UNITED
      STATESSECURITIES
      AND EXCHANGE COMMISSIONWASHINGTON,
      D.C. 20549**FORM
      10-K**FOR
      ANNUAL AND TRANSITION REPORTSPURSUANT
      TO SECTIONS 13 OR 15(d) OF THESECURITIES
      EXCHANGE ACT OF 1934x   ANNUAL REPORT PURSUANT TO SECTION
      13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934For
      the fiscal year ended December 31, 2004ORo    TRANSITION REPORT PURSUANT TO
      SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
  1934For
      the transition period from ________ to ________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 incorporation or organization)
    
    (I.R.S.
      Employer Identification No.)965
      Atlantic Avenue, Alameda, CA 94501(Address
      of Principal Executive Offices, including Zip Code)Registrant's
      telephone number, including area code: (510) 865-8800Securities
      registered pursuant to Section 12(b) of the Act:Title
      of each class
    
    Name
      of each exchangeon
      which registeredCommon
      Stock, $0.01 Par Value
    
    American
      Stock ExchangeSecurities
      registered pursuant to Section 12(g) of the Act: NoneIndicate
      by check mark whether the registrant: (1) has filed all reports required
      to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934
      during the preceding 12 months (or for such shorter period that the
      registrant was required to file such reports), and (2) has been subject to
      such filing requirements for the past 90 days. Yes þ   No  oIndicate
      by check mark if disclosure of delinquent filers pursuant to Item 405 of
      Regulation S-K is not contained herein, and will not be contained, to the
      best of the registrant’s knowledge, in definitive proxy or information
      statements incorporated by reference in Part III of this Form 10-K or any
      amendment to this Form 10-K.  þIndicate
      by check mark whether the registrant is an accelerated filer (as defined
      in Rule 12b-2 of the Securities Exchange Act of 1934). Yes  oNo  þThe
      aggregate market value of registrant’s Common Stock, $0.01 par value, held
      by non-affiliates of the Registrant as of June 30, 2004: was approximately
      $12,742,170 (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 28, 2005:
62,381,808.**DOCUMENTS
      INCORPORATED BY REFERENCE**Designated
      portions of the following document are incorporated by reference into this
      Report on Form 10-K where indicated: portions of the Proxy Statement for
      the registrant’s 2005 Annual Meeting of Stockholders which we expect to be
      held on June 1, 2005 are incorporated by reference into Part III of this
      report.




















**ANNUAL
REPORT ON FORM 10-K**


**FOR
THE FISCAL YEAR ENDED DECEMBER 31, 2004**





**TABLE
OF CONTENTS**





PagePART
      IItem
      1. Business
    1Item
      2. Properties
    28Item
      3. Legal Proceedings
    28Item
      4. Submission of Matters to a Vote of Security Holders
    29PART
      IIItem
      5. Market for Registrant's Common Equity, Related Stockholder Matters and
      Issuer Purchases of Equity Securities
    29Item
      6. Selected Financial Data
    30Item
      7. Management's Discussion and Analysis of Financial Condition and Results
      of Operation
    31Item
      7A. Quantitative and Qualitative Disclosures About Market
    Risk
    38Item
      8. Financial Statements and Supplementary Data
    39Item
      9. Changes in and Disagreements with Accountants on Accounting and
      Financial Disclosure
    60Item
      9A. Controls and Procedures
    60Item
      9B. Other Information
    60PART
      IIIItem
      10. Directors and Executive Officers of the Registrant
    60Item
      11. Executive Compensation
    60Item
      12. Security Ownership of Certain Beneficial Owners and Management and
      Related Stockholder Matters
    61Item
      13. Certain Relationships and Related Transactions
    61Item
      14. Principal Accounting Fees and Services
    61PART
      IVItem
      15. Exhibits, Financial Statement Schedules
    61Signatures
    62






















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





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





**PART
I**





**Item
1. Business**





**THE
COMPANY**





We are an
ophthalmic product development company focused on ocular infections, glaucoma
and retinal diseases through three technology platforms that include our
patented time-release ophthalmic drug delivery system DuraSite®; genomic
research for the diagnosis, prognosis and management of glaucoma; and a retinal
drug delivery device.





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





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


·
    AzaSite
      PlusTM(ISV-502), a DuraSite formulation of azithromycin and a steroid;
      and


·
    targeted
      activities to support the scientific/clinical foundation and market
      introduction of our OcuGene
      glaucoma genetic test based on our ISV-900
technology.





*AzaSite
(ISV-401).* We have
developed a topical formulation 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, to treat bacterial
conjunctivitis and other infections of the outer eye. We believe that the key
advantages of AzaSite may include a significantly reduced dosing regimen (as few
as 7 doses vs. 36 doses for comparable products), the high and persistent levels
of azithromycin achieved in the tissues of the eye and its wide spectrum of
activity. Product safety and efficacy have been shown, respectively, in Phase 1
and Phase 2 clinical trials. The Phase 2 study compared an AzaSite formulation
containing 1% azithromycin to a placebo. The results of this study showed that
the AzaSite formulation was more effective than the placebo in bacterial
eradication and clinical cure, which includes reduction in inflammation and
redness.





In July
2004, we initiated two pivotal Phase 3 clinical trials for AzaSite. One of the
Phase 3 clinical trials is a multi-center study in which patients in one arm
will be dosed with a 1% AzaSite formulation and the patients in the second arm
will be dosed with a placebo. This study is designed to include approximately
550 patients, of which 224 must be confirmed positive for bacterial
conjunctivitis in at least one eye. The other Phase 3 clinical trial is a
multi-center study in which patients in one arm will be dosed with a 1% AzaSite
formulation and the patients in the second arm will be dosed with a 0.3%
formulation of the antibiotic tobramycin. This study is designed to include
approximately 775 patients, of which 310 must be confirmed positive for
bacterial conjunctivitis in at least one eye. The Phase 3 trials are being
conducted in the United States and we anticipate including both children and
adults to permit enrollment of the subjects necessary to complete the studies.
The primary endpoints of both trials will be microbial eradication and clinical
cure. In October 2004, we announced that over 100 of the centers at which the
clinical trials will be conducted had been activated and were able to begin to
enroll patients in the two clinical trials.








1





In 2003,
we secured a new source for the active ingredient used in AzaSite and have a
contract-manufacturing site for production of clinical trial supplies and
registration batches. In the first quarter of 2005 we signed a development
supply agreement with our new drug supplier and anticipate executing a
commercial supply agreement during 2005. The supplies are being manufactured
under the supervision of our personnel. During 2004 we manufactured the clinical
supplies and the registration batches needed to support the filing of a New Drug
Application, or NDA, for AzaSite with the United States Food and Drug
Administration, or FDA. We anticipate that our contract manufacturing facility
will be ready for inspection by the FDA at the time of our NDA
submission.





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





*Ocu* *G* *ene* . Our
Ocu G ene
glaucoma genetic test is based on our glaucoma genetics program, which has been
pursued in collaboration with academic researchers, and is focused on
discovering genes that are associated with glaucoma, and the mutations on these
genes that cause and regulate the severity of the disease. In June 2003, a
peer-reviewed study was published in *Clinical Genetics* titled
"Association of the Myocilin mt.1 Promoter Variant with the Worsening of
Glaucomatous Disease Over Time," (2003: 64: 18-27). "The results of this study
indicate substantial evidence that the TIGR/MYOC mt.1(+) variant provides a
strong marker for accelerated worsening of both optic disc and visual field
measures of glaucoma progression above and beyond other baseline risk factors,"
stated one of the authors of the study, Jon Polansky, M.D., University of
California, San Francisco, who also serves on our Scientific Advisory Board.





In 2003,
the information from this article and previous publications was used to target
specific thought leaders and ophthalmic centers in an effort to support the
focused introduction of the Ocu G ene
glaucoma genetic test. Expanded marketing efforts were curtailed as we limited
our cash use and we have not resumed the marketing efforts as we focus on our
AzaSite clinical trials. Our current focus is on the clinical validation
necessary to support use of this technology.





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





To date,
our academic collaborators have identified genes associated with primary open
angle glaucoma, or POAG, (the most prevalent form of glaucoma in adults), normal
tension glaucoma, juvenile glaucoma and primary congenital glaucoma, or PCG. Our
academic collaborators for our glaucoma genetics program include: the University
of California, San Francisco, or UCSF; the University of Connecticut Health
Center, or UCHC; Institute National de la Sante et de la Recherche Medicale, or
INSERM, the French equivalent of U.S. National Institutes of Health; Okayama
University in Japan; and other institutions in North America and Europe. This
research, other than what has been incorporated into our Ocu G ene test,
still must be converted into commercial products.





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







2


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





**Ophthalmic
Pharmaceutical Market**





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 recent improvements in
medical technology, such as increasingly sophisticated diagnostic techniques,
will allow identification of ocular diseases at an earlier stage, enabling more
effective treatments and expanding the range of treatment regimens available to
the ophthalmologist. Further, we believe that the emergence of new laser-based
procedures to correct certain vision problems has begun to increase the need for
comfortable, extended-release drug therapy during the post-surgical ocular
healing process.





The
worldwide ophthalmic anti-infective market was anticipated to reach
approximately $1.0 billion in 2004, according to a variety of sources. The
market was driven by the expansion of the use of fourth generation
fluoroquinolones introduced in 2003. The market has been, and we believe will
continue to be, impacted by the use of antibiotics in connection with the
continued acceptance of refractive procedures including cataract and laser-based
vision correction procedures.





According
to the Glaucoma Research Foundation, glaucoma is the leading cause of
preventable blindness, affecting two to three million people in the U.S., and 67
million people worldwide. The prevalence of the disease in first-degree
relatives of affected patients has been documented to be as high as seven to ten
times that of the general population. Glaucoma also may occur as a complication
of conditions such as diabetes, or as a result of extended steroid
use.





Age-related
macular degeneration, which affects 15 million or more people in the U.S., is
the leading cause of severe blindness in Americans age 60 and above, according
to the Macular Degeneration Partnership. Laser treatment and the photo-dynamic
therapy introduced in 2000, are the only known therapies, but are effective in
only a certain portion of affected patients. Even with treatment, the disease
usually progresses and eventually leads to vision loss.





Also,
approximately 10 to 14 million Americans are diabetic and many of them will
develop diabetic retinopathy later in their life. According to the American
Diabetes Association, diabetic retinopathy is responsible for 8 percent of the
legal blindness in the U.S. and is the leading cause of new cases of blindness
in adults 20 to 74 years of age. Laser therapy is effective only in a certain
segment of the diabetic population, and has potential side effects such as loss
of peripheral vision, retinal detachment, and loss of vision.







3




**Products
and Product Candidates**





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





**Products
and Product Candidates**


**Product**
    
    **Indications**
    
    **Anticipated
      Benefits**
    
    **Status(1)****Ophthalmic
      Anti-infectives**AzaSite
    
    Bacterial
      infection including ophthalmia neonatorum
    
    Broad
      spectrum antibiotic with reduced dosing frequency
    
    Phase
      3AzaSite
      Plus
    
    Blepharitis
    
    Broad
      spectrum antibiotic with reduced dosing frequency
    
    Preclinical**Glaucoma
      Genetics**OcuGene-
      Glaucoma Genetic Test
    
    Glaucoma
      severity (TIGR gene)
    
    Determine
      disease severity among glaucoma patients
    
    MarketedPCG
      - Primary Congenital Glaucoma Test
    
    Glaucoma
      detection in infants
    
    Patient
      identification to allow early treatment before complications and
      irreversible vision loss
    
    Pre-commercialization
      (2)ISV
      - 900
    
    Glaucoma
      prognostic/diagnostic
    
    Identify
      new genetic markers to detect disease susceptibility and determine disease
      severity
    
    Research**Glaucoma
      Product Candidates**ISV
      - 205
    
    Steroid-induced
      intraocular pressure elevation, glaucoma
    
    Treat/prevent
      disease progression
    
    Phase
      2(b) completed**Other
      Topical Product Candidates and Product**ISV
      - 205
    
    Inflammation
      and analgesia
    
    Reduced
      dosing frequency
    
    PreclinicalAquaSite
    
    Dry
      eye
    
    Reduced
      dosing frequency and extended duration of action
    
    Marketed
      (OTC)**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, ISV-900, 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.”


2)
    A
      prognostic technology has been developed and plans for use in screening a
      limited population prior to being available for a broader market will be
      dependent upon available funding.




****


4


****


**Ophthalmic
Anti-infectives**





*AzaSite.* We have
developed a topical formulation of the antibiotic, azithromycin to treat
bacterial conjunctivitis and other infections of the outer eye. Azithromycin has
a broad spectrum of antibiotic activity and is widely used to treat respiratory
and other infections in its oral and parenteral forms. The eye drop of 1%
azithromycin (ISV-401) is formulated to deliver sufficient tissue concentrations
over a 5-day dosing period using our proprietary DuraSite technology. The
eyedrop is designed to enable superior bactericidal activity against common
ocular pathogens and pseudomonas. We believe the key advantages of AzaSite may
include a significantly reduced dosing regimen (7 doses vs. 36 doses for
comparable products), the high and persistent levels of azithromycin achieved in
the tissues of the eye and its wide spectrum of activity. Phase 1 and 2 studies
have shown that AzaSite is well tolerated and effective. AzaSite also has patent
protection (see “ *Risk
Factors -- Our business depends upon our proprietary rights, and we may not be
able to adequately protect, enforce or secure our intellectual property
rights* ”).





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





Product
safety and efficacy have been demonstrated, respectively, in Phase 1 and Phase 2
clinical trials. In July 2004, we initiated two Phase 3 clinical trials for
AzaSite. We are currently conducting both of the trials in the United States but
we may extend them internationally to permit aggressive enrollment of the
subjects, including both children and adults, necessary to complete the studies.
We further anticipate that the primary endpoints of both trials will be
microbial eradication and clinical cure.





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





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





**Glaucoma
Genetics**





According
to the Glaucoma Research Foundation, glaucoma is the leading cause of
preventable blindness in the U.S., affecting an estimated two to three million
people. The most prevalent form of glaucoma in adults is POAG. Other forms of
the disease include PCG, a leading cause of blindness in infants, and juvenile
glaucoma that affects children and young adults.





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






5





*ISV-900* . There
is accumulating evidence that genetic predisposition is a major factor in the
development of several forms of glaucoma. According to the Glaucoma Research
Foundation, a family history of POAG increases the risk of developing glaucoma
by 4 to 9 times that of the general population. We have formed research
collaborations with scientists at institutions located in North America, Europe
and Japan both to identify the genes associated with different forms of glaucoma
and to build a database of information on how these genes affect the progression
of the disease in different populations.





Researchers
with whom we collaborate have identified several disease-causing, or modifying,
genes related to POAG including TIGR/MYOC, OPTN, OCLM and APOE. Additional
research has revealed mutations in the CYP1B1 gene that are related to PCG. We
have obtained exclusive worldwide licenses for the rights to commercialize
certain research related to the TIGR gene and associated mutations from the
Regents of the University of California, the CYP1B1 gene and associated
mutations from UCHC and APOE, as it interacts with TIGR, from INSERM.





We
currently hold licenses to patents issued on the TIGR cDNA, TIGR antibodies,
methods for the diagnosis of glaucoma using the TIGR technology and methods for
the diagnosis of glaucoma using the CYP1B1 technology. Additional patents
related to the ISV-900 program are currently pending and if issued will be
included in the licenses we hold.





*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. Our ISV-900 program is intended to discover the
appropriate genetic markers for certain forms of glaucoma and to incorporate
those markers into prognostic, diagnostic and management tools. The first
version of these tests, 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 anticipate that as further research identifies new
genes, and additional mutations, we will bring these to market as additional
tests.





In
December 2002, we entered into an agreement with Società Industria Farmaceutica
Italiana (SIFI) that grants them the exclusive right to manufacture/perform,
distribute and market Ocu G ene in
Italy for eight years. SIFI introduced the Ocu G ene test
at two Italian ophthalmic meetings in late 2003, and is currently evaluating the
market opportunity and feasability to support a product
launch.





