug Administration, or FDA. The bacterial eradication rate
      was also equivalent for both groups .





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 patients in the second arm were
      dosed with a placebo. In January 2006, we completed enrollment in this study
      of
      685 patients, of which 279 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 (p < 0.03), which includes reduction in
      discharge and redness, and bacterial eradication (p < 0.001).




1




In
      June
      2006, we completed the compilation and assembly of an AzaSite New Drug
      Application, or NDA, and submitted the documentation to the FDA. Based on the
      FDA’s Prescription Drug User Fee Act, or PDUFA, we anticipate a ruling by the
      FDA on the potential approval of AzaSite by the end of April 2007.




On
      February 15, 2007, we entered into a worldwide, exclusive, royalty bearing
      licensing agreement with Pfizer Inc. and Pfizer Products, Inc., or collectively
      Pfizer, under Pfizer’s patent family titled “Method of Treating Eye Infections
      with Azithromycin” for ocular anti-infective product candidates known as AzaSite
      and AzaSite Plus, or the Pfizer License. Under the Pfizer License, we are
      required to pay Pfizer a single digit royalty based on net sales of
      the licensed products and to use reasonable commercial efforts to seek
      regulatory approval for and market licensed products.





On
      February 15, 2007, we entered into a license agreement, or the Inspire License,
      with Inspire Pharmaceuticals, Inc., or Inspire, under which we licensed to
      Inspire exclusive development and commercialization rights, under our AzaSiteTM
patent rights and certain know-how, for topical anti-infective products
      containing azithromycin as the sole active ingredient for human ocular or
      ophthalmic indications, or the Subject Products, in the United States and Canada
      and their respective territories, or the Territory. Inspire
      is a biopharmaceutical company dedicated to discovering, developing and
      commercializing prescription pharmaceutical products focused in the ophthalmic
      and respiratory/allergy therapeutic areas.The Inspire License also
      provides for nonexclusive licenses under our DuraSite® patent rights, container
      patent rights, certain patent rights licensed from Columbia Laboratories, Inc,
      or the Columbia patent rights, and certain know-how in the same field of use
      as
      described above. We also granted Inspire an exclusive sublicense under the
      Pfizer patent rights that we have licensed under the Pfizer License discussed
      above. Inspire has the right to grant sublicenses under the terms of the Inspire
      License.





Upon
      the
      closing of the Inspire License, Inspire paid us an upfront license fee of $13
      million and is obligated to pay us an additional $19 million upon regulatory
      approval and the approval of an acceptable label for any Subject Product by
      the
      U.S. FDA. Inspire will also pay a royalty on net sales of any Subject Product
      in
      the Territory, if approved by regulatory authorities. The royalty rate will
      be
      20% of net sales of any Subject Product in the first two years of
      commercialization and 25% thereafter. Inspire is obligated to pay us royalties
      under the Inspire License for the longer of (i) eleven years from the launch
      of
      the first product and (ii) the period during which a valid claim under a patent
      licensed from us covers a Subject Product. For five years after the first year
      of commercial sale, Inspire is required to pay us the greater of the running
      royalty discussed above and certain tiered minimum royalties. The royalties
      discussed above are subject to certain reductions in the event of patent
      invalidity, generic competition, uncured material breach or in the event that
      Inspire is required to pay license fees to third parties for the continued
      use
      of such Subject Product. Such reductions are cumulative but will in no event
      fall below a low single digit royalty based on applicable net sales. There
      are
      certain permitted offsets against both running royalties and minimum royalties
      which are not subject to a floor amount. In the event of a substantial reduction
      in our royalty rate, our royalties under the Inspire License could fall below
      our royalty obligations to Pfizer and other parties related to the products
      licensed to Inspire.





Under
      the
      Inspire License, we are responsible for obtaining regulatory approval of
      AzaSiteTM in each country in the Territory. We also granted Inspire an exclusive
      option to negotiate with us for a license agreement for AzaSite PlusTM, a
      combination antibiotic/corticosteroid product formulated with DuraSite®
technology.





We
      also
      entered into a trademark license agreement with Inspire on February 15, 2007
      under which we granted to Inspire an exclusive license to the AzaSiteTM trademark
      and domain name and a nonexclusive license to the DuraSite® trademark in
      connection with the commercialization of Subject Products in the Territory
      under
      the terms of the Inspire License.





We
      also
      entered into a supply agreement, or the Supply Agreement, with Inspire on
      February 15, 2007 for the active pharmaceutical ingredient azithromycin. We
      had
      previously entered into a third party supply agreement for the production of
      such active ingredient. Under the Supply Agreement, we agreed to supply
      Inspire’s requirements of such active ingredient, pursuant to certain
      forecasting and ordering procedures.





Cardinal
      Health PTS, L.L.C., or Cardinal Health has manufactured the AzaSite clinical
      trial supplies used in our two Phase 3 bacterial conjunctivitis clinical trials,
      and also the registration batches submitted with the AzaSite NDA. We believe
      this contract manufacturing facility is ready for inspection in relation to
      our
      NDA submission. As part of the Inspire License we are required to assist Inspire
      to enter into a manufacturing supply agreement consistent with the agreement
      we
      entered into with Cardinal Health in September 2005 for the production of
      AzaSite for the United States if the NDA is approved by the FDA.




2




*AzaSite
      Plus (ISV-502).* The
      expansion of our AzaSite product franchise will begin with the development
      of a
      combination of azithromycin 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. In 2006,
      we
      completed our preclinical development of this combination product candidate,
      filed an Investigational New Drug Application, or IND, with the FDA and
      conducted a Phase 1 clinical trial.





The
      Phase
      1 clinical study was intended to evaluate both the safety and tolerability
      of
      the AzaSite Plus formulation in normal volunteers. The trial enrolled 46
      subjects with ages ranging from 19 to 67 years. Trial participants received
      eye
      drops of either placebo or AzaSite Plus two times daily for 14 days. Demographic
      characteristics were evenly distributed across treatment groups.





In
      February 2007, we announced that the preliminary safety data indicated that
      AzaSite Plus was well tolerated. No serious adverse events were reported.
      Treatment-related ocular adverse events were minimal in frequency and equivalent
      between the two groups. There were no significant differences in intraocular
      pressure between the AzaSite Plus group and placebo group after 14 days of
      treatment.





*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, 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 commercialize our own product candidates.





*Corporate
      Information.*  Our
      principal 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 reincorporated in Delaware in 1987.
      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.





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 over 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 in
      the
      United States alone.




3




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 1.5 billion dollars in 2006 according
      to
      a study conducted by Navigant Consulting. 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.





4





**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****Anti-infectives**AzaSite
              (ISV-401)
            
            Bacterial
                infection including ophthalmia neonatorum
            
            Broad
                spectrum antibiotic with reduced dosing frequency
            
            NDA
                filedAzaSite
                Plus
              (ISV-502)
            
            Blepharitis
                and other
              ophthalmic
                infections
            
            Broad
                spectrum antibiotic with reduced dosing frequency
            
            Phase
                1
              completedAzaSite
                Otic
              (ISV-016)
            
            Otic
                infections
            
            Broad
                spectrum antibiotic with reduced dosing frequency
            
            Preclinical**Other
                Topical Product Candidates and Marketed 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.”


5


**Anti-infectives**





*AzaSite.* We
      have
      developed a topical formulation of the antibiotic azithromycin to treat
      bacterial conjunctivitis and other infections of the outer eye. 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.





Azithromycin
      has a broad spectrum of antibiotic activity and is widely used to treat
      respiratory and other infections in its oral and parenteral forms. AzaSite
      is an
      eye drop of 1% azithromycin 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 significantly fewer doses per day, 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 efficacious.




AzaSite
      has been formulated to meet the regulatory requirements for the United
      States and most other countries. Our marketing emphasis, through our partner
      Inspire, will focus on pediatricians, general practitioners, optometrists,
      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.





*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, as well as
      other
      ophthalmic infections. In 2006, we completed our preclinical development of
      this
      combination product candidate, filed an IND with the FDA and conducted a
      Phase 1 clinical trial.





*AzaSite
      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.





**Other
      Topical Product Candidates and Marketed Product**





*AquaSite* .
      The
      first product utilizing our DuraSite technology was introduced to the OTC market
      in the United States 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 Co., Ltd, or SSP, for the sale and distribution of AquaSite
      in
      Japan.





**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 intraocular pressure, or IOP, elevation by
      inhibiting the production of the trabecular meshwork glucocorticoid response,
      or
      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.





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.




6




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 sequence
      variations in approximately 70% of the ocular hypertensive patients
      participating in the study. In patients with the TIGR sequence variations,
      a
      0.1% formulation of our ISV-205 product candidate was significantly more
      effective than placebo in lowering 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 will we plan further clinical studies of ISV-205.
      To the extent that we initiate further studies, we cannot assure you that
      similar clinical results will be achieved.





Other
      potential indications for ISV-205 may include glaucoma prevention, analgesia
      and
      anti-inflammatory indications. Co-exclusive rights, in the United States, 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. See
“Business - Collaborative, Licensing and Service Agreements.”





**Glaucoma
      Genetics**





According
      to the Glaucoma Research Foundation, glaucoma is the leading cause of
      preventable blindness in the United States, affecting an estimated two to three
      million people. The most prevalent form of glaucoma in adults is primary open
      angle glaucoma, or 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 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. Yoshiaki 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 at least such
      time
      as we obtain substantial additional 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.





In
      December 2002, we entered into an agreement with Società Industria Farmaceutica
      Italiana, or SIFI, that grants SIFI 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 clinical studies to evaluate the technology in the Italian
      population.




7




**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 United States, and diabetic retinopathy, a common side effect
      of diabetes. According to the National Diabetes Education Foundation,
      approximately 16 million people in the United States 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, photo-dynamic
      therapies and intravitreal drug injection, each of which can lead to loss of
      vision, retinal detachment, infection and may not slow the progression of the
      disease.





*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
      United States 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
      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.





*Pfizer
      Inc. and Pfizer Products, Inc.* On
      February 15, 2007, we entered into a worldwide, exclusive, royalty-bearing
      licensing agreement with Pfizer, under Pfizer’s patent family titled “Method of
      Treating Eye Infections with Azithromycin” for ocular anti-infective product
      candidates known as AzaSite and AzaSite Plus. Under the Pfizer License, we
      are
      required to pay Pfizer a single digit royalty based on net sales of the licensed
      products and to use reasonable commercial efforts to seek regulatory approval
      for and market licensed products. We have the right to grant sublicenses,
      subject to Pfizer's prior approval which under the Pfizer License shall not
      be
      unreasonably withheld. On February 15, 2007, with Pfizer’s approval, we granted
      a sublicense to Inspire as described below.





*Inspire
      Pharmaceuticals, Inc.* On
      February 15, 2007, we entered into the Inspire License with Inspire, under
      which
      we licensed to Inspire exclusive development and commercialization rights,
      under
      our AzaSiteTM patent rights and certain know-how, for topical anti-infective
      products containing azithromycin as the sole active ingredient for human ocular
      or ophthalmic indications, or each a Subject Product, in the United States
      and
      Canada and their respective territories, or the Territory. The Inspire License
      also provides for nonexclusive licenses under our DuraSite® patent rights,
      container patent rights, Columbia patent rights and certain know-how in the
      same
      field of use as described above. We also granted Inspire an exclusive sublicense
      under the Pfizer patent rights that we have licensed under the Pfizer License
      discussed above. Inspire has the right to grant sublicenses under the terms
      of
      the Inspire License.





Upon
      the
      closing of the Inspire License, Inspire paid us an upfront license fee of $13
      million and is obligated to pay us an additional $19 million upon regulatory
      approval and the approval of an acceptable label for any Subject Product by
      the
      U.S. FDA. Inspire will also pay us a royalty on net sales of any Subject Product
      in the Territory, if approved by regulatory authorities. The royalty rate will
      be 20% of net sales of any Subject Product in the first two years of
      commercialization and 25% thereafter. Inspire is obligated to pay us royalties
      under the Inspire License for the longer of (i) eleven years from the launch
      of
      the first product, and (ii) the period during which a valid claim under a patent
      licensed from us covers a Subject Product. For five years after the first year
      of commercial sale, Inspire is required to pay us the greater of the running
      royalty discussed above or certain tiered minimum royalties. The royalties
      discussed above are subject to certain reductions in the event of patent
      invalidity, generic competition, uncured material breach or in the event that
      Inspire is required to pay license fees to third parties for the continued
      use
      of such Subject Product. Such reductions are cumulative but will in no event
      fall below a low single digit royalty based on applicable net sales. There
      are
      certain permitted offsets against both running royalties and minimum royalties
      which are not subject to a floor amount.




8





Under
      the
      Inspire License, we are responsible for obtaining regulatory approval of
      AzaSiteTM in each country in the Territory. No more than 25 days after obtaining
      regulatory approval for each country in the Territory, we will be responsible
      for transferring regulatory documentation regarding AzaSiteTM, including the New
      Drug Application and Canadian equivalent, to Inspire. Thereafter, Inspire will
      be responsible for all regulatory obligations and strategies relating to the
      further development and commercialization of products in each country in the
      Territory. Inspire will also be responsible for all commercialization in the
      Territory.





Under
      the
      Inspire License we also granted Inspire an exclusive option to negotiate with
      us
      for a license agreement for AzaSite PlusTM, a combination
      antibiotic/corticosteroid product formulated with DuraSite® technology. If we
      enter into a definitive agreement with Inspire with respect to AzaSiteTM Plus or
      if we publicly announces that we are no longer pursuing the development of
      AzaSiteTM Plus, then the AzaSiteTM trademark, the AzaSiteTM domain names and the
      AzaSiteTM Plus trademark, including all goodwill associated therewith, will be
      assigned to Inspire in the Territory.





We
      are
      obligated to provide to Inspire certain future developments, including know-how
      and patent rights, developed up to the effective transfer date of regulatory
      materials in the Territory that are necessary or useful to develop or
      commercialize any Subject Product for bacterial conjunctivitis in the Territory.
      Such developments will be provided without additional fees but any Subject
      Product that includes such developments will be subject to the same royalty
      rates described above. For certain further developments completed after
      such regulatory transfer date in the Territory, Inspire has a time-limited
      exclusive option to license such further developments upon terms and conditions
      to be separately negotiated.





We
      also
      entered into a trademark license agreement with Inspire on February 15, 2007
      under which we granted to Inspire an exclusive license to the AzaSiteTM trademark
      and domain name and a nonexclusive license to the DuraSite® trademark in
      connection with the commercialization of Subject Products in the Territory
      under
      the terms of the Inspire License.





We
      also
      entered into a supply agreement, or the Supply Agreement, with Inspire on
      February 15, 2007 for the active pharmaceutical ingredient azithromycin. We
      had
      previously entered into a third party supply agreement for the production of
      such active ingredient. Under the Supply Agreement, we agreed to supply
      Inspire’s requirements of such active ingredient, pursuant to certain
      forecasting and ordering procedures. The initial term of the Supply Agreement
      is
      until 2012, subject to customary termination provisions, such as termination
      for
      material breach. Either party may terminate the Supply Agreement upon 180 days
      notice to the other party. In addition, Inspire may also terminate the Supply
      Agreement if our third-party supplier moves the location at which the active
      ingredient is manufactured. After 2012, the Supply Agreement automatically
      renews for successive three-year periods unless terminated pursuant to the
      foregoing termination provisions. If we are in breach of our supply obligations
      under the Supply Agreement, Inspire is permitted to qualify a second source
      supplier, at our expense, and obtain the active ingredient from such second
      source. We are obligated under the Supply Agreement to maintain a minimum
      quantity of the active ingredient in inventory for Inspire's use in
      manufacturing such products and to maintain the quality agreement negotiated
      with its supplier. The Supply Agreement also contains certain provisions
      regarding the rights and responsibilities of the parties with respect to
      manufacturing specifications, delivery arrangements, quality assurance,
      regulatory compliance, product recall, and indemnification, as well as certain
      other customary matters.





