UNITED
STATES


SECURITIES
AND EXCHANGE COMMISSION


WASHINGTON,
D.C. 20549





FORM
10-K





x
            
            ANNUAL
      REPORT PURSUANT TO SECTION 13 OR 15(d) OF THESECURITIES
      EXCHANGE ACT OF 1934For
      the fiscal year ended December 31, 2008ORo
            
            TRANSITION
      REPORT PURSUANT TO SECTION 13 OR 15(d) OF THESECURITIES
      EXCHANGE ACT OF 1934





Commission
file number:  1-14207





INSITE
VISION INCORPORATED


(Exact
name of registrant as specified in its charter)


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





(510)-865-8800


(Registrant’s
telephone number, including area code)




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




Title
      of each class
            
            Name
      of each exchange on which registeredCommon
      Stock, $0.01 par value per share
            
            New
      York Stock Exchange Alternext US




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





Indicate
by check mark if the registrant is a well-known seasoned issuer, as defined in
Rule 405 of the Securities Act. Yes  ̈No  x





Indicate
by check mark if the registrant is not required to file reports pursuant to
Section 13 or Section 15(d) of the Act. Yes  ̈No  x





Indicate
by check mark whether the registrant (1) has filed all reports required to be
filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the
preceding 12 months (or for such shorter period that the registrant was required
to file such reports), and (2) has been subject to such filing requirements for
the past 90 days.


Yes xNo   ̈





Indicate
by check mark if disclosure of delinquent filers pursuant to Item 405 of
Regulation S-K (§ 229.405) is not contained herein, and will not be contained,
to the best of registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K.  x





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


Large
      accelerated filer  ̈
              Accelerated
      filer  ̈
 Non-accelerated
      filer o
              Smaller
      reporting company x




Indicate
by check mark whether the registrant is a shell company (as defined in Rule
12b-2 of the Exchange Act). Yes  ̈No  x








The
aggregate market value of registrant’s Common Stock, $0.01 par value, held by
non-affiliates of the Registrant as of June 30, 2008 was approximately
$36,277,543 (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 10,
2009:  94,681,618.




Documents
Incorporated By Reference




Listed
below is the document incorporated by reference and the part of the
Form 10-K into which the document is incorporated:




Portions
of the Registrant’s definitive proxy statement (the “Proxy Statement”) to be
mailed to stockholders in connection with the solicitation of proxies for the
Registrant’s 2009 annual meeting of stockholders (the “Annual Meeting”) are
incorporated herein by reference in Parts II and III of this Annual Report on
Form 10-K to the extent stated herein.










ANNUAL
REPORT ON FORM 10-K


FOR
THE FISCAL YEAR ENDED DECEMBER 31, 2008





TABLE
OF CONTENTS





PagePART
      IItem
      1.
                                            Business
                                            1Item
      1A.
                                            Risk
      Factors
                                            15Item
      1B.
                                            Unresolved
      Staff Comments
                                            27Item
      2.
                                            Properties
                                            27Item
      3.
                                            Legal
      Proceedings
                                            28Item
      4.
                                            Submission
      of Matters to a Vote of Security Holders
                                            28PART
      IIItem
      5.
                                            Market
      for Registrant's Common Equity, Related Stockholder Matters and
      Issuer Purchases of Equity Securities
                                            28Item
      6.
                                            Selected
      Consolidated Financial Data
                                            30Item
      7.
                                            Management's
      Discussion and Analysis of Financial Condition and Results of
      Operations
                                            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
                                            59Item
      9A.
                                            Controls
      and Procedures
                                            59Item
      9B.
                                            Other
      Information
                                            60PART
      IIIItem
      10.
                                            Directors,
      Executive Officers and Corporate Governance
                                            60Item
      11.
                                            Executive
      Compensation
                                            60Item
      12.
                                            Security
      Ownership of Certain Beneficial Owners and Management and Related
      Stockholder Matters
                                            60Item
      13.
                                            Certain
      Relationships and Related Transactions, and Director
      Independence
                                            61Item
      14.
                                            Principal
      Accountant Fees and Services...
                                            61PART
      IVItem
      15.
                                            Exhibits
      and Financial Statement Schedules
                                            61Signatures
                                            
                                            
                                            62











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





PART
I


Item
1.  Business


THE
COMPANY








InSite Vision Incorporated (“InSite” or
the “Company”) is an ophthalmic product development company committed
to advancing ophthalmic pharmaceutical products to address unmet eye care
needs.  Our current portfolio of ophthalmic pharmaceutical products is
based on our proprietary DuraSite® drug
delivery technology.





Our
DuraSite sustained drug delivery technology is a proven, patented synthetic
polymer-based formulation designed to extend the residence time of a drug
relative to conventional topical therapies.  It enables topical
delivery of a solution, gel or suspension and can be customized for delivering a
wide variety of potential drug candidates.  We are currently focusing
our research, development and commercial support efforts on the following
topical anti-infective products that formulate the antibiotic azithromycin with
our DuraSite drug delivery technology.





·
            AzaSite®
      (azithromycin ophthalmic solution) 1% is a DuraSite formulation of
      azithromycin developed as a broad spectrum ocular antibiotic and approved
      by the U.S. Food and Drug Administration  (FDA) in April 2007 to
      treat bacterial conjunctivitis (pink eye). AzaSite was launched by Inspire
      Pharmaceuticals in August 2007.  The key advantages of AzaSite
      are a significantly reduced dosing regimen leading to better compliance
      and patient outcome and a lowered probability of bacterial resistance
      based on high tissue concentration.


·
            ISV-502
      is a DuraSite formulation of azithromycin and dexamethasone in development
      for the treatment of ocular inflammation and infection (blepharitis and/or
      blepharoconjunctivitis) for which there is no FDA-approved
      treatment.  We completed the first of two pivotal Phase 3 trials
      in November 2008.


·
            ISV-405,
      is a DuraSite formulation utilizing a higher percentage of azithromycin,
      and is in preclinical development for the treatment of ocular infection
      for markets outside the United
States.





Business
Strategy.





Our
business strategy includes three key pillars:





1.    Support and extend sales of
AzaSite.  Working with our North American commercial partner,
Inspire Pharmaceuticals, we will seek to increase AzaSite sales through a
variety of approaches, including the evaluation of AzaSite for additional
indications such as blepharitis, or inflammation of the eyelid.  We
are also seeking additional commercial partners outside the United States to
market AzaSite in Japan and Europe.





2.    Develop and monetize our pipeline of
ocular product candidates.We plan to conduct preclinical and
clinical testing of product candidates in our portfolio, and then partner with
pharmaceutical companies to complete clinical development, manufacture, and
market these products.





3.    Invest in long-term Research and
Development opportunities.We will seek to in-license or
acquire promising product candidates and technologies from companies and
academic institutions, then apply our expertise to create novel differentiated
ophthalmic product opportunities.  We may also utilize our DuraSite
technology platform for the formulation of new ocular product candidates using
either non-proprietary drugs or compounds originally developed by others for
non-ophthalmic indications.





1




Corporate
Information.      Our principal executive
offices are located at 965 Atlantic Avenue, Alameda,
California  94501.  Our telephone number is (510)
865-8800.  We were incorporated in 1986 as a California corporation
and reincorporated in Delaware in 1987.  We make our periodic and
current reports available, free of charge, through our website
(http:///www.insitevision.com) under “Investor Relations – SEC Filings” as soon
as reasonably practicable after such material is electronically filed with the
Securities and Exchange Commission.





Ophthalmic
Anti-Infective Market





Today, eye infections are routinely
treated with topical antibiotics as well as antibiotic/corticosteroid
combination products.  The ocular anti-infective market represented
global sales of $1.8 billion in 2008 according to Hygea Strategies LLC IMS-based
data and comprises two separate product segments:





·
            Ocular
      antibiotic products


·
            Ocular
      antibiotic/corticosteroid combination
products





We have concentrated most recently on
the need for differentiated topical anti-infectives.  We continue to
support the need for differentiated topical products to treat eye and eye-lid
infections.  Some of these infections are either under-treated or do
not have an FDA-approved product indication.  These infections can be
both acute and chronic.  Our goal is to provide effective and
differentiated therapeutics for the treatment of acute and chronic ocular
infection and inflammation.  There are two general areas where our
topical ocular anti-infective products have been utilized by eye care
physicians:





·
            Eye
      Infections.


o
            Acute bacterial
      conjunctivitis (pink eye) is a common condition experienced by most
      people at some point in their lives, but is especially prevalent among
      children.  The conjunctiva is the transparent lining on the
      inside of the eyelids.  In bacterial conjunctivitis, bacteria
      infects this lining, and the white part of the eye may look pink from the
      inflammation.  As it is a contagious condition, immediate
      treatment is recommended.  Our ocular antibiotic, AzaSite, is
      targeted at treating this disease with significantly lower dosing and a
      lowered probability of bacterial resistance due to high tissue
      concentration.





·
            Eye-lid
      infections.


o
            Blepharitis is an
      inflammation of the eyelids, particularly the eyelid margins where the
      eyelashes grow.  It is a common disorder, particularly among the
      elderly, that results from a malfunction of the oil glands at the base of
      the eyelashes.  This malfunction can lead to the growth of
      bacteria, which can irritate and inflame the eyelids.  An eyelid
      with blepharitis may become itchy and appear red and swollen with scaly,
      greasy debris along the lid margin.  Blepharitis can be a
      chronic condition that is difficult to
treat.





o
            Blepharoconjunctivitisoccurs when conjunctivitis accompanies blepharitis, as it
      frequently does.  A unilateral or bilateral conjunctivitis that
      persists for four or more weeks is considered chronic.  There is
      a considerable overlap of symptoms of all types of
      blepharitis.  It frequently leads to associated ocular surface
      inflammation, including conjunctivitis, function tear deficiency, and
      keratitis, an inflammation of the cornea which can develop into corneal
      ulcers.  Blepharoconjunctivitis is a disease with no approved
      drug therapy indicated for the relief of its chronic
      symptoms.  The typical treatment is eye hygiene using lid
      scrubs, topical and/or systemic antibiotics, and topical
      corticosteroids.  Our combination antibiotic/corticosteroid
      product, ISV-502, is targeted at this unmet need by treating both the
      infection and inflammation.





2




AzaSite
Products and Product Candidates





The following table summarizes the
current status of our principal AzaSite product and product candidates in our
development pipeline. A more detailed description of each product and product
candidate follows the table.





Principal
AzaSite Products and Product Candidates


Active
Programs


Product
                                    
                                    Indications
                                    
                                    Anticipated Benefits
                                    
                                    StatusTopical Anti-infectivesAzaSite
                                    
                                    Bacterial
      conjunctivitis (pink eye)
                                    
                                    Broad
      spectrum antibiotic with reduced dosing frequency
                                    
                                    *Approved
      and launched in US
                                      *New
      Drug Submission (NDS) filed in CanadaISV-502
                                    
                                    Blepharitis/
      Blepharoconjunctivitis
                                    
                                    Broad
      spectrum antibiotic combined with an anti-inflammatory corticosteroid with
      reduced dosing frequency to treat both inflammation and
      infection
                                    
                                    *Pivotal
      Phase 3(a) trial completedISV-405
                                    
                                    Eye
      infections
                                    
                                    Broad
      spectrum antibiotic with reduced dosing frequency
                                    
                                    Preclinical





The
AzaSite Product Family of Topical Anti-infectives





AzaSite:
Launched commercially in the United States by Inspire Pharmaceuticals in August
2007 for Bacterial Conjunctivitis (pink eye)





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





Azithromycin
has a broad spectrum of antibiotic activity and is widely used to treat
respiratory and other infections in its oral and parenteral forms. AzaSite is an
eye drop of 1% azithromycin formulated to deliver sufficient tissue
concentrations over a seven-day dosing period using our proprietary DuraSite
technology.  The eye drop is designed to enable superior bactericidal
activity against common ocular pathogens and even difficult bacteria such as
pseudomonas.  We believe the key advantages of AzaSite include its
once-a-day dosing after the first two days of treatment and the high and
persistent levels of azithromycin achieved in the tissues of the eye. Clinical
studies have shown that AzaSite is well tolerated and efficacious.





In August
2007, Inspire Pharmaceuticals commercially launched AzaSite (azithromycin
ophthalmic solution) 1% in the United States pursuant to their license of
AzaSite from InSite and approval by the FDA in April 2007.





In the
United States, our commercial partner Inspire focuses on ophthalmologists,
optometrists, pediatricians, and primary care physicians who routinely treat eye
infections. AzaSite is positioned to compete favorably with the newer fourth
generation fluoroquinolones for antibacterial coverage.  Further,
AzaSite possesses the advantage of reduced dosing frequency that we believe may
increase patient compliance and reduce the likelihood of the development of
bacterial resistance.





3





ISV-502 in Phase 3 Trials forBlepharitis/Blepharoconjunctivitis





Expansion
of our AzaSite product into a larger franchise is the development of a
combination of azithromycin with platform corticosteroid (dexamethasone) for the
treatment of blepharitis/blepharoconjunctivitis,
an infection of the eyelid and the conjunctiva and one of the most common eye
problems in older adults, as well as other ophthalmic infections. In 2006, we
completed our preclinical development of this combination product candidate,
filed an Investigational New Drug Application (IND), with the FDA and conducted
a Phase 1 clinical trial.





In
February 2007, we announced that the preliminary safety data from our Phase 1
trial indicated that ISV-502 was well tolerated and no serious adverse events
were reported. Treatment-related ocular adverse events were minimal in frequency
and equivalent between the treatment and placebo groups. There were no
significant differences in intraocular pressure between the ISV-502 group and
placebo group after 14 days of treatment.





In the
fall of 2007, we conducted a pilot study to evaluate endpoints and time points
for use in the Phase 3 trials for ISV-502.  There were 32 patients
with blepharoconjunctivitis who completed the double-masked and randomized trial
and received eye drops two times a day for 14 days.  The results led
to the selection of endpoints for the first Phase 3(a) trial, which included lid
margin redness, lid swelling, conjunctival redness, ocular discharge, and lid
irritation in at least one eye.





The Phase
3(a) trials tested a total of 417 patients.  The dosing regimen
consists of one drop in the eye and one on the eyelid, two times a day for 14
days.  The trial design included three treatment arms with the
objective of demonstrating the superiority of ISV-502 in treating
blepharoconjunctivitis over AzaSite and dexamethasone.





Preliminary
results from the Phase 3(a) trial indicate that ISV-502 improved clinical
outcomes as compared to treatment with AzaSite alone or dexamethasone alone in
bacterial eradication and the reduction of inflammatory signs and symptoms,
respectively.  However, an initial evaluation of the data indicates
that the trial did not achieve its primary endpoint as defined by the
protocol.  In addition, ISV-502 was very well tolerated.





We plan
to discuss results from this trial with the FDA and, based on this meeting, we
will determine our plans for a confirmatory Phase 3 clinical trial or additional
testing of the compound.  We currently plan to seek a partner for
ISV-502 to work with on the final stages of product development and
commercialization.





ISV-405:
Pre-clinical Development for Ocular Infections in International
Markets





We are in
the early stages of developing ISV-405, a product
candidate with a higher percentage of azithromycin (2%) as part of its
formulation than with AzaSite (1%).  ISV-405 is being developed for
the treatment of eye infections.  We intend to partner this product
for markets outside of the United States.





DuraSite
Sustained Delivery Technology





At the
core of our AzaSite franchise is our proprietary DuraSite drug delivery
technology.  Our DuraSite sustained drug delivery technology is a
patented, synthetic polymer-based formulation designed to extend the residence
time of a drug relative to conventional topical therapies.  It enables
topical delivery of a solution, gel, or suspension and can be customized for
delivering a wide variety of potential drug candidates.





The combination of DuraSite and proven
drug products results in differentiated products that have increased efficacy
and improved compliance through a reduced dosing frequency that yields better
outcomes; lowers the development risk by using the proven DuraSite technology
with a proven drug product; and lowers development costs.  In addition
to its formulation with azithromycin in our AzaSite family of products , our
DuraSite technology may be used in the formulation of new ocular product
candidates using either non-proprietary drugs or compounds developed by others
for non-ophthalmic indications.





Physical
Properties.DuraSite is composed of a cross-linked polyacrylic
acid polymer, water and salts.  We have developed considerable
knowledge of how to formulate it for topical applications that have a range of
viscosities and physical forms including gels, suspensions and
solutions.  The size of the dry polymer particle averages 5
microns.  The molecular weight of the polymer exceeds 3x107
Daltons.  Upon the addition of water, DuraSite swells to ~100x its
original weight.





4


The
polymer entraps water and the active drug product in a bioadhesive
matrix.  The viscosity of the matrix is controlled by
pH.  The bioavailability and release characteristics of the drug can
be adjusted by altering the chemical environment.  The resulting drug
delivery system is bioadhesive, sustained release, and compatible with both
water soluble and water insoluble molecules.





Regulatory
Status.The ingredients in the DuraSite sustained release
technology are classified by the FDA as Category 1 GRAS (generally regarded as
safe).  It has been approved by many pharmacopeias, which helps to
facilitate worldwide approvals of drugs that contain it.  DuraSite has
been used commercially in AquaSite, an ophthalmic product for dry eye syndrome,
and in AzaSite, a topical anti-infective product for the treatment of bacterial
conjunctivitis.  It will also be utilized in Bausch & Lomb’s new
anti-infective eye drop besifloxacin ophthalmic suspension, 0.6%, which the FDA
Dermatologic and Ophthalmic Drugs Advisory Committee recently recommended
approval.  Bausch & Lomb’s intent is to bring this product to
market in the first half of 2009.





Additional
Research and Development Opportunities





In
addition to products leveraging our DuraSite technology, we will seek to
in-license or acquire promising product candidates and technologies from
academic institutions and other companies and to apply our expertise to create
novel differentiated ophthalmic product opportunities.