**Glaucoma
Product Candidates**





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





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





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






6





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





**Other
Topical Product Candidates and Marketed Product**





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





**Retinal
Device**





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





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





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





**Collaborative,
Licensing and Service Agreements**





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





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




7





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.





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





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





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





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





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





*INSTITUTE
NATIONAL DE LA SANTE ET DE LA RECHERCHE MEDICALE (INSERM).* In
December 1999, we entered into a license agreement with INSERM granting us
certain exclusive rights for the diagnostic, prognostic and therapeutic uses of
a gene for chronic open angle glaucoma. We paid a licensing fee and will make
royalty payments on future product sales, if any.





*University
of Connecticut Health Center (UCHC)* . In July
1997, we exercised our option granted pursuant to a research agreement with UCHC
to obtain certain exclusive rights from UCHC for diagnostic uses of the newly
discovered gene for PCG. Under the agreement, we will pay a licensing fee and
will make royalty payments on future product sales, if any.





In
December 2001, we entered into an agreement whereby we exercised our option
granted pursuant to a research agreement with UCHC to obtain certain exclusive
rights from UCHC for diagnostic uses of the Optineuron gene and associated
mutations. Under this agreement, we will pay a licensing fee and will make
royalty payments on future product sales, if any.





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





8
 **


**


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





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





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





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





**Patents
and Proprietary Rights**





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






9


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 interfer-ence
proceedings declared by the U.S. Patent and Trademark Office, or USPTO, to
determine priority of invention, which could result in substantial cost to us,
even if the eventual outcome were favorable. There can be no assurance that our
patents will be held valid or enforceable by a court or that a competitor's
technology or product would be found to infringe such patents.





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





In
addition to patent protection, we also rely upon trade secret protection for our
confiden-tial 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, 2004, our research and development staff numbered 16 people, of
whom 3 have Ph.D.s. In 2004, our research and development expenses were $7.3
million, including the expenses related to contract research activities for
which we received $537,000 from Bausch & Lomb. In 2003, our research and
development expenses, including third party research we sponsored, were $4.4
million, including the expenses related to contract research activities for
which we received $128,000 from Bausch & Lomb. In 2002, our research and
development expenses, including third party research we sponsored, were $7.1
million, of which $166,000 was funded by third parties.





**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.





10





We have a
contract with 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. While
we are in discussions regarding a commercial manufacturing agreement, we
could encounter delays or difficulties in finalizing such an agreement which
would adversely impact our potential market introduction and subsequent sales of
AzaSite.





We
contract with a third party to assemble the sample collection kits used in our
Ocu G ene
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 could be adversely affected.





**Marketing
and Sales**




We have
developed a limited marketing and sales organization focused on the targeted
introduction of Ocu G ene and
we are primarily using external marketing and sales resources that
include:


·
    marketing
      consultants;


·
    a
      network of key ophthalmic clinicians; and


·
    other
      resources with ophthalmic expertise.





We are
evaluating expansion of our external marketing and sales resources to support
our continuing Ocu G ene
efforts. Potential resources being evaluated include:


·
    contract
      sales forces;


·
    co-marketing
      and co-promotion arrangements in the U.S.;
and


·
    licensing
      arrangements with companies outside of the
U.S.





We do not
currently plan on establishing a dedicated sales force or a marketing
organization for our other product candidates.





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





Our
current collaborators include:





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





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





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





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





11


*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**





We have
many competitors in the U.S. and abroad. These companies include
ophthalmic-oriented companies that market a broad portfolio of products, as well
as large integrated pharmaceutical companies that market a limited number of
ophthalmic pharmaceuticals in addition to many other pharmaceuticals. Many of
these companies have substantially greater financial, technical, marketing and
human resources than we do and may succeed in developing technologies and
products that are more effective, safer or more commer-cially accepted than any
which we have developed or are developing. These competitors may also succeed in
obtaining cost advantages, patent protection or other intellectual property
rights that would block our ability to develop and commercialize our potential
products, or may obtain regulatory approval for the commercialization of their
products more rapidly or effectively than we do. The ophthalmic prescrip-tion
pharmaceutical market in the U.S. is dominated by six companies: Allergan
Pharmaceuticals, a division of Allergan, Inc.; Alcon Laboratories, Inc., a
division of Nestle Company; Bausch and Lomb; CIBA Vision, a division of Novartis
Ltd.; Merck, Sharp & Dohme, a division of Merck & Co., Inc.; and Pfizer,
Inc. It is very difficult for smaller companies, such as ours, that do not have
large and well-developed research and development, and sales and marketing
staffs, to successfully develop and market products.





We
believe there will be increasing competition from new products entering the
market that are covered by patents and, to a lesser degree, from pharmaceuticals
that become generic. We are aware of certain products manufactured or under
development by competitors that are used for the treatment of certain ophthalmic
indications we have targeted for product development. Our competitive position
will depend on our ability to develop enhanced or innovative pharmaceuticals,
maintain a proprietary position in our technology and products, obtain required
U.S. and foreign governmental approvals on a timely basis, attract and retain
key personnel and enter into effective collaborations for the manufacture and
marketing of our products.





Over the
longer term, our, and our partners', ability to successfully market our current
products, and product candidates, expand their usage and bring new products to
the marketplace, will depend on many factors, including the degree of patent
protection afforded to particular products, and obtaining approval from managed
care and governmental organizations to purchase or reimburse for the purchase of
our products.





**Government
Regulation**





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





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





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


·
    preclinical
      laboratory and animal tests;


·
    submission
      to the FDA of an IND;


12
  ·
    adequate
      and well-controlled human clinical trials to establish the safety and
      efficacy of the drug;


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


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





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





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





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





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





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





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





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








**Scientific
and Business Advisors**





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





13


Our
advisors are as follows:





Name
    
    PositionMark
      Abelson, M.D.
    
    Associate
      Clinical Professor of Ophthalmology, Department of Ophthalmology, Harvard
      Medical SchoolChandler
      R. Dawson, M.D.
    
    Emeritus
      Professor, Department of Ophthalmology, University of California, San
      FranciscoHenri-Jean
      Garchon, M.D., Ph.D.
    
    Director,
      INSERM, FranceSyd
      Gilman, Ph.D.
    
    Partner,
      Trident Rx Consultant ServiceDavid
      G. Hwang, M.D.
    
    Professor
      of Clinical Ophthalmology, Co-Director, Cornea and Refractive Surgery
      Service, University of California, San Francisco School of
      MedicineKazuhide
      Kawase, M.D.
    
    Associate
      Professor, Gifu University, JapanEliot
      Lazar, M.D.
    
    President,
      El Con Medical Consulting, Buffalo, New YorkMichael
      Marmor, M. D.
    
    Professor,
      Department of Ophthalmology, Stanford University School of
      MedicineGary
      D. Novack, Ph.D.
    
    Founder
      and President, PharmaLogic Development, Inc.; former Associate Director
      for Glaucoma Research at Allergan, Inc.Jon
      R. Polansky, M. D.
    
    Adjunct
      Professor of Ophthalmology, University of California, San
      FranciscoRoger
      Vogel, M. D.
    
    Medical
      DirectorClaes
      Wadelius, M.D., Ph.D.
    
    Professor,
      Uppsala University, Sweden








**Employees**





As of
December 31, 2004, we had 29 employees, 26 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.








14


**RISK
FACTORS**











**Our
Current Cash Will Only Fund Our Business Until Approximately the begining
of June 2005; We Will Need to Seek Additional Funding or Partnering Arrangements
that Could Be Further Dilutive to Our Stockholders and Could Negatively Affect
Us and Our Stock Price**





Our
independent auditors included an explanatory paragraph in their audit report
related to our consolidated financial statements for the fiscal year ended
December 31, 2004 referring to our recurring operating losses and a
substantial doubt about our ability to continue as a going concern.


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





In
addition, we expect to enter into partnering and collaborative arrangements in
the future as part of our business plan, regardless of whether we require
additional funding to continue our operations. Such arrangements could include
the licensing or sale of certain assets or the issuance of securities, which may
adversely affect the market price of our Common Stock. It is difficult to know
our future capital requirements precisely and such requirements depend upon many
factors, including:





·
    the
      progress and results of our preclinical and clinical testing, especially
      with respect to our AzaSite product
candidate;


·
    the
      progress of our research and development
programs;


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


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


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


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


·
    the
      time and cost involved in obtaining regulatory
  approvals;


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


·
    competing
      technological and market developments;


·
    the
      purchase of additional capital equipment;
and


·
    the
      outcome of existing or possible future legal
actions.








**If
We Do Not Receive Additional Funding When Needed to Continue Our Operations We
Will Likely Cease Operations and Liquidate Our Assets, Which are Secured by
Notes Payable to Our Chief Executive Officer**





15


In the
event that we are unable to secure additional funding when required to continue
our operations, we will likely be forced to wind down our operations, either
through liquidation, voluntary or involuntary bankruptcy or a sale of our
assets. As of December 31, 2004, our chief executive officer had outstanding
loans to us in an aggregate principal amount of $250,000, which are secured by a
lien on substantially all of our assets including our intellectual property. The
notes issued by us in connection with these loans are due on the earlier to
occur of March 31, 2007 or 30 days subsequent to the successful completion of a
pivotal Phase 3 clinical trial with AzaSite. In the event that we wind down
operations, whether voluntarily or involuntarily, while these secured loans are
outstanding, this security interest enables our chief executive officer to
control the disposition of these assets. If we are unable to repay the amounts
due under the secured notes when due, our chief executive officer could cause us
to enter into involuntary liquidation proceedings in the event we default on our
obligations. If we wind down our operations for any reason, it is likely that
our stockholders will lose their entire investment in us.





**Clinical
Trials Are Very Expensive, Time-Consuming and Difficult to Design and
Implement**





We
commenced Phase 3 trials of our AzaSite
product candidate in the third quarter of 2004. The AzaSite Phase 3 trials will
be expensive and may be difficult to implement due to the number of patients and
testing sites and
could be subject to delay or failure at any stage of the trials . We
expect our current funding will only be sufficient to enable us to continue our
operations as currently planned until approximately the begining of June 2005.
Accordingly, we will require additional funds to complete these trials, obtain
the necessary FDA approvals and market the product. Any delay or failure of the
AzaSite trials will likely require us to obtain even further funding in order to
address such delays or failures or to refocus our efforts on other product
candidates. Human clinical trials for our product candidates are very expensive
and difficult to design and implement, in part because they are subject to
rigorous regulatory requirements. The clinical trial process is also
time-consuming. We estimate that clinical trials of our other product candidates
will take at least several years to complete once initiated. Furthermore,
failure can occur at any stage of the trials, and 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.





**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, including with respect to
AzaSite. Even if pre-clinical testing and early clinical trials for a product
candidate, including AzaSite, 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. The clinical trial process may fail to demonstrate that
our product candidates, including AzaSite, are safe for humans or effective for
indicated uses. 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 our current AzaSite
Phase 3 trials do not produce positive results or we are otherwise unable to
obtain FDA approval for the commercialization of AzaSite, our business could 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. 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.





16


**Physicians
and Patients May Not Accept and Use Our Drugs**





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





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


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


·
    the
      perceived benefits of competing products or
treatments;


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


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





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





**Questions
Concerning Our Financial Condition May Cause Customers and Current and Potential
Partners to Reduce or Not Conduct Business with Us**





Our
recent 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 product
development and commercialization efforts would suffer and our business will be
significantly harmed.





**It
Is Difficult to Evaluate Our Business Because We Are in an Early Stage of
Development and Our Technology Is Untested**





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





·
    are
      found to be unsafe or ineffective;


·
    fail
      to receive necessary marketing clearance from regulatory
      authorities;


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


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


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





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





**We
Have a History of Operating Losses and We Expect to Continue to Have Losses in
the Future**





We have
incurred significant operating losses since our inception in 1986 and have
pursued numerous drug development candidates that did not prove to have
commercial potential. As of December 31, 2004, our accumulated deficit was
approximately $121.2 million. We expect to incur net losses for the foreseeable
future or until we are able to achieve significant royalties or other revenues
from sales of our products. In addition, we recognize revenue when all services
have been performed and collectibility is reasonably assured, accordingly,
revenue for the sales of OcuGene may be recognized in a later period than the
associated recognition of costs of the services provided, especially during the
initial launch of the product. In addition, due to this delay in revenue
recognition, our revenues recognized in any given period may not be indicative
of our then current viability and market acceptance of our Ocu G ene
product.





17


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





**We
May Not Successfully Manage Our Growth**





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





**We
Are Dependent Upon Key Employees and We May Not Be Able to Retain or Attract Key
Employees, and Our Ability to Attract and Retain Key Employees is Likely to be
Harmed by Our Current Financial Situation**





We are
highly dependent on Dr. Chandrasekaran, who is our chief executive officer,
president and chief financial officer, and Dr. Lyle Bowman, our vice president,
development and operations. The loss of services from either of these key
personnel might significantly delay or prevent the achievement of planned
development objectives. We carry a $1.0 million life insurance policy on Dr.
Chandrasekaran under which we are the sole beneficiary, however in the event of
the death of Dr. Chandrasekaran such policy would be unlikely to fully
compensate us for the hardship such a loss would cause us. 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 financial
situation and our past reductions in force. For example, during 2003 we laid off
approximately 42% of our employees and salaries of our senior management were
reduced. Although we have recently increased salaries to their pre-reduction
levels and paid performance bonuses, and we are not aware of any plans of our
management or scientific personnel to leave us, the voluntary salary reductions
and other cost reduction measures we have undertaken in the past or may
undertake in the future make it more likely that such individuals will seek
other employment opportunities and may leave our company permanently. The loss
of key personnel or the failure to recruit additional personnel or to develop
needed expertise could 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, such as our corporate collaborators. These partners may terminate
their relationships with us and may not diligently or successfully market our
products. In addition, marketing consultants and contract sales organizations,
such as those deployed by us currently for OcuGene, or in the future for OcuGene
and potential future products such as AzaSite, may market products that compete
with our products and we must rely on their efforts and ability to market and
sell our products effectively. We may not be able to conclude arrangements with
other companies to support the commercialization of our products on acceptable
terms, or at all. Moreover, our current financial condition may make us a less
attractive partner to potential collaborators. In addition, our collaborators
may take the position that they are free to compete using our technology without
compensating or entering into agreements with us. Furthermore, our collaborators
may pursue alternative technologies or develop alternative products either on
their own or in collaboration with others, including our competitors, as a means
for developing treatments for the diseases or disorders targeted by these
collaborative programs.





**Our
Business Depends Upon Our Proprietary Rights, and We May Not Be Able to Protect,
Enforce or Secure Our Intellectual Property Rights
Adequately**





18


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





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





A number
of pharmaceutical and biotechnology companies and research and academic
institutions have developed technologies, filed patent applications or received
patents on various technologies that may be related to our business. Some of
these technologies, applications or patents may conflict with our technologies
or patent applications. Such conflicts could limit the scope of the patents, if
any, we may be able to obtain or result in the denial of our patent applications
or block our rights to exploit our technology. In addition, if the USPTO or
foreign patent agencies have issued or issue patents that cover our activities
to other companies, we may not be able to obtain licenses to these patents at
all, or at a reasonable cost, or be able to develop or obtain alternative
technology. If we do not obtain such licenses, we could encounter delays in or
be precluded altogether from introducing products to the market. For example, we
are aware that Pfizer has been recently issued a U.S. patent by the USPTO and
the European Patent Office has issued a notice of allowance on a patent, both of
which cover the use of azithromycin in a topical formulation to treat bacterial
infections in the eye. We may conclude that we require a license under these
patents to develop or sell AzaSite in the U.S. and/or Europe, which may not be
available on reasonable commercial terms if at all. If we are unable to obtain a
license to these patents and our technology is deemed to infringe these patents,
we could be enjoined from pursuing the commercialization of AzaSite in Europe
and/or the U.S.





We may
need to litigate in order to defend against or assert claims of infringement, 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. 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.