9





*Cardinal
      Health PTS, L.L.C.* In
      September 2005, we entered into a commercial manufacturing supply agreement
      with
      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,
      or the Purchase Agreement and a License Agreement dated December 30, 2003,
      or
      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. We believe that Bausch & Lomb is continuing its
      development of ISV-403.





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-patented 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 an
      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 of 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.





*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 United States. 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 which granted
      CIBA Vision certain co-exclusive rights to manufacture, have manufactured,
      use
      and sell, in the United States 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,
      we
      entered into another license agreement with the UC Regents 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.




10




*Columbia
      Laboratories, Inc* .
      In
      February 1992, we entered into a cross-license agreement with 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,
      collectively 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.




*SSP.* In April
      2001, we entered into a royalty-bearing license agreement with 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 them.
      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 United States relating to our DuraSite technology
      with delivery tips and drug compounds. Of these applications, seven 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. Three 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 our patents as well as those we have licensed
      from others have been filed 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.




11




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.





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, 2006, our research and development staff numbered 32 people, of
      whom 6 have Ph.D.s. In 2006, our research and development expenses were $8.9
      million. In 2005, our research and development expenses were $10.7 million.
      In
      2004, our research and development expenses, including third-party research
      we
      sponsored, were $6.8 million, including the expenses related to contract
      research activities for which we received $537,000 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
      will
      manufacture the required validation batches for FDA review. Cardinal Health’s
      facility and the line that may 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 filed 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
      have
      entered into a licensing agreement with Inspire under which they will be
      responsible for the manufacture of AzaSite for the United States and Canada
      if
      it is approved by the related regulatory agencies. As part of the license we
      have agreed to assist in the transition of our manufacturing supply agreement
      with Cardinal to Inspire. If Inspire encounters delays or difficulties in the
      transfer or in the future with maintaining their relationship with Cardinal
      or
      with establishing an arrangement with another qualified manufacturer, subsequent
      sales of AzaSite would be adversely affected.




12




**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:





*Inspire.*  In
      February 2007, we entered into an exclusive agreement with Inspire under which
      Inspire will be responsible for all sales and marketing associated with
      AzaSite and the other subject products under the Inspire License in the
      United States and Canada, if approved by the appropriate regulatory authorities.
      We received an upfront licensing fee and are entitled to a
      milestone payment if AzaSite is approved by the FDA and to royalties based
      on
      net sales of the subject products, if any. Inspire currently promotes to a
      select number of eye care professionals and allergists using 64 territory
      managers. Inspire also has a marketing team and a training and operations team
      to support its commercialization effort. Inspire's small, specialty sales and
      marketing organization focuses its promotional efforts on ophthalmologists,
      optometrists and allergists but upon an approval of AzaSite,will
      expand to select high prescribing pediatricians and primary care physicians.
      Inspire has publicly disclosed that if AzaSite receives regulatory approval,
      Inspire expects to increase its sales force to a total of approximately 98
      representatives who will call on targeted specialists and selected pediatricians
      and primary care providers.





*CIBA
      Vision* .
      In
      1991, we entered into a co-exclusive rights agreement with CIBA Vision under
      which CIBA Vision obtained the right to market the AquaSite product in the
      United States 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 United States 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.


*SSP.* 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 and we are entitled
      to royalties based on net sales of the product, if any. We believe that Bausch
      & Lomb is continuing its development of ISV-403.





*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.




13




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.





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, Johnson & Johnson,
      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 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
      United States and other countries. In the United States, 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 United States 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 takes a number of years and involves 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 United States
      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,
                or PLA to the FDA; and





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





14




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.





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 Good Manufacturing Practice, or 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 United States, we or our licensees 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 United
      States





**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.




15




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.
            
            Co-Founder
                and Chief Medical Officer, Sirion Therapeutics,
                Inc.





**Employees**





As
      of
      December 31, 2006, we had 44 employees, 40 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
      2007. We will need additional funding, either through achievement of a licensing
      milestone, equity or debt financings or partnering arrangements, that, if
      available, 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
      to
      our consolidated financial statements for the fiscal year ended
      December 31, 2006 referring to our recurring operating losses and a
      substantial doubt about our ability to continue as a going concern.





We
      expect
      that our cash on hand (including cash received from the Inspire License in
      February 2007), together with a refund from the FDA relating to our NDA filing
      fee, anticipated cash flow from operations and current cash commitments to
      us
      will only enable us to continue operations until approximately the end of June
      2007. At that point, or earlier if circumstances change from our current
      expectations, we will require substantial additional funding from the issuance
      of debt or equity securities, payments under existing collaboration agreements,
      asset sales or other sources. We cannot assure you that additional funding
      will
      be available on a timely basis, or on reasonable terms, or at all.





If
      we are
      able to secure additional equity financing, the terms of any securities issued
      in connection with such financing 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
      lien on all of our assets, including our intellectual property, will require
      us
      to make principal and interest payments in cash, securities or a combination
      thereof, and may subject us to restrictive covenants. Such equity or debt
      financings may also include the issuance of warrants exercisable for our Common
      Stock at a discount to the then current market price. In addition, the existence
      of the explanatory paragraph in the audit report may make it more difficult
      for
      us to raise additional financing, may adversely affect the terms of such
      financing and could prevent investors from purchasing our shares in the open
      market as certain investors may be restricted or precluded from investing in
      companies that have received this explanatory paragraph 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.
      If we do not obtain additional financing when required, we would likely have
      to
      cease operations and liquidate our assets.




16




It
      is
      difficult to precisely predict our future capital requirements, and therefore
      the amount and timing of our future funding requirements depend upon many
      factors, including:





·
            the
                progress and results of the review of our NDA by the
                FDA;





·
            the
                progress and results of our preclinical and clinical
                testing;





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





·
            the
                progress of our research and development
                programs;





·
            the
                initiation and outcome of possible future legal
                actions;





·
            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.





***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
      are
      currently seeking FDA approval of an NDA for our AzaSite product and have
      completed Phase 1 clinical trials for our AzaSite Plus product candidate. We
      expect our cash on hand (including cash received from the Inspire License
      in February 2007), together with a refund from the FDA relating to our NDA
      filing fee, anticipated cash flow from operations and current cash commitments
      to us will only enable us to continue our operations until approximately
      the end of June 2007. While we have completed Phase 3 trials and submitted
      an NDA for AzaSite, the FDA may require further information or even additional
      clinical trials before granting final approval for AzaSite. Any delay or failure
      in the FDA approval process will delay our receipt of the milestone payment
      due
      under the Inspire License and 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 product candidates, including AzaSite Plus, will
      take at least several years to complete. 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:





·
            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.




17




***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 accept or approve
      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.





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





Our
      limited financial resources make it more difficult for us to enforce our
      intellectual property rights, through filing or maintaining our patents, taking
      legal action against those that may infringe on our proprietary rights,
      defending infringement and other patent 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.





***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, particularly Inspire. 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
      that we may use in the future for other products 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.
      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 our collaborations.





***Inspire’s
      failure to successfully market and commercialize AzaSite would negatively impact
      our future revenues***





In
      February 2007, we entered into the Inspire License where we exclusively licensed
      AzaSite to Inspire in the U.S. and Canada, or the Territory. If approved by
      the
      FDA in the United States or by the relevant regulatory
      authorities in Canada, Inspire will assume full control of all sales and
      marketing activities for AzaSite and other subject products. Accordingly, our
      royalty revenue on the net sales of AzaSite in the Territory will be entirely
      dependent on the actions, efforts and success of Inspire, over whom we have
      little or no control. The commercial success of AzaSite ** will
      depend on a number of factors, including:


·
            timing
                and scope of Inspire’s launch and initiation of the commercialization of
                AzaSite in the United States and
                Canada;  ·
            effectiveness
                and extent of Inspire’s promotional, sales and marketing
                efforts;  ·
            Inspire’s
                ability to build, train and retain an effective sales
                force; 
 18
  ·
            Inspire’s
                ability to successfully sell AzaSite to physicians and
                patients;  ·
            Inspire’s
                pricing decisions regarding AzaSite;  ·
            our
                competitors’ ability to market and sell current or future competing
                products;  ·
            patient
                and physician satisfaction with existing alternative
                products;  ·
            prevalence
                and severity of adverse side effects;  ·
            the
                perceived efficacy of AzaSite relative to other available products;  ·
            coverage
                and reimbursement under Medicare and other governmental or privately
                sponsored insurance plans;  ·
            duration
                of market exclusivity of AzaSite;  ·
            pricing
                and availability of alternative products, including generic or
                over-the-counter products; and  ·
            shifts
                in the medical community to new treatment paradigms or standards
                of
                care.




***Our
      license of AzaSite to Inspire may not be profitable for
      us***





Under
      the
      Inspire License, if we receive regulatory approval for AzaSite or other subject
      products, Inspire will assume responsibility for all further commercialization
      activities, and we are entitled to receive royalties on the net sales of AzaSite
      and other subject products. Inspire’s obligation to pay us royalties expires
      upon the later of eleven years from the launch of the first product, and the
      period during which a valid claim under one of our licensed patents covers
      a
      subject product, in each country in the Territory. While we are entitled to
      minimum royalty payments from Inspire for five years after the first year of
      a
      commercial sale, such minimum royalty payments will not be sufficient for us
      to
      cover our operating expenses, and we are dependent on Inspire’s sales and
      marketing efforts for AzaSite in order for us to receive royalties in excess
      of
      these minimum amounts. In addition, our royalties are subject to a cumulative
      reduction in the event of patent invalidity, generic competition, uncured
      material breach or in the event that Inspire is required to pay license fees
      to
      third parties for the continued use of AzaSite. These cumulative reductions
      could result in us receiving a low single digit royalties on net sales of
      AzaSite and other subject products. Generic competition, over which we have
      little control, could also result in substantial reductions to our royalties
      under the Inspire License. In the event of generic competition, our royalty
      rate
      is reduced based on the economic impact to Inspire of such generic competition,
      potentially down to a low single digit royalty. We could ultimately lose money
      under the Inspire License in the event of a substantial reduction in our royalty
      rate combined with our royalty obligations to Pfizer and other parties related
      to the products licensed to Inspire.





If
      Inspire terminates the Inspire License as a result of our uncured material
      breach or insolvency, Inspire will have a 12-month wind-down period to sell
      products in inventory and the Inspire License will be terminated after the
      wind-down period. During such wind-down period our royalty payments would be
      subject to reduction and there is no guarantee that we could enter into a new
      license agreement with a third-party or otherwise commercialize AzaSite after
      the Inspire License is terminated.





***Inspire
      has limited experience in sales and marketing of pharmaceutical
      products***




If
      AzaSite receives regulatory approval in the United States and Canada, we will
      be
      dependent upon Inspire to market and sell AzaSite in those countries. Inspire
      has only recently established its sales force and did not have a sale
      organization prior to 2004. Inspire has disclosed that it has encountered
      difficulties and incurred substantial expenses in maintaining its sales force.
      Inspire may encounter similar or new problems in the future related to
      maintaining and growing its sales force that could have a negative impact on
      sales of AzaSite. We have no control over how Inspire manages and operates
      its
      sales force. In addition, there is no guarantee that Inspire can effectively
      compete with our competitors that currently have more extensive, more
      experienced and better funded marketing and sales operations.





***Revenues
      in future periods could vary significantly and will be based on Inspire’s
      financial reports***





We
      will
      recognize revenue based on Inspire’s net sales of AzaSite and other subject
      products as reported to us by Inspire. Inspire’s net sales of AzaSite may vary
      quarter to quarter which would cause our royalty revenue to also vary. In
      addition our royalty revenues will be based upon Inspire’s revenue recognition
      and other accounting policies over which we have no control. Inspire’s filings
      with the SEC indicate that Inspire maintains disclosure controls and procedures
      in accordance with applicable laws, which are designed to provide reasonable
      assurance that the information required to be reported by Inspire in its
      Exchange Act filings is reported timely and in accordance with applicable laws,
      rules and regulations. However, if Inspire’s reported revenue amounts or net
      sales reports were inaccurate, it could have a material impact on our financial
      statements, including financial statements for previous periods.




19




***Our
      future success depends on our ability to enter into successful collaboration
      arrangements with third parties in order to develop new products and new
      indications for existing products that achieve regulatory approval for
      commercialization***





For
      our
      business model to succeed, we must continually develop new products or achieve
      new indications for the use of our existing products. As a part of that process,
      we rely on third parties for clinical testing and certain other product
      development activities especially in the area of our glaucoma programs. 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. 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. 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. 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 be pursued using
      external resources including:





·
            a
                network of key ophthalmic clinicians;
                and


·
            other
                resources with ophthalmic
                expertise.





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,
      thereby 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.





While
      we
      expect to enter into additional partnering and collaborative arrangements in
      the
      future, 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. We cannot
      assure you that such arrangements will be beneficial to us. The success of
      our
      partnering and collaboration arrangements will depend upon many factors,
      including:





·
            the
                progress and results of the review of our NDAs by the
                FDA;


·
            the
                progress and results of our preclinical and clinical testing;


·
            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 possible future legal
                actions;


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




20




·
            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.




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





Even
      if
      the FDA approves our product candidates, including AzaSite, physicians and
      patients may not accept and use them. Acceptance and use of our products 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 products relative to competing
                products;


·
            perceived
                benefits of competing products or
                treatments;


·
            physicians’
                comfort level and prior experience with and use of competing
                products;


·
            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.





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.





***We
      may require additional licenses or be subject to expensive and uncertain patent
      litigation in order to sell AzaSite in the United States and/or Europe***





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. As is not unusual in the pharmaceutical and biotech
      industry, from time to time we receive notices from third parties alleging
      various challenges to our patent rights, and we investigate the merits of each
      allegation that we receive. 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.
      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
      may
      need to litigate in order to defend against claims of infringement by 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.




21




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 significant 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.





***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, particularly with respect to
      commercializing our products. 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. With respect to our leading product
      candidate, AzaSite, the FDA must approve our NDA. Before regulatory authorities
      grant us marketing approval for additional products, we need to conduct
      significant additional research and development and preclinical and clinical
      testing. 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;




22


·
            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
      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. S. Kumar 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
      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, 2006, our accumulated deficit was
      approximately $153.1 million. We expect to incur net losses for theforeseeable
      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 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 the 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 growth***





Even
      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, all of which will cause us to incur
      significant additional expense. If we are unable to manage our growth
      effectively, our business would be harmed.




23




***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. If the FDA determines regulatory approval is required any
      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.





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, or Quest, 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 Clinical Laboratory Improvement Amendments, or
      CLIA,
      which are 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 to successfully enter into another genetic testing
      arrangement or perform these analytical procedures ourselves on a cost-efficient
      basis, or at all.




24




***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 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, if the FDA were to identify
      issues in the production of the drug that the supplier was unable to resolve
      quickly and cost-effectively, or if other issues were to arise that impact
      production, our ability to commence the commercial sale of AzaSite if and when
      it is approved, could be interrupted, which would significantly 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. There is also no guarantee that these additional suppliers can
      supply sufficient quantities at a reasonable price, or at all.





Under
      the
      Inspire License we will be the supplier of azithromycin to Inspire for the
      manufacture of AzaSite in the United States and Canada. If our supply
      becomes interrupted this will also interrupt the supply of the drug to Inspire
      until either of the companies are able to obtain a new supplier. While we are
      required to maintain a certain level of inventory of the raw material to support
      Inspire’s manufacturing needs, this amount may not be sufficient to prevent an
      interruption in the availability of the product and would harm our ability
      to
      receive royalties. In the event of a disruption in the our supply of
      azithromycin to Inspire, Inspire is entitled to use a secondary source at our
      expense.