Collaborative,
Licensing and Service Agreements





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





Shin Poong Pharm Co.,
Ltd.  In December 2007, we entered into an international
licensing and distribution agreement for AzaSite with Shin Poong, Seoul, South
Korea, one of the top ten South Korean pharmaceutical companies.  This
was the first international agreement for AzaSite outside of North
America.  Under the terms of the agreement, the Company granted
exclusive rights to Shin Poong to commercialize AzaSite for ocular bacterial
infection in South Korea.





Bioceutica S.A.  In
March 2008, the Company entered into a licensing and distribution agreement for
AzaSite with Bioceutica S.A. in Argentina. Under the terms of the agreement, the
Company granted exclusive rights to Bioceutica to commercialize AzaSite for
ocular bacterial infection in Argentina, Chile, Paraguay and
Uruguay.





Biem
Pharmaceuticals.  In April 2008, the Company entered into a
licensing and distribution agreement for AzaSite with Biem Pharmaceuticals in
Turkey. Under the terms of the agreement, the Company granted exclusive rights
to Biem Pharmaceuticals to commercialize AzaSite for ocular bacterial infection
in Turkey.





Essex
Bio-Technology.  In May 2008, the Company entered into a
licensing and distribution agreement for AzaSite with Essex Bio-Technology in
the People’s Republic of China. Under the terms of the agreement, the Company
granted exclusive rights to Essex Bio-Technology to commercialize AzaSite
for ocular bacterial infection in the People’s Republic of China.





In all of
these agreements, the licensee is responsible for obtaining regulatory approval
and will generally pay the Company a double digit royalty on net sales of
AzaSite in these countries, if approved by regulatory
authorities.  The Company will be responsible for providing AzaSite
inventory to these licensees at a fee per respective agreed upon licensing
agreement.





Pfizer Inc. and Pfizer Products,
Inc.  In February 2007, we entered into a worldwide, exclusive,
royalty-bearing licensing agreement with Pfizer, under Pfizer’s patent family
titled “Method of Treating Eye Infections with Azithromycin” for ocular
anti-infective product candidates known as AzaSite and ISV-502.  Under
the Pfizer License, we are required to pay Pfizer a single-digit royalty based
on net sales of the licensed products and to use reasonable commercial efforts
to seek regulatory approval for and market licensed products. We have the right
to grant sublicenses, subject to Pfizer's prior approval which shall not be
unreasonably withheld.





5


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





Upon the
closing of the Inspire License, Inspire paid us an upfront license fee of $13
million and paid us an additional $19 million upon FDA approval in April
2007.  Inspire also pays us a royalty on net sales.  The
royalty rate is 20% on net sales in the first two years of commercialization and
25% thereafter. Inspire is obligated to pay us royalties under the Inspire
License for the longer of (i) eleven years from the launch of the first product
(August 13, 2007) and (ii) the period during which a valid claim under a patent
licensed from us covers a licensed product.  For five years after the
first year of commercial sale, Inspire is required to pay us the greater of the
royalty discussed above or certain tiered minimum royalties.  The
royalties discussed above are subject to certain reductions in the event of
patent invalidity, third party licenses, generic competition and uncured
material breach.  Such reductions are cumulative but will in no event
fall below a low single digit royalty based on applicable net sales. There are
certain permitted offsets against both royalties and minimum royalties which are
not subject to a floor amount.





Under the
Inspire License, we were responsible for obtaining regulatory approval of
AzaSite in the U.S. which occurred in April 2007.  We subsequently
transferred regulatory documentation regarding AzaSite, including the New Drug
Application (NDA), to Inspire.  We are also responsible for obtaining
regulatory approval of AzaSite in Canada.  On November 30, 2007, we
filed a NDS with Health Canada for AzaSite.  Within 25 days after
obtaining regulatory approval for Canada, we will be responsible for
transferring regulatory documentation regarding AzaSite to
Inspire.  Thereafter, Inspire will be responsible for all regulatory
obligations and strategies relating to the further development and
commercialization of products in each country. Inspire will also be responsible
for commercialization in both the U.S. and Canada.





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





In
addition, we also entered into a trademark license agreement with Inspire in
February 2007 under which we granted to Inspire an exclusive license to the
AzaSite trademark and domain name and a nonexclusive license to the DuraSite
trademark in connection with the commercialization of products in the U.S. and
Canada under the terms of the Inspire License.





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





6


Catalent Pharma Solutions,
formerly Cardinal
Health PTS, L.L.C.  In September 2005, we entered into a
commercial manufacturing supply agreement with Catalent Pharma Solutions, or
Catalent for the manufacture of AzaSite commercial units.  The
agreement had a term of four years subsequent to the approval by the FDA of
Catalent as a manufacturer of AzaSite.  Payments under the contract
are dependent upon rolling production forecasts we provide to Catalent and are
subject to certain minimum purchase commitments which escalate over the term of
the contract. According to plan, the AzaSite NDA was transferred to Inspire and
manufacturing responsibilities for AzaSite were transferred to Inspire for
manufacturing AzaSite for the U.S. and Canada.  We continue to have a
relationship with Catalent for the manufacture of AzaSite for international
partners as well as for other products in our pipeline.





Bausch and Lomb
Incorporated.  In December 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 and a License Agreement, or the License Agreement, and collectively,
the Asset Sale.





We are
entitled to a single-digit royalty on 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-patented intellectual property used in ISV-403. The License Agreement
provides for Bausch & Lomb to complete development of the SS734
fluoroquinolone products that combine certain compounds we licensed from SSP
Co., Ltd. (SSP) with the DuraSite delivery system and to commercialize any such
products.  The patent license is exclusive in the particular field of
developing, testing, manufacturing, obtaining regulatory approval of, marketing,
selling and otherwise disposing of such products.  The license of
non-patented intellectual property granted to Bausch & Lomb is
nonexclusive.





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





Other.As part of our basic
strategy, we continually pursue agreements with other companies, universities
and research institutions concerning 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, although 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 valuable.  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, and we
have filed a number of patent applications in the United States relating to our
DuraSite technology with delivery tips and drug compounds.  Of these
applications, eight U.S. patents have been issued.  We have four U.S.
patents on our retinal drug delivery device that have been
issued.  Three U.S. patents have been issued related to our antibiotic
programs with three applications pending.  At least five other patent
applications by us relating to the foregoing and other aspects of our business
and potential business are also pending.  Foreign counterparts of our
patents as well have filed/issued in many countries.





The patent positions of pharmaceutical
companies, including ours, are uncertain and involve complex legal and factual
questions.  In addition, the coverage claimed in a patent application
can be significantly reduced before a patent is issued.  Consequently,
we do not know whether any of our pending patent applications will result in the
issuance of patents or if any of our patents will provide significant
proprietary protection.  Since patent applications are maintained in
secrecy until they are




7




published,
we cannot be certain that we or any licensor was the first to file patent
applications for such inventions or that patents issued to our competitors will
not block or limit our ability to exploit our technology.  Moreover,
we might have to participate in interference proceedings declared by the U.S.
Patent and Trademark Office, or USPTO, to determine priority of invention, which
could result in substantial cost to us, even if the eventual outcome were
favorable.  There can be no assurance that our patents will be held
valid or enforceable by a court or that a competitor's technology or product
would be found to infringe such patents.





A number of pharmaceutical companies
and research and academic institutions have developed technologies, filed patent
applications or received patents on various technologies that may be related to
our business.  Some of these technologies, applications or patents may
conflict with our technologies or patent applications.  This conflict
could limit the scope of the patents, if any, that we may be able to obtain or
result in the denial of our patent applications.  In addition, if
patents that cover our activities have been or are issued to other companies,
there can be no assurance that we would be able to obtain licenses to these
patents at a reasonable cost or at all, or be able to develop or obtain
alternative technology.  If we do not obtain such licenses, we could
encounter delays in or be precluded altogether from introducing products to the
market.





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





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





Research
and Development





On December 31, 2008, our research and
development staff numbered 26 people, of whom 7 have Ph.D.s.  Our
research and development expenses for the years ended December 31, 2008, 2007
and 2006 were:





Research
and Development Cost by Program


(in
millions)





Program
                  
                  2008
                  
                  
                  2007
                  
                  
                  2006ISV-502
                  
                  $
                  12.0
                  
                  
                  $
                  6.0
                  
                  
                  $
                  2.7AzaSite
                  
                  
                  0.6
                  
                  
                  
                  2.7
                  
                  
                  
                  6.1AzaSite
      Otic
                  
                  
                  1.3
                  
                  
                  
                  1.3
                  
                  
                  
                  -ISV-405
                  
                  
                  0.6
                  
                  
                  
                  0.4
                  
                  
                  
                  -Other
                  
                  
                  1.7
                  
                  
                  
                  -
                  
                  
                  
                  0.1Total
                  
                  $
                  16.2
                  
                  
                  $
                  10.4
                  
                  
                  $
                  8.9





In 2008,
our ISV-502 program activities consisted primarily of the Phase 3(a) clinical
trial and preparation for the production of Canadian AzaSite registration
batches at our contract manufacturing site. Our activities related to our
AzaSite Otic program mainly consisted of preclinical testing prior to its
discontinuation in July 2008. Our ISV-405 activities also mainly related to
preclinical experiments. Further development of this program has been
deferred.  Other program activities consisted primarily of new product
development and activities related to commercializing AzaSite in the
international markets.





In 2007, our ISV-502 program activities
related to the completion of preclinical studies to support Phase 3 clinical
trials, the completion and data analysis of a Phase 1 clinical trial, conduct of
a pilot study and the initiation of a Phase 3(a) clinical trial.  Our
AzaSite program activities included producing United States registration batches
at our contract manufacturing site and assembling and filing the application for
regulatory approval in Canada.  Our activities related to
the




8




AzaSite
Otic program mainly consisted of preclinical testing to support filing of an
IND.  Our ISV-405 activities mainly related to preclinical
experiments.





In 2006, our ISV-502 program activities
mainly focused on preclinical testing, preparation of an IND and initiation of
Phase 1 clinical trails.  Our AzaSite activities mainly related to the
completion of the Phase 3 clinical trials and compilation and filing of an NDA
in the United States.





Although
the majority of our personnel were focused on our ISV-502 program in 2008, 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 research and development
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.





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 building 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, we rely on third parties for supplies and materials
necessary for our Phase 3 clinical trials and commercial needs.  If we
should encounter delays or difficulties in establishing and maintaining our
relationship with qualified manufacturers to produce, package and distribute our
finished products, then clinical trials, regulatory filings, market introduction
and subsequent sales of such products would be adversely affected.





We have entered into a licensing
agreement with Inspire under which they are responsible for the manufacture of
AzaSite for the United States and Canada.  The AzaSite NDA was
transferred to Inspire and manufacturing responsibilities for AzaSite were
transferred to Inspire for the U.S. and Canada.  We have a
relationship with Catalent for the manufacture of AzaSite for international
partners as well as for other products in our pipeline.





Marketing
and Sales





The cost
to develop and maintain a marketing organization and sales force is significant
and would result in the reallocation of resources needed for the development of
our product candidates.  We do not currently plan on establishing a
dedicated sales force or a marketing organization for our AzaSite, ISV-502 or
other product candidates.





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





Our current active collaborators
include:





Shin Poong Pharm Co.,
Ltd.  In December 2007, we entered into an international
licensing and distribution agreement for AzaSite with Shin Poong, Seoul, South
Korea, one of the top ten South Korean pharmaceutical
companies.  Under the terms of the agreement, InSite grants exclusive
rights to Shin Poong to commercialize AzaSite for ocular bacterial infection in
South Korea.





9


Bioceutica S.A.  In
March 2008, the Company entered into a licensing and distribution agreement for
AzaSite with Bioceutica S.A. in Argentina. Under the terms of the agreement, the
Company granted exclusive rights to Bioceutica to commercialize AzaSite for
ocular bacterial infection in Argentina, Chile, Paraguay and
Uruguay.





Biem
Pharmaceuticals.  In April 2008, the Company entered into a
licensing and distribution agreement for AzaSite with Biem Pharmaceuticals in
Turkey.  Under the terms of the agreement, the Company granted
exclusive rights to Biem Pharmaceuticals to commercialize AzaSite for ocular
bacterial infection in Turkey.





Essex
Bio-Technology.  In May 2008, the Company entered into a
licensing and distribution agreement for AzaSite with Essex Bio-Technology in
the People’s Republic of China. Under the terms of the agreement, the Company
granted exclusive rights to Essex Bio-Technology to commercialize AzaSite
for ocular bacterial infection in the People’s Republic of China.





In all of
these agreements, the licensee is responsible for obtaining regulatory approval
and will generally pay the Company a double-digit royalty on net sales of
AzaSite in these countries, if approved by regulatory
authorities.  The Company will be responsible for providing AzaSite
inventory to these licensees at a fee per respective agreed upon licensing
agreement.





Inspire Pharmaceuticals,
Inc.  In February 2007, we entered into an exclusive agreement
with Inspire under which Inspire obtained the right to exclusively market
AzaSite in the United States and Canada.  We received a licensing fee,
a milestone payment when AzaSite was approved by the FDA and received the first
royalty payment based on net sales of the product in the third quarter
2007.





Bausch &
Lomb.  In December 2003, we sold our ISV-403 product candidate
to Bausch & Lomb.  Bausch & Lomb has the exclusive marketing
rights for the world except for Japan, which were retained by SSP, and shared
rights in the rest of Asia with SSP.Bausch & Lomb has
also assumed the development and manufacturing responsibilities for the ISV-403
formulation for their sales and distribution and we are entitled to royalties
based on net sales of the product, if any.   We anticipate that
ISV-403 will be approved in the United States in the first half of
2009.





Competition





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





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





Many
companies are engaged in activities similar to our own. Some of these companies
have substantially greater financial, technical, marketing and human resources
available to them, which may allow them to succeed in developing technologies
and products at a faster rate, thereby gaining greater market acceptance than
the therapies that we are developing or have developed with our more limited
resources.  By being first to the market, these competitors may also
succeed in obtaining cost advantages or intellectual property rights that would
limit our ability to develop and commercialize our own product
opportunities.  Consequently, they might obtain a more timely and
effective regulatory approval for the commercialization of their products in
comparison to our timeline.





10




The
global ophthalmic pharmaceutical market is currently dominated by a number of
large and well-established companies, including Alcon Laboratories, Inc.,
Allergan, Inc., Bausch & Lomb, Novartis Ophthalmics, Johnson & Johnson,
Merck & Co., and Pfizer.  While there are many other large- and
medium-sized companies participating in the ophthalmic market, smaller companies
such as our own find it challenging to successfully develop and market products
without entering into collaborations.





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





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





Government
Regulation





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





The steps required before a
pharmaceutical agent may be marketed in the United States include:





·
            preclinical
      laboratory;


·
            submission
      to the FDA of an IND;


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


·
            the
      submission of an NDA or Biological License Application, or BLA to the FDA;
      and


·
            the
      FDA approval of the NDA or BLA, 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.





11


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 BLA 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 BLA approval is the requirement that the
prospective manufacturer's quality control and manufacturing procedures conform
to current Good Manufacturing Practice, or cGMP.  Prior to approval,
manufacturing facilities are subject to FDA and/or other regulatory agency
inspection to ensure compliance with cGMP.  Manufacturing facilities
are subject to periodic regulatory inspection to ensure ongoing
compliance.





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





12





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.





Our
advisors are as follows:




Name
                      
                      PositionMark
      Abelson, M.D.
                      
                      Associate
      Clinical Professor of Ophthalmology, Department of Ophthalmology, Harvard
      Medical SchoolD.
      Bruce Burlington, M.D.
                      
                      Consultant,
      RegulatoryChandler
      R. Dawson, M.D.
                      
                      Emeritus
      Professor, Department of Ophthalmology, University of California, San
      FranciscoSyd
      Gilman, Ph.D.
                      
                      Partner,
      Trident Rx Consultant ServiceAllan
      Flach, MD, Pharm D
                      
                      Director,
      Evening Ophthalmology Outpatient Unit, UCSFDirector,
      Ophthalmic Clinical Pharmacology, Department of Veterans Affairs, San
      FranciscoDavid
      G. Hwang, M.D.
                      
                      Professor
      of Clinical Ophthalmology, Co-Director, Cornea and Refractive Surgery
      Service, University of California, San Francisco School of
      MedicineHenrick
      K. Kulmala, Ph.D.
                      
                      Consultant,
      Pharmaceutical DevelopmentMichael
      Marmor, M.D.
                      
                      Professor,
      Department of Ophthalmology, Stanford University School of
      MedicineGholam
      Payman, M.D.
                      
                      Associated
      Retina Consultants, Phoenix AZJames
      G. Shook, Ph.D.
                      
                      President,
      Jim Shook Research, Inc.Christopher
      Ta, M.D.
                      
                      Associate
      Professor of Ophthalmology, Stanford Medical
  Center


Executive
Officers of the Company





As of March 13, 2009, our executive
officers were as follows:




Name
                            
                            Age
                            
                            TitleLouis
      Drapeau
                            
                            65
                            
                            Interim
      Chief Executive Officer, Vice President and Chief
                              Financial
      OfficerLyle
      M. Bowman, Ph.D.
                            
                            60
                            
                            Vice
      President, DevelopmentDavid
      F. Heniges
                            
                            65
                            
                            Vice
      President and General Manager, Commercial OpportunitiesKamran
      Hosseini, M.D., Ph.D.
                            