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





**Our
Current Financial Situation May Impede Our Ability to Protect or Enforce
Adequately Our Legal Rights Under Agreements and to Our Intellectual
Property**





Our
current cash will only enable us to continue our operations as currently planned
until approximately the begining of June 2005. Our limited financial
resources makes it more difficult for us to enforce our intellectual property
rights, through the filing or maintenance of patents, taking legal action
against those that may infringe on our proprietary rights, defending
infringement claims against us, or otherwise. Our current financial situation
may impede our ability to enforce our legal rights under various agreements we
are currently a party to or may become a party to due to our inability to incur
the costs associated with such enforcement. Our inability to protect our legal
and intellectual property rights adequately may make us more vulnerable to
infringement and could harm our business.





19


**If
We Infringe the Rights of Third Parties We Could Be Prevented From Selling
Products and Forced to Pay Damages and to Defend Against
Litigation**





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
Products Are Subject to Government Regulations and Approval Which May Delay or
Prevent the Marketing of Potential Products and Impose Costly Procedures Upon
Our Activities**





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





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
Rely on Third Parties to Develop, Market and Sell Our Products, We May Not Be
Able to Continue or Enter into Third Party Arrangements, and these Third
Parties’ Efforts May Not Be Successful**





20


Following
the termination of our ISV-900 agreement with Pharmacia in December 2000, we
began to develop a marketing organization focused on the launch of our OcuGene
glaucoma genetic test. We do not plan on establishing a dedicated sales force or
a marketing organization for our other product candidates and primarily use
external marketing and sales resources even for OcuGene. We also rely on third
parties for clinical testing or product development. In addition, in May 2001,
Pharmacia terminated the licensing agreement we had entered into with them in
January 1999, that granted Pharmacia an exclusive worldwide license for ISV-205
for the treatment of glaucoma. We now must enter into another third party
collaboration agreement for the development, marketing and sale of our ISV-205
product or develop, market and sell the product ourselves. There can be no
assurance that we will be successful in finding a new corporate partner for our
ISV-205 program or that any collaboration will be successful, either of which
could significantly harm our business. In addition, we have no experience in
marketing and selling products and we cannot assure you that we would be
successful in marketing ISV-205 ourselves. If we are to develop and
commercialize our product candidates successfully, including ISV-205, we will be
required to enter into arrangements with one or more third parties that
will:





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


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


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





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





We are
marketing and selling our OcuGene glaucoma genetic test mainly using external
marketing and sales resources that include:





·
    marketing
      consultants;


·
    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, as we have experienced with Pharmacia, these
relationships can be terminated forcing us to seek alternatives. We may not be
able to build a marketing staff or sales force and our sales and marketing
efforts may not be cost-effective or successful.





In
addition, we currently contract with a third party to assemble the sample
collection kits used in our Ocu G ene
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.





21


**We
Have No Experience in Performing the Analytical Procedures Related to Genetic
Testing and Have Established an Exclusive Commercial Agreement with a Third
Party to Perform These Procedures For Our OcuGene Glaucoma Genetic Test; If We
Are Unable to Maintain this Arrangement, and Are Unable to Establish New
Arrangements with Third Parties, We Will Have to Establish Our Own Regulatory
Compliant Analytical Process for Genetic Testing and May Not Have the Financial
Resources to Do So**





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





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





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


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


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





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




**We
Rely on a Sole Source for Some of the Raw Materials in Our Products, Including
AzaSite, and the Raw Materials We Need May Not be Available to
Us**





We
currently have a single supplier for azithromycin, the active drug incorporated
into our AzaSite product candidate. The supplier has submitted a Drug Master
File on the compound with the FDA and is subject to the FDA’s review and
oversight. If the FDA were to identify issues in the production of the drug that
the supplier was unable to resolve quickly, or other issues were to arise that
impact production, our ability to continue with the development of AzaSite, and
potentially the commercial sale if the product is approved, could be
interrupted, which would harm our business. In addition, while we do have a
supply agreement for azithromycin through the clinical development of the
product, we do not currently have a contractual agreement with this supplier of
azithromycin for commercial production and consequently this supplier is not
obligated to provide us any particular quantities of the drug for
commercialization. Additional suppliers for this drug exist, but qualification
of an alternative source could be time consuming, expensive and could result in
a delay that could harm our business and there is no guarantee that these
additional suppliers can supply sufficient quantities at a reasonable price, or
at all.





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 to supply Bausch & Lomb with sufficient quantities of the drug,
Bausch & Lomb’s ability to continue with the development, and potentially
the commercial sale if the product is approved, of ISV-403 would be interrupted
or impeded, and our royalties from commercial sales of the ISV-403 product could
be delayed or reduced and our business could be harmed.





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





22


**We
Have No Experience in Commercial Manufacturing and Need to Establish
Manufacturing Relationships with Third Parties, and If Contract Manufacturing Is
Not Available to Us or Does Not Satisfy Regulatory Requirements, We Will Have to
Establish Our Own Regulatory Compliant Manufacturing Capability and May Not Have
the 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 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. While
we are in discussions towards a commercial manufacturing agreement, we could
encounter delays or difficulties in finalizing such an agreement, which would
adversely impact our potential market introduction and subsequent sales of
AzaSite.





We
currently contract with a third party to assemble the sample collection kits
used in our Ocu G ene
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. 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 obtain cost
advantages, patent protection or other intellectual property rights that would
block or limit our ability to develop our potential products. Our competitors
may also obtain regulatory approval for commercialization of their products more
effectively or rapidly than we will. If we decide to manufacture and market our
products by ourselves, we will be competing in areas in which we have limited or
no experience such as manufacturing efficiency and marketing capabilities. See
“— We Have No Experience in Commercial Manufacturing and Need to Establish
Manufacturing Relationships with Third Parties, and If Contract Manufacturing Is
Not Available to Us or Does Not Satisfy Regulatory Requirements, We Will Have to
Establish Our Own Regulatory Compliant Manufacturing Capability and May Not Have
the Financial Resources to Do So.”





23


**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
suffer.





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 ours
already approved or in development including Zymar and Ocuflox by Allergan,
Vigamox and Ciloxan by Alcon, Quixin by Johnson & Johnson and Chibroxin by
Merck. 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.





**Uncertainties
Regarding Healthcare Reform and Third-Party Reimbursement May Impair Our Ability
to Raise Capital, Form Collaborations and Sell Our
Products**





The
continuing efforts of governmental and third-party payers to contain or reduce
the costs of healthcare through various means may harm our business. For
example, in some foreign markets the pricing or profitability of health care
products is subject to government control. In the United States, there have
been, and we expect there will continue to be, a number of federal and state
proposals to implement similar government control. The implementation or even
the announcement of any of these legislative or regulatory proposals or reforms
could harm our business by impeding our ability to achieve profitability, raise
capital or form collaborations.





In
addition, the availability of reimbursement from third-party payers determines,
in large part, the demand for healthcare products in the United States and
elsewhere. Examples of such third-party payers are government and private
insurance plans. Significant uncertainty exists as to the reimbursement status
of newly approved healthcare products, and third-party payers are increasingly
challenging the prices charged for medical products and services. If we succeed
in bringing one or more products to the market, reimbursement from third-party
payers may not be available or may not be sufficient to allow us to sell our
products on a competitive or profitable basis.





**Our
Insurance Coverage May Not Adequately Cover Our Potential Product Liability
Exposure**





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





24


**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 $10,400 and $6,000 for the years ended 2004 and 2003,
respectively. In the event of such an accident involving these materials, we
could be held liable for any damages that result, and any such liability could
exceed our resources. Moreover, as our business develops we may be required to
incur significant costs to comply with federal, state and local environmental
laws, regulations and policies, especially to the extent that we manufacture our
own products.





**If
We Engage in Acquisitions, We Will Incur a Variety of Costs, and the Anticipated
Benefits of the Acquisition May Never be Realized**





We may
pursue acquisitions of companies, product lines, technologies or businesses that
our management believes are complementary or otherwise beneficial to us. Any of
these acquisitions could have negative effects 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. Any of these results could
harm our financial condition. 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 and Security Interests in Our Assets Held
by Management May Enable Them to Control the Disposition of Such
Assets**





As of
December 31, 2004, our management and principal stockholders together
beneficially owned approximately 20% of our outstanding shares of common stock.
As a result, these stockholders, acting together, may be able to exert
significant control on matters requiring approval by our stockholders, including
the election of a majority of our directors and the approval of business
combinations.





In July
2003, we issued a $400,000 short-term senior secured note payable to Dr.
Chandrasekaran, our chief executive officer, chief financial officer and a
member of our board of directors, for cash. As of December 31, 2004, $250,000 of
this note remained outstanding. This note bears an interest rate of five and
one-half percent (5.5%) and is due on the earlier to occur of March 31, 2007 or
30 days subsequent to the successful completion of a pivotal Phase 3clinical
trial with AzaSite and is secured by a lien on substantially all of our assets
including our intellectual property and certain other equipment secured by the
lessor of such equipment.





This
security interest enables Dr. Chandrasekaran to control the disposition of these
assets in the event of our liquidation. If we are unable to repay the amounts
due under this note, he could, or cause us to, enter into involuntary
liquidation proceedings in the event we default on our obligation.





In
addition, investors in our March 2004 private placement, as a group, owned
approximately 50% of our outstanding shares of common stock as of October 29,
2004. If such investors were to exercise the warrants they currently hold,
assuming no additional acquisition or distributions, such investors would own
approximately 61% of our outstanding shares of common stock based on their
ownership percentages as of October 29, 2004. Thus, these stockholders, acting
together, may be able to effectively control all matters requiring approval by
our stockholders, including the election of a majority of our directors and
approval of business combinations.





25


**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 the Operating Performance and Progress
of Our Company**





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 this report on Form 10-K that includes an explanatory paragraph
referring to our recurring operating losses and a substantial doubt about our
ability to continue as a going concern, our ability to obtain new financing, the
terms of any financing we are able to raise, the results of testing and clinical
trials, developments in patent or other proprietary rights of us or our
competitors, the status of our relationships with third-party collaborators,
technological innovations or new therapeutic products, governmental regulation,
litigation 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.





Further,
conversions of convertible securities and the sale of the shares of our Common
Stock underlying those convertible securities, such as the warrants issued to
Xmark and others, could cause a significant decline in the market price for our
common stock. Additionally, the warrants issued to Xmark contain anti-dilution
provisions that would decrease the conversion or exercise price of these
instruments and, in the case of the Xmark warrants, result in an increase in the
number of shares of our common stock issuable under them. 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, the terrorist attacks in the U.S. and abroad, the U.S. retaliation for
these attacks, the war in Iraq and continued worldwide economic weakness and the
related decline in consumer confidence have had, and may continue to have, an
adverse impact on the U.S. and world economy. These and similar events, as well
as fluctuations in our operating results and market conditions for
biopharmaceutical and biotechnology stocks in general, could have a significant
effect on the volatility of the market price for our common stock and on the
future price of our common stock.





**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, 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.





26


**Legislative
Actions, Higher Insurance Costs and Potential New Accounting Pronouncements Are
Likely to Impact Our Future Financial Position and Results of
Operations.**





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








**EXECUTIVE
OFFICERS AND OTHER SENIOR MANAGEMENT OF THE REGISTRANT**





As of
March 30, 2005, our executive officers and other senior management were as
follows:




**Name**
    **Age**
    **Title**S.
      Kumar Chandrasekaran, Ph.D.
    62
    Chairman
      of the Board, President, Chief Executive Officer and Chief Financial
      OfficerLyle
      M. Bowman, Ph.D.
    56
    Vice
      President, Development and OperationsDavid
      F. Heniges
    61
    Vice
      President and General Manager, Commercial
      OpportunitiesSandra
      C. Heine
    43
    Vice
      President, Finance and AdministrationErwin
      C. Si, Ph.D.
    51
    Senior
      Director, Preclinical Research





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





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





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






27





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.




**Item
2. Properties**





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





**Item
3. Legal Proceedings** .





On July
8, 2004, Bristol Investment Group, or Bristol, filed with the American
Arbitration Association (“AAA”) a demand for arbitration against us seeking
payment of $218,684 and warrants to purchase 461,400 shares of our common stock
based on a letter agreement dated January 28, 2003 pursuant to which Bristol was
engaged as a non-exclusive placement agent of investment capital for us. 
In subsequent filings with the AAA Bristol claimed it is entitled to recover
$249,925 plus interest and attorneys’ fees, plus warrants to purchase 922,800
shares of our common stock. We dispute Bristol’s claim and have vigorously
defended against the claim. An evidentiary hearing has been held in the
arbitration but no ruling has yet been issued by the
arbitrator.





On or
about October 8, 2003, Thai Nguyen (“Nguyen”) filed a complaint in the Superior
Court of California, County of San Francisco (No. CGC 03425230) against us, our
CEO Kumar Chandrasekaran, the Regents of the University of California
(“Regents”) and two individuals associated with Regents. Nguyen alleged that we
breached an obligation to continue supporting his research; he also made a
variety of other related claims and allegations against us and the other
defendants. Nguyen filed a Second Amended Complaint on or about July 19,
2004.





While the
amount of monetary relief was not specifically quantified in the Second Amended
Complaint, in general Nguyen sought to enforce a claimed agreement, which states
that we would pay him between $100,000 and $200,000 in annual laboratory support
“for the life of patent” and make a bonus payment to him of $50,000. Nguyen also
sought relief in connection with 30,000 InSite options provided to him by us but
which he gave back at the direction of Regents. The Second Amended Complaint
also sought unspecified punitive damages, attorneys’ fees and other damages and
relief including an exclusive, royalty free license to certain patents.





In
December 2004, the parties reached a settlement resulting in a total payment
owed to Nguyen of  $250,000, of which $100,000 was reimbursed by our
insurance carrier, and issuance of 30,000 stock options valued at $23,253 using
the Black-Scholes option pricing model. At December 31, 2004 we had paid $75,000
of the settlement payment owed and accrued the remainder, which was paid January
2005.





28





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





None





**PART
II**





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





**Market
Information**





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





**2004**
    
    **High**
    
    **Low**First
      Quarter
    
    $
    1.15
    
    $
    0.49Second
      Quarter
    
    $
    0.93
    
    $
    0.60Third
      Quarter
    
    $
    0.70
    
    $
    0.47Fourth
      Quarter
    
    $
    0.88
    
    $
    0.55**2003**
    
    
    **High**
    
    
    **Low**First
      Quarter
    
    $
    1.00
    
    $
    0.63Second
      Quarter
    
    $
    0.70
    
    $
    0.53Third
      Quarter
    
    $
    0.66
    
    $
    0.45Fourth
      Quarter
    
    $
    0.69
    
    $
    0.33








**Holders**





As of
March 28, 2005, we had approximately 400 stockholders of record. On March 28,
2005, the last sale price reported on The American Stock Exchange for our common
stock was $0.51 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.