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 future 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, or Noveon. Although
      we do not have a current supply agreement with Noveon, 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, including sales of
      AzaSite, 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. Under the
      Inspire License we will assist Inspire in establishing its own commercial
      manufacturing agreement with Cardinal Health for production of AzaSite upon
      approval of the AzaSite NDA. Other commercial manufacturers exist and we
      currently believe that we, or Inspire, 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
      Inspire’s potential market introduction and subsequent sales of AzaSite, which
      would impact our potential royalty revenues. Cardinal Health’s facility and the
      line that will be used to produce the AzaSite units may be subject to inspection
      by the FDA prior to the approval of the related NDA that we submitted to the
      FDA
      in June 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 Inspire’s potential market
      introduction and subsequent sales of AzaSite.




25




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:





·
            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.





***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.




26




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;


·
            formulating
                and manufacturing drugs;


·
            launching,
                marketing and selling drugs; and


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







27







***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 will not be
      adequate to cover all potential claims we may encounter, particularly if and
      when AzaSite is commercialized. Once AzaSite is commercialized we will have
      to
      significantly increase our coverage, which will be expensive 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 $11,800 and $7,400 for the years ended 2006 and 2005,
      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.




28




***If
      we engage in acquisitions, we will incur a variety of costs, and the anticipated
      benefits of the acquisitions 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:





·
            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***





As
      of
      December 31, 2006, our management and principal stockholders together
      beneficially owned approximately 25% 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 22% of our outstanding shares of Common Stock
      as
      of December 31, 2006. If such investors were to exercise the warrants they
      currently hold, assuming no additional acquisitions, sales or distributions,
      such investors would own approximately 32% of our outstanding shares of Common
      Stock based on their ownership percentages as of December 31, 2006. 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.





***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,
      2006
      that included 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 status of our relationships or proposed
      relationships with third-party collaborators, 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, any litigation
      regarding the same, 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.





Future
      equity financings that we may pursue as well as the exercise of outstanding
      options and 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.
      In connection with our December 2005 and January 2006 Private Placement of
      Notes
      and Warrants, we issued Warrants to purchase 1,460,000 shares of our Common
      Stock. In connection with our August 2006 Private Placement we issued warrants
      to purchase 958,015 shares of our Common Stock.




29




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
      addition, terrorist attacks in the United States and abroad, United
      States retaliation for these attacks, the war in Iraq or potential
      worldwide economic weakness and the related decline in consumer confidence
      have
      had, and may continue to have, an adverse impact on the United
      States 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, the future price of our
      Common Stock and on our ability to raise additional financing.





***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 adoption of 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. Beginning with our 2006 fiscal year we must comply with Section
      404 of the Sarbanes-Oxley Act of 2002 regarding certification of our internal
      control over financial reporting, which has and will continue to significantly
      increase our compliance costs. The Sarbanes-Oxley Act of 2002 and other rule
      changes and proposed legislative initiatives are likely to continue 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. These and other potential changes could
      materially increase the expenses we report under generally accepted accounting
      principles, and adversely affect our operating results.





30


**Item
      1B. Unresolved Staff Comments**





Not
      applicable.





**Item
      2. Properties**





We
      currently lease approximately 39,123 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, 2013, 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**





None





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





On
      October 3, 2006, we held our Annual Meeting of Stockholders at which our
      stockholders approved:





(1)  The
      election of S. Kumar Chandrasekaran, Ph.D., Mitchell H. Friedlaender, M.D.,
      John
      L. Mattana, Jon S. Saxe and Anders P. Wiklund to our Board of Directors to
      serve
      until the next annual meeting or until their successors are elected and
      qualified. The following directors received the number of votes set opposite
      their respective names:





For
                Election
            
            WithheldS.
                Kumar Chandrasekaran, Ph.D.
            
            
            61,511,935
            
            
            1,046,154Mitchell
                H. Friedlaender, M.D.
            
            
            61,175,347
            
            
            1,382,742John
                L. Mattana
            
            
            61,209,935
            
            
            1,348,154Jon
                S. Saxe
            
            
            61,163,397
            
            
            1,394,692Anders
                P. Wiklund
            
            
            61,170,467
            
            
            1,387,622





(2)  An
      amendment to our Restated Certificate of Incorporation to increase the number
      of
      shares of our common stock authorized for issuance by an additional 120,000,000
      shares, resulting in an aggregate of 240,000,000 shares of authorized common
      stock. Such proposal received 53,177,374 votes for approval, 9,355,037 votes
      against approval, and 25,677 votes abstaining.





(3)  The
      ratification of our audit committee’s appointment of Burr, Pilger & Mayer
      LLP as our independent public accountants for the fiscal year ending December
      31, 2006. Such proposal received 62,310,482 votes for ratification, 111,204
      votes against ratification and 136,400 abstentions.




31


**Executive
      Officers of the Company**





As
      of
      March 15, 2007, our executive officers and other senior management were as
      follows:





Name
            
            Age
            
            TitleS.
                Kumar Chandrasekaran, Ph.D.
            
            64
            
            Chairman
                of the Board, President, Chief Executive Officer and Chief Financial
                OfficerLyle
                M. Bowman, Ph.D.
            
            58
            
            Vice
                President, Development and OperationsRonald
                H. Carlson
            
            53
            
            Vice
                President, Regulatory and QualityDavid
                F. Heniges
            
            63
            
            Vice
                President and General Manager, Commercial OpportunitiesSandra
                C. Heine
            
            45
            
            Vice
                President, Finance and AdministrationErwin
                C. Si, Ph.D.
            
            53
            
            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.





Ronald
      Carlson joined us in April 2006 as Vice President, Regulatory and Quality.
      From 1999 to 2006, Dr. Carlson worked at XOMA LLC, a biotechnology company
      focused on the development of therapeutic antibodies, where he held
      positions of Vice President of Quality and Senior Director of Regulatory
      Affairs. Dr. Carlson was also Vice President of Development at Berkeley HeartLab
      Inc. and has held managerial positions at Bayer, Isis, Berlex, and Genentech.
      Dr. Carlson holds a Bachelor of Science in both Chemistry and Mathematics and
      a
      Ph.D. in Chemistry from Southern Illinois University.





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 spent 23 years
      in
      total with Johnson and Johnson in various sales, marketing, and business
      development positions. 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.





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.




32


**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.





**2006**
            
            **High**
            
            **Low**First
                Quarter
            
            $
            2.17
            
            $
            0.90Second
                Quarter
            
            $
            2.69
            
            $
            1.53Third
                Quarter
            
            $
            1.90
            
            $
            1.26Fourth
                Quarter
            
            $
            1.88
            
            $
            1.27





**2005**
            ****
            **High**
            
            **Low**First
                Quarter
            
            $
            0.92
            
            $
            0.48Second
                Quarter
            
            $
            0.87
            
            $
            0.42Third
                Quarter
            
            $
            0.70
            
            $
            0.49Fourth
                Quarter
            
            $
            0.95
            
            $
            0.61




**Holders**





As
      of
      March 13, 2007, we had approximately 250 stockholders of record of our Common
      Stock. On March 13, 2007, the last sale price reported on The American Stock
      Exchange for our common stock was $1.45 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.




33


**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, 2006 (in thousands except per share
      amounts):





**Year
                Ended December 31,********2006**
            
            ******2005**
            
            ******2004**
            
            **2003**
            
            ******2002****Consolidated
                Statements of Operations Data**Revenues
            
            $
            2
            
            $
            4
            
            $
            542
            
            $
            134
            
            $
            36Cost
                of goods
            
            
            28
            
            
            14
            
            
            14
            
            
            20
            
            
            114Operating
                expenses:Research
                and development, net
            
            
            8,890
            
            
            10,690
            
            
            6,788
            
            
            4,007
            
            
            5,991Selling,
                general and administrative
            
            
            6,182
            
            
            4,510
            
            
            3,826
            
            
            3,450
            
            
            4,942Total
                expenses
            
            
            15,072
            
            
            15,200
            
            
            10,614
            
            
            7,457
            
            
            10,933Gain
                on sale of assets
            
            
            —
            
            
            —
            
            
            4,616
            
            
            1,153
            
            
            —Interest
                (expense) and other income, net
            
            
            (1,513
            )
            
            (5
            )
            
            (44
            )
            
            (561
            )
            
            62Net
                income loss
            
            
            (16,611
            )
            
            (15,215
            )
            
            (5,514
            )
            
            (6,751
            )
            
            (10,949
            )Non
                cash preferred dividend
            
            
            —
            
            
            —
            
            
            —
            
            
            221
            
            
            48Net
                income loss applicable to common stockholders
            
            $
            (16,611
            )
            $
            (15,215
            )
            $
            (5,514
            )
            $
            (6,972
            )
            $
            (10,997
            )Basic
                and diluted loss per share applicable to common
                stockholders
            
            $
            (0.19
            )
            $
            (0.21
            )
            $
            (
                0.11
            )
            $
            (0.27
            )
            $
            (0.44
            )Shares
                used to calculate basic and diluted net loss per share
            
            
            88,339
            
            
            72,647
            
            
            47,984
            
            
            25,767
            
            
            24,997




**December
                31,****2006**
            
            **2005**
            
            **2004**
            
            **2003**
            
            **2002****Consolidated
                Balance Sheet Data**Cash
                and cash equivalents, unrestricted
            
            $
            987
            
            $
            4,027
            
            $
            5,351
            
            $
            1,045
            
            $
            1,179Working
                capital
            
            
            (6,836
            )
            
            (3,424
            )
            
            3,515
            
            
            (6,434
            )
            
            353Total
                assets
            
            
            2,439
            
            
            5,079
            
            
            5,696
            
            
            1,405
            
            
            1,866Long
                term notes payable
            
            
            —
            
            
            —
            
            
            —
            
            
            16
            
            
            10Convertible
                preferred stock
            
            
            —
            
            
            —
            
            
            —
            
            
            —
            
            
            2,048Accumulated
                deficit
            
            
            (153,062
            )
            
            (136,451
            )
            
            (121,236
            )
            
            (115,722
            )
            
            (108,750
            )Total
                stockholders’ equity (deficit)
            
            
            (6,302
            )
            
            (2,545
            )
            
            3,601
            
            
            (6,200
            )
            
            887





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




34


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





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 the development of 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 2007. Our independent auditors
      included an explanatory paragraph in their audit report related to our
      consolidated financial statements for the fiscal year ended December 31,
      2006 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*TM* ’ (ISV-401), a DuraSite formulation of azithromycin, to serve as a broad spectrum
      ocular antibiotic; and




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





In
      June
      2006, we completed the compilation and assembly of an AzaSite NDA, and submitted
      the documentation to the FDA. Based on the FDA’s Prescription Drug User Fee Act,
      or PDUFA, we anticipate a ruling by the FDA on the potential approval of AzaSite
      by the end of April 2007.





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 equity and debt securities, issuance
      of
      convertible debentures, collaborative agreements and bridge loans.





**Recent
      Developments**





On
      February 15, 2007, we entered into a worldwide, exclusive, royalty-bearing
      licensing agreement with Pfizer, under Pfizer’s patent family titled “Method of
      Treating Eye Infections with Azithromycin” for ocular anti-infective product
      candidates known as AzaSite and AzaSite Plus. Under the Pfizer License, we
      are
      required to pay Pfizer a single digit royalty based on net sales of
      the licensed products and to use reasonable commercial efforts to seek
      regulatory approval for and market licensed products. We can grant sublicenses
      under the Pfizer License, subject to Pfizer’s prior approval, which the Pfizer
      License provides shall not be unreasonably withheld.





On
      February 15, 2007, we entered into a license agreement with Inspire, under
      which
      we licensed to Inspire exclusive development and commercialization rights,
      under
      our AzaSiteTM patent rights and certain know-how, for topical anti-infective
      products containing azithromycin as the sole active ingredient for human ocular
      or ophthalmic indications in the Territory. The Inspire License also provides
      for nonexclusive licenses under our DuraSite® patent rights, container patent
      rights, Columbia patent rights and certain know-how in the same field of use
      as
      described above as well as an exclusive sublicense under the Pfizer patent
      rights that we have licensed under the Pfizer License discussed above.




35


Upon
      the
      closing of the Inspire License, Inspire paid us an upfront license fee of $13
      million and is obligated to pay us an additional $19 million upon regulatory
      approval and the approval of an acceptable label for any Subject Product by
      the FDA. The royalty rate will be 20% of net sales in the first two years of
      commercialization and 25% thereafter. For five years after the first year of
      commercial sale, Inspire is required to pay us the greater of the running
      royalty discussed above or certain tiered minimum royalties. The royalties
      from Inspire are subject to certain reductions, but will in no event fall below
      a low single digit royalty based on applicable net sales.




We
      also
      entered into a trademark license agreement with Inspire on February 15, 2007
      under which we granted to Inspire an exclusive license to the AzaSiteTM trademark
      and domain name and a nonexclusive license to the DuraSite® trademark in
      connection with the commercialization of AzaSite and other subject products
      in
      the Territory under the terms of the Inspire License.





We
      also
      entered into a supply agreement with Inspire on February 15, 2007 for the active
      pharmaceutical ingredient azithromycin. We had previously entered into a third
      party supply agreement for the production of such active ingredient. Under
      the
      Supply Agreement, we agreed to supply Inspire’s requirements of such active
      ingredient, pursuant to certain forecasting and ordering procedures.





On
      December 22, 2006, the holders of our Senior Notes extended the maturity date
      under such Senior Notes from December 30, 2006 to February 15, 2007. On February
      15, 2007, we redeemed and repaid in full the $7,325,739 in principal and
      interest due under our Senior Notes. Such funds were paid from a portion of
      the
      upfront license fee we received under the Inspire License. In connection with
      the redemption and cancellation of our Senior Notes, all liens on our assets,
      including our intellectual property, were automatically released and all of
      our
      obligations to the holders of the Senior Notes under the Amended and Restated
      Security Agreement, dated as of December 30, 2005 and the Intercreditor and
      Collateral Agency Agreement, dated as of December 30, 2005 were terminated.
      Of
      such Senior Notes redeemed, $231,000 in aggregate principal amount was held
      by
      our Chief Executive Officer. We also redeemed and cancelled that certain amended
      and restated promissory note dated as of December 30, 2005, with an aggregate
      principal amount of $35,000 issued to our Vice President, Finance and
      Administration.





In
      February 2007, we announced that preliminary safety data showed that AzaSite
      Plus was well tolerated. No serious adverse events were reported.
      Treatment-related ocular adverse events were minimal in frequency and equivalent
      between the two groups. There were no significant differences in intraocular
      pressure between the AzaSite Plus group and placebo group after 14 days of
      treatment.





**Reclassifications**





In
      2006,
      we changed our classification of patent costs to be a selling, general and
      administrative expense, which had previously been classified as a research
      and
      development expense. This is consistent with Statement of Financial Accounting
      Standard (“SFAS”) No. 2 on Research and Development costs. SFAS No. 2 requires
      that research and development costs exclude legal work in connection with patent
      applications, litigation and the sale or licensing of patents. We made the
      change to better reflect the expenses incurred related to active research and
      development activities as legal expenses which are more administrative in nature
      and accordingly should be charged to selling, general and administrative
      expense. The impact of this change on our previously reported research and
      development and selling, general and administrative expenses in the years ended
      December 31, 2005 and 2004 is as follows:




36





Year
                ended
            
            Year
                ended(in
                thousands)
            
            December
                31, 2005
            
            December
                31, 2004Research
                and development as previously reported
            
            $
            11,321
            
            $
            7,273Reclassification
                of patent expense
            
            
            (631
            )
            
            (485
            )Research
                and development
            
            $
            10,690
            
            $
            6,788Selling,
                general and administrative as previously reported
            
            $
            3,879
            
            $
            3,341Reclassification
                of patent expense
            
            
            631
            
            
            485Selling,
                general and administrative
            
            $
            4,510
            
            $
            3,826




**Critical
      Accounting Policies and Use of Estimates**





The
      preparation of financial statements in conformity with generally accepted
      accounting principles in the United
      States 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 year ended 2004, 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.