                            44
                            
                            Vice
      President, Clinical Affairs and Chief Medical OfficerSurendra
      Patel
                            
                            54
                            
                            Vice
      President,
Operations
  13


Louis Drapeau joined us on October 1,
2007 as Vice President and Chief Financial Officer and was appointed the interim
Chief Executive Officer in October 2008.  Mr. Drapeau served as Senior
Vice President, Finance and Chief Financial Officer of Nektar Therapeutics, a
biopharmaceutical company, from January 2006 until September
2007.  From August 2002 to August 2005, Mr. Drapeau was Senior Vice
President and Chief Financial Officer of BioMarin Pharmaceutical, a fully
integrated biopharmaceutical company.  From August 2004 to May 2005,
Mr. Drapeau also held the position of Acting Chief Executive Officer of
BioMarin.  Prior to that, Mr. Drapeau spent over 30 years with Arthur
Andersen including 19 years as an Audit Partner in Arthur Andersen’s Northern
California Audit and Business Consulting practice which also included 12 years
as Managing Partner.  He holds an undergraduate degree in mechanical
engineering and masters in business administration from Stanford
University.





Lyle M. Bowman joined us in October
1988 as Director of Drug Delivery Systems.  Previously, Dr. Bowman had
worked at Syntex Ophthalmics as Manager/Director of Analytical Polymer
Characterization working on contact lenses and solutions from 1979 through
September 1988.  From 1989 to 1991, Dr. Bowman served as Vice
President, Science and Technology. From 1991 to 1995, he served as Vice
President, Development, and from 1995 to 2008 served as Vice President
Development and Operations.  Dr. Bowman currently is Vice President
Development, holds a Ph.D. in Physical Chemistry from the University of Utah and
has considerable experience in material science as applied to ophthalmic
products.





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 KeraVision, Inc., a manufacturer of implantable ophthalmic devices and
equipment.  From 1996 to 1998 he was Vice President, Global Marketing
for the cardiovascular group at Baxter Healthcare Corporation.  From
1982 to 1995 he served in various managerial positions, including Director,
Product Management and International Marketing; Vice President, Marketing; and
Vice President, Worldwide Business Development, at IOLAB Corporation, a Johnson
& Johnson company, which manufactured ophthalmic devices, equipment and
pharmaceuticals.  Mr. Heniges spent 23 years in total with Johnson and
Johnson in various sales, marketing, and business development
positions.  Mr. Heniges holds a B.S. in Sociology with a minor in
science from Oregon State University.





Kamran
Hosseini joined us in February 2008 as Vice President, Clinical Affairs and
Chief Medical Officer.  From November 2007 to February 2008, Dr.
Hosseini served as the ophthalmic expert at JGB BioPharma consulting for
R&D, preclinical, clinical, and business development
projects.  From May 2005 to October 2007, he was the resident expert
in the ocular drug delivery program at Alza Corporation, a member of the Johnson
and Johnson Family of Companies, where he provided ophthalmology and visual
science expertise for new technology assessment activities aimed at enhancing
the drug/device unit pipeline.  From November 2003 to May 2005, he was
a post doctoral fellow in retinal degenerative diseases at the University of
California, San Francisco.  Dr. Hosseini received his M.D. from the
University of Groningen Faculty of Medicine, The Netherlands; and his Ph.D. as
part of a joint program at the University of Texas, Medical Branch in Galveston
and the University of Maastricht, The Netherlands.





Surendra Patel joined us in April 2008
as Vice President, Operations.  From 2002 to 2008, Mr. Patel served as
Senior Director, Manufacturing Operations at Nektar Therapeutics where he
managed clinical and commercial manufacturing operations and played a strategic
role in the selection of domestic and international contract manufacturing
sites.  Mr. Patel has more than 30 years of development and
operational experience in various management positions at pharmaceutical and
biotechnology companies, including Syntex, Roche Bioscience, Oread Inc., and
DrugAbuse Sciences.  Mr. Patel has a Bachelor of Science degree in
pharmaceutical formulation from De Montford University, Leicester, United
Kingdom.





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.





Employees





As of December 31, 2008, we had 36
employees, 34 of whom were full time.  None of our employees is
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





Item
1A.  Risk Factors





It
is difficult to evaluate our business because we are in an early stage of
development and our technology is untested and successful development of
pharmaceutical products is highly uncertain and requires significant
expenditures and time





We are in
the early stages of developing our business, particularly with respect to
commercializing our products.  We received regulatory approval for
AzaSite in April 2007 and commercial sales of AzaSite began in the third quarter
of 2007.  We must receive approval in other countries prior to
marketing AzaSite in such countries.  Before regulatory authorities
grant us marketing approval for additional products, we need to conduct
significant additional research and development and preclinical and clinical
testing and submit a NDA.  Successful development of pharmaceutical
products is highly uncertain. Products that appear promising in research or
development, including ISV-502, may be delayed or fail to reach later stages of
development or the market for several reasons, including:




§
            preclinical
      tests may show the product to be toxic or lack efficacy in animal
      models;




§
            failure
      to receive the necessary U.S. and international regulatory approvals or a
      delay in receiving such approvals. Among other things, such delays may be
      caused by slow enrollment in clinical studies; extended length of time to
      achieve study endpoints; additional time requirements for data analysis or
      BLA or NDA preparation; discussions with the United States (U.S.) Food and
      Drug Administration (FDA); FDA requests for additional preclinical or
      clinical data; analyses or changes to study design; or unexpected safety,
      efficacy, or manufacturing issues;




§
            clinical
      trial results may show the product to be less effective than desired or to
      have harmful or problematic side
effects;




§
            difficulties
      in formulating the product, scaling the manufacturing process, or getting
      approval for manufacturing;




§
            even
      if safe and effective, manufacturing costs, pricing, reimbursement issues,
      or other factors may make the product
  uneconomical;




§
            proprietary
      rights of others and their competing products and technologies may prevent
      the product from being developed or commercialized;
  or




§
            is
      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 ISV-502, 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.  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.  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 AzaSite, our
lead product which has not yet been commercially launched outside the United
States.





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





We
recently completed our Phase 3(a) clinical trial for our ISV-502 product
candidate. 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 for ISV-502 and
any




15


other
product candidates may take over a year to complete.  Furthermore, we
could encounter problems that might cause us to abandon or repeat clinical
trials resulting in additional expense, further delays and potentially
preventing the completion of such trials.  The commencement and
completion of clinical trials may be delayed or terminated due to several
factors, including:




§
            unforeseen
      safety issues;




§
            lack
      of effectiveness during clinical
trials;




§
            difficulty
      in determining dosing and trial
protocols;




§
            slower
      than expected rates of patient
recruitment;




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




§
            inability
      or unwillingness of clinical 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.  In any such case, we may not be able to obtain regulatory
approval for our product candidates in which case we would not obtain any
benefit from our substantial investment in developing the product and conducting
clinical trials for such products.





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 the
results will support our product candidate claims.  Even if
pre-clinical testing and early clinical trials for a product candidate are
successful, this does not ensure that later clinical trials will be successful
and we cannot be sure that the results of later clinical trials will replicate
the results of prior clinical trials and pre-clinical testing or meet our
expectations.  The clinical trial process may fail to demonstrate that
our product candidates are safe for humans or effective for indicated
uses.  In addition, our clinical trials involve relatively small
patient populations.  Because of the small sample size, the results of
these clinical trials may not be indicative of future results.  Any
such failure would likely cause us to abandon the product candidate and may
delay development of other product candidates.  Any delay in, or
termination of, our clinical trials will delay or preclude the filing of our
NDAs with the FDA and, ultimately, our ability to commercialize our product
candidates and generate product revenues.




Preliminary
results from the Phase 3(a) clinical trial of ISV-502 for the treatment of
blepharoconjunctivitis showed  improved clinical outcomes as compared
to treatment with a corticosteroid alone or antibiotic alone in the reduction of
inflammatory signs and symptoms and bacterial eradication,
respectively.  In addition, ISV-502 was very well tolerated. However,
an evaluation of the data indicated that the trial did not achieve its primary
endpoint as defined by the protocol.  The Company will utilize data
from this Phase 3(a) trial in the finalization of a planned confirmatory Phase 3
clinical study. The Company anticipates discussing the results of this trial
with the U.S. Food and Drug Administration (FDA) in the second quarter of 2009.
Following these discussions, the Company will announce anticipated timing for
initiating a second Phase 3 clinical trial.


Our
strategy for commercialization of our products requires us to enter into
successful arrangements with corporate collaborators





We
generally intend to enter into future partnering and collaborative arrangements
with respect to the commercialization of our product candidates, such as
ISV-502.  However, we cannot assure you that we will be able to enter
into such arrangements or that they will be beneficial to us.  The
success of our partnering and collaboration arrangements will depend upon many
factors, including:




§
            the
      progress and results of our preclinical and clinical testing and research
      and development programs;




§
            the
      time and cost involved in obtaining regulatory
  approvals;




§
            our
      ability to negotiate favorable terms with potential
      collaborators;




§
            the
      efforts and success of our collaborators in marketing the
      product;




§
            our
      ability to prosecute, defend and enforce patent claims and other
      intellectual property rights;




§
            the
      outcome of possible future legal actions;
and




§
            competing
      technological and market
developments.




16


We may
not be able to conclude arrangements with third parties to support the
commercialization of our products on acceptable terms, or at all, and may not be
able to maintain any arrangement that we do enter into.





The
commercial success of our products is dependent on the diligent efforts of our
corporate collaborators





Because
we generally rely on third parties for the marketing and sale of our products,
revenues that we receive will be highly dependent on the efforts of these third
parties, particularly our partner Inspire.  These partners may
terminate their relationships with us and may not diligently or successfully
market or sell our products.  These partners may also pursue
alternative or competing technologies or develop alternative products either on
their own or in collaboration with others, including our
competitors.  In addition, marketing consultants and contract sales
organizations that we may use in the future for our products may market products
that compete with our products and we must rely on their efforts and ability to
market and sell our products effectively.





If
we fail to enter into future collaborations or our current collaborations are
terminated, we will need to enter into new collaborations or establish our own
sales and marketing organization





We may
not be able to enter into or maintain collaborative arrangements with third
parties.  If we are not successful in entering into future
collaborations or maintaining our existing collaborations, particularly with
Inspire, we may be required to find new corporate collaborators or establish our
own sales and marketing organization.  Under the terms of the Inspire
License, Inspire may terminate the agreement at any time.  We have no
experience in sales, marketing or distribution and establishing such an
organization will be costly.  Moreover, there is no guarantee that a
sales and marketing organization would be successful once established.  If we are unable
to enter into additional collaborations or successfully market our products
ourselves, our revenues and financial results would be significantly
harmed.





Our
future success depends on our ability to engage third parties to assist us with
the development of new products, new indications for existing products, and in
the conduct of our clinical trials to achieve regulatory approval for
commercialization and any failure or delay by those parties to fulfill their
obligations could adversely affect our development and commercialization
plans





For our
business model to succeed, we must continually develop new products or discover
new indications for our existing products.  As part of that process,
we rely on third parties such as clinical research organizations, clinical
investigators and outside testing labs for development activities such as
Phase 2 and/or Phase 3 clinical testing and to assist us in obtaining
regulatory approvals for our product candidates. We rely heavily on these
parties for successful execution of their responsibilities but have no control
over how these parties manage their businesses and cannot assure you that such
parties will diligently or effectively perform their activities.  For example, the
clinical investigators conducting our clinical trials, including our recent
Phase 3(a) trial for ISV-502, are not our employees.  However, we are
responsible for ensuring that each of our clinical trials is conducted in
accordance with applicable protocols, rules and regulations or in accordance
with the general investigational plan and protocols for the trial as well as the
various rules and regulations governing clinical trials in the U.S. and
abroad.  Any failure by those parties to perform their duties
effectively and on a timely basis could harm our ability to develop and
commercialize new products and harm our business.





Physicians
and patients may not accept or use our products





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




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




§
            cost-effectiveness
      of our products relative to competing
products;




§
            actual
      or perceived benefits of competing products or
  treatments;




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





17


§
            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.





We
may require additional licenses or be subject to expensive and uncertain patent
litigation in order to sell our products





A number
of pharmaceutical and biotechnology companies and research and academic
institutions have developed technologies, filed patent applications or received
patents on various technologies that may be related to our
business.  Some of these technologies, applications or patents may
conflict with our technologies or patent applications.  As is common
in the pharmaceutical and biotech industry, from time to time we receive notices
from third parties alleging various challenges to our patent rights, and we
investigate the merits of each allegation that we receive.  Such
conflicts, if proven, could invalidate our issued patents, limit the scope of
the patents, if any, that we may be able to obtain, result in the denial of our
patent applications or block our rights to exploit our technology.  If
the U.S. Patent and Trademark Office, or USPTO, or foreign patent agencies have
issued or in the future issue patents to other companies that cover our
activities, we may not be able to obtain licenses to these patents at a
reasonable cost, or at all, 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.  If we are required to obtain additional licenses from third
parties with respect to the February 2008 issuance of $60 million in aggregate
principal amount of non-convertible, non-recourse promissory notes due in 2019,
or the AzaSite Notes in the United States and Canada, we will be required to pay
such amounts from our existing cash.




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




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




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




§
            redesign
      our products or processes to avoid
infringement;




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




§
            pay
      damages; or




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





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





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


18


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




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





In certain
circumstances, we may lose the potential to receive future royalty payments
after the AzaSite Notes are repaid in full or we may be required to pay damages
for breaches of representations, warranties or covenants under certain of the
AzaSite Note Financing Agreements.





In February 2008, through a
wholly-owned subsidiary, we issued $60 million in aggregate principal amount of
AzaSite Notes, which are secured principally by royalty payments from future
sales of AzaSite in North America, but not the right to receive such payments,
and by a pledge by us of all the outstanding equity interest in our subsidiary.
If the AzaSite royalty payments are insufficient to repay the AzaSite Notes or
if an event of default occurs under the indenture governing the AzaSite Notes,
in certain circumstances, the royalty payments and our equity interest in our
subsidiary may be foreclosed upon and we would lose the potential to receive
future royalty payments after the AzaSite Notes are repaid in full and our
intellectual property and other rights related to AzaSite. In addition, in
connection with the issuance of the AzaSite Notes, we have made certain
representations, warranties and covenants to our subsidiary and the holders of
the AzaSite Notes, or the Noteholders. If we breach these representations,
warranties or covenants, such breach could trigger an event of default under the
indenture and we could also be liable to our subsidiary or the Noteholders for
substantial damages in respect of any such breach, which could harm our
financial condition and ability to conduct our business as currently
planned.   See Note 5 to the Consolidated Financial Statements
included herein for a more complete description of the terms of the AzaSite
Notes.





Inspire’s
failure to successfully market and commercialize AzaSite would harm sales of
AzaSite and, therefore, would delay or prevent repayment of the AzaSite Notes,
which would delay or prevent us from receiving future revenue from sales of
AzaSite.





The AzaSite Notes issued by our
subsidiary will be repaid solely from royalties on net sales of AzaSite in the
United States and Canada by Inspire under the Inspire
Agreement.  Inspire has assumed full control of all promotional, sales
and marketing activities for AzaSite in these territories, and has sole control
over the pricing of AzaSite.  Accordingly, royalty payments in respect
of net sales of AzaSite in the United States and, upon regulatory approval, in
Canada, will be entirely dependent on the actions, efforts and success of
Inspire, over whom neither we nor our subsidiary have control.  The
success of Inspire’s commercialization of AzaSite and the timely repayment of
the AzaSite Notes will depend on a number of factors, including:





·
            the
      scope of Inspire’s launch of AzaSite in the United States and
      Canada;




·
            the
      effectiveness and extent of Inspire’s promotional, sales and marketing
      efforts;




·
            Inspire’s
      ability to build, train and retain an effective sales
    force;




·
            Inspire’s
      ability to successfully sell AzaSite to physicians and
      patients;




·
            Inspire’s
      pricing decisions regarding
AzaSite;




·
            Inspire’s
      marketing and selling of any current or future competing
      products;


19


·
            Inspire’s
      ability to compete against larger and more experienced
      competitors;




·
            the
      discovery of any side effects or negative efficacy findings for
      AzaSite;




·
            product
      recalls or product liability claims relating to
  AzaSite;




·
            the
      introduction of generic
competition;




·
            if
      competing products for the treatment of bacterial conjunctivitis obtain
      more favorable formulary status than AzaSite;
  and




·
            the
      relevant parties’ ability to adequately maintain or enforce the
      intellectual property rights relevant to
  AzaSite.




Inspire has only recently established
its sales force for AzaSite.  Inspire has reported that it has
incurred substantial expenses in establishing and maintaining its sales force
for AzaSite, including substantial additional expenses for the training and
management of personnel and the infrastructure to enable its sales force to be
effective and compliant with the multiple laws and regulations affecting sales
and promotion of pharmaceutical products.  Although individual members
of the sales force have experience in sales with other companies, Inspire did
not have a sales force prior to 2004 and may experience difficulties building
and maintaining its sales force, which could harm sales of AzaSite.




Inspire
is promoting AzaSite primarily to eye care professionals, and to a lesser
degree, pediatricians and primary care providers.  However, Inspire
has no prior experience calling on pediatricians and primary care physicians and
has focused its sales efforts on eye care
professionals.  Pediatricians and primary care physicians write more
than 67% of prescriptions to ophthalmic antibiotics.  A large number
of pharmaceutical companies, including those with competing products, much
larger sales forces and much greater financial resources, and those with
products for indications that are completely unrelated to AzaSite, compete for
the time and attention of pediatricians and primary care
physicians.  Neither we nor our subsidiary have any control over how
Inspire manages and operates its sales force, how effective Inspire’s sales
efforts will be or Inspire’s pricing decisions regarding AzaSite.


In addition, Inspire depends on three
pharmaceutical wholesalers for the vast majority of its AzaSite sales in the
United States.  These companies are Cardinal Health, McKesson
Corporation and AmerisourceBergen.  The loss of any of these
wholesalers could harm sales of AzaSite.  It is also possible that
these wholesalers, or others, could decide to change their policies or fees, or
both, in the future. This could cause Inspire to incur higher product
distribution costs, which would result in lower net sales of
AzaSite.