29


**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 consolidated financial statements and notes thereto elsewhere in this
Annual Report on Form 10-K and the following Management’s Discussion and
Analysis of Financial Condition and Results of Operations. The following
table sets forth selected consolidated financial data for us for the five years
ended December 31, 2004 (in thousands except per share amounts):





**Year Ended December
      31,****2004**
    
    **2003**
    
    **2002**
    
    **2001**
    
    **2000****Consolidated
      Statements of Operations Data**Contract,
      product and other revenues
    
    $
    542
    
    $
    134
    
    $
    36
    
    $
    5
    
    $
    4,513Cost
      of goods
    
    
    14
    
    
    20
    
    
    114
    
    
    —
    
    
    —Operating
      expenses:Research
      and development, net
    
    
    7,273
    
    
    4,436
    
    
    6,911
    
    
    6,610
    
    
    1,674Selling,
      general and administrative
    
    
    3,341
    
    
    3,021
    
    
    4,022
    
    
    3,523
    
    
    2,584Total
      expenses
    
    
    10,614
    
    
    7,457
    
    
    10,933
    
    
    10,133
    
    
    4,258Gain
      on sale of assets
    
    
    4,616
    
    
    1,153
    
    
    —
    
    
    —
    
    
    —Interest
      (expense), and other income net
    
    
    (44
    )
    
    (561
    )
    
    62
    
    
    572
    
    
    791Income
      (loss) before cumulative
      effect
      of accounting change
    
    
    (5,514
    )
    
    (6,751
    )
    
    (10,949
    )
    
    (9,556
    )
    
    1,046Cumulative
      effect of accounting change (1)
    
    
    —
    
    
    —
    
    
    —
    
    
    —
    
    
    (4,486
    )Net
      income (loss)
    
    
    (5,514
    )
    
    (6,751
    )
    
    (10,949
    )
    
    (9,556
    )
    
    (3,440
    )Non
      cash preferred dividend
    
    
    
    
    
    221
    
    
    48
    
    
    —
    
    
    3Net
      income (loss) applicable to common stockholders
    
    $
    (5,514
    )
    $
    (6,972
    )
    $
    (10,997
    )
    $
    (9,556
    )
    $
    (3,443
    )Basic
      earnings (loss) per share:Net
      income (loss) per share applicable to common stockholders before
      cumulative effect of accounting change
    
    $
    (0.11
    )
    $
    (0.27
    )
    $
    (0.44
    )
    $
    (0.38
    )
    $
    0.04Cumulative
      effect of accounting change (1)
    
    
    —
    
    
    —
    
    
    —
    
    
    —
    
    
    (0.19
    )Net
      income (loss) per share applicable to common stockholders
    
    $
    (0.11
    )
    $
    (0.27
    )
    $
    (0.44
    )
    $
    (0.38
    )
    $
    (0.15
    )Diluted
      earnings (loss) per share:Net
      income (loss) per share applicable to common stockholders before
      cumulative effect of accounting change
    
    $
    (0.11
    )
    $
    (0.27
    )
    $
    (0.44
    )
    $
    (0.38
    )
    $
    0.04Cumulative
      effect of accounting change (1)
    
    
    —
    
    
    —
    
    
    —
    
    
    —
    
    
    (0.18
    )Net
      income (loss) per share applicable to common stockholders
    
    $
    (0.11
    )
    $
    (0.27
    )
    $
    (0.44
    )
    $
    (0.38
    )
    $
    (0.14
    )Pro-forma
      net income (loss) assuming the accounting change is applied
      retroactively
    
    $
    (5,514
    )
    $
    (6,972
    )
    $
    (10,997
    )
    $
    (9,556
    )
    $
    1,043Pro-forma
      net income (loss) per share assuming the accounting change is applied
      retroactively, basic and diluted
    
    $
    (0.11
    )
    $
    (0.27
    )
    $
    (0.44
    )
    $
    (0.38
    )
    $
    0.04Shares
      used to calculate basic net income (loss) per share
    
    
    47,984
    
    
    25,767
    
    
    24,997
    
    
    24,897
    
    
    23,574Shares
      used to calculate diluted net income (loss) per share
    
    
    47,984
    
    
    25,767
    
    
    24,997
    
    
    24,897
    
    
    24,483Shares
      used to calculate pro-forma basic net income (loss) per
    share
    
    
    47,984
    
    
    25,767
    
    
    24,997
    
    
    24,897
    
    
    23,574Shares
      used to calculate pro-forma diluted net income (loss) per
      share
    
    
    47,984
    
    
    25,767
    
    
    24,997
    
    
    24,897
    
    
    24,483





(1)
Reflects the impact of the adoption of SAB 101 on revenue recognition effective
January 1, 2000.





30


****


**December
    31,****2004**
    
    **2003**
    
    **2002**
    
    **2001**
    
    **2000****Consolidated
      Balance Sheet Data**Cash
      and cash equivalents, unrestricted
    
    $
    5,351
    
    $
    1,045
    
    $
    1,179
    
    $
    10,095
    
    $
    18,904Working
      capital
    
    
    3,515
    
    
    (6,434
    )
    
    353
    
    
    8,747
    
    
    18,305Total
      assets
    
    
    5,696
    
    
    1,405
    
    
    1,866
    
    
    11,051
    
    
    20,000Long
      term notes payable
    
    
    —
    
    
    16
    
    
    10
    
    
    45
    
    
    26Convertible
      preferred stock
    
    
    —
    
    
    —
    
    
    2,048
    
    
    —
    
    
    —Accumulated
      deficit
    
    
    (121,236
    )
    
    (115,722
    )
    
    (108,750
    )
    
    (97,753
    )
    
    (88,197
    )Total
      stockholders’ equity (deficit)
    
    
    3,601
    
    
    (6,200
    )
    
    887
    
    
    9,485
    
    
    18,770





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




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





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





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





**Overview**





We are an
ophthalmic product development company focused on ocular infections, glaucoma,
and retinal diseases through three technology platforms that include our
patented time-release ophthalmic drug delivery system DuraSite; genomic research
for the diagnosis, prognosis and management of glaucoma; and a retinal drug
delivery device.





In 2003,
we faced significant challenges related to our lack of financial resources. To
continue our operations we took a number of actions to reduce our cash usage
including:





·
    we
      laid-off approximately 42% of our
personnel;


·
    our
      senior management voluntarily reduced their
salaries;


·
    we
      placed several development programs on hold, including those related to
      our ISV-900 technology, ISV-014 our retinal delivery device, and
      treatments for retinal diseases;


·
    we
      slowed the clinical activities related to AzaSiteTM(ISV-401); and


·
    we
      instituted other cash saving actions including extending the payment of
      our liabilities.





On June
14, 2004, after receiving stockholder approval, we completed the final closing
of a private placement of shares of our common stock and warrants to purchase
shares of our common stock pursuant to subscription agreements entered into
between us and certain accredited investors on March 26, 2004. We raised an
aggregate of approximately $15.1 million, net of fees and expenses, through the
sale and issuance of an aggregate of 33,000,000 shares of our common stock and
warrants to purchase 16,500,000 shares of our common stock in the initial and
final closings of this private placement. We expect that our current funds will
be sufficient to permit us to continue our operations as currently planned until
approximately the begining of June 2005. Although we continue to carefully
monitor our expenses, with the receipt of the additional funds from the 2004
private placement, we were able in June 2004 to restore management salaries to
the same level as they were prior to the voluntary salary reductions and fully
resume our clinical activities related to AzaSite.





31





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





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


·
    AzaSite
      Plus (ISV-502), a DuraSite formulation of azithromycin and a steroid;
      and


·
    targeted
      activities to support the scientific/clinical foundation and market
      introduction of ourOcuGene
      glaucoma genetictest
      based on our ISV-900 technology.





*AzaSite
(ISV-401).* We have
developed a topical formulation 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, to treat bacterial
conjunctivitis and other infections of the outer eye. We believe that the key
advantages of AzaSite may include a significantly reduced dosing regimen (7
doses vs. 36 doses for comparable products), the high and persistent levels of
azithromycin achieved in the tissues of the eye and its wide spectrum of
activity. Product safety and efficacy have been shown, respectively, in Phase 1
and Phase 2 clinical trials. The Phase 2 study compared an AzaSite formulation
containing 1% azithromycin to a placebo. The results of this study showed that
the AzaSite formulation was statistically significantly more effective than the
placebo in bacterial eradication and clinical cure, which includes reduction in
inflammation and redness.





In July
2004, we initiated two pivotal Phase 3 clinical trials for AzaSite. One of the
Phase 3 clinical trials is a multi-center study in which patients in one arm
will be dosed with a 1% AzaSite formulation and the patients in the second arm
will be dosed with a placebo. This study is designed to include approximately
550 patients, of which 224 must be confirmed positive for acute bacterial
conjunctivitis in at least one eye. The other Phase 3 clinical trial is a
multi-center study in which patients in one arm will be dosed with a 1% AzaSite
formulation and the patients in the second arm will be dosed with a 0.3%
formulation of the antibiotic tobramycin. This study is designed to include
approximately 775 patients, of which 310 must be confirmed positive for acute
bacterial conjunctivitis in at least one eye. The Phase 3 trials are being
conducted in the United States and we anticipate including both children and
adults to permit aggressive enrollment of the subjects necessary to complete the
studies. The primary endpoints of both trials will be microbial eradication and
clinical cure. In October 2004, we announced that over 100 of the centers at
which the clinical trials will be conducted have been activated and are able to
begin to enroll patients in the two clinical trials.





In 2003,
we secured a new source for the active ingredient used in AzaSite and have a
contract-manufacturing site for production of clinical trial supplies and
registration batches. The supplies are being manufactured under the supervision
of our personnel. We are planning to manufacture the registration batches needed
to support the filing of the New Drug Application, or NDA, for AzaSite with the
United States Food and Drug Administration, or FDA, at this contract facility in
the fourth quarter of 2004. We anticipate that our contract manufacturing
facility will be ready for inspection by the FDA at the time of our NDA
submission.





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





*Ocu* *G* *ene* . Our
Ocu G ene
glaucoma genetic test is based on our glaucoma genetics program, which has been
pursued in collaboration with academic researchers, is focused on discovering
genes that are associated with glaucoma, and the mutations on these genes that
cause and regulate the severity of the disease. In June 2003, a peer-reviewed
study was published in *Clinical Genetics* titled
"Association of the Myocilin mt.1 Promoter Variant with the Worsening of
Glaucomatous Disease Over Time," (2003: 64: 18-27). "The results of this study
indicate substantial evidence that the TIGR/MYOC mt.1(+) variant provides a
strong marker for accelerated worsening of both optic disc and visual field
measures of glaucoma progression above and beyond other baseline risk factors,"
stated one of the authors of the study, Jon Polansky, M.D., University of
California, San Francisco, who also serves on our Scientific Advisory Board.





32


In 2003,
the information from this article and previous publications was used to target
specific thought leaders and ophthalmic centers in an effort to support the
focused introduction of the Ocu G ene
glaucoma genetic test. Expanded marketing efforts were curtailed as we limited
our cash use and we have not resumed the marketing efforts as we focus on our
AzaSite clinical trials. Our current focus is on the clinical validation
necessary to support use of this technology.





*ISV-403* . In
December 2003, we sold the ISV-403 product candidate to Bausch & Lomb, or
B&L, which resulted in the receipt of $1.5 million in cash, the return of
the $4.0 million of Series A-1 Preferred Stock, and the related dividends, to us
for cancellation, and entitles us to receive royalties on future
product sales, if any. During the first nine months of 2004, we provided
contract research services to B&L. These activities have been completed and
due to the sale, B&L now is responsible for the further clinical development
of the product and we are focusing our development efforts on our AzaSite
product candidate.





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





**Critical
Accounting Policies and Use of Estimates**





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





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





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





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





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





We
directly reduced expenses for amounts reimbursed due to cost sharing agreements
during the year ended December 31, 2002. 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. During the years ended 2004 and 2003, we recognized cost reimbursements
as contract and other revenue in accordance with EITF 01-14, “Income Statement
Characterization of Reimbursement for “Out of Pocket” Expenses
Incurred.”





33


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 the 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 the
sales of Ocu G ene may
be recognized in a later period than the associated recognition of costs of the
services provided, especially during the initial launch of the product. The
revenue in connection with the sale of ISV-403 to B&L was recognized over
the contract period.





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





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





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





**Results
of Operations**





*Revenues.*


We had
total net revenues of $542,000, $134,000, and $36,000 for the years ended
December 31, 2004, 2003 and 2002, respectively, from contract research
activities, sales of Ocu G ene and
sales of AquaSite Ò by CIBA
Vision and Kukje Pharma Ind. Co., Ltd., our AquaSite manufacturing partner in
Korea. The increase in revenue is due to contract research activities conducted
for Bausch & Lomb in 2004 and 2003 under the ISV-403 Asset Purchase
Agreement. We are no longer providing services to B&L and we do not expect
to derive revenue from these activities in 2005 or future years.





*Cost
of goods.*


Cost of
goods of $14,000, $20,000 and $114,000 for 2004, 2003 and 2002, respectively,
reflect the cost of Ocu G ene tests
performed as well as the cost of sample collection kits distributed for use.





*Research
and development.*


Research
and development expenses increased to $7.3 million from $4.4 million in 2004
compared to 2003. 93% of this increase is due to the initiation of the AzaSite
Phase 3 clinical trials and production of the related clinical supplies and
registration batches. The remainder of the increase reflects salary increases to
our research staff to return such salaries to the same level they were prior to
the voluntary salary reductions instituted in 2003 and costs related to
increased research activities in support of our AzaSite program.





Research
and development expenses decreased to $4.4 million from $7.1 million in 2003
compared to 2002. This 38% decrease reflects the personnel cost containment
actions taken in the second quarter of 2003 and the reduction in support for
external research which was begun in the first quarter of 2003. Additionally,
costs incurred in 2002 for the license of the Optineuron gene from University of
Connecticut Health Center (“UCHC”) and the related cost of new patent filings,
were not incurred in 2003 as the majority of the initial filings were completed
in 2002.





34


In 2004
and 2003, we received no R&D cost reimbursements and in 2002 our R&D
cost reimbursements were $0.2 million. Cost reimbursement in 2002 related to
joint development programs to evaluate compounds for ophthalmic
use.





Our
R&D activities can be separated into two major segments, research and
clinical development. Research includes activities involved in evaluating a
potential product and the related pre-clinical testing. 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 2004, 2003 and 2002 (in thousands):




2004
    
    2003
    
    2002Research
    
    $
    2,874
    
    $
    2,707
    
    $
    4,860Clinical
      development
    
    
    4,398
    
    
    1,729
    
    
    2,217Total
      research and development
    
    $
    7,273
    
    $
    4,436
    
    $
    7,077





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





The
increase in research activities in 2004 compared to 2003 reflects salary
increases to our research staff to return such salaries to the same level they
were prior to the voluntary salary reductions instituted in 2003 and costs
related to increased patent and research activities in support of the AzaSite
program. The decrease in research activities in 2003 compared to 2002 reflects
the cost containment efforts initiated in the second quarter of 2003. In May
2003, we instituted a one-month furlough, which included 80% of our research
personnel. In June 2003, approximately 75% of the furloughed research personnel
were laid-off. In 2003 we also continued to reduce our financial support of the
research related to our genetics programs by not renewing certain research
contracts pending the receipt of additional funding. In a further effort to
reduce expenses, we have reviewed, and will continue to review, our patent
filings and will discontinue maintenance of patents and patent applications
related to programs that we have determined not to pursue.





90% of
the increase in Clinical development expenses to $4.4 million in 2004 from $1.7
million in 2003 is related to the initiation of the AzaSite Phase 3 clinical
trials in 2004. The remainder of the increase reflects the increase in staffing
to support the AzaSite clinical trials and preparation for the related
regulatory filings. The 22% decrease in Clinical development expenses from $2.2
million in 2002 to $1.7 million in 2003 reflects the cost containment efforts
initiated across the company in the second quarter of 2003. In May 2003, we
instituted a one-month furlough, which included 50% of our clinical development
personnel. In June 2003, approximately 83% of the furloughed clinical
development personnel were laid-off. Additionally, clinical development costs
related to the Ocu G ene
glaucoma genetic test were reduced as the studies were completed in 2002 and no
new studies were begun in 2003.





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.





35


*Selling,
general and administrative.*





Selling,
general and administrative expenses increased to $3.3 million in 2004 from $3.0
million in 2003. Personnel-related expenses increased 139% in 2004 due to the
payment of performance bonuses to our selling, general and administrative
personnel in June 2004 and salary increases to these staff members to return
such salaries to the same level they were prior to the salary reduction in 2003.
This increase was partially offset by a reduction in our legal and financial
service activities as expenses incurred in the second half of 2003 towards
raising funds were not incurred in the second half of 2004.





Selling,
general and administrative expenses decreased 25% to $3.0 million in 2003 from
$4.0 in 2002. This reflects the approximately 79% decrease in selling expenses
related to the initial market introduction of Ocu G ene in
2002, such as advertising and our limited initial contract sales force. The
remaining decrease includes a 47% decrease in personnel-related costs due to the
impact of the employee furloughs, lay-offs and voluntary salary reductions
instituted in 2003. While our legal costs related to our fund raising efforts
and the cost of our insurance coverage, including directors and officers
insurance increased approximately 56% in 2003 compared to 2002, these costs were
more than offset by the other expense containment measures.





*Gain
on sale of assets.*





The gain
on sale of assets reflects the sale of the ISV-403 product candidate to B&L
in December 2003. We received $1.5 million in cash and B&L surrendered the
$4.0 million of Series A-1 Preferred Stock, plus accumulated dividends, we had
issued to them under the August 2002 License and Preferred Stock Purchase
Agreements. The total gain was recognized over the five-month period that we had
an obligation to provide contract research support for ISV-403, which began in
December 2003 and resulted in $4.6 million and $1.2 million being recognized in
2004 and 2003, respectively.