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




37


Stock-Based
      Compensation. Our
      stock-based compensation programs consist of stock options granted to employees
      as well as our employee stock purchase plan, or ESPP.





Effective
      January 1, 2006, we adopted the provisions of Statement of Financial Accounting
      Standards (“SFAS”) No. 123 (revised 2004) “Share-Based Payment” (“SFAS No.
      123 (R)”). SFAS No. 123 (R) establishes accounting for stock-based
      awards exchanged for employee services. Accordingly, stock-based compensation
      cost is measured at the grant date, based on the fair value of the award, and
      is
      recognized as expense over the requisite service period. All of our stock
      compensation is accounted for as an equity instrument. We previously applied
      Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock
      Issued to Employees,” and related interpretations and provided the required pro
      forma disclosures of SFAS No. 123, “Accounting for Stock-Based
      Compensation”.





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, our inventory solely consisted of
      Ocu G ene
      kits
      which are considered finished goods.





**Results
      of Operations**





*Revenues.*




We
      had
      total net revenues of $2,000, $4,000, and $542,000 for the years ended December
      31, 2006, 2005 and 2004, respectively, from contract research activities and
      sales of Ocu G ene.
      Our
      revenue in 2004 was due to contract research activities conducted for Bausch
      & Lomb in 2004 under the ISV-403 Asset Purchase Agreement. We are no longer
      providing services to Bausch & Lomb and we do not expect to derive revenue
      from these activities in 2007 or future years.





*Cost
      of goods.*




Our
      cost
      of goods of $28,000, $14,000 and $14,000 for 2006, 2005 and 2004, 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, net.*




Net
      research and development expenses decreased to $8.9 million in 2006 from $10.7
      in 2005. Costs related to clinical research organizations and the
      microbiological testing related to our AzaSite Phase 3 clinical trials decreased
      approximately 71% due to the completion of the trials in January 2006. Costs
      related to additional headcount, consultants and temporary labor to assist
      with
      the preparation of the AzaSite NDA and to file the AzaSite Plus IND offset
      these
      expense decreases. Preclinical costs related to the AzaSite Plus program, the
      manufacture of the AzaSite Plus Phase 1 clinical trial supplies and preparation
      to manufacture AzaSite Phase 3 clinical units at our contract manufacturing
      site
      also partially offset this decrease in external clinical costs in 2006.
      Additionally, in 2006 we incurred approximately $245,000 of non-cash expense
      related to the adoption of FAS 123R and the expensing of options granted to
      employees and our employee stock purchase plan.





Research
      and development expenses increased to $10.7 million in 2005 from $6.8 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 NDA.




38


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 2006, 2005 and 2004 (in thousands):





2006
            
            2005
            
            2004Research
            
            $
            3,291
            
            $
            2,142
            
            $
            2,390Clinical
                development
            
            
            5,599
            
            
            8,548
            
            
            4,398Total
                research and development
            
            $
            8,890
            
            $
            10,690
            
            $
            6,788





Although
      the majority of our personnel were focused on our AzaSite program in 2006,
      due
      to our limited personnel and the number of projects that we are developing
      including our AzaSite Plus program, 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
      increase in research activities in 2006 compared to 2005 mainly reflected
      activities to support the filing of the AzaSite NDA, preparation for commercial
      manufacture of AzaSite, preclinical testing to support the AzaSite Plus IND,
      manufacture of AzaSite Plus Phase 1 clinical units and preparation for
      manufacture of Phase 3 AzaSite Plus clinical units at our contract manufacturing
      site. 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
      decrease in clinical development expenses in 2006 as compared to 2005 reflects
      the completion of the AzaSite Phase 3 clinical trials early in the year. This
      reduction was partially offset by the increase in headcount, consultants and
      outside services, primarily in the regulatory departments, to support the
      preparation and filing of our AzaSite NDA. Additionally, in 2006 we filed our
      AzaSite Plus IND and conducted a Phase 1 clinical trial. The cost of such a
      trial is significantly less than a Phase 3 trial mainly due to the few number
      of
      patients included in a Phase 1 trial. The majority of the increase from 2004
      to
      2005 is related to our AzaSite Phase 3 clinical trials which were initiated
      in
      2004.





Other
      than AzaSite, 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 $6.2 million in 2006 from
      $4.5
      million in 2005. This increase mainly reflects the amortization of deferred
      debt
      issuance costs related to our short-term Senior Secured Notes, consulting costs
      related to compliance with Section 404 of the Sarbanes-Oxley Act of 2002 and
      approximately $565,000 of non-cash expense related to the adoption of FAS 123R
      and the expensing of options granted to directors and employees and our employee
      stock purchase plan.





Selling,
      general and administrative expenses increased to $4.5 million in 2005 from
      $3.8
      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.




39




*Interest
      (expense) and other income,
      net.*




Interest
      (expense) and other income, net was an expense of $1.5 million, $5,000 and
      $44,000 in 2006, 2005 and 2004, respectively. The increased expense in 2006
      mainly reflects accrued interest payable on our short-term Senior Secured Notes
      issued in December 2005 and January 2006 and the accretion of the value of
      the
      debt discount related to the warrants issued as part of the note financing.
      The
      decrease in 2005 from 2004 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. Any interest earned
      or paid in the future will be dependent on our ability to raise additional
      funding or execute collaborative or other partnering agreements 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, 2006, our unrestricted cash and cash equivalents were $1.0 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,
      including under the Inspire License, asset sales, or other sources, we expect
      that our cash on hand, including cash received from the Inspire License in
      February 2007, a refund of approximately $767,000 from the FDA related to our
      AzaSite NDA filing, 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 2007. If we are unable to secure sufficient
      additional funding prior to that time, we will need to cease operations and
      liquidate our assets. 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 2007, we will require and will
      seek additional funding through collaborative or other partnering arrangements,
      public or private equity or debt financings 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 likely 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. If we raise funds through one or more equity
      offerings, our stockholders may suffer substantial dilution.





For
      the
      years ended December 31, 2006, 2005 and 2004, cash used for operating activities
      was $16.2 million, $13.4 million and $10.0 million, respectively. Cash used
      in
      investing activities was $322,000, $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. ****





Cash
      provided by financing activities was $13.5 million, $12.2 million and $14.5
      million for the years ending December 31, 2006, 2005 and 2004, respectively.
      In
      2006 we received net proceeds of $5.8 million from the exercise of warrants,
      options and stock purchases under our employee stock purchase plan compared
      to
      $536,000 and $14,000 in 2005 and 2004, respectively.




The
        tables below set forth the amount of cash that we raised for fiscal years
        2004
        through 2006 from warrant and option exercises, stock purchases under our
        employee stock purchase plan, equity financings and debt
        financings.
 
 *Cash
        Received from Warrant and Option Exercises and Employee Stock Purchase
        Plan*
 
 Year
              Net
                  Proceeds2006
              $5.8
                  million2005
              $536,0002004
              $14,000
 
 *Cash
        Received from Private Placements of Equity Securities*
 
 Date
              Net
                  Proceeds
              Shares
                  of Common Stock IssuedAugust
                  2006
              $5.8
                  million
              4.8
                  million plus warrants to purchase 1.0 million sharesMay
                  2005
              $8.1
                  million
              16.4
                  million plus warrants to purchase 4.9 million sharesMarch
                  2004
              $15.1
                  million
              33.0
                  million plus warrants to purchase 16.5 million
                  shares
 
 *Cash
        Received from Private Placement of Notes*
 
 Date
              Net
                  Proceeds
              Type
                  of Notes
              Interest
                  Rates and Terms
              
              Maturity
                  DateJanuary
                  2006
              $1.8
                  million
              Short-Term
                  Senior Secured Notes
              10%
                  through July 10, 2006, 12% from July 11, 2006 through February
                  15,
                  2007
              
              February
                  15, 2007 *December
                  2005
              $3.8
                  million
              Short-Term
                  Senior Secured Notes
              10%
                  through June 30, 2006, 12% from July 1, 2006 through February 15,
                  2007
              
              February
                  15, 2007 *
 
 *
        On
        February 15, 2007, we repaid and redeemed all outstanding principal and interest
        due under such Notes.


In
      addition to the above, 2005 and 2004 we repaid $73,000 and $621,000,
      respectively, of short-term notes payable to directors, members of senior
      management and other stockholders, which bear interest at rates from 2% to
      12%
      and are due March 31, 2007. We received payments on a note to a stockholder
      of
      $168,000, $19,000, and $21,000 in 2006, 2005 and 2004, respectively. We also
      made $10,000 and $13,000 of payments on capital leases for certain laboratory
      equipment in 2006 and 2004, respectively.




40


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, AzaSite Plus, 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 2007. 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, 2006 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.





41





Payments
                due by period
              (in
                thousands)Total
            
            Less
                than
              1
                year
            
            1
                -
                3
              years
            
            3
                -
                5
              Years
            
            More
                than
              5
                yearsCapital
                Lease Obligations (1)
            
            $
            75
            
            $
            18
            
            $
            35
            
            $
            22
            
            $
            -Facilities
                Lease Obligations (2)
            
            
            4,285
            
            
            559
            
            
            1,170
            
            
            1,240
            
            
            1,316Purchase
                obligations (3)
            
            
            676
            
            
            676
            
            
            -
            
            
            -
            
            
            -Licensing
                agreement obligations (4)
            
            
            220
            
            
            20
            
            
            40
            
            
            40
            
            
            120Notes
                Payable (5)
            
            
            6,566
            
            
            6,566Accrued
                Interest (6)
            
            
            702
            
            
            702
            
            
            -
            
            
            -
            
            
            -Total
                commitments
            
            $
            12,524
            
            $
            8,541
            
            $
            1,245
            
            $
            1,302
            
            $
            1,436





(1)
            We
                lease our telephones and telephone equipment under two capital lease
                agreements, which expire in 2011.




(2)
            We
                lease our facilities under a non-cancelable operating lease that
                expires
                in 2013.




(3)
            Purchase
                obligations include commitments related to clinical development,
                consulting contracts, equipment maintenance, and other significant
                purchase commitments.




(4)
            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 that 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.




(5)
            We
                repaid these notes in full in February 2007. See further discussion
                of our
                debt issuances above in
“Liquidity.”




(6)
            We
                have accrued interest related to our Notes Payable. This interest
                was paid
                in February 2007 when the related Notes were repaid in
                full.





**Recent
      Accounting Pronouncements**





In
      February 2006, the FASB issued Statement of Financial Accounting Standards
      No. 155, *Accounting
      for Certain Hybrid Financial Instruments — an amendment of FASB Statements
      No. 133 and 140* (SFAS
      No. 155). SFAS No. 155 permits an entity to measure at fair value any
      financial instrument that contains an embedded derivative that otherwise would
      require bifurcation. This statement is effective for all financial instruments
      acquired, issued, or subject to a remeasurement event occurring after the
      beginning of an entity’s first fiscal year that begins after September 15,
      2006, which is our fiscal year 2007. We do not expect the adoption of SFAS
      No. 155 to have a material impact on our consolidated financial statements.





In
      June 2006, the FASB issued FASB Interpretation No. (FIN) 48, *Accounting
      for Uncertainty in Income Taxes — An Interpretation of FASB Statement
      No. 109* (FIN48),
      which prescribes a recognition threshold and measurement attribute for the
      financial statement recognition and measurement of a tax position taken or
      expected to be taken in a tax return. FIN 48 will be effective for fiscal years
      beginning after December 15, 2006, which is our fiscal year 2007. We are
      currently in the process of evaluating the potential impact of adopting FIN
      48
      on our consolidated financial statements.




In
      September 2006, the FASB issued Statement of Financial Accounting Standards
      No. 157, *Fair
      Value Measurements* (SFAS
      No. 157), which defines fair value, establishes a framework for measuring
      fair value under GAAP, and expands disclosures about fair value measurements.
      SFAS No. 157 will be effective for fiscal years beginning after
      November 15, 2007, which is our fiscal year 2008. We have not yet evaluated
      the potential impact of adopting SFAS No. 157 on our consolidated financial
      statements.




In
      September 2006, the FASB issued Statement of Financial Accounting Standards
      No. 158, *Employers’
      Accounting for Pensions and Other Postretirement Benefits* (SFAS
      No. 158). SFAS No. 158 requires employers to recognize on their
      balance sheet an asset or liability equal to the over- or under-funded benefit
      obligation of each defined benefit pension and other postretirement plan and
      to
      recognize as a component of other comprehensive income, net of tax, the gains
      or
      losses and prior service costs or credits that arise during the period but
      are
      not recognized as components of net periodic benefit cost. Amounts recognized
      in
      accumulated other comprehensive income, including the gains or losses, prior
      service costs or credits, and the transition asset or obligation remaining
      from
      the initial application of (i) FASB Statement No. 87, *Employers’
      Accounting for Pensions* and
      (ii) FASB Statement No. 106, *Employers’
      Accounting for Postretirement Benefits Other Than Pensions* ,
      are
      adjusted as they are subsequently recognized as components of net periodic
      benefit cost pursuant to the recognition and amortization provisions of those
      statements. This change in balance sheet reporting is effective for fiscal
      years
      ending after December 15, 2006 for public companies, which is our fiscal
      year 2006. SFAS No. 158 also eliminates the ability to use an early
      measurement date, commencing with fiscal years ending after December 15,
      2008, which is our fiscal year 2008. The adoption of SFAS No. 158 did not
      have a material impact on our December 31, 2006 consolidated financial
      statements.




42


In
      September 2006, the SEC issued Staff Accounting Bulletin No. 108 (“SAB
      108”), “Considering the Effects of Prior Year Misstatements when Quantifying
      Misstatements in Current Year Financial Statements.” SAB 108 is effective for
      fiscal years ending on or after November 15, 2006 and addresses how
      financial statement errors should be considered from a materiality perspective
      and corrected. The literature provides interpretive guidance on how the effects
      of the carryover or reversal of prior year misstatements should be considered
      in
      quantifying a current year misstatement. Historically there have been two common
      approaches used to quantify such errors: (i) the “rollover” approach, which
      quantifies the error as the amount by which the current year income statement
      is
      misstated, and (ii) the “iron curtain” approach, which quantifies the error
      as the cumulative amount by which the current year balance sheet is misstated.
      The SEC Staff believes that companies should quantify errors using both
      approaches and evaluate whether either of these approaches results in
      quantifying a misstatement that, when all relevant quantitative and qualitative
      factors are considered, is material. We adopted the provisions of SAB 108 in
      our
      2006 fourth fiscal quarter and it had no impact on our consolidated financial
      statements.





In
      February 2007, the FASB issued FASB Statement No. 159, “The Fair Value Option
      for Financial Assets and Financial Liabilities—Including an amendment of FASB
      Statement No. 115” (“SFAS 159”). SFAS 159 creates a “fair value option” under
      which an entity may elect to record certain financial assets or liabilities
      at
      fair value upon their initial recognition. Subsequent changes in fair value
      would be recognized in earnings as those changes occur. The election of the
      fair
      value option would be made on a contract-by contract basis and would need to
      be
      supported by concurrent documentation or a preexisting documented policy. SFAS
      159 requires an entity to separately disclose the fair value of these items
      on
      the balance sheet or in the footnotes to the financial statements and to provide
      information that would allow the financial statement user to understand the
      impact on earnings from changes in the fair value. SFAS 159 is effective for
      us
      beginning with fiscal year 2008. We are currently evaluating the impact that
      the
      adoption of SFAS 159 will have on our consolidated financial
      statements.





**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, 2006, we had $1.0 million invested in interest bearing operating accounts.
      While a hypothetical decrease in market interest rates by 10 percent from the
      December 31, 2006 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.