Inspire could experience financial or
other difficulties unrelated to AzaSite that could adversely affect the
marketing or sale of AzaSite.  Moreover, Inspire could change its
commercial strategy and deemphasize or sell or sublicense its rights to
AzaSite.  Neither we nor our subsidiary can prevent Inspire from
developing or licensing a product that competes with AzaSite or limiting or
withdrawing its support of AzaSite.  Our subsidiary’s ability to pay
amounts due on the AzaSite Notes may be materially harmed to the extent Inspire
fails or is unable to successfully market and sell AzaSite.  Our
ability to receive future revenue from sales of AzaSite is dependent on our
subsidiary repaying the AzaSite Notes in a timely fashion.  If our
subsidiary takes longer than anticipated to repay the AzaSite Notes, or if it
defaults on the AzaSite Notes, in each case due to lower sales of AzaSite by
Inspire for any of the reasons described above, or due to other unforeseen
events, we may not receive future revenue from AzaSite as currently planned, or
at all.





Royalties
under the Inspire License Agreement may not be sufficient for our subsidiary to
meet its payment obligations under the AzaSite Notes.





Inspire’s obligation to pay royalties
on net sales of AzaSite under the Inspire Agreement expires on a
country-by-country basis upon the later of 11 years from the first commercial
sale of AzaSite, which, in the United States, is August 13, 2018, or when the
last valid claim under one of our licensed patents covering a subject product
under the Inspire Agreement in the United States and Canada
expires.  While our subsidiary will be entitled to minimum royalties
under the Inspire Agreement from Inspire for five years after the first year of
a commercial sale, such minimum royalties will not be sufficient for our
subsidiary to meet its payment obligations under the AzaSite Notes and,
therefore, it will be dependent on Inspire’s successful sales and marketing
efforts for AzaSite in order for it to receive royalties in excess of these
minimum amounts.  In addition, Inspire’s obligation to pay minimum
royalties is suspended during any period in which (i) the FDA or any other
applicable


20


regulatory
authority has required any Inspire licensed product to be withdrawn from the
market or the marketing thereof otherwise to be suspended in the United States
or (ii) Inspire is unable, despite use of commercially reasonable efforts, to
obtain supply of any Inspire licensed product in finished form in commercially
reasonable amounts necessary to launch or market such Inspire licensed product
in the United States.





Royalties under the Inspire Agreement
are subject to a cumulative reduction or offset in the event of patent
invalidity, generic competition, uncured material breaches by us or in the event
that Inspire is required to pay royalties, milestone payments or license fees to
third parties for the continued use of AzaSite.  The applicable
royalty rate is also subject to reduction by up to 50% in any country during any
period in which AzaSite does not have patent protection.  These
cumulative reductions or offsets could result in our subsidiary receiving
significantly reduced or no royalties under the Inspire Agreement, which would
delay repayment of the AzaSite Notes, or result in a default under the AzaSite
Notes.  In such circumstances we may not receive future revenue from
AzaSite as currently planned, or at all.





If
the Inspire Agreement is terminated in whole or in part while the AzaSite Notes
remain outstanding, we will be forced to find a new third party collaborator for
AzaSite, pursue commercialization efforts ourselves or else we will lose our
right to certain intellectual property rights related to AzaSite to our
subsidiary.





In February 2008, in connection with
our subsidiary’s issuance of the AzaSite Notes, we entered into the Residual
License Agreement with our subsidiary.  Under the terms of the
Residual License Agreement, if the Inspire Agreement is terminated in the United
States or Canada while the AzaSite Notes are outstanding, all of our rights to
AzaSite in such country or countries will be licensed to our subsidiary and we
have three months under the terms of the Interim Sublicense, which is a part of
the Residual License, to find a new third party collaborator to undertake
commercialization efforts with respect to AzaSite or pursue commercialization
efforts ourselves in such country or countries.  Inspire can terminate
the Inspire Agreement unilaterally in a variety of circumstances, including at
any time in its discretion.  If the Inspire Agreement is terminated,
our efforts to find a new third party collaborator or pursue direct
commercialization efforts ourselves will divert the attention of senior
management from our current business operations, which could delay the
development or licensing of our other product candidates.  If we elect
to commercialize AzaSite ourselves, we may expend significant resources as we
currently have no sales, marketing or distribution capabilities or experience,
and have no current plans to establish any such resources, which could harm our
financial condition and results of operation.





If we are unsuccessful in finding a new
third party collaborator for AzaSite or elect not to pursue commercialization
efforts ourselves, the Interim Sublicense will terminate and our subsidiary will
retain all rights to the intellectual property with respect to AzaSite in the
related country or countries in which the Inspire Agreement was
terminated.  If the Interim Sublicense terminates in accordance with
the Residual License Agreement, our subsidiary may grant a sublicense under the
license granted under the Residual License Agreement or pursue commercialization
efforts itself. In any such circumstances, our subsidiary will remit for payment
on the AzaSite Notes any royalties and other payments arising from the exercise
of the license under the Residual License Agreement.  As all economic
value arising from the intellectual property subject to the Inspire Agreement
shall remain with our subsidiary (whether or not the Inspire Agreement remains
in effect and whether or not our subsidiary continues to be owned by us or our
equity in the subsidiary  is foreclosed upon by the Noteholders),
while the AzaSite Notes are outstanding and following repayment thereof, we may
never receive any future royalties or economic benefit from AzaSite and may lose
rights to the intellectual property relating thereto.





We
rely on a sole source for the supply of the active pharmaceutical ingredient for
AzaSite.





We currently have a single supplier for
azithromycin, the active drug incorporated into AzaSite.  Under the
Inspire License Agreement and the Inspire Supply Agreement, we have agreed to
provide a supply of azithromycin to Inspire for the manufacture of AzaSite in
the Territory, which we currently arrange through one supplier.  The
supplier of azithromycin has a drug master file on the compound with the FDA and
is subject to the FDA’s review and oversight.  The supplier’s
manufacturing facility is subject to potential natural disasters, including
earthquakes, hurricanes, tornadoes, floods, fires or explosions, and other
interruptions in operation due to factors including labor unrest or strikes,
failures of utility services or microbial or other contamination.  If
the supplier failed or refused to continue to supply us, if the FDA were to
identify issues in the production of azithromycin that the supplier was unable
to resolve quickly and cost-effectively, or if other issues were to arise that
impact production, Inspire’s ability to manufacture and commercialize AzaSite
could be interrupted, and our subsidiary’s ability to pay amounts due on the
AzaSite Notes may be materially harmed, which could prevent or delay our ability
to receive future revenue from AzaSite.  Additional suppliers for
azithromycin exist, but qualification of an alternative


21


source
could be time consuming and expensive and, during such qualification process,
could negatively impact the sales of AzaSite.  There is also no
guarantee that these additional suppliers can supply sufficient quantities or
quality product at a reasonable price, or at all.  While we are
required to maintain a certain level of inventory of azithromycin to support
Inspire’s manufacturing needs, this amount may not be sufficient to prevent an
interruption in the availability of AzaSite.





In addition, certain of the raw
materials that we use in formulating DuraSite, the drug delivery system used in
AzaSite, are available only from Lubrizol Advanced Materials, Inc., or
Lubrizol.  Although we do not have a current supply agreement with
Lubrizol, we have not encountered any difficulties obtaining necessary materials
from Lubrizol.  Any significant interruption in the supply of these
raw materials could delay sales of AzaSite, which could then harm our
subsidiary’s ability to pay amounts due on the AzaSite Notes and affect our
ability to receive future revenue from AzaSite.





We
have experienced senior management departures, which could harm our ability to
attract and retain key employees.





Dr. S. Kumar
Chandrasekaran, our former chief executive officer and president, concluded his
employment with us in October 2008 and Louis Drapeau, our vice president and
chief financial officer, was appointed to succeed him in the position of interim
chief executive officer. The new Board of Directors elected September 23, 2008
has commenced a search for a new chief executive officer. While this search has
been suspended until we further execute on our strategic priorities, there is no
guarantee this search will be successful when, and if,
recommenced.  There is no guarantee that Mr. Drapeau will remain at
our Company until a new chief executive officer can be recruited or for an
extended period of time.  We are currently highly dependent on Mr.
Drapeau and the loss of Mr. Drapeau’s services could significantly delay or
prevent the achievement of planned development objectives. Furthermore, the
changes in the composition of our Board of Directors and chief executive officer
may cause us to lose additional employees and may harm the ability of our senior
management team to coalesce, motivate our employees and address challenges faced
by our Company. We are also highly dependent on Dr. Lyle Bowman, our vice
president, development. We do not carry a life insurance policy on Mr. Drapeau
or on Dr. Bowman.




A
critical factor to our success will be recruiting and retaining additional
qualified personnel.  Competition for skilled individuals in the
biotechnology business, particularly in the San Francisco Bay Area 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 current financial situation and the
challenges faced by our Company  The loss of key personnel, the
failure to recruit additional personnel or to develop needed expertise would
harm our business.





We
may not successfully manage growth





Our
success will depend upon the expansion of our operations and the effective
management of our growth, which will place a significant strain on our
management and on our administrative, operational and financial
resources.  To manage this growth, we will have to expand our
facilities, augment our operational, financial and management systems and hire
and train additional qualified personnel, all of which will cause us to incur
significant additional expense and may not be accomplished
effectively.  If we are unable to manage our growth effectively, our
business would be harmed.





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





The FDA
and comparable agencies in state and local jurisdictions and in foreign
countries impose substantial requirements upon preclinical and clinical testing,
manufacturing and marketing of pharmaceutical products.  Lengthy and
detailed preclinical and clinical testing, validation of manufacturing and
quality control processes, and other costly and time-consuming procedures are
required.  Satisfaction of these requirements typically takes several
years and the time needed to satisfy them may vary substantially, based on the
type, complexity and novelty of the pharmaceutical product.  The
effect of government regulation may be to delay or to prevent marketing of
potential products for a considerable period of time and to impose costly
procedures upon our activities.  The FDA or any other regulatory
agency may not grant approval on a timely basis, or at all, for any products we
develop.  Success in preclinical or early stage clinical trials does
not assure success in later stage clinical trials.  Data obtained from
preclinical and clinical activities are susceptible to varying interpretations
that could delay, limit or prevent regulatory approval.  If regulatory
approval of a product is granted, such approval may impose limitations on the
indicated uses for which a product may be marketed.  Further, even
after we have obtained regulatory approval, later discovery of previously
unknown problems with a product may result in restrictions on the product,
including withdrawal of the


22


product
from the market.  Moreover, the FDA has recently reduced previous
restrictions on the marketing, sale and prescription of products for indications
other than those specifically approved by the FDA.  Accordingly, even
if we receive FDA approval of a product for certain indicated uses, our
competitors, including our collaborators, could market products for such
indications even if such products have not been specifically approved for such
indications.  If the FDA determines regulatory approval is required,
any delay in obtaining or failure to obtain regulatory approvals would make it
difficult or impossible to market our products and would harm our business,
prospects, financial condition, and results of operations.




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





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





We have
no experience manufacturing products for Phase 3 and commercial purposes at
our own facility.  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.




Contract
manufacturers must adhere to current 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
NDA.  Some of the material manufacturing changes that occur after
approval are also subject to FDA review and clearance or
approval.  While the FDA has approved the AzaSite manufacturing
process and facility, the FDA or other regulatory agencies may not approve the
process or the facilities by which any of our other products may be
manufactured.  Our dependence on third parties to manufacture our
products may harm our ability to develop and deliver products on a timely and
competitive basis.  Should we be required to manufacture products
ourselves, we:




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




§
            will
      be subject to the regulatory requirements described
  above;




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




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




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





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





Our
success depends upon developing and maintaining a competitive advantage in the
development of products and technologies in our areas of focus.  We
have many competitors in the United States and abroad, including pharmaceutical,
biotechnology and other companies with varying resources and degrees of
concentration in the ophthalmic market.  Our competitors may have
existing products or products under development which may be technically
superior to ours or which may be less costly or more acceptable to the
market.  Our competitors may obtain cost advantages, patent protection
or other intellectual property rights that would block or limit our ability to
develop our potential products.  Competition from these companies is
intense and is expected to increase as new products enter the market and new
technologies become available.  Many of our competitors have
substantially greater financial, technical, marketing, manufacturing and human
resources than we


23


do,
particularly in light of our current financial condition.  In
addition, they may succeed in developing technologies and products that are more
effective, safer, less expensive or otherwise more commercially acceptable than
any that we have or will develop.  Our competitors may also obtain
regulatory approval for commercialization of their products more effectively or
rapidly than we will.  If we decide to manufacture and market our
products by ourselves, we will be competing in areas in which we have limited or
no experience such as manufacturing efficiency and marketing
capabilities.





If
we cannot compete successfully for market share against other drug companies, we
may not achieve sufficient product revenues and our business will
suffer





The
market for our product candidates is characterized by intense competition and
rapid technological advances.  If our product candidates receive FDA
approval, they will compete with a number of existing and future drugs and
therapies developed, manufactured and marketed by others.  Existing or
future competing products may provide greater therapeutic convenience or
clinical or other benefits for a specific indication than our products or may
offer comparable performance at a lower cost.  If our products fail to
capture and maintain market share, we may not achieve sufficient product
revenues and our business will be harmed.




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




§
            developing
      drugs;




§
            undertaking
      pre-clinical testing and human clinical
trials;




§
            obtaining
      FDA and other regulatory approvals of
drugs;




§
            formulating
      and manufacturing drugs;




§
            launching,
      marketing and selling drugs; and




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




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 reducing the prices we or our partners are able to
charge for our products 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 expensive.  Although we


24


believe
our current insurance coverage is adequate to cover likely claims we may
encounter given our current stage of development and activities, our present
product liability insurance coverage will not be adequate to cover all potential
claims we may encounter, particularly as AzaSite is commercialized outside the
United States and Canada.  Once AzaSite is commercialized in other
countries, we may have to increase our coverage, which will be expensive, and we
may not be able to obtain or afford adequate insurance coverage against
potential claims in sufficient amounts or at a reasonable cost.





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





Our
research, development and manufacturing processes involve the controlled use of
small amounts of hazardous solvents used in pharmaceutical development and
manufacturing, including acetic acid, acetone, acrylic acid, calcium chloride,
chloroform, dimethyl sulfoxide, ethyl alcohol, hydrogen chloride, nitric acid,
phosphoric acid and other similar solvents.  We retain a licensed
outside contractor that specializes in the disposal of hazardous materials used
in the biotechnology industry to properly dispose of these materials, but we
cannot completely eliminate the risk of accidental contamination or injury from
these materials.  Our cost for the disposal services rendered by our
outside contractor was not material for the years ended 2008, 2007, or 2006,
respectively.  In the event of an accident involving these materials,
we could be held liable for any damages that result and any such liability could
exceed our resources.  Moreover, as our business develops we may be
required to incur significant costs to comply with federal, state and local
environmental laws, regulations and policies, especially to the extent that we
manufacture our own products.





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





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




If we
fail to adequately manage these risks we may not achieve the intended benefits
from our acquisitions.





Management
and principal stockholders may be able to exert significant control on matters
requiring approval by our stockholders





As of
December 31, 2008, our management and principal stockholders (those owning more
than 5% of our outstanding shares) together beneficially owned approximately 33%
of shares of common stock.  In addition, investors in our March/June
2004 and May 2005 private placements, as a group, owned approximately 13% of our
outstanding shares of common stock as of December 31, 2008.  If such
investors were to exercise the warrants they currently hold, assuming no
additional acquisitions, sales or distributions, such investors would own
approximately 23% of our outstanding shares of common stock based on their
ownership percentages as of December 31, 2008.  As a result, these two
groups of stockholders, acting together or as individual groups, may be able to
exert significant control on matters requiring approval by our stockholders,
including the election of all or at least a majority of our Board of Directors,
amendments to our charter, and the approval of business combinations and certain
financing transactions.  A group of our stockholders recently
prevailed in a proxy contest that resulted in the replacement of all members of
our Board of Directors.


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 our operating performance and
progress; we have not paid dividends in the past and do not anticipate doing so
in the future





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, the status of our relationships or
proposed relationships with third-party collaborators, the results of testing
and clinical trials, the exercise of outstanding options and warrants that could
result in dilution to our current holders of common stock, developments in
patent or other proprietary rights of us or our competitors, our or Inspire’s
failure to meet analyst expectations, any litigation regarding the same,
technological innovations or new therapeutic products, governmental regulation,
or public concern as to the safety of products developed by us or others and
general market conditions concerning us, our competitors or other
biopharmaceutical companies may have a significant effect on the market price of
our common stock.  For example, in the twelve months ended December
31, 2008, our closing stock price fluctuated from a high of $0.87 to a low of
$0.18.  Such fluctuations can lead to securities class action
litigation.  Securities litigation against us could result in
substantial costs and a diversion of our management’s attention and resources,
which could have an adverse effect on our business.




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.





Our
common stock may be delisted from the New York Stock Exchange Alternext
US





On
February 26, 2009, the Company received a notice from NYSE Alternext US LLC, or
the Exchange, that our  common stock is subject to immediate delisting
proceedings because we were not in compliance with (a) Section 1003(a)(i) of the
Exchange’s Company Guide, or the Company Guide, because our shareholders’ equity
was less than the required $2,000,000 and we had losses from continuing
operations and net losses in two of our three most recent fiscal years or (b)
Section 1003(a)(ii) of the Company Guide because our shareholders’ equity was
less than the required $4,000,000 and we had losses from continuing operations
and net losses in three of our four most recent fiscal years.





The
Company has requested an oral hearing to appeal the
determination.  There is no assurance that the decision will be
overturned at this hearing.  If the decision is not overturned, our
common stock would be subject to delisting proceedings immediately following the
hearing.  Delisting would harm the trading volume and liquidity of our
common stock and, as a result, the market price for our common stock might
become more volatile.  Delisting could also cause a reduction in the
number of investors willing to hold or acquire our common stock, transactions in
our common stock could be delayed, and securities analysts’ and news media
coverage of us may be further reduced. These factors could result in lower
prices and larger spreads in the bid and ask prices for shares of common
stock.  Delisting could also make it more difficult for us to raise
additional capital.