*Interest,
other income and expenses.*





Net
interest, other income and expense was an expense of $44,000 and $561,000 in
2004 and 2003, respectively, compared to income of $62,000 in 2002. This change
both from 2004 to 2003, and 2003 to 2002, principally reflects the $545,000 of
interest expense related to the debt discount of the convertible debentures
recorded in 2003, and interest expense related to the short-term notes payable
in 2003 and 2004. Any interest earned or paid in the future will be dependent on
our ability to raise additional funding and prevailing interest rates.


**Liquidity
and Capital Resources**





We have
financed our operations since inception primarily through private placements and
public offerings of debt and equity securities, equipment and leasehold
improvement financing, other debt financing and payments from corporate
collaborations. At
December 31, 2004, our unrestricted cash and cash equivalents balance was $5.4
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.





In March
2004, we received approximately $1.7 million, net of placement fees, from the
initial closing of a total private placement of up to $16.5 million. In June
2004, we completed the final closing of this private placement and received
approximately $13.4 million, net of placement fees.





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 other private or
public equity or debt financings, collaborative or other partnering
arrangements, asset sales, or other sources, we expect that our cash on hand,
anticipated cash flow from operations and current cash commitments to us will
only be adequate to fund our operations until approximately the begining of
June 2005. If we are unable to secure sufficient additional funding prior
to that time, we will need to cease operations and liquidate our assets, most of
which is secured by a note to an officer who is also a board member. 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.





36


Even if
we are able to obtain additional financing in order to continue long-term
operations beyond the begining of June 2005, we will require
and will seek additional funding through collaborative or other partnering
arrangements, public or private equity or debt financings, asset sales and from
other sources. However, there can be no assurance that we will obtain interim or
longer-term financing or that such funding, if obtained, will be sufficient to
continue our operations as currently conducted or in a manner necessary for the
continued development of our products or the long-term success of our company.
If we raise funds through the issuance of debt securities, such debt will be
secured by a security interest or pledge of all of our assets, will require us
to make principal and interest payments, would likely include the issuance of
warrants and may subject us to restrictive covenants. In addition, our
stockholders may suffer substantial dilution if we raise additional funds by
issuing equity securities.





For the
years ended December 31, 2004, 2003 and 2002, cash used for operating activities
was $10.0 million, $5.6 million and $11.0 million, respectively. Cash from (used
in) investing activities were ($183,000), $1,477,000 and ($61,000) primarily
related to an increase in restricted cash, proceeds received from the sale of
assets and cash outlays for additions to laboratory and other equipment made
during 2004, 2003 and 2002, respectively. ****





Cash
provided by financing activities was $14.5 million, $4.0 million and $2.1
million for the years ending December 31, 2004, 2003 and 2002, respectively. We
received net proceeds of $15.1 million from the issuance of an aggregate of 33.0
million shares of common stock and warrants to purchase 16.5 million shares of
common stock in the initial and final closings of the March 2004 private
placement. We received $2.0 million in the first quarter of 2003 from the
issuance of 2,000 shares of our Series A-1 preferred stock to B&L under the
ISV-403 license agreement. We issued $1.0 million of short-term notes payable in
2003 to directors, members of senior management and other stockholders. These
notes bear interest at rates from 2% to 12% and are due from January 15, 2003
through March 31, 2007. In 2004 we repaid $621,000 of these notes in cash. In
the year ended December 2003, we received $845,000, net of debt issuance costs
of approximately $154,000, from the issuance of convertible debentures. These
debentures were later converted into 3,763,651 shares of common stock in 2003.
In 2004, we received $12,000 from the issuance of our common stock from the
exercise of stock options by employees and purchases under the employee stock
purchase plan compared to $3,000 in 2003 and $125,000 in 2002. During 2003 we
also received $134,000 in connection with private placements of our common
stock. We received payments on a note to a stockholder of $21,000, $23,000 and
$26,000 in 2004, 2003 and 2002, respectively. We also made $13,000 of payments
on capital leases for certain laboratory equipment in 2004 compared to $18,000
in 2003 and $31,000 in 2002.





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





We
anticipate no material capital expenditures to be incurred for environmental
compliance in fiscal year 2004. 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, 2004 and the effect such obligations are expected to have on our
liquidity and cash flows in the future periods. This table excludes amounts
already recorded on our balance sheet as current liabilities.








37










Payments
      due by period(in
      thousands)Total
    
    Less
      than 1 year
    
    1 -
      3 years
    
    3 -
      5 years
    
    More
      than 5 yearsOperating
      lease obligations (1)
    
    $
    1,512
    
    $
    743
    
    $
    769
    
    $
    -
    
    $
    -Licensing
      agreement obligations (2)
    
    
    105
    
    
    15
    
    
    45
    
    
    45
    
    
    45Total
      commitments
    
    $
    1,617
    
    $
    758
    
    $
    814
    
    $
    45
    
    $
    45





(1)
    
    We lease our facilities under a
      non-cancelable operating lease that expires in 2006.(2)
    
    We have entered into certain license
      agreements that require us to make minimum royalty payments for the life
      of the licensed patents. The life of the patents which may be issued and
      covered by the license agreements cannot be determined at this time, but
      the minimum royalties due under such agreements are as noted for 2004
      through 2011 and are approximately $15,000 per year until the first
      commercial sale, increase to $25,000 per year in the first three years of
      sales, and then increase to $40,000 per year until the expiration of the
      related patents.





**Recent
Accounting Pronouncements**





In
December 2004, the Financial Accounting Standards Board (“FASB”) issued
Statement of Financial Accounting Standards No. 123 (revised), “Share-Based
Payment” (“SFAS 123R”) which requires the measurement of all employee
share-based payments to employees, including grants of employee stock options,
using a fair-value-based method and the recording of such expense in
consolidated statements of operations. The statement requires companies to
assess the most appropriate model to calculate the value of the options. There
are a number of requirements under the new standard that would result in
differing accounting treatment than currently required. These differences
include, but are not limited to, accounting for the tax benefit on employee
stock options and for stock issued under our employee stock purchase plan.
SFAS 123R must be adopted no later than July 1, 2005 and we will begin
to apply it in the quarter beginning on that date. We believe that employee
stock options represent an appropriate and essential component of our overall
compensation program. We grant options to substantially all employees and
believes that this broad-based program helps us to attract, motivate, and retain
high quality employees, to the ultimate benefit of our stockholders. The
adoption of SFAS 123R is expected to result in a material increase in expense
during the second half of 2005 based on unvested options outstanding as of
December 31, 2004 and current compensation plans. While the effect of adoption
depends on the level of share-based payments granted in the future and unvested
grants on the date we adopt SFAS 123R, the effect of this accounting standard on
its prior operating results would approximate the effect of SFAS 123 as
described in the disclosure of pro forma net loss and net loss per
share.




In
March 2004, the FASB issued Emerging Issues Task Force No. 03-1, “The
Meaning of Other-Than-Temporary Impairment and Its Application to Certain
Investments” (“EITF 03-1”), which provided new guidance for assessing impairment
losses on investments. Additionally, EITF 03-1 includes new disclosure
requirements for investments that are deemed to be temporarily impaired. In
September 2004, the FASB delayed the accounting provisions of EITF 03-1;
however, the disclosure requirements remain effective for annual periods ending
after June 15, 2004. The Company will evaluate the impact of EITF 03-1 once
final guidance is issued.





**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, 2004, we had $5.5 million invested in interest bearing operating accounts.
While a hypothetical decrease in market interest rates by 10 percent from the
December 31, 2004 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.





38


****


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





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


PageReports
      of Independent Auditors
    
    40
      - 41Consolidated
      Balance Sheets - December 31, 2004 and 2003
    
    42Consolidated
      Statements of Operations
      Years
      Ended December 31, 2004, 2003 and 2002
    
    43Consolidated
      Statements of Stockholders' Equity (Deficit)
      Years
      ended December 31, 2004, 2003 and 2002
    
    44Consolidated
      Statements of Cash Flows
      Years
      Ended December 31, 2004, 2003 and 2002
    
    45Notes
      to Consolidated Financial Statements
    
    46
      - 59




****


****


39


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











To the
Board of Directors and Stockholders of


InSite
Vision Incorporated





We have
audited the accompanying consolidated balance sheets of InSite Vision
Incorporated (the “Company”) as of December 31, 2004 and 2003 and the related
consolidated statements of operations, stockholders’ equity, and cash flows for
the years then ended. The consolidated financial statements are the
responsibility of the Company’s management. Our responsibility is to express an
opinion on these consolidated financial statements based on our
audits.





We
conducted our audits in accordance with the standards of the Public Company
Accounting Oversight Board (United States). Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements. An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.





In our
opinion, the consolidated financial statements referred to above present fairly,
in all material respects, the financial position of InSite Vision, Incorporated
as of December 31, 2004 and 2003 and the results of their operations and their
cash flows for the years then ended, in conformity with accounting principles
generally accepted in the United States of America.







As
discussed in Note 1 to the financial statements, the Company’s recurring losses
from operations raise substantial doubt about its ability to continue as a going
concern. Management’s plans as to these matters are also described in Note 1.
The 2004 financial statements do not include any adjustments that might result
from the outcome of this uncertainty.







/s/ Burr,
Pilger & Mayer LLP





Palo
Alto, California


March 4,
2005







40


**Report
of Ernst & Young LLP, Independent Registered Public Accounting
Firm**








The Board
of Directors and Stockholders


InSite
Vision Incorporated





We have
audited the consolidated statements of operations, stockholders’ equity and cash
flows of Insite Vision Incorporated for the year ended December 31, 2002. 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 audit.





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 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 audit provides a
reasonable basis for our opinion.





In our
opinion, the consolidated financial statements referred to above present fairly,
in all material respects, the consolidated results of operations and cash flows
of InSite Vision Incorporated for the year ended December 31, 2002, in
conformity with U.S. generally accepted accounting principles.





The
accompanying consolidated financial statements have been prepared assuming
InSite Vision Incorporated will continue as a going concern. As more fully
described in Note 1, the Company has incurred recurring operating losses, has an
accumulated deficit as of December 31, 2002 of $108.8 million and does not
currently have available sufficient funds to sustain its operations through
fiscal year 2003. These conditions raise substantial doubt about the Company’s
ability to continue as a going concern. Management’s plans in regard to these
matters are also described in Note 1. 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.











/s/ Ernst
& Young LLP





Palo
Alto, California


January
30, 2003







41


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


December
      31,(in
      thousands, except share and per share amounts)
    
    
    2004
    
    
    2003**Assets**Current
      assets:Cash
      and cash equivalents
    
    $
    5,351
    
    $
    1,045Restricted
      cash and cash equivalents
    
    
    170
    
    
    -Inventory
    
    
    18
    
    
    19Prepaid
      expenses and other current assets
    
    
    71
    
    
    91Total
      current assets
    
    
    5,610
    
    
    1,155Property
      and equipment, at cost:Laboratory
      and other equipment
    
    
    288
    
    
    837Leasehold
      improvements
    
    
    73
    
    
    73Furniture
      and fixtures
    
    
    -
    
    
    3361
    
    
    913Accumulated
      depreciation
    
    
    275
    
    
    66486
    
    
    249Deferred
      debt issuance cost
    
    
    -
    
    
    1Total
      assets
    
    $
    5,696
    
    $
    1,405**Liabilities
      and stockholders' equity (deficit)**Current
      liabilities:Short-term
      notes payable to related parties, unsecured
    
    $
    91
    
    $
    326Short-term
      notes payable to related parties, secured
    
    
    251
    
    
    682Accounts
      payable
    
    
    574
    
    
    972Accrued
      liabilities
    
    
    787
    
    
    650Accrued
      compensation and related expense
    
    
    317
    
    
    160Deferred
      revenue
    
    
    -
    
    
    4,616Deferred
      rent
    
    
    75
    
    
    183Total
      current liabilities
    
    
    2,095
    
    
    7,589Convertible
      note payable (net of beneficial conversion feature of $1)
    
    
    -
    
    
    16Total
      liabilities
    
    
    2,095
    
    
    7,605Commitments
      (Note 5)**Stockholders
      equity (deficit)**Preferred
      stock, $0.01 par value, 5,000,000 shares authorized, none issued
      and outstanding at December 31, 2004 and 2003
    
    
    -
    
    
    -Common
      stockholders' equity:Common
      stock, $0.01 par value, 120,000,000 shares
      authorized;62,381,808 issued and outstanding at December 31,
      2004;29,253,294 issued and outstanding at December 31,
      2003
    
    
    624
    
    
    293Additional
      paid-in capital
    
    
    124,400
    
    
    109,437Notes
      receivable from stockholder
    
    
    (187
    )
    
    (208
    )Accumulated
      deficit
    
    
    (121,236
    )
    
    (115,722
    )Common
      stockholders’ equity (deficit)
    
    
    3,601
    
    
    (6,200
    )Total
      liabilities and stockholders' equity (deficit)
    
    $
    5,696
    
    $
    1,405


**
 *See
accompanying notes to consolidated financial
statements.*





42


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




Year
      Ended December 31,(in
      thousands, except per share amounts)
    
    
    2004
    
    
    2003
    
    
    2002Contract,
      product and other revenues
    
    $
    542
    
    $
    134
    
    $
    36Cost
      of goods
    
    
    14
    
    
    20
    
    
    114Gross
      profit (loss)
    
    
    528
    
    
    114
    
    
    (78
    )Operating
      expenses:Research
      and development
    
    
    7,273
    
    
    4,436
    
    
    7,077Cost
      reimbursement
    
    
    —
    
    
    —
    
    
    166Research
      and development, net
    
    
    7,273
    
    
    4,436
    
    
    6,911Selling,
      general and administrative
    
    
    3,341
    
    
    3,021
    
    
    4,022Total
    
    
    10,614
    
    
    7,457
    
    
    10,933Loss
      from operations
    
    
    (10,086
    )
    
    (7,343
    )
    
    (11,011
    )Gain
      on sale of assets
    
    
    4,616
    
    
    1,153
    
    
    —Interest
      (expense) and other income, net
    
    
    (44
    )
    
    (561
    )
    
    62Net
      loss
    
    
    (5,514
    )
    
    (6,751
    )
    
    (10,949
    )Non-cash
      preferred stock dividend
    
    
    —
    
    
    221
    
    
    48Net
      loss applicable to common stockholders
    
    $
    (5,514
    )
    $
    (6,972
    )
    $
    (10,997
    )Net
      loss per share applicable to common stockholders, basic and
      diluted
    
    $
    (0.11
    )
    $
    (0.27
    )
    $
    (0.44
    )Shares
      used to calculate basic and diluted net loss per share applicable to
      common stockholders
    
    
    47,984
    
    
    25,767
    
    
    24,997





*See
accompanying notes to consolidated financial
statements.*


































43


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


**Note**
    
    
    
    **Total****Additional**
    
    **Receivable**
    
    
    
    **Stockholders’****Preferred**
    
    **Common**
    
    **Paid
      In**
    
    **From**
    
    **Accumulated**
    
    **Equity**(dollars
      in thousands)
    
    **Stock**
    
    **Stock**
    
    **Capital**
    
    **Stockholder**
    
    **Deficit**
    
    **(deficit)****Balances,****January****1,****2002**
    
    **$**
    **—**
    
    **$**
    **249**
    
    **$**
    **107,246**
    
    **$**
    **(257**
    **)**
    **$**
    **(97,753**
    **)**
    **$**
    **9,485**Issuance
      of 201,436 shares of common stock from exercise of options and employee
      stock purchase plan
    
    
    —
    
    
    2
    
    
    123
    
    
    —
    
    
    —
    
    
    125Issuance
      of 2,000 shares of Series A-1 preferred stock
    
    
    2,000
    
    
    —
    
    
    —
    
    
    —
    
    
    —
    
    
    2,000Loan
      payment from stockholder
    
    
    —
    
    
    —
    
    
    —
    
    
    26
    
    
    —
    
    
    26Non-employee
      stock option and warrantCompensation
    
    
    —
    
    
    —
    
    
    200
    
    
    —
    
    
    —
    
    
    200Net
      loss and comprehensive loss
    
    
    —
    
    
    —
    
    
    —
    
    
    —
    
    
    (10,949
    )
    