43


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





The
      following Consolidated Financial Statements and Report of Independent Registered
      Public Accounting Firm are included on the pages that follow:





PageReport
                of Independent Registered Public Accounting Firm
            
            
            45Consolidated
                Balance Sheets - December 31, 2006 and 2005
            
            
            46Consolidated
                Statements of Operations for theYears
                Ended December 31, 2006, 2005 and 2004
            
            
            47Consolidated
                Statements of Stockholders' Equity (Deficit) for theYears
                ended December 31, 2006, 2005 and 2004
            
            
            48Consolidated
                Statements of Cash Flows for theYears
                Ended December 31, 2006, 2005 and 2004
            
            
            49
                - 50Notes
                to the Consolidated Financial Statements
            
            
            51
                - 67





44


**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 and its subsidiaries (the “Company”) as of December 31, 2006
      and 2005, and the related consolidated statements of operations, stockholders’
equity (deficit), and cash flows for each of the three years in the period
      ended
      December 31, 2006. These 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
      and its subsidiary as of December 31, 2006 and 2005, and the results of
      their operations and their cash flows for each of the three years in the period
      ended December 31, 2006, in conformity with accounting principles generally
      accepted in the United States of America.





As
      discussed in Note 1 to the consolidated 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 2006 consolidated financial statements do not include
      any adjustments that might result from the outcome of this uncertainty.





As
      discussed in Note 1 and Note 10 to the consolidated financial statements, on
      January 1, 2006 the Company changed its method of accounting for stock-based
      compensation as a result of adopting Statement of Financial Accounting Standards
      No. 123 (revised 2004), “Share-Based Payment” applying the modified prospective
      method.





We
      also
      have audited, in accordance with the standards of the Public Company Accounting
      Oversight Board (United States), the effectiveness of the Company’s internal
      control over financial reporting as of December 31, 2006, based on criteria
      established in Internal Control — Integrated Framework issued by the
      Committee of Sponsoring Organizations of the Treadway Commission and our report
      dated March 15, 2007 expressed an unqualified opinion on management’s
      assessment of, and the effective operation of, internal control over financial
      reporting.


/s/  BURR,
                  PILGER, &
                  MAYERLLPPalo
                Alto, California
                March 15,
                  2007





45





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




December
                31,(in
                thousands, except share and per share amounts)
            
            2006
            
            2005**Assets**Current
                assets:Cash
                and cash equivalents
            
            $
            986
            
            $
            4,027Restricted
                cash and cash equivalents
            
            
            75
            
            
            75Inventory
            
            
            -
            
            
            17Deferred
                debt issuance cost
            
            
            22
            
            
            614Prepaid
                expenses and other current assets
            
            
            795
            
            
            81Total
                current assets
            
            
            1,878
            
            
            4,814Property
                and equipment, at cost:Laboratory
                and other equipment
            
            
            580
            
            
            313Leasehold
                improvements
            
            
            5
            
            
            73Furniture
                and fixtures
            
            
            77
            
            
            10662
            
            
            396Accumulated
                depreciation
            
            
            101
            
            
            131561
            
            
            265Total
                assets
            
            $
            2,439
            
            $
            5,079**Liabilities
                and stockholders’ deficit**Current
                liabilities:Short-term
                notes payable to related parties, unsecured
            
            $
            35
            
            $
            35Short-term
                notes payable to related parties, secured
            
            
            231
            
            
            231Short-term
                notes payable, secured, (net of debt discount of $0 atDecember
                31, 2006 and $491 at December 31, 2005)
            
            
            6,300
            
            
            3,809Current
                portion of capital lease obligation
            
            
            12
            
            
            -Accrued
                interest
            
            
            702
            
            
            3Accounts
                payable
            
            
            377
            
            
            1,941Accrued
                liabilities
            
            
            381
            
            
            1,167Accrued
                compensation and related expense
            
            
            648
            
            
            388Deferred
                rent
            
            
            6
            
            
            50Total
                current liabilities
            
            
            8,692
            
            
            7,624Capital
                lease obligation, less current portion
            
            
            49
            
            
            -Total
                liabilities
            
            
            8,741
            
            
            7,624**Stockholders
                deficit**Preferred
                stock, $0.01 par value, 5,000,000 shares authorized, noneissued
                and outstanding at December 31, 2006 and 2005
            
            
            -
            
            
            -Common
                stock, $0.01 par value, 240,000,000 and 120,000,000 sharesauthorized
                at December 31, 2006 and 2005, respectively;93,284,934
                issued and outstanding at December 31, 2006;79,614,806
                issued and outstanding at December 31, 2005
            
            
            933
            
            
            796Additional
                paid-in capital
            
            
            145,827
            
            
            133,278Notes
                receivable from stockholder
            
            
            -
            
            
            (168
            )Accumulated
                deficit
            
            
            (153,062
            )
            
            (136,451
            )Common
                stockholders’ deficit
            
            
            (6,302
            )
            
            (2,545
            )Total
                liabilities and stockholders’ deficit
            
            $
            2,439
            
            $
            5,079




*See
                accompanying notes to consolidated financial
                statements.*




46





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




Year
                Ended December 31,(in
                thousands, except per share amounts)
            
            
            2006
            
            
            2005
            
            
            2004Revenues
            
            $
            2
            
            $
            4
            
            $
            542Cost
                of revenue
            
            
            28
            
            
            14
            
            
            14Gross
                margin
            
            
            (26
            )
            
            (10
            )
            
            528Operating
                expenses:Research
                and development (a)
            
            
            8,890
            
            
            10,690
            
            
            6,788Selling,
                general and administrative (a)
            
            
            6,182
            
            
            4,510
            
            
            3,826Total
            
            
            15,072
            
            
            15,200
            
            
            10,614Loss
                from operations
            
            
            (15,098
            )
            
            (15,210
            )
            
            (10,086
            )Gain
                on sale of assets
            
            
            -
            
            
            -
            
            
            4,616Interest
                (expense) and other income, net
            
            
            (1,513
            )
            
            (5
            )
            
            (44
            )Net
                loss
            
            $
            (16,611
            )
            $
            (15,215
            )
            $
            (5,514
            )Net
                loss per share - basic and diluted
            
            $
            (0.19
            )
            $
            (0.21
            )
            $
            (0.11
            )Shares
                used to calculate basic and diluted net loss per share
            
            
            88,339
            
            
            72,647
            
            
            47,984(a)
                Includes the following amounts related to stock based
                compensation:Research
                and development
            
            $
            245
            
            $
            -
            
            $
            -Selling,
                general and administrative
            
            
            565
            
            
            -
            
            
            -$
            810
            
            $
            -
            
            $
            -




*See
                accompanying notes to consolidated financial
                statements.*





47


**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,
                December 31, 2003**
            
            **$**
            **-**
            
            **$**
            **293**
            
            **$**
            **109,437**
            
            **$**
            **(208**
            **)**
            **$**
            **(115,722**
            **)**
            **$**
            **(6,200**
            **)**Issuance
                of 19,623 shares of common stock from exercise of options and employee
                stock purchase plan
            
            
            -
            
            
            -
            
            
            12
            
            
            -
            
            
            -
            
            
            12Issuance
                of 33,000,000 shares of common stock from private
                placement
            
            
            -
            
            
            330
            
            
            14,781
            
            
            -
            
            
            -
            
            
            15,111Non-employee
                stock compensation
            
            
            -
            
            
            -
            
            
            96
            
            
            -
            
            
            -
            
            
            96**Issuance
                of 2,940 shares of common stock**from exercise of warrants
            
            
            -
            
            
            **-**
            
            
            2
            
            
            -
            
            
            -
            
            
            2Loan
                payment from stockholder
            
            
            **-**
            
            
            **-**
            
            
            **-**
            
            
            21
            
            
            **-**
            
            
            21Issuance
                of 105,951 shares of common stock from conversion of notes
                payable
            
            
            -
            
            
            1
            
            
            72
            
            
            -
            
            
            -
            
            
            73Net
                loss
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            (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 stock from exercise of options and employee
                stock purchase plan
            
            
            -
            
            
            -
            
            
            33
            
            
            -
            
            
            -
            
            
            33Issuance
                of 803,725 shares of common stock from exercise of
                warrants
            
            
            -
            
            
            8
            
            
            495
            
            
            -
            
            
            -
            
            
            503Issuance
                of 16,363,626 shares of common stock from private
                placement
            
            
            -
            
            
            164
            
            
            7,978
            
            
            -
            
            
            -
            
            
            8,142Non-employee
                stock compensation
            
            
            -
            
            
            -
            
            
            14
            
            
            -
            
            
            -
            
            
            14Loan
                payment from stockholder
            
            
            -
            
            
            -
            
            
            -
            
            
            19
            
            
            -
            
            
            19**Issuance
                of warrants in connection with**private
                placement of notes payable
            
            
            -
            
            
            -
            
            
            620
            
            
            -
            
            
            -
            
            
            620Net
                loss
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            (15,215
            )
            
            (15,215
            )**Balances,
                December 31, 2005**
            
            
            **-**
            
            
            **796**
            
            
            **133,278**
            
            
            **(168**
            **)**
            
            **(136,451**
            **)**
            
            **(2,545**
            **)**Issuance
                of 203,920 shares of common stock from exercise of options and employee
                stock purchase plan
            
            
            -
            
            
            2
            
            
            131
            
            
            -
            
            
            -
            
            
            133Issuance
                of 8,676,132 shares of common stock from exercise of warrants,
                net
            
            
            -
            
            
            87
            
            
            5,539
            
            
            -
            
            
            -
            
            
            5,626Issuance
                of 4,790,076 shares of common stock from private placement
            
            
            
            
            
            48
            
            
            5,762
            
            
            
            
            
            
            
            
            5,810**Issuance
                of warrants in connection with**private
                placement of notes payable
            
            
            -
            
            
            -
            
            
            307
            
            
            -
            
            
            -
            
            
            307Loan
                payment from stockholder
            
            
            -
            
            
            -
            
            
            -
            
            
            168
            
            
            -
            
            
            168Non-employee
                stock compensation
            
            
            -
            
            
            -
            
            
            6
            
            
            -
            
            
            -
            
            
            6Employee
                stock compensation
            
            
            -
            
            
            -
            
            
            804
            
            
            -
            
            
            -
            
            
            804Net
                loss
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            (16,611
            )
            
            (16,611
            )**Balances,
                December 31, 2006**
            
            **$**
            **-**
            
            **$**
            **933**
            
            **$**
            **145,827**
            
            **$**
            **-**
            
            **$**
            **(153,062**
            **)**
            **$**
            **(6,302**
            **)**




48





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




Year
                Ended December 31,(in
                thousands)
            
            2006
            
            2005
            
            2004**Operating
                activities:**Net
                loss
            
            $
            (16,611
            )
            $
            (15,215
            )
            $
            (5,514
            )Adjustments
                to reconcile net loss to net cash used in operating
                activities:Depreciation
                and amortization
            
            
            97
            
            
            57
            
            
            176Stock-based
                compensation
            
            
            810
            
            
            14
            
            
            96Gain
                on sale of asset
            
            
            -
            
            
            (4
            )
            
            (4,616
            )Amortization
                of deferred debt issuance costs
            
            
            809
            
            
            -
            
            
            1Accretion
                of debt discount
            
            
            798
            
            
            -
            
            
            -Changes
                in:Inventories,
                prepaid expenses and other current assets
            
            
            (697
            )
            
            (9
            )
            
            21Accrued
                interest
            
            
            699
            
            
            -
            
            
            20Accounts
                payable
            
            
            (1,564
            )
            
            1,367
            
            
            (398
            )Accrued
                liabilities
            
            
            (786
            )
            
            380
            
            
            142Accrued
                compensation and related expense, and deferred rent
            
            
            216
            
            
            46
            
            
            49Net
                cash used in operating activities
            
            
            (16,229
            )
            
            (13,364
            )
            
            (10,023
            )**Investing
                activities:**Purchases
                of property and equipment
            
            
            (322
            )
            
            (236
            )
            
            (13
            )Proceeds
                from sale of asset
            
            
            -
            
            
            4
            
            
            -Restricted
                cash decrease (increase)
            
            
            -
            
            
            95
            
            
            (170
            )Net
                cash used in investing activities
            
            
            (322
            )
            
            (137
            )
            
            (183
            )**Financing
                activities:**Payment
                of capital lease obligation
            
            
            (10
            )
            
            -
            
            
            (13
            )Note
                payment received from stockholder
            
            
            168
            
            
            19
            
            
            21Payments
                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
            
            
            1,783
            
            
            3,815
            
            
            -Issuance
                of common stock from exercise of options, employee stock
              Purchase
                plan and warrants, net of issuance costs
            
            
            5,759
            
            
            536
            
            
            14Issuance
                of common stock from private placement, net of issuance
                costs
            
            
            5,810
            
            
            8,142
            
            
            15,111Net
                cash provided by financing activities
            
            
            13,510
            
            
            12,177
            
            
            14,512Net
                decrease in cash andcashequivalents
            
            
            (3,041
            )
            
            (1,324
            )
            
            4,306Cash
                and cash equivalents, beginning of year
            
            
            4,027
            
            
            5,351
            
            
            1,045Unrestricted
                cash and cash equivalents, end of year
            
            $
            986
            
            $
            4,027
            
            $
            5,351




49





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




Year
                Ended December 31,(continued,
                in thousands)
            
            2006
            
            2005
            
            2004Supplemental
                cash flow information:Cash
                paid for interest
            
            $
            16
            
            $
            2
            
            $
            11Taxes
                paid
            
            $
            1
            
            $
            1
            
            $
            1Non
                cash investing and financing activities:Conversion
                of debentures and interest payable to common stock
            
            $
            -
            
            $
            -
            
            $
            73Issuance
                of warrants to lenders in connection with note payable
            
            $
            307
            
            $
            491
            
            $
            -Issuance
                of warrants to placement agent in connection with notes
                payable
            
            $
            -
            
            $
            129
            
            $
            -Acquisition
                of property and equipment through capital lease
            
            $
            71
            
            $
            -
            
            $
            -




*See
                accompanying notes to consolidated financial
                statements.*




50




**InSite
      Vision Incorporated**





Notes
      to
      Consolidated Financial Statements


December
      31, 2006





**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 $16.6 million for the year ended December 31, 2006,
      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 $16.2 million for the year ended
      December 31, 2006. As of December 31, 2006, the Company had an accumulated
      deficit of $153.1 million and a cash and cash equivalents balance of $1.0
      million. In these circumstances the Company believes it may not have enough
      cash
      to meet its various cash needs for fiscal 2007 unless the Company is able to
      obtain additional cash from reaching a milestone related to a licensing
      agreement (see Note 13, Subsequent Events), sales of debt or equity securities,
      new license or collaborative agreements or exercise of outstanding warrants.
       There is no assurance that the milestone will be reached or additional
      funds from sales of equity or debt securities or from 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 the risk that the Company will cease operations at or around the end
      of
      June 2007 if additional funding is not obtained. All of the statements set
      forth
      in this report are qualified by reference to those facts.





**Reclassifications**





In
      2006,
      the Company changed its classification of patent costs to be a selling, general
      and administrative expense, which had previously been classified as a research
      and development expense. This is consistent with Statement of Financial
      Accounting Standard (“SFAS”) No. 2 on Research and Development costs. SFAS No. 2
      requires that research and development costs exclude legal work in connection
      with patent applications, litigation and the sale or licensing of patents.
      The
      Company made the change to better reflect the expenses incurred related to
      active research and development activities as legal expenses which are more
      administrative in nature and accordingly should be charged to selling, general
      and administrative expense. The impact of this change on the Company’s
      previously reported research and development and selling, general and
      administrative expenses in the years ended December 31, 2005 and 2004 is as
      follows:




Year
                ended
            
            Year
                ended(in
                thousands)
            
            December
                31, 2005
            
            December
                31, 2004Research
                and development as previously reported
            
            $
            11,321
            
            $
            7,273Reclassification
                of patent expense
            
            
            (631
            )
            
            (485
            )Research
                and development
            
            $
            10,690
            
            $
            6,788Selling,
                general and administrative as previously reported
            
            $
            3,879
            
            $
            3,341Reclassification
                of patent expense
            
            
            631
            
            
            485Selling,
                general and administrative
            
            $
            4,510
            
            $
            3,826




51




Certain
      other prior year balance sheet and cash flow amounts have been reclassified
      to
      conform to the current financial statement presentation. These reclassifications
      had no impact on previously reported results of operations or stockholders’
equity.