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, or Preferred Stock, 7,070 of
which have been designated as Series A Convertible Preferred Stock and 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


26


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.





If
earthquakes and other catastrophic events strike, our business may be negatively
affected





Our
corporate headquarters, including our research and development and pilot plant
operations, are located in the San Francisco Bay area, a region known for
seismic activity.  A significant natural disaster such as an
earthquake would have a material adverse impact on our business, results of
operations, and financial condition.  If we were able to schedule use
of the equipment at our contract manufacturing site we could conduct our pilot
plant operations however, we would incur significant additional costs and delays
in our product development time-lines.





We face the risk
of a decrease in our cash balances and losses in our investment
portfolio





Our
investment policy is structured to limit credit risk and manage interest rate
risk. By policy, we only invest in what we view as very high quality debt
securities, such as U.S. Government securities. However, the recent
uncertainties in the credit markets could prevent us from liquidating our
positions in securities that we currently believe constitute high quality
investments and could also result in the loss of some or all of our principal if
the issuer of such securities defaults on its credit obligations. 
Following completion of our $60.0 million financing on February 21, 2008,
investment income will likely become a more substantial component of our net
income. The ability to achieve our investment objectives is affected by many
factors, some of which are beyond our control. Our interest income will be
affected by changes in interest rates, which are highly sensitive to many
factors, including governmental monetary policies and domestic and international
economic and political conditions.   The outlook for our investment income
is dependent on the future direction of interest rates and the amount of cash
flows from operations, if any, that are available for investment. Any
significant decline in our investment income or the value of our investments as
a result of falling interest rates, deterioration in the credit of the
securities in which we have invested or general market conditions, could harm
our ability to liquidate our investments, our cash position and our net
income.





Item
1B.  Unresolved Staff Comments





None.





Item
2.  Properties





We currently lease approximately 39,123
square feet of research laboratory and office space located in Alameda,
California.  The facility includes laboratories for formulation,
analytical, microbiology, pharmacology, quality control and development as well
as a pilot manufacturing plant.  The lease expires on December 31,
2013, and may be renewed by us for an additional 5-year term.  We
believe our existing facilities will be suitable and adequate to meet our needs
for the immediate future.


27


Item
3.  Legal Proceedings





The Company is
subject to various claims and legal actions during the ordinary course of our
business. We believe that there are currently no claims or legal actions that
would have a material adverse impact on our financial position, operations or
potential performance.





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 September 30, 2008, our common
stock has traded on The New York Stock Exchange Alternext US under the symbol
“ISV.”  From June 10, 1998 to September 29, 2008, our common stock was
traded on The American Stock Exchange under the symbol “ISV”.  The New
York Stock Exchange Euronext acquired the American Stock Exchange on September
30, 2008.  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 New York
Stock Exchange Alternext US or The American Stock Exchange for the periods
indicated.  These prices do not include retail mark-ups, mark-downs or
commissions.





2008
                      
                      High
                      
                      
                      LowFirst
      Quarter
                      
                      
                      0.87
                      
                      
                      
                      0.57Second
      Quarter
                      
                      
                      0.71
                      
                      
                      
                      0.53Third
      Quarter
                      
                      
                      0.66
                      
                      
                      
                      0.43Fourth
      Quarter
                      
                      
                      0.47
                      
                      
                      
                      0.18
 
 2007
                      
                      High
                      
                      
                      LowFirst
      Quarter
                      
                      
                      1.73
                      
                      
                      
                      1.42Second
      Quarter
                      
                      
                      1.79
                      
                      
                      
                      1.42Third
      Quarter
                      
                      
                      1.49
                      
                      
                      
                      1.04Fourth
      Quarter
                      
                      
                      1.32
                      
                      
                      
                      0.69





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.





Other
Information





Information
regarding employee stock based compensation is provided in Note 9 in the Notes
to the Consolidated Financial Statements in Item 8 of Part II of this Annual
Report on Form 10-K.  The remaining information required by this Item
will be included in our Proxy Statement and such required information is
incorporated herein by reference.





As of
March 10, 2009, we had approximately 205 stockholders of record of our Common
Stock. On March 10, 2009, the last sale price reported on The New York Exchange
Alternext US for our common stock was $0.17 per share.


28




Stock
Performance Graph





The following graph compares the
percentage change in (i) the cumulative total stockholder return on our common
stock from December 31, 2003 through December 31, 2008 with (ii) the cumulative
total return on (a) the American Stock Exchange (U.S. Index) and (b) the
American Stock Exchange (biotech) index.  The comparison assumes (i)
an investment of $100 on December 31, 2003 in each of the foregoing indices and
(ii) reinvestment of dividends, in any.





The
stock price performance shown on the graph below represents historical price
performance and is not necessarily indicative of any future stock price
performance.










ISV
              
              AMEX
              
              AMEX
                BIOTECH12/31/03
              100
              
              100
              
              10012/31/04
              154
              
              122
              
              8012/31/05
              146
              
              150
              
              10012/31/06
              272
              
              175
              
              11112/31/07
              132
              
              205
              
              11512/31/08
              35
              
              119
              
              95





Notwithstanding
anything to the contrary set forth in any of our previous filings under the
Securities Act of 1933 or the Securities Exchange Act of 1934 which might
incorporate any of our future filings made under those statutes, the preceding
Stock Performance Graph will not be incorporated by reference into any of those
prior filings, nor will such graph be incorporated by reference into any of our
future filings made under those statues.





Recent
Sales of Unregistered Securities





None.




Issuer
Purchases of Securities





None.




29




Item 6.  Selected
Consolidated Financial Data





The comparability of the following selected financial data
is affected by a variety of factors, and this data is qualified by reference to
and should be read in conjunction with the audited consolidated financial
statements and notes thereto and the Management’s Discussion and Analysis of
Financial Condition and Results of Operations contained elsewhere in this Annual
Report on Form 10-K.  Thefollowing table sets forth selected
consolidated financial data for us for the five years ended December 31, 2008
(in thousands except per share amounts):




Year Ended December 31,(in thousands, except per share data)
                        
                        2008
                        
                        
                        2007
                        
                        
                        2006
                        
                        
                        2005
                        
                        
                        2004Consolidated
      Statements of Operations DataRevenues
                        
                        $
                        13,706
                        
                        
                        $
                        23,761
                        
                        
                        $
                        2
                        
                        
                        $
                        4
                        
                        
                        $
                        542Cost
      of revenues
                        
                        
                        630
                        
                        
                        
                        982
                        
                        
                        
                        28
                        
                        
                        
                        14
                        
                        
                        
                        14Operating
      expenses:Research
      and development
                        
                        
                        16,242
                        
                        
                        
                        10,384
                        
                        
                        
                        8,890
                        
                        
                        
                        10,690
                        
                        
                        
                        6,788General
      and administrative
                        
                        
                        8,251
                        
                        
                        
                        6,760
                        
                        
                        
                        6,182
                        
                        
                        
                        4,510
                        
                        
                        
                        3,826Severance
                        
                        
                        1,909Total
      expenses
                        
                        
                        26,402
                        
                        
                        
                        17,144
                        
                        
                        
                        15,072
                        
                        
                        
                        15,200
                        
                        
                        
                        10,614Gain
      on sale of assets
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        4,616Interest
      (expense) and other income, net
                        
                        
                        (7,984
                        )
                        
                        
                        (100
                        )
                        
                        
                        (1,513
                        )
                        
                        
                        (5
                        )
                        
                        
                        (44
                        )Net
      income (loss)
                        
                        
                        (21,310
                        )
                        
                        
                        5,535
                        
                        
                        
                        (16,611
                        )
                        
                        
                        (15,215
                        )
                        
                        
                        (5,514
                        )Net
      income (loss) per share:Earnings
      (loss) per share - basic
                        
                        $
                        (0.23
                        )
                        
                        $
                        0.06
                        
                        
                        $
                        (0.19
                        )
                        
                        $
                        (0.21
                        )
                        
                        $
                        (0.11
                        )Earnings
      (loss) per share - diluted
                        
                        $
                        (0.23
                        )
                        
                        $
                        0.06
                        
                        
                        $
                        (0.19
                        )
                        
                        $
                        (0.21
                        )
                        
                        $
                        (0.11
                        )Weighted
      average shares used in per-share calculation:-
      basic
                        
                        
                        94,607
                        
                        
                        
                        94,168
                        
                        
                        
                        88,339
                        
                        
                        
                        72,647
                        
                        
                        
                        47,984-
      diluted
                        
                        
                        94,607
                        
                        
                        
                        100,110
                        
                        
                        
                        88,339
                        
                        
                        
                        72,647
                        
                        
                        
                        47,984


As
      of December 31,(in thousands)
                          
                          2008
                          
                          
                          2007
                          
                          
                          2006
                          
                          
                          2005
                          
                          
                          2004Consolidated
      Balance Sheet Data:Cash
      and cash equivalents
                          
                          $
                          37,456
                          
                          
                          $
                          11,532
                          
                          
                          $
                          986
                          
                          
                          $
                          4,027
                          
                          
                          $
                          5,351Working
      capital, exclusive of deferred revenue
                          
                          
                          35,068
                          
                          
                          
                          9,589
                          
                          
                          
                          (6,836
                          )
                          
                          
                          (3,424
                          )
                          
                          
                          3,515Total
      assets
                          
                          
                          44,943
                          
                          
                          
                          15,012
                          
                          
                          
                          2,439
                          
                          
                          
                          5,079
                          
                          
                          
                          5,696Secured
      notes payable
                          
                          
                          60,000
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -Accumulated
      deficit
                          
                          
                          (168,837
                          )
                          
                          
                          (147,527
                          )
                          
                          
                          (153,062
                          )
                          
                          
                          (136,451
                          )
                          
                          
                          (121,236
                          )Total
      stockholders’ equity (deficit)
                          
                          $
                          (19,506
                          )
                          
                          $
                          746
                          
                          
                          $
                          (6,302
                          )
                          
                          $
                          (2,545
                          )
                          
                          $
                          3,601




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





30




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





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 committed to advancing ophthalmic
pharmaceutical products to address unmet eye care needs.  Our current
portfolio of products is based on our proprietary DuraSite® drug
delivery technology.





Our
DuraSite®
sustained drug delivery technology is a proven, patented synthetic polymer-based
formulation designed to extend the residence time of a drug relative to
conventional topical therapies.  It enables topical delivery of a
solution, gel or suspension and can be customized for delivering a wide variety
of potential drug candidates. We have focused our research and development and
commercial support efforts on the following topical anti-infective products that
formulate the antibiotic azithromycin with our DuraSite® drug delivery
technology.





·
            AzaSite®
      (azithromycin ophthalmic solution) 1% is a DuraSite formulation of
      azithromycin, was developed to serve as a broad spectrum ocular antibiotic
      and approved by the FDA in April 2007 to treat bacterial conjunctivitis
      (pink eye); and launched by Inspire Pharmaceuticals in August
      2007.  The key advantages are a significantly reduced dosing
      regimen leading to better compliance and outcome, with a broad spectrum
      antibiotic, and a lowered probability of bacterial resistance based on
      high tissue concentration.


·
            ISV-502
      is a DuraSite formulation of azithromycin and dexamethasone is under
      development for the treatment of ocular inflammation and infection
      (blepharitis and/or blepharoconjunctivitis) for which there is no FDA
      approved indicated treatment; we completed the first of two pivotal Phase
      3 trials in November 2008.


·
            ISV-405
      is a DuraSite formulation with a higher percentage of azithromycin, is in
      preclinical development for the treatment of ocular infection for markets
      outside the United States.





Major
Developments and Events in 2008





Our major developments and events in
2008 included:





·
            increased
      sales of AzaSite by Inspire in the United
  States;


·
            completed
      our  Phase 3(a) trial for
ISV-502;


·
            execution
      of a licensing agreement with Bioceutica in March 2008 to commercialize
      AzaSite for ocular bacterial infection in Argentina, Chile, Paraguay and
      Uruguay;


·
            execution
      of a licensing agreement with Essex Bio-Technology in May 2008 to
      commercialize AzaSite for ocular bacterial infection in China including
      the Mainland, Hong Kong and Macao;


·
            execution
      of a licensing agreement with Biem Pharmaceuticals in April 2008 to
      commercialize AzaSite for ocular bacterial infection in
      Turkey;


·
            the
      February 2008 issuance of $60 million in aggregate principal amount of
      secured, non-convertible, non-recourse promissory notes due in 2019 (the
      “AzaSite Notes”);


·
            discontinuation
      of pre-clinical development of AzaSite Otic (ISV-016) as the product
      formulation did not meet expected product
  profile;


·
            as
      a result of a proxy contest, new Board of Directors were elected at our
      annual meeting on September 22,
2008;


·
            in
      October 2008, our former Chief Executive Officer was relieved of his
      position.  Our VP, Chief Financial Officer was appointed interim
      Chief Executive Officer; and


·
            in
      December 2008, a corporate restructuring plan was implemented to focus on
      growth opportunities and to conserve resources.  The plan
      decreased the Company’s personnel by approximately
  35%.




31




Business
Strategy





Our business strategy consists of the
following three key pillars:





1.
            Support and extend sales of
      AzaSite.  Working with our North American commercial
      partner, Inspire Pharmaceuticals, we will seek to increase AzaSite sales
      through a variety of approaches, including the evaluation of AzaSite for
      additional indications such as blepharitis, or inflammation of the
      eyelid.  We are also seeking additional commercial partners
      outside the United States to market AzaSite in Japan and
      Europe.





2.
            Develop and monetize our
      pipeline of ocular product candidates.We plan to
      conduct preclinical and clinical testing of product candidates in our
      portfolio, and then partner with pharmaceutical companies to complete
      clinical development, manufacture, and market these
    products.





3.
            Invest in long-term research
      and development opportunities.We will seek to
      in-license or acquire promising product candidates and technologies from
      companies and academic institutions,then apply our expertise to create
      novel differentiated ophthalmic product opportunities.  We may
      also utilize our DuraSite technology platform for the formulation of new
      ocular product candidates using either non-proprietary drugs or compounds
      originally developed by others for non-ophthalmic
      indications.  .





Critical
Accounting Policies and Use of Estimates





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





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





Revenue
Recognition.  We recognize revenue in accordance with
Securities and Exchange Commission Staff Accounting Bulletin No. 104,
Revenue Recognition, or SAB 104. SAB 104 requires that four basic criteria
must be met before revenue can be recognized: persuasive evidence of an
arrangement exists; delivery has occurred or services have been rendered; the
fee is fixed or determinable; and collectibility is reasonably assured.
Arrangements with multiple elements are accounted for in accordance with
Emerging Issues Task Force, or EITF, Issue No. 00-21, Revenue Arrangements with
Multiple Deliverables. We analyze our multiple element arrangements to determine
whether the elements can be separated and accounted for individually as separate
units of accounting in accordance with EITF 00-21. Our revenues are primarily
related to our licensing agreements, and such agreements may provide for various
types of payments to us, including upfront payments, research funding and
related fees during the term of the agreement, milestone payments based on the
achievement of established development objectives, licensing fees, and royalties
on product sales.





Upfront,
non-refundable payments under licensing agreements are recorded as deferred
revenues once received and recognized ratably over the period related activities
are performed. Revenues from non-refundable milestones are recognized when the
earnings process is complete and the payment is reasonably assured.
Non-refundable milestone payments related to arrangements under which we have
continuing performance obligations are recognized ratably over the period
related activities are performed.





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





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


32
  Income
Taxes.  We account for income taxes in accordance with the
provisions of Financial Accounting Standard Board (“FASB”), Statement of
Financial Accounting Standard  No. 109, “Accounting for Income Taxes”(SFAS 109) and Financial Interpretation No. 48, “Accounting for Uncertainty in Income
Taxes” — an interpretation of FASB Statement No. 109
(FIN 48). FIN 48 clarifies the accounting for uncertainty in income
taxes recognized in an enterprise’s financial statements in accordance with
SFAS 109. The interpretation applies to all tax positions accounted for in
accordance with SFAS 109 and requires a recognition threshold and
measurement attribute for the financial statement recognition and measurement of
a tax position taken, or expected to be taken, in an income tax return.
Subsequent recognition, derecognition and measurement is based on management’s
best judgment given the facts, circumstances and information available at the
reporting date.




We file
U.S. federal and California state income tax returns. To date, we have not
been audited by the Internal Revenue Service or any state.





Our
policy is to recognize interest and penalties related to the underpayment of
income taxes as a component of income tax expense. To date, there have been no
interest or penalties charged to us in relation to the underpayment of income
taxes.





For the
year ended December 31, 2007, we generated net income and were able to
offset it with our accumulated net operating losses, or NOLs. For the year ended
December 31, 2008, we generated net losses and, accordingly, did not record a
provision for income taxes. As of December 31, 2008, our total deferred tax
assets were $59.8 million. The deferred tax assets were primarily comprised
of federal and state tax NOL carryforwards. Due to uncertainties surrounding our
ability to continue to generate future taxable income to realize these tax
assets, a full valuation allowance has been established to offset our deferred
tax assets. Additionally, the future utilization of our NOL carryforwards to
offset future taxable income is subject to an annual limitation as a result of
ownership changes that have occurred previously and may be further impacted by
future ownership changes. As necessary, the deferred tax assets have been
reduced by any carryforwards that expire prior to utilization as a result of
such limitations, with a corresponding reduction of the valuation
allowance.  These carryforwards may be further reduced if we have any
additional ownership changes in the future.