    (10,949
    )Non-cash
      preferred dividend
    
    
    48
    
    
    —
    
    
    —
    
    
    —
    
    
    (48
    )
    
    —Net
      loss applicable to common stockholders
    
    
    48
    
    
    —
    
    
    —
    
    
    —
    
    
    (10,997
    )
    
    (10,949
    )**Balances,****December****31,****2002**
    
    **$**
    **2,048**
    
    **$**
    **251**
    
    **$**
    **107,569**
    
    **$**
    **(231**
    **)**
    **$**
    **(108,750**
    **)**
    **$**
    **887**Issuance
      of 5,000 shares of common stock from exercise of options
    
    
    —
    
    
    —
    
    
    3
    
    
    —
    
    
    —
    
    
    3Issuance
      of 2,000 shares of Series A-1 preferred stock
    
    
    2,000
    
    
    —
    
    
    —
    
    
    —
    
    
    —
    
    
    2,000Issuance
      of 352,857 shares of common stock from private placements
    
    
    —
    
    
    4
    
    
    130
    
    
    —
    
    
    —
    
    
    134Issuance
      of convertible notes payable with beneficial conversion
      feature
    
    
    —
    
    
    —
    
    
    547
    
    
    —
    
    
    —
    
    
    547Issuance
      of 3,763,651 share of common stock from conversion of
      debentures
    
    
    —
    
    
    38
    
    
    946
    
    
    —
    
    
    —
    
    
    984Surrender
      of Series A-1 preferred stock as part of sale of assets
    
    
    (4,269
    )
    
    —
    
    
    —
    
    
    —
    
    
    —
    
    
    (4,269
    )Loan
      payment from stockholder
    
    
    —
    
    
    —
    
    
    —
    
    
    23
    
    
    —
    
    
    23Non-employee
      stock option and warrantCompensation
    
    
    —
    
    
    —
    
    
    242
    
    
    —
    
    
    —
    
    
    242Net
      loss and comprehensive loss
    
    
    —
    
    
    —
    
    
    —
    
    
    —
    
    
    (6,751
    )
    
    (6,751
    )Non-cash
      preferred dividend
    
    
    221
    
    
    —
    
    
    —
    
    
    —
    
    
    (221
    )
    
    —Net
      loss applicable to common stockholders
    
    
    221
    
    
    —
    
    
    —
    
    
    —
    
    
    (6,972
    )
    
    (6,751
    )**Balances,****December****31,****2003**
    
    **$**
    **—**
    
    **$**
    **293**
    
    **$**
    **109,437**
    
    **$**
    **(208**
    **)**
    **$**
    **(115,722**
    **)**
    **$**
    **(6,200**
    **)**Issuance
      of 19,623 shares of common stockfrom exercise of options and employee stock purchase plan
    
    
    —
    
    
    —
    
    
    12
    
    
    —
    
    
    —
    
    
    12Issuance
      of 33,000,000 shares of commonstock
      from private placement
    
    
    —
    
    
    330
    
    
    14,781
    
    
    —
    
    
    —
    
    
    15,111Non-employee
      stock option and warrantcompensation
    
    
    —
    
    
    —
    
    
    96
    
    
    —
    
    
    —
    
    
    96Issuance
      of 2,940 shares of common stock from exercise of warrants
    
    
    —
    
    
    **—**
    
    
    2
    
    
    —
    
    
    —
    
    
    2Loan
      payment from stockholder
    
    
    **—**
    
    
    **—**
    
    
    **—**
    
    
    21
    
    
    **—**
    
    
    21Issuance
      of 105,951 shares of commonstock from conversion of notes payable
    
    
    —
    
    
    1
    
    
    72
    
    
    
    
    
    
    
    
    73Net
      loss applicable to common stockholders
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (5,514
    )
    
    (5,514
    )**Balances,****December****31,****2004**
    
    **$**
    **—**
    
    **$**
    **624**
    
    **$**
    **124,400**
    
    **$**
    **(187**
    **)**
    **$**
    **(121,236**
    **)**
    **$**
    **3,601**


**
 *See*  *accompanying*  *notes*  *to*  *consolidated*  *financial*  *statements.*






44




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


Year
      Ended December 31,(in
      thousands)
    
    2004
    
    2003
    
    2002**Operating
      activities:**Net
      loss
    
    $
    (5,514
    )
    $
    (6,751
    )
    $
    (10,949
    )Adjustments
      to reconcile net loss to net cash used in operating
      activities:Depreciation
      and amortization
    
    
    176
    
    
    275
    
    
    300Stock-based
      compensation
    
    
    96
    
    
    242
    
    
    200Loss
      on disposal of capital lease asset
    
    
    —
    
    
    27
    
    
    —Non-cash
      interest expense
    
    
    20
    
    
    —
    
    
    —Gain
      on sale of asset
    
    
    (4,616
    )
    
    (1,153
    )
    
    —Amortization
      of beneficial conversion feature
    
    
    —
    
    
    546
    
    
    —Debt
      issuance cost amortization
    
    
    1
    
    
    153
    
    
    —Accrued
      interest on convertible notes payable
    
    
    —
    
    
    2
    
    
    —Changes
      in:Inventories,
      prepaid expenses and other current assets
    
    
    21
    
    
    33
    
    
    30Accounts
      payable, accrued liabilities, accrued compensation and related expense,
      and deferred rent
    
    
    (207
    )
    
    1,031
    
    
    (556
    )Net
      cash used in operating activities
    
    
    (10,023
    )
    
    (5,595
    )
    
    (10,975
    )**Investing
      activities:**Purchases
      of property and equipment
    
    
    (13
    )
    
    (23
    )
    
    (61
    )Proceeds
      from sale of asset
    
    
    —
    
    
    1,500
    
    
    —Increase
      in restricted cash
    
    
    (170
    )
    
    —
    
    
    —Net
      cash provided by (used in) investing activities
    
    
    (183
    )
    
    1,477
    
    
    (61
    )**Financing
      activities:**Payment
      of capital lease obligation
    
    
    (13
    )
    
    (18
    )
    
    (31
    )Note
      payment received from stockholder
    
    
    21
    
    
    23
    
    
    26Payments
      of notes payable to related parties
    
    
    (604
    )
    
    —
    
    
    —Payment
      of convertible note payable
    
    
    (17
    )
    
    —
    
    
    —Issuance
      of short-term notes payable to related parties
    
    
    —
    
    
    997
    
    
    —Issuance
      of convertible notes payable, net of issuance costs
    
    
    —
    
    
    845
    
    
    —Issuance
      of preferred stock
    
    
    —
    
    
    2,000
    
    
    2,000Issuance
      of common stock from exercise of options and warrants
    
    
    14
    
    
    3
    
    
    —Issuance
      of common stock, net of issuance costs
    
    
    15,111
    
    
    134
    
    
    125Net
      cash provided by financing activities
    
    
    14,512
    
    
    3,984
    
    
    2,120Net
      decrease in cash andcashequivalents
    
    
    4,306
    
    
    (134
    )
    
    (8,916
    )Cash
      and cash equivalents, beginning of year
    
    
    1,045
    
    
    1,179
    
    
    10,095Unrestricted
      cash and cash equivalents, end of year
    
    $
    5,351
    
    $
    1,045
    
    $
    1,179Supplemental
      cash flow information:Cash
      paid for interest
    
    $
    11
    
    $
    —
    
    $
    —Taxes
      paid
    
    $
    1
    
    $
    1
    
    $
    1Non
      cash investing and financing activities:Surrender
      of preferred stock in connection with sale of asset
    
    $
    —
    
    $
    4,269
    
    $
    —Preferred
      stock dividends
    
    $
    —
    
    $
    221
    
    $
    48—Conversion
      of debentures and interest payable to common stock
    
    $
    73
    
    $
    984
    
    $
    —Beneficial
      conversion feature on convertible notes payable
    
    $
    —
    
    $
    547
    
    $
    —


**
 *See
accompanying notes to consolidated financial
statements.*


45





**InSite
Vision Incorporated**





Notes to
Consolidated Financial Statements


December
31, 2004


****


**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. InSite Vision Limited was formed for the purpose of
holding and licensing intellectual property rights. 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 $5.5 million for the year ended December 31, 2004, 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 $10.0 million for the year
ended December 31, 2004. As of December 31, 2004, the Company had an accumulated
deficit of $121.2 million and a cash and cash equivalents balance of $5.5
million. In these circumstances the Company believes it may not have enough cash
to meet its various cash needs for fiscal 2005 unless the Company is able to
obtain additional cash from activities it is actively pursuing such as
placements of debt or equity securities, new license or collaborative
agreements, or exercise of outstanding warrants.  There is no assurance
that additional funds or license or collaborative agreements will be available
for the Company to finance its operations on acceptable terms, if at all. If the
Company can not obtain such additional financing when required, management would
likely have to cease operations and liquidate the Company's assets. These
conditions raise substantial doubt about the Company's ability to continue as a
going concern. The financial statements do not include any adjustments to
reflect the possible future effects on the recoverability and classification of
assets or the amounts and classification of liabilities that may result from the
outcome of this uncertainty.





Any
person considering an investment in the Company's securities is urged to
consider both the risk that the Company will cease operations at or around the
begining of June 2005 if an additional source of funds is not obtained. All of
the statements set forth in this report are qualified by reference to those
facts.





**Accounting
Policies and Use of Estimates**





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





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





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





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





46


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





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.





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 directly reduced expenses for amounts reimbursed due to cost
sharing agreements during the year ended December 31, 2002. The Company
recognizes 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. During the years ended
2004 and 2003, the Company 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.





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. The revenue in connection
with the asset purchase agreement with Bausch & Lomb will be recognized over
the contract period.





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





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





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





Advertising. Advertising costs are expensed as incurred. Advertising expenses for the period
ended December 31, 2004 and 2003 were not significant.





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





47


Pro forma
information regarding net loss and loss per share is required by Statement of
Financial Accounting Standards (SFAS) No. 123, “Accounting for Stock Based
Compensation,” as amended by SFAS No. 148, and has been determined as if we had
accounted for our employee stock options under the fair value method of that
Statement. The fair value for these options was estimated at the date of grant
using a Black-Scholes option pricing model with the following weighted-average
assumptions for 2004, 2003 and 2002, respectively: risk-free interest rates
ranging from 0.89% to 4.44%; volatility factors for the expected market price of
our common stock of 1.05, 1.06 and 1.07; and a weighted-average expected life
for the options of 4 years.








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





Year
      Ended December 31,2004
    
    2003
    
    2002Net
      loss applicable to common stockholders-as reported
    
    $
    (5,514
    )
    $
    (6,972
    )
    $
    (10,997
    )Deduct:
      Total stock-based employee compensation expense determined under fair
      value method for all awards
    
    
    (372
    )
    
    (473
    )
    
    (184
    )Net
      loss applicable to common stockholders-pro forma
    
    $
    (5,886
    )
    $
    (7,445
    )
    $
    (11,181
    )Loss
      applicable to common stockholders per share:Basic
      and diluted-as reported
    
    $
    (0.11
    )
    $
    (0.27
    )
    $
    (0.44
    )Basic
      and diluted-pro forma
    
    $
    (0.12
    )
    $
    (0.29
    )
    $
    (0.45
    )








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





The pro
forma impact of options on the net loss for 2004, 2003 and 2002 is not
necessarily representative of the effects on net income (loss) for future years,
as future years will include the effects of additional stock
grants.





Accounting
for Stock Options and Warrants Exchanged for Services. The
Company issues stock options and warrants to consultants of the Company in
exchange for services. The Company has valued these options and warrants using
the Black-Scholes option pricing model in accordance with the Emerging Issues
Task Force (EITF) Consensus No. 96-18, “Accounting for Equity Investments that
are Issued to Other Than Employees for Acquiring or in Conjunction with Selling
Goods, or Services,” at each reporting period and has recorded charges to
operations over the vesting periods of the individual stock options or warrant.
Such charges amounted to approximately $96,000, $242,000 and $200,000 in 2004,
2003 and 2002, respectively.





Income
(Loss) per Share . Basic
and diluted net income (loss) per share information for all periods is presented
under the requirement of SFAS No. 128, “Earnings per Share.” Basic earnings per
share has been computed using the weighted-average number of common shares
outstanding during the period. Dilutive earnings per share is computed using the
sum of the weighted-average number of common shares outstanding and the
potential number of dilutive common shares outstanding during the period.
Potential common shares consist of the shares issuable upon exercise of stock
options, warrants and convertible securities. Potentially dilutive securities
have been excluded from the computation of diluted net loss per share in 2004,
2003 and 2002 as their inclusion would be antidilutive.





48


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





(in
      thousands, except per share amounts)
    
    2004
    
    2003
    
    2002Numerator:Net
      loss
    
    $
    (5,514
    )
    $
    (6,751
    )
    $
    (10,949
    )Non-cash
      preferred stock dividend
    
    
    —
    
    
    (221
    )
    
    (48
    )Net
      loss applicable to common stockholders
    
    $
    (5,514
    )
    $
    (6,972
    )
    $
    (10,997
    )Denominator:Denominator
      for basic and diluted loss per share -weighted-average common
      shares outstanding
    
    
    47,984
    
    
    25,767
    
    
    24,997Basic
      and diluted net loss per share
    
    $
    (0.11
    )
    $
    (0.27
    )
    $
    (0.44
    )





Due to
the loss applicable to common stockholders, loss per share for 2004, 2003 and
2002 is based on the weighted average number of common shares only, as the
effect of including equivalent shares from stock options would be anti-dilutive.
If the Company had recorded net income, the calculation of earnings per share
would have been impacted by the dilutive effect of the convertible notes payable
in 2003, and the Series A-1 Preferred Shares in 2002, but would not have been
effected by the minimal number of outstanding stock options and warrants priced
below the market price of the common shares at December 31, 2003. At
December 31, 2004, 2003 and 2002, 21,646,284, 5,223,651 and 4,192,568
options and warrants were excluded from the calculation of diluted earnings per
share because the effect was anti-dilutive.





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





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





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





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





Recent
Accounting Pronouncements . In
December 2004, the Financial Accounting Standards Board (“FASB”) issued
Statement of Financial Accounting Standards No. 123 (revised), “Share-Based
Payment” (“SFAS 123R”) which requires the measurement of all employee
share-based payments to employees, including grants of employee stock options,
using a fair-value-based method and the recording of such expense in
consolidated statements of income . The
statement requires companies to assess the most appropriate model to calculate
the value of the options. There are a number of requirements under the new
standard that would result in differing accounting treatment than currently
required. These differences include, but are not limited to, accounting for the
tax benefit on employee stock options and for stock issued under our employee
stock purchase plan. SFAS 123R must be adopted no later than July 1,
2005 and the Company will begin to apply it in the quarter beginning on that
date. The Company believes that employee stock options represent an appropriate
and essential component of our overall compensation program. The Company grants
options to substantially all employees and believes that this broad-based
program helps us to attract, motivate, and retain high quality employees, to the
ultimate benefit of our stockholders. The adoption of SFAS 123R is expected to
result in a material increase in expense during the second half of 2005 based on
unvested options outstanding as of December 31, 2004 and current compensation
plans. While the effect of adoption depends on the level of share-based payments
granted in the future and unvested grants on the date the Company adopts SFAS
123R, the effect of this accounting standard on its prior operating results
would approximate the effect of SFAS 123 as described in the disclosure of pro
forma net loss and net
loss per share.




49


In
March 2004, the FASB issued Emerging
Issues Task Force No. 03-1, “The Meaning of Other-Than-Temporary Impairment and Its
Application to Certain Investments” (“EITF 03-1”), which provided new guidance
for assessing impairment losses on investments. Additionally, EITF 03-1 includes
new disclosure requirements for investments that are deemed to be temporarily
impaired. In September 2004, the FASB delayed the accounting provisions of
EITF 03-1; however, the disclosure requirements remain effective for annual
periods ending after June 15, 2004. The Company will evaluate the impact of
EITF 03-1 once final guidance is issued.