**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 the Company
      to
      make estimates and assumptions that affect the amounts reported in the
      consolidated financial statements and accompanying notes. Actual results could
      differ from those estimates.





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


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.





Prepaid
      expenses and other current assets.  At
      December 31, 2006, prepaid expenses included a receivable from the FDA of the
      $767,000. This receivable represents the filing fee the Company paid in June
      2006 when if filed its AzaSite New Drug Application. The FDA subsequently
      determined the fee would be waived and refunded to the Company.





Inventory .
      The
      Company’s inventories are stated at the lower of cost or market. The cost of
      inventory is based on the first-in first-out method. If the cost of inventory
      exceeds the expected market value a provision is recorded for the difference
      between cost and market. At December 31, 2005, 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 and property
      acquired under capital lease are amortized over the lives of the related leases
      or their estimated useful lives, whichever is shorter, using the straight-line
      method. The Company’s policy is to write-off our fully depreciated assets.
      Depreciation and amortization expense for the years ended December 31, 2006,
      2005 and 2004 were $97,000, $57,000 and $176,000, respectively.





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. No such impairments have been recorded
      to
      date.





The
      costs
      of repairs and maintenance are expensed as incurred.




52




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's product, the Ocu G ene
      glaucoma genetic test, is recognized when all related services have been
      rendered and collectibility is reasonably assured. Any revenue in connection
      with the Company's asset purchase agreement with Bausch & Lomb was
      recognized over the contract period. See Note 2, “Sale of Assets and Licenses:
      for further discussion on the Bausch & Lomb agreement.





Cost
      of revenue. 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. The Company recognizes such costs
      as they are incurred.





Advertising. Advertising costs are expensed as incurred. Advertising expenses for the periods
      ended December 31, 2006, 2005 and 2004 were not significant.





Stock-Based
      Compensation. Our
      stock-based compensation programs consist of stock options granted to employees
      as well as our employee stock purchase plan, or ESPP.





Effective
      January 1, 2006, the Company adopted the provisions of Statement of Financial
      Accounting Standards (“SFAS”) No. 123 (revised 2004) “Share-Based Payment”
(“SFAS No. 123 (R)”). SFAS No. 123 (R) establishes accounting for
      stock-based awards exchanged for employee services. Accordingly, stock-based
      compensation cost is measured at the grant date, based on the fair value of
      the
      award, and is recognized as expense over the requisite service period. All
      of
      the Company’s stock compensation is accounted for as an equity instrument. The
      Company previously applied Accounting Principles Board (“APB”) Opinion
      No. 25, “Accounting for Stock Issued to Employees,” and related
      interpretations and provided the required pro forma disclosures of SFAS
      No. 123, “Accounting for Stock-Based Compensation”. See Note 10, “Employee
      Stock-Based Compensation” for further discussion of employee stock-based
      compensation.





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 warrants.
      Such charges amounted to approximately $6,000, $14,000 and $96,000 in 2006,
      2005
      and 2004, respectively.




53




Net
      Loss per Share .
      Basic
      and diluted net 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 2006, 2005 and 2004 as their
      inclusion would be antidilutive.





The
      following table sets forth the computation of basic and diluted net loss per
      share:





(in
                thousands, except per share amounts)
            
            2006
            
            2005
            
            2004Numerator:Net
                loss
            
            $
            (16,611
            )
            $
            (15,215
            )
            $
            (5,514
            )Denominator:Denominator
                    for basic and diluted loss per share - weighted-average common
                    shares
                    outstanding
            
            
            88,339
            
            
            72,647
            
            
            47,984Basic
                and diluted net loss per share
            
            $
            (0.19
            )
            $
            (0.21
            )
            $
            (0.11
            )





Due
      to
      the loss applicable to common stockholders, loss per share for 2006, 2005 and
      2004 is based on the weighted average number of common shares only, as the
      effect of including equivalent shares from stock options and warrants would
      be
      anti-dilutive. At December 31, 2006, 2005 and 2004, 23,412,320, 30,253,869
      and 21,646,284 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.




54




Recent
      Accounting Pronouncements .
      In
      February 2006, the FASB issued Statement of Financial Accounting Standards
      No. 155, *Accounting
      for Certain Hybrid Financial Instruments — an amendment of FASB Statements
      No. 133 and 140* (SFAS
      No. 155). SFAS No. 155 permits an entity to measure at fair value any
      financial instrument that contains an embedded derivative that otherwise would
      require bifurcation. This statement is effective for all financial instruments
      acquired, issued, or subject to a remeasurement event occurring after the
      beginning of an entity’s first fiscal year that begins after September 15,
      2006, which is the Company’s fiscal year 2007. The Company does not expect the
      adoption of SFAS No. 155 to have a material impact on its consolidated
      financial statements.





In
      June 2006, the FASB issued FASB Interpretation No. (FIN) 48, *Accounting
      for Uncertainty in Income Taxes — An Interpretation of FASB Statement
      No. 109* (FIN48),
      which prescribes a recognition threshold and measurement attribute for the
      financial statement recognition and measurement of a tax position taken or
      expected to be taken in a tax return. FIN 48 will be effective for fiscal years
      beginning after December 15, 2006, which is the Company’s fiscal year 2007.
      The Company is currently in the process of evaluating the potential impact
      of
      adopting FIN 48 on its consolidated financial statements.




In
      September 2006, the FASB issued Statement of Financial Accounting Standards
      No. 157, *Fair
      Value Measurements* (SFAS
      No. 157), which defines fair value, establishes a framework for measuring
      fair value under GAAP, and expands disclosures about fair value measurements.
      SFAS No. 157 will be effective for fiscal years beginning after
      November 15, 2007, which is the Company’s fiscal year 2008. The Company has
      not yet evaluated the potential impact of adopting SFAS No. 157 on its
      consolidated financial statements.




In
      September 2006, the FASB issued Statement of Financial Accounting Standards
      No. 158, *Employers’
      Accounting for Pensions and Other Postretirement Benefits* (SFAS
      No. 158). SFAS No. 158 requires employers to recognize on their
      balance sheet an asset or liability equal to the over or under-funded benefit
      obligation of each defined benefit pension and other postretirement plan and
      to
      recognize as a component of other comprehensive income, net of tax, the gains
      or
      losses and prior service costs or credits that arise during the period but
      are
      not recognized as components of net periodic benefit cost. Amounts recognized
      in
      accumulated other comprehensive income, including the gains or losses, prior
      service costs or credits, and the transition asset or obligation remaining
      from
      the initial application of (i) FASB Statement No. 87, *Employers’
      Accounting for Pensions* and
      (ii) FASB Statement No. 106, *Employers’
      Accounting for Postretirement Benefits Other Than Pensions* ,
      are
      adjusted as they are subsequently recognized as components of net periodic
      benefit cost pursuant to the recognition and amortization provisions of those
      statements. This change in balance sheet reporting is effective for fiscal
      years
      ending after December 15, 2006 for public companies, which is the Company’s
      fiscal year 2006. SFAS No. 158 also eliminates the ability to use an early
      measurement date, commencing with fiscal years ending after December 15,
      2008, which is the Company’s fiscal year 2008. The Company adopted the balance
      sheet reporting provisions of SFAS No. 158 in the Company’s 2006 fourth
      fiscal quarter. Adoption of SFAS 158 did not have a material impact on our
      December 31, 2006 consolidated financial statements.





In
      September 2006, the SEC issued Staff Accounting Bulletin No. 108 (“SAB
      108”), “Considering the Effects of Prior Year Misstatements when Quantifying
      Misstatements in Current Year Financial Statements.” SAB 108 is effective for
      fiscal years ending on or after November 15, 2006 and addresses how
      financial statement errors should be considered from a materiality perspective
      and corrected. The literature provides interpretive guidance on how the effects
      of the carryover or reversal of prior year misstatements should be considered
      in
      quantifying a current year misstatement. Historically there have been two common
      approaches used to quantify such errors: (i) the “rollover” approach, which
      quantifies the error as the amount by which the current year income statement
      is
      misstated, and (ii) the “iron curtain” approach, which quantifies the error
      as the cumulative amount by which the current year balance sheet is misstated.
      The SEC Staff believes that companies should quantify errors using both
      approaches and evaluate whether either of these approaches results in
      quantifying a misstatement that, when all relevant quantitative and qualitative
      factors are considered, is material. The Company adopted the provisions of
      SAB
      108 in the Company’s 2006 fourth fiscal quarter and it had no impact on its
      consolidated financial statements.





In
      February 2007, the FASB issued FASB Statement No. 159, “The Fair Value Option
      for Financial Assets and Financial Liabilities—Including an amendment of FASB
      Statement No. 115” (“SFAS 159”). SFAS 159 creates a “fair value option” under
      which an entity may elect to record certain financial assets or liabilities
      at
      fair value upon their initial recognition. Subsequent changes in fair value
      would be recognized in earnings as those changes occur. The election of the
      fair
      value option would be made on a contract-by contract basis and would need to
      be
      supported by concurrent documentation or a preexisting documented policy. SFAS
      159 requires an entity to separately disclose the fair value of these items
      on
      the balance sheet or in the footnotes to the financial statements and to provide
      information that would allow the financial statement user to understand the
      impact on earnings from changes in the fair value. SFAS 159 is effective for
      us
      beginning with fiscal year 2008. The Company is currently evaluating the impact
      that the adoption of SFAS 159 will have on its consolidated financial
      statements.





55





**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 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.





**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, 2006, $35,000 remains outstanding. These notes bear interest at
      a
      rate of two percent (2%). In February 2007 these notes were repaid in full.




56




**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 to
      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. In July 2004,
      the
      Company repaid $169,000 of these Senior Secured Notes and the related accrued
      interest. In December 2005 the due date of the remaining note was further
      extended to March 31, 2007. The Company had $231,000 of one of these short-term
      secured notes payable to related parties outstanding at December 31, 2006.
      In
      February 2007 these notes were repaid in full.





**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 engaged for such financing. 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 103%
      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.





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 103%
      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.





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 had an original
      maturity date of June 30, 2006, but were extended for an additional six months
      at an interest rate of twelve percent (12%). In December 2006 the due date
      was
      further extended to February 15, 2007. Payments of principal and interest under
      the Notes are due in one lump sum upon the earlier of the applicable maturity
      date or an “Event of Acceleration” under the Notes. In February 2007 these notes
      were repaid in full.





The
      weighted average interest rate for the unsecured and secured notes payable
      was
      11.7% and 9.7% at December 31, 2006 and 2005, respectively.





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





At
      December 31, 2006, the Company had purchase commitments and contractual
      obligations of approximately $0.9 million, primarily related to its insurance
      coverage, minimum license fees and consultants. 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.




57




Capital
      lease obligations represent the present value of future rental payments under
      capital lease agreements for telephones and telephone equipment. The original
      cost and accumulated amortization on the equipment under capital leases was
      $71,000 and $7,000, respectively, at December 31, 2006.





Future
      minimum payments under capital leases are as follows:





Year
                ending December 31,
            
            Capital
              Leases2007
            
            $
            17,6622008
            
            
            17,6622009
            
            
            17,6612010
            
            
            17,6612011
            
            
            4,750Total
                minimum lease payments
            
            
            75,396Amount
                representing interest
            
            
            (14,241
            )Present
                value of net minimum lease payments
            
            
            61,155Current
                portion
            
            
            (12,134
            )Long-term
                portion
            
            $
            49,021





The
      Company its operations from leased facilities in Alameda, California under
      non-cancelable operating lease agreements that expire in 2013. Lease payments
      include rent and the Company’s pro-rata share of operation expenses. For
      accounting purposes, the Company is amortizing all rent payments ratably over
      the life of the lease. Future minimum lease payments under the terms of the
      amended lease agreement dated November 28, 2006 and a reconciliation of rent
      expense to rent paid is in the table below. Rent expense was $706,000, $719,000,
      and $719,000 for 2006, 2005 and 2004, respectively.





Facility
                LeaseYear
                ending December 31,
            
            Cash
                Payments Required
            
            Expense
            
            Deferred
                Rent2006
            
            $
            45,244
            
            $
            50,945
            
            $
            (5,701
            )2007
            
            
            559,300
            
            
            611,356
            
            
            (52,056
            )2008
            
            
            575,677
            
            
            611,356
            
            
            (35,679
            )2009
            
            
            594,319
            
            
            611,356
            
            
            (17,037
            )2010
            
            
            610,696
            
            
            611,356
            
            
            (660
            )2011
            
            
            629,337
            
            
            611,356
            
            
            17,981Thereafter
            
            
            1,315,864
            
            
            1,222,712
            
            
            93,152Total
                minimum lease payments
            
            $
            4,330,437
            
            $
            4,330,437




58




**8.**  **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, 2006, 2005 and 2004.





Significant
      components of the Company’s deferred tax assets for federal and state income
      taxes as of December 31, 2006 and 2005 are as follows (in
      thousands):





2006
            
            2005Deferred
                tax assets:Net
                operating loss carryforwards
            
            $
            40,614
            
            $
            35,503Tax
                credit carryforwards
            
            
            6,456
            
            
            6,038Capitalized
                research and development
            
            
            12,263
            
            
            11,016Depreciation
            
            
            398
            
            
            453Other
            
            
            95
            
            
            192Total
                deferred tax assets
            
            
            59,826
            
            
            53,202Valuation
                allowance
            
            
            (59,826
            )
            
            (53,202
            )Net
                deferred tax assets
            
            $
            -
            
            $
            -





The
      valuation allowance increased by $6.6 million, $4.4 million, and $857,000 during
      the years ended December 31, 2006, 2005 and 2004, respectively.





At
      December 31, 2006, the Company had net operating loss carryforwards for federal
      income tax purposes of approximately $106.7 million, which expire in the years
      2006 through 2025 and federal tax credits of approximately $3.4 million, which
      expire in the years 2006 through 2025. At December 31, 2006, the Company also
      has net operating loss carryforwards for state income tax purposes of
      approximately $72.1 million which expire in the years 2006 through 2015, and
      state research and development tax credits of approximately and $3.0 million
      which carryforward indefinitely.





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 may expire before ultimately becoming
      available for offset against taxable income. Additional losses and credits
      may
      be subject to limitation if the Company incurs another change in ownership
      in
      the future.





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





In
      2006,
      the Company issued 8,676,132 shares of Common Stock and received approximately
      $5,626,000, net of approximately $162,000 of fees, from the exercise of warrants
      to purchase 9,207,452 shares of Common Stock. The following table summarizes
      the
      exercises by the transaction that the warrants related to:




Warrants
                issued as part of:
            
            Exercise
                Price
            
            Net
                Cash
              Received
            
            Fees
              Incurred
            
            Warrants
              Exercised
            
            Shares
                of Common Stock IssuedMarch
                2004 private placement
            
            $
            0.75
            
            $
            5,256,000
            
            $
            162,000
            
            
            7,223,763
            
            
            7,223,763Placement
                agent warrants related to the March 2004 private placement, cashless
                exercise
            
            $
            0.55
            
            
            -
            
            
            -
            
            
            29,077
            
            
            17,719May
                2005 private placement
            
            $
            0.6325
            
            
            345,000
            
            
            -
            
            
            545,451
            
            
            545,451May
                2005 private placement, cashless exercise
            
            $
            0.6325
            
            
            -
            
            
            -
            
            
            436,361
            
            
            274,074Legal
                settlement
            
            $
            0.50
            
            
            -
            
            
            -
            
            
            922,800
            
            
            565,1252003
                services provided
            
            $
            0.50
            
            
            25,000
            
            
            -
            
            
            50,000
            
            
            50,000Total
            
            
            
            
            $
            5,626,000
            
            $
            162,000
            
            
            9,207,452
            
            
            8,676,132




59




In
      2006,
      the Company also received approximately $133,000 from the exercise of options
      to
      purchase 136,257 shares of Common Stock issued to employees and the purchase
      of
      67,663 shares under the Company’s employee stock purchase plan.