Stock-Based
Compensation.  We granted stock-based awards to eligible
employees and directors to purchase shares of our common stock under our stock
compensation plan approved in 1994 (the 1994 Plan) and its successor the 2007
Performance Incentive Plan (the 2007 Plan).  In addition, we have a
qualified employee stock purchase plan in which eligible employees may elect to
withhold up to 15% of their compensation to purchase shares of our common stock
on a quarterly basis at a discounted price equal to 85% of the lower of the
employee’s offering price or the closing price of the stock on the date of
purchase. The benefits provided by these plans qualify as stock-based
compensation under the provisions of Statement of Financial Accounting Standards
No. 123 (revised 2004), “Share-Based Payment” (SFAS 123R), which
requires us to recognize compensation expense based on their estimated fair
values determined on the date of grant for all stock-based awards granted,
modified or cancelled.





We
estimate the fair value of share-based awards on the date of grant using the
Black-Scholes option-pricing method (Black-Scholes method). The determination of
fair value of share-based awards using an option-pricing model requires the use
of certain estimates and assumptions that affect the reported amount of
share-based compensation cost recognized in our Consolidated Statements of
Income. These include estimates of the expected term of share-based awards,
expected volatility of our stock price, expected dividends and the risk-free
interest rate. These estimates and assumptions are highly subjective and may
result in materially different amounts should circumstances change and we employ
different assumptions in our application of SFAS 123R in future
periods.





For
stock-based awards issued, we estimated the expected term by considering various
factors including the vesting period of options granted and employees’
historical exercise and post-employment termination behavior.  Our
estimated volatility was derived using our historical stock price
volatility.  We have never declared or paid any cash dividends on our
common stock and currently do not anticipate paying such cash
dividends.  We currently anticipate that we will retain all of our
future earnings for use in the development and expansion of our business and for
general corporate purposes.  Any determination to pay dividends in the
future will be at the discretion of our Board of Directors and will depend upon
our results of operations, financial condition, financial covenants, tax laws
and other factors as the Board of Directors, in its discretion, deems
relevant.  The risk-free interest rate is based upon U.S. Treasury
securities with remaining terms similar to the expected term of the stock-based
awards.




33




Results
of Operations





Revenues.





We had
total revenues of $13.7 million, $23.8 million, and $2,000 for the years ended
December 31, 2008, 2007 and 2006, respectively.  $10.0 million of our
revenues in 2008 primarily represented the non-cash amortization of the license
fee for AzaSite. The amortization period for the license fee from Inspire for
AzaSite ended in April 2008.  $3.6 million of our revenues represented
royalties from 2008 net sales of AzaSite by Inspire through December 31, 2008.
The remaining revenue in 2008 represented contract services provided to Inspire
related to its AzaSite activities.  $22.1 million of our revenues in
2007 represented the amortization of the license fee and milestone payments for
AzaSite that we received from Inspire in February and April 2007,
respectively.  $701,000 of our revenues represented royalties from
2007 net sales of AzaSite by Inspire through December 31, 2007. The remainder of
our 2007 revenues represented sales of materials to Inspire under the Supply
Agreement, sales of our AzaSite finished goods inventory to Inspire and contract
services provided to Inspire related to their AzaSite
activities.  Revenues for 2006 were from sales of OcuGene.





Cost
of revenues.





Our cost
of revenues was $0.6 million, $1.0 million and $28,000 for 2008, 2007 and 2006,
respectively.  Cost of revenues for 2008 was comprised of royalties
accrued for third parties, including Pfizer, based on the royalty report
provided to us by Inspire.  Cost of revenues for 2007 reflects
royalties accrued for third parties, including Pfizer, through December 31,
2007, the cost of the azithromycin supplied to Inspire under the Supply
Agreement and the cost of the AzaSite inventory sold to Inspire.  Cost
of revenues in 2006 reflected the cost of OcuGene tests performed as well as
the cost of sample collection kits distributed for use.





Research
and development.





Our
research and development activities can be separated into two major segments,
research and clinical development.  Research includes activities
involved in evaluating a potential product, related preclinical testing and
manufacturing.  Clinical development includes activities related to
filings with the FDA and the related human clinical testing required to obtain
marketing approval for a potential product.  We estimate that the
following represents the approximate cost of these activities for 2008, 2007 and
2006 (in thousands):





As
      of December 31,2008
                        
                        
                        2007
                        
                        
                        2006Research
                        
                        $
                        7,286
                        
                        
                        $
                        4,372
                        
                        
                        $
                        3,291Clinical
      development
                        
                        
                        8,956
                        
                        
                        
                        6,012
                        
                        
                        
                        5,599Total
      research and development
                        
                        $
                        16,242
                        
                        
                        $
                        10,384
                        
                        
                        $
                        8,890




Research
and development expenses were $16.2 million in 2008.  In 2008, our
activities primarily included the Phase 3(a) clinical trial of ISV-502,
preparation for the production of Canadian AzaSite registration batches at our
contract manufacturing site, preclinical testing of AzaSite Otic, and
preclinical experiments of ISV-405. Our activities related to the AzaSite Otic
program were discontinued in July 2008 and our ISV-405 activities have been
deferred.





Research
and development expenses were $10.4 million in 2007.  In 2007 our
activities primarily included production of United States AzaSite process
validation batches, expenses related to the AzaSite Canadian NDS filing, ISV-502
preclinical activities, Phase 1 clinical trial data evaluation, pilot study,
Phase 3 clinical trial design and initiation and preclinical work on AzaSite
Otic and ISV-405.  Our research and development personnel costs were
higher in 2007 due to success bonuses related to the successful FDA approval of
AzaSite.





Research
and development expenses were $8.9 million in 2006.  In 2006, our
activities had been primarily related to the AzaSite clinical trials,
preparation of the related NDA and the FDA filing fee.




34




Our
future research and development expenses will depend on the results and
magnitude or cope of our clinical, preclinical and research activities and
requirements imposed by regulatory agencies.  Accordingly, our
research and development expense may fluctuate significantly from period to
period.  In addition, if we in-license or out-license rights to
product candidates, our research and development expenses may fluctuate
significantly from prior periods.





General
and administrative.





General
and administrative expenses increased to $8.3 million in 2008 from $6.8 million
in 2007.  This increase is primarily due to legal and other expenses
related to our proxy contest.





General
and administrative expenses increased to $6.8 million in 2007 from $6.2 million
in 2006.  This increase mainly reflects higher personnel related
expenses associated with an increase in headcount, payment of bonuses upon the
approval of the AzaSite NDA, salary and health insurance cost increases and
higher non-cash stock-based compensation in the second year after implementation
of FAS123R.





Severance.





Severance
expenses were $1.9 million in 2008 which were associated with our corporate
restructuring that occurred in 2008.





Interest,
other income (expenses),net.





Interest
expense and other income was an expense of $8.0 million, $100,000 and $1.5
million in 2008, 2007 and 2006, respectively.  The increased expense
in 2008 was primarily due to the interest expense on the $60 million
non-convertible, non-recourse promissory notes issued (the “AzaSite Notes”) in
February 2008 and related amortization of the debt issuance costs incurred from
our issuance of the AzaSite Notes.  The increase in interest expense
was partially offset by the interest income on our higher cash and cash
equivalents and short-term investments balance.  The decreased expense
in 2007 was primarily due to the repayment of short-term notes in February
2007.  The expense in 2006 primarily reflects accrued interest payable
on short-term notes and the accretion of the value of the debt discount related
to the warrants issued as part of the note financing.





Liquidity
and Capital Resources





We have
financed our operations since inception primarily through private placements and
public offerings of debt and equity securities, debt financings, equipment and
leasehold improvement financing and payments from corporate
collaborations.  For the year ended December 31, 2008, we have
financed our operations primarily from the issuance of the AzaSite
Notes.  At December 31, 2008, our unrestricted cash and cash
equivalents were $37.5 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.  The current
uncertain credit markets may affect the liquidity of such money market funds or
other cash investments.





For the
year ended December 31, 2008, cash used by operating activities was $29.5
million.  For the year ended December 31, 2007 cash provided for
operating activities was $18.2 million.   In February 2007, the
Company received a $32 million license and milestone payment from Inspire for
AzaSite.  In 2008, $9.9 million represented the non-cash amortization
of the license fee and the remainder was amortized in 2007.  For the
year ended December 31, 2006, cash used for operating activities was $16.2
million.





Cash used
in investing activities was $0.5 million, $1.0 million and $322,000, for 2008,
2007 and 2006, respectively, primarily related to cash outlays for additions to
laboratory and other equipment.





Cash provided by financing activities
was $55.8 million for 2008, reflecting the net proceeds from the issuance of the
AzaSite Notes.  Cash used in financing activities was $6.6 million for
2007, primarily due to the repayment of short-term notes payable in February
2007 and prepayment of debt issuance costs related to the AzaSite
Notes.  Cash provided by financing activities was $13.5 million for
2006, principally due to warrant and option exercises, private placement equity
offerings and debt issuances.




35




The tables below set forth the amount
of cash that we raised for fiscal years 2008 through 2006 from warrant and
option exercises, stock purchases under our employee stock purchase plan, equity
financings and debt financings.





Cash
received from Warrant and Option Exercises and Employee Stock Purchase
Plans





Year
                                          
                                          Net
      Proceeds2008
                                          
                                          $28,0002007
                                          
                                          $512,0002006
                                          
                                          $5.8
      million





Cash
Received from Private Placements of Equity Securities





Date
                
                Net
      Proceeds
                
                Shares
      of Common Stock IssuedAugust
      2006
                
                $5.8
      million
                
                4.8
      million plus warrants to purchase 1.0 million
  shares





Cash
Received from Private Placement of Notes





Date
                                    
                                    Net
      Proceeds
                                    
                                    Type
      of Notes
                                    
                                    Interest
      Rates and Terms
                                    
                                    Maturity
      DateFebruary
      2008
                                    
                                    $55.3
      million
                                    
                                    Long-Term
      Secured Notes
                                    
                                    16%
      through May 15, 2019
                                    
                                    May
      15, 2019January
      2006
                                    
                                    $1.8
      million
                                    
                                    Short-Term
      Senior Secured Notes
                                    
                                    10%
      through July 10, 2006, 12% from July 11, 2006 through February 15,
      2007
                                    
                                    February
      15,
2007*





*On
February 15, 2007, we repaid and redeemed all outstanding principal and interest
due under such Notes.





In February 2008, the Company’s
wholly-owned subsidiary, Azithromycin Royalty Sub, LLC completed a private
placement of $60.0 million in aggregate principal amount of non-convertible,
non-recourse promissory notes due in 2019. Net proceeds from the financing were
approximately $55.3 million after transaction costs of approximately $4.7
million. In addition, $5.0 million of the proceeds was set aside for interest
reserves. The annual interest rate on the notes is 16% with interest payable
quarterly in arrears beginning May 15, 2008. The notes are secured by, and will
be repaid from, royalties to be paid to the Company by Inspire Pharmaceuticals
from sales of AzaSite in the United States and Canada. The secured notes payable
are non-recourse to InSite Vision Incorporated.  When the AzaSite
royalties received for any quarter exceed the interest payments and certain
expenses due that quarter, the excess will be applied to the repayment of
principal of the notes until the notes have been paid in full. Any shortfall of
interest payments from the royalty payments will be paid out of the interest
reserves. As of December 31, 2008, no balance remained on the interest
reserve.  Further shortfalls, if any, can be paid by the Company at
their option to avoid default under the agreement.  The notes may be
redeemed at the Company’s option, subject to the payment of a redemption premium
through May 2012. As of December 31, 2008, the $60.0 million of secured notes
payable is classified as long-term.





In
addition to the above, we received payments on a note from a stockholder of
$168,000 in 2006.





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 tosuccessfully commercialize AzaSite, ISV-502, 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 2009.  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.




36




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, 2008 and the effect such obligations are expected to have on our
liquidity and cash flows in future periods.  Some of these amounts are
based on management’s estimates and assumptions about these obligations
including their duration, the possibility of renewal and other
factors.  Because these estimates are necessarily subjective, our
actual payments in the future may vary from those listed in this
table.




Payments due by period(in thousands)Less
      than
                          
                          
                          1-3
                          
                          
                          3-5
                          
                          
                          More
      thanTotal
                          
                          
                          1
      year
                          
                          
                          years
                          
                          
                          Years
                          
                          
                          5
      yearsCapital
      Lease Obligations (1)
                          
                          $
                          40
                          
                          
                          $
                          18
                          
                          
                          $
                          22
                          
                          
                          $
                          -
                          
                          
                          $
                          -Facilities
      Lease Obligations (2)
                          
                          $
                          3,997
                          
                          
                          
                          754
                          
                          
                          
                          1,574
                          
                          
                          
                          1,669Licensing
      agreement obligations (3)
                          
                          
                          9,275
                          
                          
                          
                          875
                          
                          
                          
                          3,360
                          
                          
                          
                          5,040Secured
      Notes Payable (4)
                          
                          
                          60,000
                          
                          
                          
                          
                          
                          
                          
                          3,300
                          
                          
                          
                          13,704
                          
                          
                          
                          42,996Interest
      Payments on Secured Notes Payable (5)
                          
                          
                          83,606
                          
                          
                          
                          9,600
                          
                          
                          
                          19,200
                          
                          
                          
                          17,256
                          
                          
                          
                          37,550Total
      commitments
                          
                          $
                          156,918
                          
                          
                          $
                          11,247
                          
                          
                          $
                          27,456
                          
                          
                          $
                          37,669
                          
                          
                          $
                          80,546





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


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


(3)
            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 certain of these agreements are as noted
      for 2008 through 2017.


(4)
            Principal
      repayments are limited to royalties received from Inspire Pharmaceutical
      from sales of AzaSite in the United States and Canada.  When the
      AzaSite royalties received for any quarter exceed the interest payments
      and certain expenses due that quarter, the excess will be applied to the
      repayment of principal of the notes until the notes have been paid in
      full. Future payments represent an estimate of expected principal
      repayments based on minimum royalty income covered by the
      agreement.  The note is due in
2019.


(5)
            Interest
      repayments represent an estimate based on expected principal
      repayments.




Recent
Accounting Pronouncements





In
December 2007, the Financial Accounting Standards Board (“FASB”) issued
Statement of Financial Accounting Standard  No. 141 (revised
2007), “Business Combinations” (SFAS 141R). SFAS 141R expands the definitions of
a business combination and includes the issuance of equity securities to be
determined on the acquisition date, be recorded at fair value at the acquisition
date; all assets, liabilities, contingent consideration, contingencies and
in-process research and development costs of an acquired business be recorded at
fair value at the acquisition date; acquisition costs generally be expensed as
incurred; restructuring costs generally be expensed in periods subsequent to the
acquisition date; and changes be made in accounting for deferred tax asset
valuation allowances and acquired income tax uncertainties after the measurement
period to impact income tax expense. Upon the Company’s adoption of SFAS 141R,
any subsequent changes to the Company’s acquired uncertain tax positions and
valuation allowances associated with acquired deferred tax assets will no longer
be applied to goodwill, regardless of acquisition date of the associated
business combination. Rather, those changes will typically be recognized as an
adjustment to income tax expense. SFAS 141R applies prospectively to business
combinations for which the acquisition date is on or after the beginning of the
first annual reporting period beginning on or after December 15, 2008. The
adoption of this statement does not have an impact to the Company’s consolidated
financial position and results of operations, although would have an effect on
reporting of any acquisitions completed after January 1, 2009.





In
September 2006, the FASB issued Statement of Financial Accounting Standards
No. 157, “Fair Value Measurements” (SFAS 157), which defines fair value as
the price that would be received to sell an asset or paid to transfer a
liability in an orderly transaction between market participants at the
measurement date. In addition, SFAS 157 establishes a





37


framework
for measuring fair value and expands disclosure about fair value measurements.
SFAS No. 157 is effective for fiscal years beginning after
November 15, 2007 and interim periods within those years. However, in
February 2008, the FASB issued FASB Staff Position (“FSP”) FAS 157-1 and FSP FAS
157-2, which delayed the effective date of SFAS 157 for all nonrecurring fair
value measurements of nonfinancial assets and nonfinancial liabilities, except
those that are recognized or disclosed at fair value in the financial statements
on a recurring basis (at least annually) and removes certain leasing
transactions from the scope of SFAS 157. FSP FAS 157-2 partially defers the
effective date of SFAS 157 to fiscal years and interim periods beginning after
November 15, 2008 for items within the scope of the FSP. The Company does
not expect the adoption of FSP FAS 157-1 and FSP FAS 157-2 to have a material
impact on the Company’s consolidated financial position and results of
operations.




In
February 2007, the FASB issued Financial Accounting Standards No. 159,
“Fair Value Option for Financial Assets and Financial Liabilities” (SFAS
159). SFAS 159 permits
entities to choose to measure many financial instruments, and certain other
items, at fair value. SFAS 159 also establishes presentation and disclosure
requirements designed to facilitate comparisons between entities that choose
different measurement attributes for similar types of assets and liabilities.
The provisions of SFAS 159 are effective for fiscal years beginning after
November 15, 2007. The Company adopted SFAS 159 and did not elect the fair
value option for any of our eligible financial assets or
liabilities.





In August
2008, the U.S. Securities and Exchange Commission, or SEC, announced that it
will issue for comment a proposed roadmap regarding the potential use by U.S.
issuers of financial statements prepared in accordance with International
Financial Reporting Standards (“IFRS”). IFRS is a comprehensive series of
accounting standards published by the International Accounting Standards Board,
or IASB. Under the proposed roadmap, the Company could be required in fiscal
year 2014 to prepare financial statements in accordance with IFRS and the SEC
will make a determination in 2011 regarding mandatory adoption of IFRS. The
Company is currently assessing the impact that this potential change would have
on our consolidated financial statements and will continue to monitor the
development of the potential implementation of IFRS.





Item
7A.  Quantitative and Qualitative Disclosures About Market
Risk





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





The
Company has long-term debt with fixed interest rates.  As a result,
our exposure to market risk caused by fluctuations in interest rates is
minimal.  Our borrowings outstanding as of December 31, 2008 was
$60 million and the interest rate was 16%.  If the market interest
rates increased by 10% from the December 31, 2008 levels, it would not result in
an increase in interest expense.  As of December 31, 2008, the face
value of our long-term debt approximates the fair value.