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





In
December 2003, the Company entered into agreements with Bausch & Lomb
Incorporated, or Bausch & Lomb, in which the Company sold the assets related
to its ISV-403 product candidate, for the treatment of ocular bacterial
infections, and licensed certain DuraSite patents for use in the ISV-403 product
candidate. Bausch & Lomb made a payment to the Company of $1.5 million,
surrendered 4,000 shares of Series A-1 Preferred Stock (See Note 7) 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 period for which
contract services were provided. Correspondingly, as of December 31, 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.





In
December 2002, the Company entered into an eight year distribution agreement
with Societa Industria Farmaceutica Italiana - S.p.A. of Italy (“SIFI”), in
which InSite granted SIFI the exclusive right in Italy to perform, market and
sell the Ocu G ene
glaucoma genetic test and to manufacture and distribute the related patient
sampling kits. SIFI will pay the Company a royalty on each Ocu G ene test
performed by them or on their behalf, if any.





In
November 2002, the Company extended its November 2001 agreement with Quest
Diagnostics Incorporated to provide laboratory services in the U.S. for the
Company’s Ocu G ene  genetic
test for the early prognosis and diagnosis of glaucoma. The Company will pay
Quest a fee for each test performed and royalties on product sales.





In August
2002, the Company entered into a license agreement and preferred stock purchase
agreement with Bausch & Lomb, in which InSite granted Bausch & Lomb a
royalty-bearing license to the Company’s product candidate ISV-403 for the
treatment of ocular bacterial infections. Bausch & Lomb obtained the right
to market ISV-403 in all geographies except Japan, with such rights being shared
in Asia (except Japan) and exclusive elsewhere. The Company was responsible for
the clinical development of ISV-403 through New Drug Application, or NDA,
approval from the U.S. Food and Drug Administration, or FDA, with Bausch &
Lomb responsible for subsequent commercial manufacturing and marketing. Bausch
& Lomb made an initial investment in preferred stock of $2.0 million in
August 2002. Bausch & Lomb made a second investment in preferred stock of
$2.0 million in February 2003 when the Company reached the first milestone
contemplated in the agreement. Upon the sale of these assets to Bausch &
Lomb in December 2003, the license agreement and preferred stock purchase
agreement were terminated and no future milestone payments by Bausch & Lomb
are required. (See Note 8.)





50


In
January 2002, the Company entered into an exclusive worldwide license agreement
with the University of Connecticut Health Center for the diagnostic, prognostic
and therapeutic uses of a gene and its mutations for normal tension glaucoma.
The Company paid a licensing fee and will make a milestone and royalty payments
on future product sales, if any.





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





In 2004
the Company received the proceeds from the sale of shares obtained from the
demutualization of an insurance company, which had provided health benefits to
the Company’s employees. These proceeds are restricted for the payment of health
insurance benefits for the employees.





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





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, 2004, $91,000 remains outstanding. These notes bear interest at a
rate of two percent (2%) and are due the earlier of March 31, 2007 or the
successful completion of the AzaSite Phase 3 clinical trials.





In July
and August 2003, the Company issued $500,000 in short-term Senior Secured Notes
payable to an officer who is also a member of the Board of Directors and an
affiliate of a member of senior management for cash. In November 2003, the
Company increased one of the short-term Senior Secured Notes by $20,000 after
receipt of cash. These notes bear interest at a rate of between five and
one-half percent (5.5%) and twelve percent (12%), were due between September 30,
2003 and October 15, 2003 and are secured by a lien on substantially all of the
assets of the Company, including the Company’s intellectual property, other than
the equipment secured under the Senior Secured Notes issued in May 2003,
described below, and certain other equipment secured by the lessor of such
equipment. Prior to September 30, 2003 the due dates of these notes were
extended to between November 15, 2003 and December 31, 2003. Subsequently, the
due dates were further extended to January 15, 2004 and March 31, 2004. In
January 2004, the Company repaid $120,000 of these Senior Secured Notes and the
related accrued interest. The Company had $251,000 of these short-term secured
notes payable to related parties outstanding at December 31, 2004 and the due
date has been extended to the sooner of March 31, 2007 or the successful
completion of the AzaSite Phase 3 clinical trials.





In May
and June 2003, the Company issued a series of short-term notes payable totaling
$288,500 to members of the Board of Directors, senior management and other
stockholders for cash. $100,000 of these notes are Senior Secured Notes, bear a
two percent (2%) annual interest rate, were due September 28, 2003 and are
secured by a lien on certain pieces of laboratory and other equipment. Prior to
September 28, 2003 the due date on these notes was extended to December 31,
2003. Subsequently, the due dates were further extended to January 15, 2004. In
January 2004, these Senior Secured Notes and the related accrued interest were
repaid by the Company. The remainder of these notes are unsecured, bear interest
rates between two percent (2%) and twelve percent (12%) and were due August 15,
2003. On August 15, 2003, the due date on these notes was extended to November
15, 2003. Prior to November 15, 2003 the due date on these notes was extended to
December 15, 2003. Subsequently, the due date on these notes was extended to
March 31, 2004. These notes were repaid in 2004.




**5.** **Lease
Commitments**





The
Company leases its facilities under non-cancelable operating lease agreements
that expire in 2006. Rent expense was $719,000, $697,000, and $659,000 for 2004,
2003 and 2002, respectively. The 2002 rent expense reflects $13,000 received by
the Company related to the January 1999 sublease of a portion of the Company’s
facility. The sublease ended in February 2002.





51


Capital
lease obligations represent the present value of future rental payments under
capital lease agreements for laboratory equipment. The original cost and
accumulated amortization on the equipment under capital leases are $0 and $0,
respectively, at December 31, 2004, $39,900 and $39,900, respectively, at
December 31, 2003 and $103,600 and $44,500, respectively, at December 31,
2002.





Future
minimum payments under capital and operating leases are as follows:





Year
      ending December 31,
    
    Operating
      Leases2005
    
    
    743,2442006
    
    
    769,248Total
      minimum lease payments
    
    $
    1,512,492





**6.** **Convertible
Notes Payable**





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





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





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





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





52


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





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





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





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





53


**7.** **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, 2004, 2003 and 2002.





Significant
components of the Company’s deferred tax assets for federal and state income
taxes as of December 31, 2004 and 2003 are as follows (in
thousands):





2004
    
    2003Deferred
      tax assets:Net
      operating loss carryforwards
    
    $
    33,441
    
    $
    32,054Tax
      credit carryforwards
    
    
    6,066
    
    
    5,970Capitalized
      research and development
    
    
    8,700
    
    
    7,549Deferred
      revenue
    
    
    —
    
    
    1,846Depreciation
    
    
    463
    
    
    434Other
    
    
    98
    
    
    58Total
      deferred tax assets
    
    
    48,768
    
    
    47,911Valuation
      allowance
    
    
    (48,768
    )
    
    (47,911
    )Net
      deferred tax assets
    
    $
    —
    
    $
    —





The
valuation allowance increased by $857,000, $2.1 million and $4.2 million during
the years ended December 31, 2004, 2003 and 2002, respectively.





At
December 31, 2004, the Company has net operating loss carryforwards for federal
income tax purposes of approximately $89.1 million, which expire in the years
2005 through 2024 and federal tax credits of approximately $3.3 million, which
expire in the years 2005 through 2024. The Company also has net operating loss
carryforwards for state income tax purposes of approximately $52.5 million which
expire in the years 2005 through 2014, and state research and development tax
credits of approximately and $2.6 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 will expire before ultimately
becoming available for offset against taxable income. Additional losses and
credits will be subject to limitation if the Company incurs another change in
ownership in the future.





**8.** **Preferred
Stock**





Series
A-1 Preferred Stock





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





54


For the
year ended December 31, 2003 and 2002, the Company reported non-cash preferred
dividends of $221,000 and $48,000, respectively. The dividends are related to
the 6% per annum premium earned on the outstanding Series A-1 Preferred Stock
and are taken into consideration to determine the net loss per share applicable
to common stockholders.




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





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





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





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





On
December 16, 2003, the Company entered into a private placement in which it
issued 142,857 shares of its common stock to an accredited investor and received
$50,000 in net proceeds. On October 20, 2003, the Company entered into a private
placement in which it issued  210,000 shares of its common stock to two
accredited investors and received $84,000 in net proceeds. During 2003 the
Company received $3,000 from the exercise of stock options.





In
December 2003, the Company issued warrants to purchase 250,000 shares of common
stock for $0.58 per share that expire in December 2006 to Xmark as part of the
settlement of a law suit which were expensed during the year (See Note 11). The
warrants issued to Xmark included an anti-dilution clause which was triggered by
the March and June 2004 private placement and resulted in the issuance of 18,519
warrants to purchase a common stock and a modification of the 250,000 warrants
to purchase common stock issued in 2003. The Company valued the additional
warrants and the effect of warrant modificaion using the Black-Scholes option
pricing model. The valuation resulted in a $31,000 charge to expense recorded in
2004.  In November 2003, the Company issued warrants to purchase 125,000
shares of common stock for $0.40 that expire in November 2008 to a financial
advisor as part of the placement of convertible notes payable. In September
2003, the Company issued warrants to purchase 81,967 shares of common stock for
$0.61 until September 2008 to a financial advisor as part of the initial
placement of convertible notes payable. In August 2003, the company issued
warrants to a financial advisor to purchase 50,000 shares of common stock for
$0.50 per share that expire in August 2006. These warrants were valued using a
Black-Scholes option pricing model, assuming no dividend yield, with the
following assumptions: risk-free interest rate of 4.44%, volatility of 1.0616
and an expected life of 5, 3 and 3 years, respectively, resulting in the
recording of an expense of $180,000 for the year ended December 31, 2003. As of
December 31, 2003 and 2004, all of these warrants were outstanding.





In April
2002, the Company issued warrants to purchase 20,000 shares of common stock for
$2.33 per share that expire in April 2006 to a financial advisor. In February
2002, the Company issued warrants to purchase 38,000 shares of Common Stock for
$2.20 per share that expire in February 2005 to a financial advisor. These
warrants were valued using a Black-Scholes option pricing model, assuming no
dividend yield, with the following assumptions: risk-free interest rate of
4.76%, volatility of 1.1361 and an expected life of 4 and 3 years, respectively,
resulting in the recording of an expense of $85,000 for the year ended December
31, 2002. As of December 31, 2003 and 2004, all of these warrants were
outstanding.




55


Stock
Option Plan





At
December 31, 2004, a total of 4,550,873 shares of common stock were reserved
under the 1994 Stock Plan for issuance upon the exercise of options or by direct
sale to employees, including officers, directors and consultants. Options
granted under the plan expire 10 years from the date of grant and become
exercisable at such times and under such conditions as determined by the
Company’s Board of Directors (generally ratably over four years, with the first
25% vesting after one year). Under the terms of the 1994 Stock Plan on automatic
share increase feature pursuant to which the number of shares available for
issuance is automatically increased on the first trading day in January each
calendar year, beginning with calendar year 2002 and continuing over the term of
the Plan by an amount equal to 0.2% of the total number of shares of common
stock outstanding on the last trading day in December in the immediately
proceeding calendar year. Activity under the 1994 Stock Plan is as
follows:





SharesOptions
      Availablefor
      Grant
    
    OptionsOutstanding
    
    Option
      Price
    
    Weighted
      Average Exercise Price ofShares
      Under PlanBalances
      at December 31, 2001
    
    
    875,953
    
    
    2,286,754
    
    $
    0.60
      - 9.25
    
    $
    2.35Additional
      shares reserved
    
    
    498,545Granted
    
    
    (395,250
    )
    
    395,250
    
    
    0.70
      - 1.97
    
    
    0.93Exercised
    
    
    —
    
    
    (184,173
    )
    
    0.73
      - 1.80
    
    
    0.96Forfeited
    
    
    20,616
    
    
    (20,616
    )
    
    0.60
      - 4.81
    
    
    1.44Balances
      at December 31, 2002
    
    
    999,864
    
    
    2,477,215
    
    
    0.60
      - 9.25
    
    
    2.26Additional
      shares reserved
    
    
    502,574Granted
    
    
    (925,500
    )
    
    925,500
    
    
    0.41
      - 0.85
    
    
    0.60Exercised
    
    
    —
    
    
    (5,000
    )
    
    0.70
      - 0.70
    
    
    0.70Forfeited
    
    
    346,384
    
    
    (346,384
    )
    
    0.41
      - 9.25
    
    
    1.48Balances
      at December 31, 2003
    
    
    923,322
    
    
    3,051,331
    
    
    0.41
      - 6.38
    
    
    1.85Additional
      shares reserved
    
    
    585,004Granted
    
    
    (968,000
    )
    
    968,000
    
    
    0.56
      - 0.88
    
    
    0.77Exercised
    
    
    —
    
    
    (8,784
    )
    
    0.63
      - 0.93
    
    
    0.70Forfeited
    
    
    174,809
    
    
    (174,809
    )
    
    0.63
      - 6.23
    
    
    1.86Balances
      at December 31, 2004
    
    
    715,135
    
    
    3,835,738
    
    $
    0.41
      - 6.38
    
    $
    1.58










56




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


Options
      Outstanding
    
    Options
      ExercisableWeighted
      AverageRange
      of Exercise Prices
    
    Number
      Number 
      Outstanding
    
    ContractualLife
    
    Exercise
      Price
    
    Number

      Exercisable
    
    Weighted 

      AverageExercise Price$0.41-$0.75
    
    1,331,000
    
    9.07
    
    $0.64
    
    603,749
    
    $0.57$0.82-$1.13
    
    1,122,964
    
    6.72
    
    0.99
    
    755,441
    
    1.03$1.20-$3.75
    
    1,177,722
    
    3.20
    
    2.59
    
    1,151,973
    
    2.62$3.88-$6.38
    
    204,052
    
    3.35
    
    5.09
    
    204,050
    
    5.093,835,738
    
    6.28
    
    $1.58
    
    2,715,213
    
    $1.91


The
weighted average grant date fair value of options granted during 2004, 2003 and
2002 was $0.77, $0.56 and $0.86 per share, respectively.




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





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 $65,000, $62,000 and $116,000 in 2004, 2003 and 2002,
respectively.





Employee
Stock Purchase Plan





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





During
the years ended December 31, 2004, 2003 and 2002, respectively, 10,739, 0, and
37,122 shares of common stock were issued pursuant to this plan. At December 31,
2004, 125,000 additional shares were reserved for issuance under this plan. The
effects of this plan on the pro forma disclosures described in Note 1 are not
material.





The
weighted average grant date fair value of the Purchase Plan shares issued during
2004 was $0.55





57


**10.** **Notes
Receivable from Stockholder**





In May
2000, the Company issued loans to Dr. Chandrasekaran, the Company’s President,
Chief Executive Officer (CEO), Chief Financial Officer (CFO) and Chairman of the
Board, related to his exercise of 126,667 options to acquire common stock. In
May 2001, the terms on the loans were extended from 4 years to 5 years. In 2004
and 2003, Dr. Chandrasekaran made principal and interest payments of $20,800 and
$38,500, 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.





**11.** **Legal
Proceedings**





On June
23, 2003 Xmark Funds, L.P. et al, or Xmark, filed a complaint in the United
States District Court, Southern District of New York against the Company
alleging that the Company breached the terms of the term sheet signed between
Xmark Funds and the Company in May 2003. On December 31, 2003 the Company
settled the suit with Xmark. As part of the settlement, the Company paid Xmark
$10,000 and issued Xmark fully vested warrants to purchase 250,000 shares of the
Company’s common stock at an exercise price of $0.58 per share. The warrants
expire on December 31, 2006 subject to certain possible extensions. Legal fees
related to this litigation were expensed as incurred.





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





On July
8, 2004, Bristol Investment Group, or Bristol, filed with the American
Arbitration Association (“AAA”) a demand for arbitration against the Company
seeking payment of $218,684 and warrants to purchase 461,400 shares of the
Company’s common stock 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.  In subsequent filings with the AAA
Bristol claimed it is entitled to recover $249,925 plus interest and attorneys’
fees, plus warrants to purchase 922,800 shares of the Company’s common stock.
The Company disputes Bristol’s claim and has vigorously defended against
the claim. An evidentiary hearing has been held in the arbitration but
no ruling has yet been issued by the arbitrator.