In
      August
      2006, the Company received, net of placement fees, approximately $5.8 million
      from a private placement pursuant to which it issued 4,790,076 shares of Common
      Stock and warrants to purchase 958,015 shares of Common Stock at an exercise
      price of $1.51 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 5.1%, volatility of 78.8% and an
      expected life of 5 years, resulting in the recording of a stock issue cost
      of
      approximately $1.0 million for the warrants issued to the investors.





On
      May
      26, 2005, the Company received, net of placement fees, approximately $8.1
      million from a private placement pursuant to which it 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 engaged for such financing. 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 paid and
      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,
      922,800 warrants were exercised using the non-cash exercise provision in the
      warrant for a total of 565,125 shares of Common Stock.





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. 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.




60




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, the warrant was partially exercised for
      2,940 shares of Common Stock.




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 engaged for such financing. 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.





**10.**  **Employee
      Stock-based Compensation**





Effective
      January 1, 2006, the Company adopted the provisions of SFAS No. 123(R),
      which supersedes our previous accounting under APB 25. SFAS No. 123
      (R) establishes accounting for stock-based awards exchanged for employee
      services. Accordingly, stock-based compensation cost is measured at the grant
      date, based on the fair value of the award, and is recognized as expense over
      the requisite service period. All of the Company’s stock compensation is
      accounted for as an equity instrument.





Impact
      of the Adoption of SFAS 123 (R)





The
      Company elected to adopt the modified prospective application method as provided
      by SFAS No. 123(R). The effect of recording stock-based compensation for
      the year ended December 31, 2006 was as follows (in thousands, except per share
      data):





Year
                endedStock-based
                compensation expense by type of award:
            
            
            December
                31, 2006Employee
                stock options
            
            $
            780Employee
                stock purchase plan
            
            
            24Non-employee
                stock options
            
            
            6Total
                stock-based compensation
            
            
            810Tax
                effect on stock-based compensation
            
            
            —Total
                stock-based compensation expense
            
            $
            810Impact
                on net loss per share
            
            $
            (0.01
            )





As
      of
      January 1, 2006, the Company had an unrecorded deferred stock-based compensation
      balance related to stock options of approximately $1.4 million before estimated
      forfeitures. In the Company’s pro forma disclosures prior to the adoption of
      SFAS No. 123 (R), the Company accounted for forfeitures upon occurrence.
      SFAS No. 123 (R) requires forfeitures to be estimated at the time of
      grant and revised if necessary in subsequent periods if actual forfeitures
      differ from those estimates. Based on the Company’s historical experience of
      option pre-vesting cancellations and estimates of future forfeiture rates,
      the
      Company has assumed an annualized forfeiture rate of 10% for its options.




61




During
      the year ended December 31, 2006, the Company granted options to purchase
      1,628,200 shares of Common Stock with an estimated total grant date fair value
      of $1.6 million. Of the $1.6 million, the Company estimated the stock-based
      compensation for awards not expected to vest was $0.3 million.





As
      of
      December 31, 2006, the unrecorded deferred stock-based compensation balance
      related to stock options was $1.8 million and will be recognized over an
      estimate weighted average remaining service period of 1.2 years.





Valuation
      assumptions





The
      Company estimates the fair value of stock options using a Black-Scholes
      valuation model, consistent with the provisions of SFAS No. 123 (R),
      Securities and Exchange Commission Staff Accounting Bulletin No. 107 and
      the Company’s prior period pro forma disclosures of net loss, including
      stock-based compensation (determined under a fair value method as prescribed
      by
      SFAS No. 123). The fair value of each option grant is estimated on the date
      of grant using the Black-Scholes option valuation model and the graded-vesting
      method with the following weighted-average assumptions:





Year
                ended
              December
                31, 2006Risk-free
                interest rate
            
            
            4.62
            %Expected
                term (years)
            
            
            5Expected
                dividends
            
            
            0.0
            %Volatility
            
            
            78.0
            %





The
      dividend yield of zero is based on the fact that the Company has never paid
      cash
      dividends and has no present intention to pay cash dividends. Expected
      volatility is based on the combination of historical volatility of the Company’s
      common stock and the common stock of the Company’s competitors, the expected
      moderation in future volatility over the period commensurate with the expected
      life of the options and other factors. The risk-free interest rates are taken
      from the Daily Federal Yield Curve Rates as of the grant dates as published
      by
      the Federal Reserve and represent the yields on actively traded Treasury
      securities for terms equal to the expected term of the options. The expected
      term calculation is based on the terms utilized by the Company’s competitors,
      observed historical option exercise behavior and post-vesting forfeitures of
      options by the Company’s employees.




62




Equity
      Incentive Program





The
      Company currently grants options under a stock option plan adopted in 1994
      and
      amended thereafter (the “1994 Plan”), that allows for the granting of
      non-qualified stock options, incentive stock options and stock purchase rights
      to the Company’s employees, directors, and consultants. At December 31, 2006, a
      total of 7,229,422 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 with 25% vesting after one year and the balance vesting on a daily
      basis over the next three years of service). Upon termination, unexercised
      options will generally expire at the end of 60 days. No stock purchase rights
      or
      incentive stock options have been granted under the 1994 Plan to date. Under
      the
      terms of the 1994 Stock Plan, there is an 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 2% of the total number of shares of common stock outstanding on the last
      trading day in December in the immediately preceding calendar year. A summary
      of
      activity under the 1994 Plan is as follows:





Number
                of shares
            
            Weighted
                Average Exercise Price
            
            Weighted
                Average Remaining Contractual Term (Years)
            
            Aggregate
                Intrinsic Value (In thousands)Balances
                at December 31, 2003
            
            
            3,051,329
            
            $
            1.85Granted
            
            
            968,000
            
            
            0.77Exercised
            
            
            (8,784
            )
            
            0.70Forfeited
            
            
            (174,809
            )
            
            1.86Balances
                at December 31, 2004
            
            
            3,835,736
            
            $
            1.58
            
            
            6.28
            
            $
            326Granted
            
            
            2,175,000
            
            
            0.65Exercised
            
            
            (25,000
            )
            
            0.41Forfeited
            
            
            (430,746
            )
            
            2.40Outstanding
                at December 31, 2005
            
            
            5,554,990
            
            $
            1.15
            
            
            7.24
            
            $
            639Granted
            
            
            1,628,200
            
            
            1.52Exercised
            
            
            (136,257
            )
            
            0.68Forfeited
            
            
            (464,055
            )
            
            2.01Balances
                at December 31, 2006
            
            
            6,582,878
            
            $
            1.19
            
            
            7.08
            
            $
            3,597Options
                vested and exerciseable and expected to be exercisable at December
                31,
                2006
            
            
            6,263,406
            
            $
            1.20
            
            
            6.99
            
            $
            3,463Options
                vested and exerciseable at December 31, 2006
            
            
            3,720,567
            
            $
            1.25
            
            
            5.80
            
            $
            2,370




At
      December 31, 2006, the Company had 646,544 shares of Common Stock available
      for
      grant or issuance under the 1994 Plan. The weighted average grant date fair
      value of options granted during the years ended December 31, 2006, 2005 and
      2004
      were $1.00, $0.65 and $0.77, respectively. The total intrinsic value of options
      exercised during the years ended December 31, 2006 and 2005 were $157,000 and
      $2,000, respectively.




The
      following table summarizes information concerning outstanding and exercisable
      options as of December 31, 2006:




Options
                Outstanding
            
            Options
                Vested and ExercisableWeighted
                  AverageWeightedNumber
            
            Contractual
            
            Exercise
            
            Number
            
            AverageRange
                of Exercise Prices
            
            Outstanding
            
            Life
            
            Price
            
            Exercisable
            
            Exercise
                Price$0.41
                - $0.60
            
            
            282,500
            
            
            6.98
            
            $
            0.41
            
            
            256,372
            
            $
            0.41$0.63
                - $0.63
            
            
            2,026,836
            
            
            8.29
            
            
            0.63
            
            
            1,043,268
            
            
            0.63$0.64
                - $1.13
            
            
            1,912,592
            
            
            6.10
            
            
            0.87
            
            
            1,628,177
            
            
            0.89$1.20
                - $6.23
            
            
            2,360,950
            
            
            6.84
            
            
            2.03
            
            
            792,750
            
            
            3.066,582,878
            
            
            7.08
            
            $
            1.19
            
            
            3,720,567
            
            $
            1.25




At
      December 31, 2005 and 2004 options to purchase
      3,173,607 and 2,715,213 shares of Common Stock were exercisable at weighted
      average exercise prices of $1.51 and $1.91 per share,
      respectively.


63




Prior
      to the Adoption of SFAS No. 123(R)





Prior
      to
      the adoption of SFAS No. 123(R), the Company provided the disclosures
      required under SFAS No. 123, “Accounting for Stock-Based Compensation,” as
      amended by SFAS No. 148, “Accounting for Stock-Based Compensation —
Transition and Disclosures.”





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
      and 2004, respectively: risk-free interest rates ranging from 0.89% to 4.44%;
      volatility factors for the expected market price of our common stock of 103%
      and
      105%; expected life of 4 years; and an expected dividend rate of
      0%.





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 to
      stock-based employee and director compensation (in thousands, except per share
      amounts):




Year
                Ended December 31,2005
            
            2004Net
                loss - as reported
            
            $
            (15,215
            )
            $
            (5,514
            )Deduct:
                Total stock-based employee compensation expense determinedunder
                fair value method for all awards
            
            
            (524
            )
            
            (372
            )Net
                loss - pro forma
            
            $
            (15,739
            )
            $
            (5,886
            )Loss
                per share:Basic
                and diluted-as reported
            
            $
            (0.21
            )
            $
            (0.11
            )Basic
                and diluted-pro forma
            
            $
            (0.22
            )
            $
            (0.12
            )





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.





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 $6,000, $14,000 and $65,000 in 2006, 2005 and 2004, respectively.





Employee
      Stock Purchase Plan





The
      Company currently has an employee stock purchase plan, adopted in 1994 and
      amended thereafter (the “Purchase Plan”). The Purchase Plan allows eligible
      employees to purchase Common Stock at 85% of the lower of the fair market value
      of the Common Stock on the subscription date or the fair market value on the
      purchase date. The offering period under the Purchase Plan is currently 24
      months, and the purchase price is established during each new offering period.
      Purchases are limited to 15% of each employee’s eligible compensation and
      subject to certain Internal Revenue Service restrictions. All of the Company’s
      employees are eligible to participate in the Purchase Plan after certain service
      periods are met. 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. As of December 31, 2006, 605,959
      shares were reserved for issuance under the Purchase Plan.




64




The
      fair
      value of shares purchased under the Purchase Plan is estimated using the
      Black-Scholes option valuation model and the graded-vesting method with the
      following weighted average assumptions for the year ended December 31, 2006:
      risk-free interest rate of 5.1%; volatility factor of 78.2%; and an expected
      life of 1.5 years. During the year ended December 31, 2006, the compensation
      cost in connection with the Purchase Plan was $24,000 and 67,663 shares were
      issued under the Purchase Plan. As of December 31, 2006, the unrecorded deferred
      stock-based compensation balance related to the Purchase Plan was $8,000 and
      will be recognized over an estimated weighted average amortization period of
      1.0
      years. The weighted average grant date fair value of the Purchase Plan shares
      issued during 2006, 2005 and 2004 was $0.60, $0.55 and $0.55,
      respectively.





**11.**  **Notes
      Receivable from Stockholder**





In
      May
      2000, the Company issued loans to Dr. Chandrasekaran, the Company’s President,
      Chief Executive Officer, Chief Financial Officer 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.





**12.**  **Legal
      Proceedings**





On
      July
      8, 2004, Bristol Investment Group, or Bristol, filed with the American
      Arbitration Association 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.





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, Dr. 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 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 cash payment owed to the
      consultant of $250,000, of which $100,000 was reimbursed by the Company’s
      insurance carrier, and the Company issued an option to purchase 30,000 shares
      of
      Common Stock 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.




65




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.





**13.**  **Related
      Party**





Included
      in accounts payable on the balance sheet at December 31, 2006 and 2005 is
      $17,000 and $27,000, 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.





**14.**  **Subsequent
      Events**





On
      February 15, 2007, the Company entered into a license agreement with Inspire
      under which the Company licensed to Inspire exclusive development and
      commercialization rights, under the Company’s AzaSite patent rights and certain
      know-how, for topical anti-infective products containing azithromycin as the
      sole active ingredient for human ocular or ophthalmic indications in the United
      States and Canada. The Inspire License also provides for nonexclusive licenses
      under the Company’s DuraSite patent rights, container patent rights, Columbia
      patent rights and certain know-how in the same field of use as described above.
      The Company also grants Inspire an exclusive sublicense under the Pfizer patent
      rights the Company has licensed under the Pfizer License discussed below.
      Inspire has the right to grant sublicenses under the terms of the Inspire
      License.





Upon
      the
      closing of the Inspire License, Inspire paid the Company an upfront license
      fee
      of $13 million and is obligated to pay the Company an additional $19 million
      upon regulatory approval and the approval of an acceptable label for any Subject
      Product by the U.S. FDA. Inspire will also pay a royalty on net sales
      of any Subject Product in the United States and Canada, if approved by
      regulatory authorities. The royalty rate will be 20% of net sales of any
      Subject Product in the first two years of commercialization and 25%
      thereafter. Inspire is obligated to pay the Company royalties under the Inspire
      License for the longer of (i) eleven years from the launch of the first product,
      and (ii) the period during which a valid claim under a patent licensed from
      the
      Company covers a Subject Product. For five years after the first year of
      commercial sale, Inspire will pay the Company certain tiered minimum royalties.
      The royalties discussed above are subject to certain reductions in the event
      of
      patent invalidity, generic competition, uncured material breach or in the even
      that Inspire is required to pay license fees to third parties for the continued
      use of such Subject Product.





The
      Company also entered into a trademark license agreement with Inspire on February
      15, 2007 under which the Company granted to Inspire an exclusive license to
      the
      AzaSiteTM trademark and domain name and a nonexclusive license to the DuraSite®
trademark in connection with the commercialization of Subject Products in the
      Territory under the terms of the Inspire License.





The
      Company also entered into a supply agreement, or the Supply Agreement, with
      Inspire on February 15, 2007 for the active pharmaceutical ingredient
      azithromycin. The Company had previously entered into a third party supply
      agreement for the production of such active ingredient. Under the Supply
      Agreement, the Company agreed to supply Inspire’s requirements of such active
      ingredient, pursuant to certain forecasting and ordering
      procedures.





The
      Company used approximately $7.3 million of the license fee it received under
      the
      Inspire License to repay its secured and unsecured short-term notes payable
      and
      the related interest.





On
      February 15, 2007, the Company entered into a worldwide, exclusive, royalty
      bearing licensing agreement with Pfizer Inc. and Pfizer Products, Inc., or
      collectively Pfizer, under Pfizer’s patent family titled “Method of Treating Eye
      Infections with Azithromycin” for ocular anti-infective product candidates known
      as AzaSite and AzaSite Plus.




66




Under
      the
      Pfizer License, the Company is required to pay Pfizer a single digit royalty
      based on net sales of the licensed products and to use reasonable commercial
      efforts to seek regulatory approval for and market licensed products. The Pfizer
      License provides the Company the right to grant sublicenses thereunder, subject
      to Pfizer's prior approval, which approval shall not be unreasonably
      withheld.





**15** **.**  **Quarterly
      Results (Unaudited)**





The
      following table is a summary of the quarterly results of operations for the
      years ended December 31, 2006 and 2005. 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.