The
securities in our investment portfolio are not leveraged and are subject to
minimal interest rate risk   Due to their short-term nature, the
securities are classified as cash and cash equivalents.  Because of
the short-term maturities of our investments, we do not believe that a change in
market rates would have a significant negative impact on the value of our
investment portfolio. While a hypothetical decrease in market interest rates by
10 percent from the December 31, 2008 levels would cause a decrease in interest
income, it would not result in loss of principal.





The
primary objective of our investment activities is to preserve principal while at
the same time maximizing the income we receive from our investments without
significantly increasing risk. In the current economic environment to achieve
this objective, we maintain our portfolio in cash equivalents, including
obligations of U.S. government-sponsored enterprises and money market funds.
These securities are classified as cash and cash equivalents and consequently
are recorded on the balance sheet at fair value. We do not utilize derivative
financial instruments to manage our interest rate risks.





38





Item
8.  Financial Statements and Supplementary Data





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




PageReport
      of Independent Registered Public Accounting Firm
                            40Consolidated
      Balance Sheets - December 31, 2008 and 2007
                            41Consolidated
      Statements of Operations for the Years
      Ended December 31, 2008, 2007 and 2006
                            42Consolidated
      Statements of Stockholders' Equity (Deficit) for the Years
      Ended December 31, 2008, 2007 and 2006
                            43Consolidated
      Statements of Cash Flows for the Years
      Ended December 31, 2008, 2007 and 2006
                            44Notes
      to the Consolidated Financial Statements
                            45
      -
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 and its subsidiaries (the “Company”) as of December 31, 2008
and 2007, and the related consolidated statements of operations, stockholders’
equity (deficit), and cash flows for each of the three years in the period ended
December 31, 2008. These financial statements are the responsibility of the
Company’s management. Our responsibility is to express an opinion on these
financial statements based on our audits.





We
conducted our audits in accordance with the standards of the Public Company
Accounting Oversight Board (United States). Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. The company is not required to
have, nor have we been engaged to perform, an audit of the company's internal
control over financial reporting. An audit includes consideration of internal
control over financial reporting as a basis for designing audit procedures that
are appropriate in the circumstances, but not for the purpose of expressing an
opinion on the effectiveness of the Company’s internal control over financial
reporting. Accordingly, we express no such opinion as of December 31, 2008. 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 financial statements referred to above present fairly, in all
material respects, the consolidated financial position of InSite Vision
Incorporated as of December 31, 2008 and 2007, and the consolidated results
of their operations and their cash flows for each of the three years in the
period ended December 31, 2008, in conformity with accounting principles
generally accepted in the United States of America.





/s/ Burr,
Pilger & Mayer LLP





San
Francisco, California


March 13,
2009





40





INSITE
VISION INCORPORATED


CONSOLIDATED
BALANCE SHEETS





December
      31,(in
      thousands, except share and per share amounts)
                            
                            2008
                            
                            
                            2007ASSETSCurrent
      assets:Cash
      and cash equivalents
                            
                            $
                            37,456
                            
                            
                            $
                            11,532Restricted
      cash
                            
                            
                            -
                            
                            
                            
                            75Accounts
      receivable
                            
                            
                            1,455
                            
                            
                            
                            719Prepaid
      deal expenses
                            
                            
                            -
                            
                            
                            
                            538Prepaid
      expenses and other current assets
                            
                            
                            212
                            
                            
                            
                            810Total
      current assets
                            
                            
                            39,123
                            
                            
                            
                            13,674Property
      and equipment, at cost:Laboratory
      and other equipment
                            
                            
                            1,744
                            
                            
                            
                            1,210Leasehold
      improvements
                            
                            
                            292
                            
                            
                            
                            289Furniture
      and fixtures
                            
                            
                            177
                            
                            
                            
                            1602,213
                            
                            
                            
                            1,659Accumulated
      depreciation
                            
                            
                            734
                            
                            
                            
                            3211,479
                            
                            
                            
                            1,338Debt
      issuance costs, net
                            
                            
                            4,341
                            
                            
                            
                            -Total
      assets
                            
                            $
                            44,943
                            
                            
                            $
                            15,012LIABILITIES
      AND STOCKHOLDERS' EQUITY (DEFICIT)Current
      liabilities:Accounts
      payable
                            
                            $
                            1,162
                            
                            
                            $
                            2,196Accrued
      liabilities
                            
                            
                            729
                            
                            
                            
                            853Accrued
      compensation and related expense
                            
                            
                            638
                            
                            
                            
                            979Accrued
      royalties
                            
                            
                            326
                            
                            
                            
                            57Accrued
      interest
                            
                            
                            1,200
                            
                            
                            
                            -Deferred
      revenues
                            
                            
                            373
                            
                            
                            
                            10,145Total
      current liabilities
                            
                            
                            4,428
                            
                            
                            
                            14,230Capital
      lease obligation, less current portion
                            
                            
                            21
                            
                            
                            
                            36Secured
      notes payable
                            
                            
                            60,000
                            
                            
                            
                            -Total
      liabilities
                            
                            
                            64,449
                            
                            
                            
                            14,266Commitments
      and contingenciesStockholders'
      equity (deficit):Preferred
      stock, $0.01 par value, 5,000,000 shares authorized, none issued and
      outstanding at December 31, 2008 and December 31, 2007
                            
                            
                            -
                            
                            
                            
                            -Common
      stock, $0.01 par value, 240,000,000 shares authorized; 94,681,618 issued
      and outstanding at December 31, 2008 and 94,585,449 issued and outstanding
      at December 31, 2007
                            
                            
                            947
                            
                            
                            
                            946Additional
      paid-in capital
                            
                            
                            148,384
                            
                            
                            
                            147,327Accumulated
      deficit
                            
                            
                            (168,837
                            )
                            
                            
                            (147,527
                            )Total
      stockholders' equity (deficit)
                            
                            
                            (19,506
                            )
                            
                            
                            746Total
      liabilities and stockholders' equity (deficit)
                            
                            $
                            44,943
                            
                            
                            $
                            15,012




_________________________________________________________


See
accompanying notes to consolidated financial statements.





41




INSITE
VISION INCORPORATED


CONSOLIDATED
STATEMENTS OF OPERATIONS





Year
      Ended December 31,(in
      thousands, except per share amounts)
                      
                      2008
                      
                      
                      2007
                      
                      
                      2006Revenues:Licensing
      fee and milestone amortization
                      
                      $
                      9,972
                      
                      
                      $
                      22,080
                      
                      
                      $
                      2Royalties
                      
                      
                      3,596
                      
                      
                      
                      701
                      
                      
                      
                      -Other
      product and service revenues
                      
                      
                      138
                      
                      
                      
                      980
                      
                      
                      
                      -Total
                      
                      
                      13,706
                      
                      
                      
                      23,761
                      
                      
                      
                      2Cost
      of revenues
                      
                      
                      630
                      
                      
                      
                      982
                      
                      
                      
                      28Gross
      profit (loss)
                      
                      
                      13,076
                      
                      
                      
                      22,779
                      
                      
                      
                      (26
                      )Operating
      expenses:Research
      and development(a)
                      
                      
                      16,242
                      
                      
                      
                      10,384
                      
                      
                      
                      8,890General
      and administrative(a)
                      
                      
                      8,251
                      
                      
                      
                      6,760
                      
                      
                      
                      6,182Severance
                      
                      
                      1,909Total
                      
                      
                      26,402
                      
                      
                      
                      17,144
                      
                      
                      
                      15,072Income
      (loss) from operations
                      
                      
                      (13,326
                      )
                      
                      
                      5,635
                      
                      
                      
                      (15,098
                      )Interest
      (expense) and other income, net
                      
                      
                      (7,984
                      )
                      
                      
                      (100
                      )
                      
                      
                      (1,513
                      )Net
      income (loss)
                      
                      $
                      (21,310
                      )
                      
                      $
                      5,535
                      
                      
                      $
                      (16,611
                      )Net
      income (loss) per share:Earnings
      (loss) per share - basic
                      
                      $
                      (0.23
                      )
                      
                      $
                      0.06
                      
                      
                      $
                      (0.19
                      )Earnings
      (loss) per share - diluted
                      
                      $
                      (0.23
                      )
                      
                      $
                      0.06
                      
                      
                      $
                      (0.19
                      )Weighted
      average shares used in per-share calculation:-
      Basic
                      
                      
                      94,607
                      
                      
                      
                      94,168
                      
                      
                      
                      88,339-
      Diluted
                      
                      
                      94,607
                      
                      
                      
                      100,110
                      
                      
                      
                      88,339(a)
      Includes the following amounts related to stock based
      compensation:Research
      and development
                      
                      $
                      290
                      
                      
                      $
                      282
                      
                      
                      $
                      245General
      and administrative
                      
                      
                      740
                      
                      
                      
                      719
                      
                      
                      
                      565




__________________________________________________________


See
accompanying notes to consolidated financial statements.





42





INSITE
VISION INCORPORATED


CONSOLIDATED
STATEMENTS OF STOCKHOLDERS’ EQUITY (DEFICIT)





Notes
                        
                        
                        Retained
                        
                        
                        TotalReceivable
                        
                        
                        Earnings
                        
                        
                        Stockholders’Preferred
      Stock
                        
                        
                        Common
      Stock
                        
                        
                        Additional
                        
                        
                        from
                        
                        
                        (Accumulated
                        
                        
                        Equity(in
      thousands, except per share amounts)
                        
                        Shares
                        
                        
                        Amount
                        
                        
                        Shares
                        
                        
                        Amount
                        
                        
                        Paid-in-Capital
                        
                        
                        Stockholders
                        
                        
                        Deficit)
                        
                        
                        (Deficit)Balances,
      December 31, 2005
                        
                        
                        -
                        
                        
                        $
                        -
                        
                        
                        
                        79,614,806
                        
                        
                        $
                        796
                        
                        
                        $
                        133,278
                        
                        
                        $
                        (168
                        )
                        
                        $
                        (136,451
                        )
                        
                        $
                        (2,545
                        )Issuance
      of common stock from exercise of options and employee stock purchase
      plan
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        203,920
                        
                        
                        
                        2
                        
                        
                        
                        131
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        133Issuance
      of common stock from exercise of warrant
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        8,676,132
                        
                        
                        
                        87
                        
                        
                        
                        5,539
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        5,626Issuance
      of common stock from private placement
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        4,790,076
                        
                        
                        
                        48
                        
                        
                        
                        5,762
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        5,810Employee
      stock compensation
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        804
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        804Non-employee
      stock compensation
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        6
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        6Loan
      payment from stockholder
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        168
                        
                        
                        
                        -
                        
                        
                        
                        168Issuance
      of warrants in connection with private placement of notes
      payable
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        307
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        307Net
      loss
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        (16,611
                        )
                        
                        
                        (16,611
                        )Balances,
      December 31, 2006
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        93,284,934
                        
                        
                        
                        933
                        
                        
                        
                        145,827
                        
                        
                        
                        -
                        
                        
                        
                        (153,062
                        )
                        
                        
                        (6,302
                        )Issuance
      of common stock from exercise of options and employee stock purchase
      plan
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        159,017
                        
                        
                        
                        2
                        
                        
                        
                        107
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        109Issuance
      of common stock from exercise of warrants, net of issuance
      costs
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        1,141,498
                        
                        
                        
                        11
                        
                        
                        
                        392
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        403Employee
      stock compensation
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        979
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        979Non-employee
      stock compensation
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        22
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        22Net
      income
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        5,535
                        
                        
                        
                        5,535Balances,
      December 31, 2007
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        94,585,449
                        
                        
                        
                        946
                        
                        
                        
                        147,327
                        
                        
                        
                        -
                        
                        
                        
                        (147,527
                        )
                        
                        
                        746Issuance
      of common stock from employee stock purchase plan
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        96,169
                        
                        
                        
                        1
                        
                        
                        
                        27
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        28Employee
      stock compensation
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        1,018
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        1,018Non-employee
      stock compensation
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        12
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        12Net
      loss
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        (21,310
                        )
                        
                        
                        (21,310
                        )Balances,
      December 31, 2008
                        
                        
                        -
                        
                        
                        $
                        -
                        
                        
                        
                        94,681,618
                        
                        
                        $
                        947
                        
                        
                        $
                        148,384
                        
                        
                        $
                        -
                        
                        
                        $
                        (168,837
                        )
                        
                        $
                        (19,506
                        )




__________________________________________________________


See
accompanying notes consolidated financial statements.




43




INSITE
VISION INCORPORATED


CONSOLIDATED
STATEMENTS OF CASH FLOWS


(in
thousands)





Year
      Ended December 31,2008
                            
                            
                            2007
                            
                            
                            2006OPERATING
      ACTIVITIES:Net
      income (loss)
                            
                            $
                            (21,310
                            )
                            
                            $
                            5,535
                            
                            
                            $
                            (16,611
                            )Adjustment
      to reconcile net income (loss) to net cash provided by (used in) operating
      activities:Depreciation
      and amortization
                            
                            
                            413
                            
                            
                            
                            236
                            
                            
                            
                            97Gain
      on sale of assets
                            
                            
                            (8
                            )
                            
                            
                            (1
                            )
                            
                            
                            -Amortization
      of deferred debt issuance costs
                            
                            
                            361
                            
                            
                            
                            22
                            
                            
                            
                            809Accretion
      of debt discount
                            
                            
                            -
                            
                            
                            
                            -
                            
                            
                            
                            798Stock-based
      compensation
                            
                            
                            1,030
                            
                            
                            
                            1,001
                            
                            
                            
                            810Changes
      in operating assets and liabilities:Accounts
      receivable
                            
                            
                            (736
                            )
                            
                            
                            (719
                            )
                            
                            
                            -Prepaid
      expenses and other current assets
                            
                            
                            598
                            
                            
                            
                            (15
                            )
                            
                            
                            (697
                            )Accounts
      payable
                            
                            
                            (1,034
                            )
                            
                            
                            1,819
                            
                            
                            
                            (1,564
                            )Accrued
      liabilities
                            
                            
                            (124
                            )
                            
                            
                            424
                            
                            
                            
                            (786
                            )Accrued
      compensation and related expense
                            
                            
                            (341
                            )
                            
                            
                            360
                            
                            
                            
                            216Accrued
      royalties
                            
                            
                            269
                            
                            
                            
                            57
                            
                            
                            
                            -Accrued
      interest
                            
                            
                            1,200
                            
                            
                            
                            (702
                            )
                            
                            
                            699Deferred
      revenues
                            
                            
                            (9,772
                            )
                            
                            
                            10,145
                            
                            
                            
                            -Net
      cash provided by (used in) operating activities
                            
                            
                            (29,454
                            )
                            
                            
                            18,162
                            
                            
                            
                            (16,229
                            )INVESTING
      ACTIVITIES:Purchase
      of property and equipment
                            
                            
                            (554
                            )
                            
                            
                            (1,013
                            )
                            
                            
                            (322
                            )Proceeds
      from sale of asset
                            
                            
                            8
                            
                            
                            
                            1
                            
                            
                            
                            -Restricted
      cash decrease
                            
                            
                            75
                            
                            
                            
                            -
                            
                            
                            
                            -Net
      cash used in investing activities
                            
                            
                            (471
                            )
                            
                            
                            (1,012
                            )
                            
                            
                            (322
                            )FINANCING
      ACTIVITIES:Issuance
      of common stock from exercise of options, employeepurchase
      plan and warrants, net of issuance costs
                            
                            
                            28
                            
                            
                            
                            512
                            
                            
                            
                            5,759Issuance
      of common stock from private placement, net of issuance
    costs
                            
                            
                            -
                            
                            
                            
                            -
                            
                            
                            
                            5,810Note
      payment received from stockholder
                            
                            
                            -
                            
                            
                            
                            -
                            
                            
                            
                            168Issuance
      of short-term notes payable, net of issuance costs
                            
                            
                            -
                            
                            
                            
                            -
                            
                            
                            
                            1,783Proceeds
      from issuance of secured notes payable
                            
                            
                            60,000
                            
                            
                            
                            
                            
                            
                            
                            -Payments
      for debt issuance costs
                            
                            
                            (4,164
                            )
                            
                            
                            (538
                            )
                            
                            
                            -Repayments
      of borrowings
                            
                            
                            -
                            
                            
                            
                            (6,300
                            )
                            
                            
                            -Payments
      of notes payable to related parties
                            
                            
                            -
                            
                            
                            
                            (266
                            )
                            
                            
                            -Payment
      of capital lease obligation
                            
                            
                            (15
                            )
                            
                            
                            (12
                            )
                            
                            
                            (10
                            )Net
      cash (used in) provided by financing activities
                            
                            
                            55,849
                            
                            
                            
                            (6,604
                            )
                            
                            
                            13,510Net
      increase (decrease) in cash and cash equivalents
                            
                            
                            25,924
                            
                            
                            
                            10,546
                            
                            
                            
                            (3,041
                            )Cash
      and cash equivalents at beginning of year
                            
                            
                            11,532
                            
                            
                            
                            986
                            
                            
                            
                            4,027Cash
      and cash equivalents at end of year
                            
                            $
                            37,456
                            
                            
                            $
                            11,532
                            
                            
                            $
                            986Supplemental
      disclosure of cash flow information:Interest
      received
                            
                            $
                            603
                            
                            
                            $
                            8
                            
                            
                            $
                            1Interest
      paid
                            
                            $
                            7,045
                            
                            
                            $
                            809
                            
                            
                            $
                            16Income
      taxes
                            
                            $
                            5
                            
                            
                            $
                            1
                            
                            
                            $
                            1Non-cash
      investing and financing activities:Issuance
      of warrants to lenders in connection with notes payable
                            
                            $
                            -
                            
                            
                            $
                            -
                            
                            
                            $
                            307Acquisition
      of property and equipment through capital lease
                            
                            $
                            -
                            
                            
                            $
                            -
                            
                            
                            $
                            71




_________________________________________________________


See
accompanying notes to consolidated financial statements.