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.





**12.** **Related
Party**





Included
in accounts payable on the balance sheet at December 31, 2004 and 2003 is $8,000
and $116,000, respectively, due to related parties for expenses incurred on
behalf of the Company. See Note 4 for discussion of related party notes payable
transactions.





58


**13.** **Subsequent
Event**





In
January 2005, the Company received $50,000 from the exercise of 125,000
placement agent warrants and $8,819 from the exercise of 11,758 warrants issued
in the 2004 private placement.





**14.** **Quarterly
Results (Unaudited)**





The
following table is a summary of the quarterly results of operations for the
years ended December 31, 2004 and 2003. 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)2004First
      Quarter
    
    Second
      Quarter
    
    Third
      Quarter
    
    Fourth
      Quarter
    
    Total
      YearRevenues
    
    $
    374
    
    $
    118
    
    $
    49
    
    $
    1
    
    $
    542Cost
      of goods
    
    
    5
    
    
    3
    
    
    3
    
    
    3
    
    
    14Loss
      from operations
    
    
    (1,093
    )
    
    (2,579
    )
    
    (3,340
    )
    
    (3,074
    )
    
    (10,086
    )Net
      income (loss) applicable to common stockholders
    
    
    2,361
    
    
    (1,460
    )
    
    (3,340
    )
    
    (3,075
    )
    
    (5,514
    )Basic
      and diluted net loss per share applicable to common
      stockholders
    
    $
    0.08
    
    $
    (0.04
    )
    $
    (0.05
    )
    $
    (0.05
    )
    $
    (0.11
    )Shares
      used to calculate basic net income (loss) per share applicable to common
      stockholders
    
    
    30,548
    
    
    40,450
    
    
    62,371
    
    
    62,374
    
    
    47,984Shares
      used to calculate diluted net income (loss) per share applicable to common
      stockholders
    
    
    30,987
    
    
    40,450
    
    
    62,371
    
    
    62,374
    
    
    47,984





2003First
      Quarter
    
    Second
      Quarter
    
    Third
      Quarter
    
    Fourth
      Quarter
    
    Total
      YearRevenues
    
    $
    4
    
    $
    1
    
    $
    4
    
    $
    125
    
    $
    134Cost
      of goods
    
    
    8
    
    
    4
    
    
    5
    
    
    3
    
    
    20Loss
      from operations
    
    
    (2,276
    )
    
    (1,826
    )
    
    (1,393
    )
    
    (1,848
    )
    
    (7,343
    )Net
      loss applicable to common stockholders
    
    
    (2,314
    )
    
    (1,886
    )
    
    (1,462
    )
    
    (1,310
    )
    
    (6,972
    )Basic
      and diluted net loss per share Applicable to common
      stockholders
    
    $
    (0.09
    )
    $
    (0.08
    )
    $
    (0.06
    )
    $
    (0.05
    )
    $
    (0.27
    )Shares
      used to calculate basic and diluted net loss per share applicable to
      common stockholders
    
    
    25,133
    
    
    25,137
    
    
    25,137
    
    
    27,661
    
    
    25,767





****


59


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





None





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





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





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





Not
applicable.




**PART
III**





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





The
information required by this item with respect to the identification of
directors is hereby incorporated by reference from the information under the
caption “Election of Directors” in the Company's Proxy Statement for its Annual
Meeting of Stockholders which is expected to be held on June 1, 2005 (the “Proxy
Statement”).





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





The
information required by this item regarding compliance with Section 16(a) of the
Securities Exchange Act of 1934 is hereby incorporated by reference from the
information under the caption “Compliance with Section 16(a) of the Securities
Exchange Act of 1934” in the Proxy Statement.





The
information required by this item regarding the audit committee of the board of
directors and information regarding an audit committee financial expert is
incorporated by reference from information contained under the
caption **** “Board
Committees and Meetings” in the Proxy Statement.





The
information required by this item regarding the Company’s code of ethics that
applies to the Company’s principal executive officer, principal financial
officer and controller is incorporated by reference from information contained
under the caption **** “Board
Committees and Meetings” in the Proxy Statement.





Information
regarding our implementation of procedures for stockholder nominations to our
board of directors is incorporated by reference from information contained under
the caption **** “Board
Committees and Meetings” in the Proxy Statement.


****


**Item
11. Executive Compensation**





The
information required by this item is hereby incorporated by reference from the
information under the caption “Executive Compensation and Related Information”
in the Proxy Statement.


****


60





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





The
information required by this item is hereby incorporated by reference from the
information under the captions “Principal Stockholders” and “Equity Compensation
Plan Information” in the Proxy Statement.








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





The
information required by this item is hereby incorporated by reference from the
information under the captions “Executive Compensation and Related Information”
and “Certain Relationships and Related Transactions” in the Proxy
Statement.





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





The
information required by this item is incorporated by reference from the
information contained under the caption **** “Principal
Accountant Fees and Services” in the Proxy Statement.





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







61


**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
      INCORPORATEDDate: March 31,
2005
    By:
    /s/ S. Kumar
      ChandrasekaranS. Kumar Chandrasekaran,
      Ph.D.Chairman
      of the Board, President,Chief
      Executive Officer andChief
      Financial Officer





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 ChandrasekaranS.
      Kumar Chandrasekaran, Ph.D.
    
    Chairman
      of the Board, President, Chief Executive Officer and Chief Financial
      Officer
    
    March
      31, 2005/s/
      Mitchell H. FriedlaenderMitchell
      H. Friedlaender, M. D.
    
    Director
    
    March
      31, 2005/s/
      John L. MattanaJohn
      L. Mattana
    
    Director
    
    March
      31, 2005/s/
      Jon S. SaxeJon
      S. Saxe
    
    Director
    
    March
      31, 2005/s/
      Anders P. WiklundAnders
      P. Wiklund
    
    Director
    
    March
      31, 2005








62


**EXHIBIT
INDEX**





Number
    
    Exhibit
      Table2.1
    
    Agreement
      and Plan of Merger, dated as of September 22, 2003, by and among InSite
      Vision Incorporated, a Delaware corporation, Arrow Acquisition, Inc., a
      Delaware corporation, and Ophthalmic Solutions, Inc., a Delaware
      corporation.3.11
    
    Restated
      Certificate of Incorporation.3.29
    
    Certificate
      of Designations, Preferences and Rights of Series A Convertible Preferred
      Stock as filed with the Delaware Secretary of State on September 11,
      1997.3.39
    
    Certificate
      of Correction of the Certificate of Designations, Preferences and Rights
      of Series A Convertible Preferred Stock as filed with the Delaware
      Secretary of State on September 26, 1997.3.415
    
    Certificate
      of Designations, Preferences and Rights of Series A-1 Preferred Stock as
      filed with the Delaware Secretary of State on July 3,
  2002.3.56
    
    Amended
      and Restated Bylaws.4.1
    
    Reference
      is made to Exhibits 3.1, 3.2, 3.3 and 3.4.4.217
    
    Convertible
      Debenture Purchase Agreement, dated as of September 22, 2003, by and
      between Ophthalmic Solutions, Inc. and HEM Mutual Assurance
      LLC.4.317
    
    $492,750
      1% Convertible Debenture Due September 21, 2008, originally issued by
      Ophthalmic Solutions, Inc., a Delaware corporation to HEM Mutual Assurance
      LLC on September 22, 3003.4.417
    
    $7,250
      1% Convertible Debenture Due September 21, 2008, originally issued by
      Ophthalmic Solutions, Inc., a Delaware corporation to HEM Mutual Assurance
      LLC on September 22, 3003.4.517
    
    $500,000
      1% Convertible Debenture Due September 21, 2008, originally issued by
      Ophthalmic Solutions, Inc., a Delaware corporation to HEM Mutual Assurance
      LLC on September 22, 3003.10.110
    
    InSite
      Vision Incorporated 1994 Employee Stock Purchase Plan (As amended and
      restated through April 17, 2000).10.28HH
    
    InSite
      Vision Incorporated 1994 Stock Option Plan (Amended and Restated as of
      June 8, 1998).10.31HH
    
    Form
      of InSite Vision Incorporated Notice of Grant of Stock Option and Stock
      Option Agreement, with Addenda.10.48HH
    
    Form
      of InSite Vision Incorporated Notice of Automatic Option Grant and
      Non-Employee Director Option Agreement.10.51
    
    InSite
      Vision Incorporated 1994 Employee Stock Purchase Plan.10.61
    
    Form
      of InSite Vision Incorporated Stock Purchase Agreement.10.71
    
    Form
      of InSite Vision Incorporated Employee Stock Purchase Plan
      Enrollment/Change Form.10.82
    
    Form
      of Indemnity Agreement Between the Registrant and its directors and
      officers.10.92
    
    Form
      of Employee's Proprietary Information and Inventions
      Agreement.10.103H
    
    License
      Agreement dated as of October 9, 1991 by and between the Company and
      CIBA Vision Corporation, as amended October 9,
  1991.10.113H
    
    Letter
      Agreement dated February 27, 1992 by and among the Company, Columbia
      Laboratories, Inc. and Joseph R. Robinson, as amended
      October 23, 1992.10.127
    
    Facilities
      Lease, dated September 1, 1996, between the Registrant and Alameda
      Real Estate Investments.10.134
    
    Common
      Stock Purchase Agreement dated January 19, 1996 between the
      Registrant and the Investors listed on Schedule 1
      thereto.10.145H
    
    ISV-205
      License Agreement dated May 28, 1996 by and between the Company and
      CIBA Vision Ophthalmics.10.155H
    
    ToPreSite
      License Agreement dated May 28, 1996 by and between the Company and
      CIBA Vision Ophthalmics.
   63
  10.165H
    
    Timolol
      Development Agreement dated July 18, 1996 by and between the Company
      and Bausch & Lomb Pharmaceuticals, Inc.10.175H
    
    Stock
      Purchase Agreement dated July 18, 1996 by and between the Company and
      Bausch & Lomb Pharmaceuticals, Inc.10.189H
    
    License
      Agreement, dated July 1, 1997, by and between the University of
      Connecticut Health Center and the Company.10.199H
    
    License
      Agreement, dated August 19, 1997, by and between the University of
      Rochester and the Company.10.2011
    
    Form
      of Stock and Warrant Purchase Agreement, dated May 1, 2000 by and among
      the Company and the purchasers thereto.10.2112
    
    Placement
      Agent Agreement with Ladenburg Thalmann & Co., Inc. dated January 9,
      2001.10.2213
    
    Amendment
      No. 1 to Marina Village Office Tech Lease, dated July 20, 2001 and
      effective January 1, 2002.10.2314H
    
    License
      Agreement, dated December 21, 2001 by and between the Company and The
      University of Connecticut Health Center.10.2416
    
    Form
      of Senior Secured Notes in the aggregate principal amount of $100,000,
      each dated May 28, 2003, issued by the Company to the holders listed on
      the signature pages to the Equipment Lien Agreement included as Exhibit
      10.25 hereto.10.2516
    
    Form
      of Equipment Lien Agreement, dated as of May 28, 2003, between the Company
      and the holders listed on the signature pages thereto.10.2616
    
    Form
      of Promissory Notes in the aggregate principal amount of $188,500, dated
      between June 13, 2003 and June 30, 2003, issued by the Company to certain
      members of the Company’s Board of Directors, senior management, and
      stockholders.10.2716
    
    Form
      of Waiver and Amendment to Promissory Notes to Promissory Notes by and
      between the Company and the holders of the promissory Notes included as
      Exhibit 10.26 hereto.10.2816
    
    Form
      of Senior Secured Note in the principal amount of $400,000, dated July 15,
      2003, issued by the Company to S. Kumar Chandrasekaran,
    Ph.D.10.2916
    
    Form
      of Senior Secured Note in the principal amount of $50,000, dated July 30,
      2003, issued by the Company to MHU Ventures, Inc.10.3016
    
    Form
      of Security Agreement, dated as of July 15, 2003, between the Company and
      the holders listed on the signature pages thereto.10.3116
    
    Form
      of Amendment to July 15, 2003 Security Agreement, dated as of July 30,
      2003, by and among the Company and the parties listed on the signature
      page thereto.10.3219H
    
    ISV-403
      Asset Purchase Agreement, dated December 19, 2003, between the Company and
      Bausch & Lomb, Inc.10.3220
    
    Form
      of Subscription Agreement, dated as of March 26, 2004, by and between the
      Company and the Subscribers named on the signature pages
      thereto.10.3420
    
    Form of Class A
      Warrants.10.3520
    
    Form
      of Class B Warrants.10.3620
    
    Form of Placement
      Warrant.10.3720
    
    Placement Agent
      Agreement, dated as of February 12, 2004, by and between the Company and
      Paramount Capital, Inc.16.118
    
    Letter
      of Ernst & Young, LLP regarding change in certifying account, dated
      October 28, 2003.23.1
    
    Consent
      of Burr, Pilger & Mayer LLP, Independent Registered Public Accounting
      Firm.23.2
    
    Consent
      of Ernst & Young 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.
   64
  3
    
    Incorporated
      by reference to an exhibit in Amendment No. 1 the Company's
      Registration Statement on Form S-1 (Registration No. 33-68024) as filed
      with the Securities and Exchange Commission on September 16,
      1993.4
    
    Incorporated
      by reference to an exhibit in the Company's Annual Report on Form 10-K for
      the year ended December 31, 1995.5
    
    Incorporated
      by reference to an exhibit in the Company's Quarterly Report on Form 10-Q
      for the quarter ended June 30, 1996.6
    
    Incorporated
      by reference to an exhibit in the Company's Quarterly Report on Form 10-Q
      for the quarter ended March 31, 1997.7
    
    Incorporated
      by reference to an exhibit in the Company's Annual Report on Form 10-K for
      the year ended December 31, 1996.8
    
    Incorporated
      by reference to exhibits in the Company's Registration Statement on Form
      S-8 (Registration No. 333-60057) as filed with the Securities and Exchange
      Commission on July 28, 1998.9
    
    Incorporated
      by reference to exhibits in the Company's Registration Statement on Form
      S-3 (Registration No. 333-36673) as filed with the Securities and Exchange
      Commission on September 29, 1997.10
    
    Incorporated
      by reference to an exhibit to the Company’s Registration Statement on Form
      S-8 (Registration No. 333-43504) as filed with the Securities and Exchange
      Commission on August 11, 2000.11
    
    Incorporated
      by reference to an exhibit to the Company’s Registration Statement on Form
      S-3 (Registration No. 333-38266) as filed with the Securities and Exchange
      Commission on June 1, 2000.12
    
    Incorporated
      by reference to an exhibit to the Company’s Registration Statement on Form
      S-3 (Registration No. 333-54912) as filed with the Securities and Exchange
      Commission on February 2, 2001.13
    
    Incorporated
      by reference to an exhibit to the Company’s Quarterly Report on Form 10-Q
      for the quarter ended September 30, 2001.14
    
    Incorporated
      by reference to an exhibit to the Company’s Annual Report of Form 10-K for
      the year ended December 31, 2001.15
    
    Incorporated
      by reference to an exhibit to the Company’s Quarterly Report on Form 10-Q
      for the quarter ended September 30, 2002.16
    
    Incorporated
      by reference to an exhibit to the Company’s Quarterly Report on Form
      10-Q/A for the quarter ended June 30, 2003.17
    
    Incorporated
      by reference to an exhibit to the Company’s Current Report on Form 8-K
      filed with the Securities and Exchange Commission on September 23,
      2003.18
    
    Incorporated
      by reference to an exhibit to the Company’s Current Report on Form 8-K
      filed with the Securities and Exchange Commission on October 28,
      2003.19
    
    Incorporated
      by reference to an exhibit to the Company’s Current Report on Form 8-K
      filed with the Securities and Exchange Commission on January 14,
      2004.20
    
    Incorporated by reference to an
      exhibit to the Company's Current Report on Form 8-K filed with the
      Securities and Exchange Commission on March 29, 2004.H
    
    Confidential
      treatment has been granted with respect to certain portions of this
      agreement.HH
    
    Management
      contract or compensatory plan.







65