(in
                thousands, except per share amounts)
            
            First
                Quarter
            
            Second
                Quarter
            
            2006Third
                     Quarter
            
            Fourth
              Quarter
            
            Total
              YearRevenues
            
            $
            1
            
            $
            -
            
            $
            1
            
            $
            -
            
            $
            2Cost
                of revenue
            
            
            3
            
            
            3
            
            
            20
            
            
            2
            
            
            28Loss
                from operations
            
            
            (4,811
            )
            
            (4,570
            )
            
            (3,091
            )
            
            (2,626
            )
            
            (15,098
            )Net
                loss
            
            
            (5,321
            )
            
            (5,129
            )
            
            (3,337
            )
            
            (2,824
            )
            
            (16,611
            )Basic
                and diluted net loss per share
            
            $
            (0.06
            )
            $
            (0.06
            )
            $
            (0.04
            )
            $
            (0.03
            )
            $
            (0.19
            )Shares
                used to calculate basic and dilutednet
                loss per share
            
            
            83,756
            
            
            86,848
            
            
            90,301
            
            
            92,868
            
            
            88,339




First
                Quarter
            
            Second
                Quarter
            
            2005Third
                   Quarter
            
            Fourth
              Quarter
            
            Total
              YearRevenues
            
            $
            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
            
            
            (3,438
            )
            
            (4,216
            )
            
            (3,488
            )
            
            (4,072
            )
            
            (15,215
            )Basic
                and diluted net loss per share
            
            $
            (0.06
            )
            $
            (0.06
            )
            $
            (0.04
            )
            $
            (0.05
            )
            $
            (0.21
            )Shares
                used to calculate basic and diluted net loss per share
            
            
            62,493
            
            
            70,699
            
            
            78,903
            
            
            79,092
            
            
            72,647




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





None





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





***Evaluation
      of Disclosure 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. Disclosure controls are controls and procedures designed
      to
      reasonably ensure that information required to be disclosed in our reports
      filed
      under the Exchange Act, such as this report, is recorded, processed, summarized
      and reported within the time periods specified in the SEC’s rules and forms.
      Disclosure controls include controls and procedures designed to reasonably
      ensure that such information is accumulated and communicated to our management,
      including our chief executive officer and chief financial officer, as
      appropriate to allow timely decisions regarding required disclosure. Our
      quarterly evaluation of disclosure controls includes an evaluation of some
      components of our internal control over financial reporting, and internal
      control over financial reporting is also separately evaluated on an annual
      basis
      for purposes of providing the management report which is set forth
      below.




67




***Report
      of Management on Internal Control Over Financial
      Reporting*** ***.*** Our
      management is responsible for establishing and maintaining a comprehensive
      system of internal control over financial reporting to provide reasonable
      assurance of the proper authorization of transactions, the safeguarding of
      assets and the reliability of the financial records. Our internal control system
      was designed to provide reasonable assurance to our management and board of
      directors regarding the preparation and fair presentation of published financial
      statements. The system of internal control over financial reporting provides
      for
      appropriate division of responsibility and is documented by written policies
      and
      procedures that are communicated to employees. The framework upon which
      management relied in evaluating the effectiveness of our internal control over
      financial reporting was set forth in *Internal
      Controls — Integrated Framework* published
      by the Committee of Sponsoring Organizations of the Treadway Commission.





Based
      on
      the results of our evaluation, our management concluded that our internal
      control over financial reporting was effective as of December 31, 2006.





Projections
      of any evaluation of effectiveness to future periods are subject to the risk
      that controls may become inadequate because of changes in conditions, or that
      the degree of compliance with the policies or procedures may deteriorate.





Our
      independent registered public accounting firm, which has audited the financial
      statements included in Item 8 of this report, has issued an attestation report
      on management’s assessment of our internal control over financial reporting
      which is included below.





***Inherent
      Limitations of Disclosure Controls and Procedures and Internal Control over
      Financial Reporting.*** It
      should
      be noted that any system of controls, however well designed and operated, can
      provide only reasonable, and not absolute, assurance that the objectives of
      the
      system will be met. In addition, the design of any control system is based
      in
      part upon certain assumptions about the likelihood of future events.





***Changes
      in Internal Control over Financial Reporting.*** There
      were no changes in our internal control over financial reporting (as defined
      in
      Exchange Act Rule 13a-15(f)) during the quarter ended December 31, 2006
      that have materially affected, or are reasonably likely to materially affect,
      our internal control over financial reporting.





***Independent
      Registered Public Accounting Firm’s Attestation Report.***





**REPORT
      OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**





To
      the
      Board of Directors and Stockholders of InSite Vision Incorporated





We
      have
      audited management’s assessment, included in the accompanying Management’s
      Annual Report on Internal Control Over Financial Reporting included in
      Item 9A, that InSite Vision Incorporated and its subsidiaries (the
“Company”) maintained effective internal control over financial reporting as of
      December 31, 2006, based on criteria established in *Internal
      Control — Integrated Framework* issued
      by
      the Committee of Sponsoring Organizations of the Treadway Commission (COSO).
      The
      Company’s management is responsible for maintaining effective internal control
      over financial reporting and for its assessment of the effectiveness of internal
      control over financial reporting. Our responsibility is to express an opinion
      on
      management’s assessment and an opinion on the effectiveness of the Company’s
      internal control over financial reporting based on our audit.




68




We
      conducted our audit 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 effective
      internal control over financial reporting was maintained in all material
      respects. Our audit included obtaining an understanding of internal control
      over
      financial reporting, evaluating management’s assessment, testing and evaluating
      the design and operating effectiveness of internal control, and performing
      such
      other procedures as we considered necessary in the circumstances. We believe
      that our audit provides a reasonable basis for our opinion.





A
      company’s internal control over financial reporting is a process designed to
      provide reasonable assurance regarding the reliability of financial reporting
      and the preparation of financial statements for external purposes in accordance
      with generally accepted accounting principles. A company’s internal control over
      financial reporting includes those policies and procedures that (1) pertain
      to the maintenance of records that, in reasonable detail, accurately and fairly
      reflect the transactions and dispositions of the assets of the company;
      (2) provide reasonable assurance that transactions are recorded as
      necessary to permit preparation of financial statements in accordance with
      generally accepted accounting principles, and that receipts and expenditures
      of
      the company are being made only in accordance with authorizations of management
      and directors of the company; and (3) provide reasonable assurance
      regarding prevention or timely detection of unauthorized acquisition, use,
      or
      disposition of the company’s assets that could have a material effect on the
      financial statements.





Because
      of its inherent limitations, internal control over financial reporting may
      not
      prevent or detect misstatements. Also, projections of any evaluation of
      effectiveness to future periods are subject to the risk that controls may become
      inadequate because of changes in conditions, or that the degree of compliance
      with the policies or procedures may deteriorate.





In
      our
      opinion, management’s assessment that InSite Vision Incorporated and its
      subsidiaries maintained effective internal control over financial reporting
      as
      of December 31, 2006, is fairly stated, in all material respects, based on
      the COSO criteria. Also, in our opinion, InSite Vision Incorporated and its
      subsidiaries maintained, in all material respects, effective internal control
      over financial reporting as of December 31, 2006, based on the COSO
      criteria.





We
      also
      have audited, in accordance with the standards of the Public Company Accounting
      Oversight Board (United States), the consolidated balance sheets of InSite
      Vision Incorporated and its subsidiaries as of December 31, 2006 and 2005,
      and the related consolidated statements of operations, stockholders’ equity
      (deficit) and cash flows for each of the three years in the period ended
      December 31, 2006 and our report dated March 15, 2007 expressed an
      unqualified opinion on those consolidated financial statements and included
      an
      explanatory paragraph regarding a substantial doubt about the Company’s ability
      to continue as a going concern.





/s/  Burr,
      Pilger, & Mayer LLP





Palo
      Alto, California


March 15,
      2007





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





Not
      applicable.





**PART
      III**





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





(a)
      The
      sections labeled “Nominees for Directors,” “Board Committees and Meetings,”
“Audit Committee Matters,” “Corporate Governance” and “Section 16(a) Beneficial
      Ownership Reporting Compliance” of our Proxy Statement in connection with the
      2007 Annual Meeting of Stockholders are incorporated herein by
      reference.




69




(b)
      Information concerning our Executive Officers is set forth in Part I of this
      Form 10-K.





**Item
      11. Executive Compensation**





The
      sections labeled “Director Compensation for 2006,” “Compensation, Discussion and
      Analysis,” “Compensation of Named Executive Officers,” “Summary Compensation
      Table for 2006,” “Grants of Plan Based Awards in 2006,” “Outstanding Equity
      Awards at Fiscal 2006 Year End,” “ Option Exercises and Stock Vested in 2006,”
“Non-Qualified Deferred Compensation for 2006,” “Compensation Committee
      Interlocks and Insider Participation” and “Compensation Committee Report” of our
      Proxy Statement in connection with the 2007 Annual Meeting of Stockholders
      are
      incorporated herein by reference.





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





The
      sections labeled “Equity Compensation Plans” and “Beneficial Ownership of
      Principal Stockholders, Directors and Management” of our Proxy Statement in
      connection with the 2007 Annual Meeting of Stockholders are incorporated herein
      by reference.





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





The
      sections labeled “Certain Relationships and Related Persons Transactions” and
“Director Independence” of our Proxy Statement in connection with the 2007
      Annual Meeting of Stockholders is incorporated herein by reference.





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





**Audit
      Fees**





The
      section labeled “Audit Committee Matters” and “Principal Accounting Fees and
      Services” of our Proxy Statement in connection with the 2007 Annual Meeting of
      Stockholders is incorporated herein by reference.





**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 72 of this Annual Report on Form 10-K.





70





**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.


INSITE
              VISION
              INCORPORATEDDated:
              March 15, 2007
            By:
            /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 each of S. Kumar Chandrasekaran and Sandra C. Heine,
      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
                    15, 2007S.
                    Kumar Chandrasekaran, Ph.D.
                
                
                Chief
                    Executive Officer andChief
                    Financial Officer/s/
                    Mitchell H. Friedlaender
                
                
                Director
                
                March
                    15, 2007Mitchell
                    H. Friedlaender, M. D./s/
                    John L. Mattana
                
                
                Director
                
                March
                    15, 2007John
                    L. Mattana/s/
                    Jon S. Saxe
                
                
                Director
                
                March
                    15, 2007Jon
                    S. Saxe/s/
                    Anders P. Wiklund
                
                
                Director
                
                March
                    15, 2007Anders
                  P.
                  Wiklund





71


**EXHIBIT
      INDEX**




Number
              
              Exhibit
                  Table3.11
              
              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,
                  2002.3.520
              
              Certificate
                  of Amendment to Restated
                  Certificate of Incorporation as filed with the Delaware Secretary
                  of State
                  on June 3, 1994.3.66
              
              Amended
                  and Restated Bylaws.3.7
              
              Certificate
                  of Amendment to Restated Certificate of Incorporation as filed
                  with the
                  Delaware Secretary of State on July 20, 2000.3.8
              
              Certificate
                  of Amendment to Restated Certificate of Incorporation as filed
                  with the
                  Delaware Secretary of State on June 1, 2004.3.926
              
              Certificate
                  of Amendment to Restated Certificate of Incorporation as filed
                  with the
                  Delaware Secretary of State on October 23, 2006.4.1
              
              Reference
                  is made to Exhibits 3.1 through 3.9.10.110
              
              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.10.61
              
              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.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.
 72
 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 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.10.2516
              
              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 10.24 hereto.10.2618H
              
              ISV-403
                  Asset Purchase Agreement, dated December 19, 2003, between the
                  Company and
                  Bausch & Lomb, Inc.10.2719
              
              Form
                  of Subscription Agreement, dated as of March 26, 2004, by and between
                  the
                  Company and the Subscribers named on the signature pages
                  thereto.10.2819
              
              Form
                  of Class A Warrants.10.2919
              
              Form
                  of Class B Warrants.10.3019
              
              Form
                  of Placement Warrant.10.3119
              
              Placement
                  Agent Agreement, dated as of February 12, 2004, by and between
                  the Company
                  and Paramount Capital, Inc.10.3220
              
              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.10.3320
              
              Form
                  of Warrant for the purchase of shares of Common Stock of the
                  Company.10.3420
              
              Form
                  of Placement Agent Warrant, dated as of May 9, 2005.10.3520
              
              Placement
                  Agent Agreement, dated as of February 24, 2005, by and between
                  the Company
                  and Paramount BioCapital, Inc.10.3621
              
              Warrant,
                  dated as of October 10, 2005, for the purchase of 922,800 shares
                  of Common
                  Stock of the Company.10.3722
              
              Form
                  of Subscription Agreement, dated as of December 30, 2005 by and
                  between
                  the Company and the Subscribers named on the signature pages
                  thereto.10.3822
              
              Form
                  of Warrant, dated as of January 11, 2006.10.3922
              
              Form
                  of Placement Agent Warrant, dated as of January 11,
                  2006.10.4022
              
              Form
                  of Consent to Expand Size of Offering of Notes and Warrants, dated
                  as of
                  January 6, 2006.10.4123
              
              Placement
                  Agent Agreement, dated as of December 16, 2005, by and between
                  the Company
                  and Paramount BioCapital, Inc.10.4223
              
              Amended
                  and Restated Security Agreement, dated as of December 30, 2005,
                  by and
                  between the Company and The Bank of New York.10.4323
              
              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.10.4423
              
              Form
                  of Senior Secured Note, dated as of December 30, 2005, issued to
                  certain
                  investors in an aggregate principal amount of
                  $4,300,000.10.4523
              
              Form
                  of Senior Secured Note, dated as of January 11, 2006, issued to
                  certain
                  investors in an aggregate principal amount of
                  $2,000,000.
  73
  10.4623
              
              Amended
                  and Restated Senior Secured Note in aggregate principal amount
                  of
                  $231,000, dated as of December 30, 2005, issued by the Company
                  to S. Kumar
                  Chandrasekaran, Ph.D.10.4724
              
              Form
                  of Subscription Agreement, dated as of August 2, 2006 by and between
                  the
                  Company and the Subscribers named on the signature pages
                  thereto.10.4824
              
              Form
                  of First Amendment, dated as of August 8, 2006, to Subscription
                  Agreement
                  dated as of August 2, 2006, by and between the Company and each
                  of the
                  Subscribers.10.4924
              
              Form
                  of Warrant, dated as of August 15, 2006.10.50
              
              Amendment
                  No. 3 to Marina Village Office Tech Lease, dated November 28, 2006.10.5125
              
              Amendment
                  Agreement, dated as of December 22, 2006, to Senior Secured Notes
                  dated as
                  of December 30, 2005 and January 11, 2006 by and among the Company
                  and
                  each of the holders of notes.16.117
              
              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.
  74
  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 June 30, 2006.7
              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, 1998.9
              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 October 28,
                  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 January 14,
                  2004.19
              Incorporated
                  by reference to an exhibit to the Company’s Current Report on Form 8-K
                  filed with the Securities and Exchange Commission on March 29,
                  2004.20
              Incorporated
                  by reference to an exhibit 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).21
              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 11,
                  2005
                  (File Number 001-14207).
  75
  22
              Incorporated
                  by reference to an exhibit 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).23
              Incorporated
                  by reference to an exhibit to the Company’s Annual Report on Form 10-K for
                  the year ended December 31, 2005.24
              Incorporated
                  by reference to an exhibit to the Company’s Registration Statement on Form
                  S-3 filed with the Securities and Exchange Commission on October
                  13, 2006
                  (File Number 333-137994).25
              Incorporated
                  by reference to an exhibit to the Company’s Current Report on Form 8-K
                  filed with the Securities and Exchange Commission on December 26,
                  2006.26
              Incorporated
                  by reference to an exhibit to the Company’s Quarterly Report on Form 10-Q
                  for the quarter ended September 30, 2006.H
              Confidential
                  treatment has been granted with respect to certain portions of
                  this
                  agreement.HH
              Management
                  contract or compensatory
                  plan.







76