44





InSite
Vision Incorporated





Notes to
Consolidated Financial Statements


December
31, 2008





1.           Summary
of Significant Accounting Policies




Basis of
Presentation.  The accompanying consolidated financial
statements include the accounts of InSite Vision Incorporated and its
wholly-owned subsidiaries (“InSite” or the “Company”).  The Company
operates in one segment and is focused on developing drugs and drug delivery
systems principally for ophthalmic indications.  All transactions have
been eliminated between the subsidiaries and the Company.





Reclassifications





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





Significant
Accounting Policies and Use of Estimates





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





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.





Accounts
receivable.  Accounts receivable represent amounts due to the
Company from its licensees, Inspire and Shin Poong.  The Company has
not recorded a bad debt allowance related to these accounts receivable as the
amounts are reasonably expected to be collected.  The need for a bad
debt allowance is evaluated each reporting period based on our assessment of the
collectiblity of the amounts.





Prepaid deal
expenses.  At December 31, 2007, prepaid deal expenses included
$538,000 of expenses incurred related to the financing completed in February
2008.  See Note 5, “Secured Notes Payable” for further discussion of
this transaction.





Property and
Equipment.  Property and equipment is stated at cost, less
accumulated depreciation and amortization.  Depreciation of property
and equipment is provided over the estimated useful lives of the respective
assets, which range from three to five years, using the straight-line
method.  Leasehold improvements and property acquired under capital
lease are amortized over the lives of the related leases or their estimated
useful lives, whichever is shorter, using the straight-line
method.  Depreciation and amortization expense for the years ended
December 31, 2008, 2007 and 2006 were $413,000, $236,000 and $97,000,
respectively.





Additionally, the Company records
impairment losses on long-lived assets used in operations when events and
circumstances indicate that the assets might be impaired and the undiscounted
cash flows estimated to be generated by those assets are less than the carrying
amounts of those assets.  No such impairments have been recorded to
date.  The costs of repairs and maintenance are expensed as
incurred.




Debt Issuance
Costs.  Debt issuance costs paid to third parties are
capitalized and amortized over the life of the underlying debt, using the
straight-line method.  Amortization of debt issuance costs for the
year ended December 31, 2008 was $361,000 and is included in interest
expense and other income in the Consolidated Statements of
Operations.  See Note 5, “Secured Notes Payable” for further
discussion of the underlying debt.




45




Fair Value
Measurements.  On January 1, 2008, the Company adopted
Statement of Financial Accounting Standards (“SFAS”) No. 157, “Fair Value
Measurements” (“SFAS No. 157”) which defines fair value, establishes a framework
for using fair value to measure assets and liabilities, and expands disclosures
about fair value measurements.  SFAS No. 157 applies whenever other
statements require or permit assets or liabilities to be measured at fair
value.  SFAS No. 157 is effective for fiscal years beginning after
November 15, 2007, except for nonfinancial assets and liabilities that are
recognized or disclosed at fair value in the financial statements on a
nonrecurring basis, for which application has been deferred for one year. The
levels of fair value measurements defined in SFAS No. 157 are:





Level 1
            
            Inputs
      are unadjusted quoted prices in active markets for identical assets or
      liabilities that the Company has the ability to access at the measurement
      date.Level
      2
            
            Observable
      inputs other than Level 1 prices, such as quoted prices for similar assets
      or liabilities; quoted prices in markets that are not active; or other
      inputs that are observable or can be corroborated by observable market
      data for substantially the full term of the assets or liabilities. The
      Company had no Level 2 assets or liabilities at December 31,
      2008.Level
      3
            
            Unobservable
      inputs that are supported by little or no market activity and that are
      significant to the fair value of the assets or liabilities. The Company
      had no material Level 3 assets or liabilities at December 31,
      2008.





As of
December 31, 2008, $37.1 million of our cash and cash equivalents consisted of
Level 1 Treasury backed money market funds.





The
Company’s financial instruments consist mainly of cash equivalents, short-term
accounts receivable, accounts payable and debt obligations. Short-term accounts
receivable and accounts payable are reflected in the accompanying consolidated
financial statements at cost, which approximates fair value due to the
short-term nature of these instruments. While the Company believes its valuation
methodologies are appropriate and consistent with other market participants, the
use of different methodologies or assumptions to determine the fair value of
certain financial instruments could result in a different estimate of fair value
at the reporting date.





Revenue
Recognition.  The Company recognizes revenue in accordance with
Securities and Exchange Commission Staff Accounting Bulletin No. 104, Revenue
Recognition, or SAB 104.  SAB 104 requires that four basic
criteria must be met before revenue can be recognized: persuasive evidence of an
arrangement exists; delivery has occurred or services have been rendered; the
fee is fixed or determinable; and collectibility is reasonably assured.
Arrangements with multiple elements are accounted for in accordance with
Emerging Issues Task Force, or EITF, Issue No. 00-21, Revenue Arrangements with
Multiple Deliverables.  The Company analyzes our multiple element
arrangements to determine whether the elements can be separated and accounted
for individually as separate units of accounting in accordance with EITF 00-21.
The Company’s revenues are primarily related to licensing agreements, and such
agreements may provide for various types of payments, including upfront
payments, research funding and related fees during the term of the agreement,
milestone payments based on the achievement of established development
objectives, licensing fees, and royalties on product sales.





Upfront,
non-refundable payments under licensing agreements are recorded as deferred
revenues once received and recognized ratably over the period related activities
are performed. Revenues from non-refundable milestones are recognized when the
earnings process is complete and the payment is reasonably assured.
Non-refundable milestone payments related to arrangements under which the
Company has continuing performance obligations are recognized ratably over the
period related activities are performed.





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





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





Revenues related to the sales of the
Company’s OcuGene glaucoma
genetic test were recognized when all related services had been rendered and
collectibility was reasonably assured.





46


Cost of
revenues.  The Company recognizes the cost of inventory shipped
and other costs related to the Company’s OcuGene glaucoma genetic test when
they are incurred.





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





The Company accrues and expenses the
costs for clinical trial activities performed by third parties based upon
estimates of the percentage of work completed over the life of the individual
study in accordance with agreements established with contract research
organizations and clinical trial sites. The Company determines the estimates
through discussions with internal clinical personnel and external service
providers as to progress or stage of completion of trials or services and the
agreed upon fee to be paid for such services. Costs of setting up clinical trial
sites for participation in the trials are expensed immediately as research and
development expenses. Clinical trial site costs related to patient enrollment
are accrued as patients are entered into the trial.





General and Administrative
(G&A) Expenses.  G&A expenses include salaries,
benefits, facility costs, services provided by outside consultants and
contractors, advertising and marketing, investor relations, financial reporting,
materials and other expenses related to general corporate and sales and
marketing activities.  The Company recognizes such costs as they are
incurred.





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





The
Company accounts for stock-based payments in accordance with the provisions of
Statement of Financial Accounting Standards (“SFAS”) No. 123 (revised 2004)
“Share-Based Payment” (“SFAS No. 123 (R)”). SFAS No. 123
(R) establishes accounting for stock-based awards exchanged for employee
services. Accordingly, stock-based compensation cost is measured at the grant
date, based on the fair value of the award, and is recognized as expense over
the requisite service period. All of the Company’s stock compensation is
accounted for as an equity instrument.





Upon
adoption of SFAS No. 123(R), the Company elected the alternative transition
method for calculating the tax effects of stock-based compensation pursuant to
SFAS No. 123(R). The alternative transition method provides a simplified
method to establish the beginning balance of the additional paid-in capital
pool, or APIC Pool, related to the tax effects of employee stock-based
compensation, and to determine the subsequent impact on the APIC Pool and
consolidated statements of cash flows of the tax effects of employee stock-based
compensation awards that are outstanding upon adoption of SFAS No.
123(R).





Consistent
with prior years, the Company uses the “with and without” approach as described
in Emerging Issues Task Force Topic No. D-32 in determining the order in which
its tax attributes are utilized. The “with and without” approach results in the
recognition of the windfall stock option tax benefits after all other tax
attributes have been considered in the annual tax accrual
computation.  SFAS No. 123(R) prohibits the recognition of a
deferred tax asset for an excess tax benefit that has not yet been realized. As
a result, the Company will only recognize a benefit from stock-based
compensation in paid-in capital if an incremental tax benefit is realized after
all other tax attributes currently available to it have been utilized. In
addition, the Company has elected to account for the indirect benefits of
stock-based compensation on items such as the alternative minimum tax, the
research tax credit or the domestic manufacturing deduction through the
consolidated statements of operations rather than through paid-in
capital.  See Note 11, “Employee Stock-Based Compensation” for further
discussion of employee stock-based compensation.





47


Accounting for Stock Options
and Warrants Exchanged for Services.  The Company issues stock
options and warrants to consultants of the Company in exchange for
services.  The Company has valued these options and warrants using the
Black-Scholes option pricing model in accordance with the Emerging Issues Task
Force (EITF) Consensus No. 96-18, “Accounting for Equity Investments that are
Issued to Other Than Employees for Acquiring or in Conjunction with Selling
Goods, or Services,” at each reporting period and has recorded charges to
operations over the vesting periods of the individual stock options or
warrants.  Such charges amounted to approximately $12,000, $22,000 and
$6,000 during the years ended 2008, 2007 and 2006, 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 net loss per share has been computed
using the weighted-average number of common shares outstanding during the
period. Dilutive net loss 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 and
warrants.  Potentially dilutive securities have been excluded from the
computation of diluted net loss per share in 2008 and 2006 as their inclusion
would be antidilutive.





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





Year Ended December 31,(in thousands, except per share data)
                      
                      2008
                      
                      
                      2007
                      
                      
                      2006Numerator:Net
      income (loss)
                      
                      $
                      (21,310
                      )
                      
                      $
                      5,535
                      
                      
                      $
                      (16,611
                      )Denominator:Weighted-average
      shares outstanding
                      
                      
                      94,607
                      
                      
                      
                      94,168
                      
                      
                      
                      88,339Effect
      of dilutive securities:Stock
      options and warrants
                      
                      
                      -
                      
                      
                      
                      5,942
                      
                      
                      
                      -Weighted-average
      shares outstanding for diluted income(loss)
                      
                      
                      94,607
                      
                      
                      
                      100,110
                      
                      
                      
                      88,339Net
      income (loss) per share:Basic
                      
                      $
                      (0.23
                      )
                      
                      $
                      0.06
                      
                      
                      $
                      (0.19
                      )Diluted
                      
                      $
                      (0.23
                      )
                      
                      $
                      0.06
                      
                      
                      $
                      (0.19
                      )





For the years ended December 31, 2008
and 2006, due to the loss applicable to common stockholders, loss per share is
based on the weighted average number of common shares only, as the effect of
including equivalent shares from stock options and warrants would be
anti-dilutive.  At December 31, 2008, 2007 and 2006, 21,471,962,
1,016,957 and 23,412,320 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 and
commercial 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 and commercial efforts.





48


Income Taxes. Income
tax expense has been provided using the liability method. Deferred tax assets
and liabilities are determined based on the difference between the financial
statement and tax bases of assets and liabilities as measured by the enacted tax
rates that will be in effect when these differences reverse. The Company
provides a valuation allowance against net deferred tax assets if, based upon
the available evidence, it is not more likely than not that the deferred tax
assets will be realized.




The
Company adopted the provisions of Financial Accounting Standard Board, Financial
Interpretation No. 48, Accounting for Uncertainty in Income Taxes — an
interpretation of FASB Statement No. 109, or FIN 48, on January 1,
2007. FIN 48 specifies how tax benefits for uncertain tax positions are to
be recognized, measured and derecognized in financial statements; requires
certain disclosures of uncertain tax matters; specifies how reserves for
uncertain tax positions should be classified on the balance sheet; and provides
transition and interim-period guidance, among other provisions.




At the
date of adoption of FIN 48, the Company had no unrecognized tax benefits
and expected no significant changes in unrecognized tax benefits in the next
12 months.




The
Company’s policy is to recognize interest and penalties related to the
underpayment of income taxes as a component of income tax expense. To date,
there have been no interest or penalties charged to the Company in relation to
the underpayment of income taxes.





Significant Customers and
Risk.  All revenues recognized and deferred were from four AzaSite
licensees. The Company is entitled to receive royalty revenue from net sales of
AzaSite under the terms of its agreements with Inspire, Shin Poong, Biem, and
Essex, and accordingly, all trade receivables are concentrated with these
parties. Due to the nature of these agreements, these parties have significant
influence over the commercial success of AzaSite.




Credit
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.




Risks from Third Party
Manufacturing Concentration. The Company relies on a single source
manufacturer for each of its product candidates and on a single source
manufacturer for the active pharmaceutical ingredient in its product candidates.
Inspire is responsible for the manufacturing of AzaSite and relies on single
source manufacturer for the product and on a single source manufacturer for the
active pharmaceutical ingredient in the product. Accordingly, delays in the
manufacture of the product or product candidate could adversely impact the
marketing of the Company’s product or the development of the Company’s product
candidates. Furthermore, the Company has no control over the manufacture of
products for which it is entitled to receive revenue and the overall product
supply chain.





Recent Accounting
Pronouncements.





In December 2007, the Financial
Accounting Standards Board (“FASB”) issued Statement of Financial Accounting
Standard  No. 141 (revised 2007), “Business Combinations” (SFAS
141R). SFAS 141R expands the definitions of a business combination and includes
the issuance of equity securities to be determined on the acquisition date, be
recorded at fair value at the acquisition date; all assets, liabilities,
contingent consideration, contingencies and in-process research and development
costs of an acquired business be recorded at fair value at the acquisition date;
acquisition costs generally be expensed as incurred; restructuring costs
generally be expensed in periods subsequent to the acquisition date; and changes
be made in accounting for deferred tax asset valuation allowances and acquired
income tax uncertainties after the measurement period to impact income tax
expense. Upon the Company’s adoption of SFAS 141R, any subsequent changes to the
Company’s acquired uncertain tax positions and valuation allowances associated
with acquired deferred tax assets will no longer be applied to goodwill,
regardless of acquisition date of the associated business combination. Rather,
those changes will typically be recognized as an adjustment to income tax
expense. SFAS 141R applies prospectively to business combinations for which the
acquisition date is on or after the beginning of the first annual reporting
period beginning on or after December 15, 2008. The adoption of this
statement does not have an impact to the Company’s consolidated financial
position and results of operations, although would have an effect on reporting
of any acquisitions completed after January 1, 2009.





In
September 2006, the FASB issued Statement of Financial Accounting Standards
No. 157, “Fair Value Measurements” (SFAS 157), which defines fair value as
the price that would be received to sell an asset or paid to transfer
a




49




liability
in an orderly transaction between market participants at the measurement date.
In addition, SFAS 157 establishes a framework for measuring fair value and
expands disclosure about fair value measurements. SFAS No. 157 is effective
for fiscal years beginning after November 15, 2007 and interim periods
within those years. However, in February 2008, the FASB issued FASB Staff
Position (“FSP”) FAS 157-1 and FSP FAS 157-2, which delayed the effective date
of SFAS 157 for all nonrecurring fair value measurements of nonfinancial assets
and nonfinancial liabilities, except those that are recognized or disclosed at
fair value in the financial statements on a recurring basis (at least annually)
and removes certain leasing transactions from the scope of SFAS 157. FSP FAS
157-2 partially defers the effective date of SFAS 157 to fiscal years and
interim periods beginning after November 15, 2008 for items within the
scope of the FSP. The Company does not expect the adoption of FSP FAS 157-1 and
FSP FAS 157-2 to have a material impact on the Company’s consolidated financial
position and results of operations.




In
February 2007, the FASB issued Financial Accounting Standards No. 159,
“Fair Value Option for Financial Assets and Financial Liabilities” (SFAS
159). SFAS 159 permits
entities to choose to measure many financial instruments, and certain other
items, at fair value. SFAS 159 also establishes presentation and disclosure
requirements designed to facilitate comparisons between entities that choose
different measurement attributes for similar types of assets and liabilities.
The provisions of SFAS 159 are effective for fiscal years beginning after
November 15, 2007. The Company adopted SFAS 159 and did not elect the fair
value option for any of our eligible financial assets or
liabilities.





In August
2008, the U.S. Securities and Exchange Commission, or SEC, announced that it
will issue for comment a proposed roadmap regarding the potential use by U.S.
issuers of financial statements prepared in accordance with International
Financial Reporting Standards (“IFRS”). IFRS is a comprehensive series of
accounting standards published by the International Accounting Standards Board,
or IASB. Under the proposed roadmap, the Company could be required in fiscal
year 2014 to prepare financial statements in accordance with IFRS and the SEC
will make a determination in 2011 regarding mandatory adoption of IFRS. The
Company is currently assessing the impact that this potential change would have
on our consolidated financial statements and will continue to monitor the
development of the potential implementation of IFRS.





2. 
           License
Agreements





In
December 2007, we entered into an international licensing and distribution
agreement for AzaSite with Shin Poong Pharm, Seoul, South Korea, one of the top
ten South Korean pharmaceutical companies.  This is the first
international agreement for AzaSite outside of North America.  Under
the terms of the agreement, InSite grants exclusive rights to Shin Poong to
commercialize AzaSite for ocular bacterial infection in South
Korea.





In March
2008, the Company entered into a licensing and distribution agreement for
AzaSite with Bioceutica S.A. in Argentina. Under the terms of the agreement, the
Company granted exclusive rights to Bioceutica to commercialize AzaSite for
ocular bacterial infection in Argentina, Chile, Paraguay and
Uruguay.





In April
2008, the Company entered into a licensing and distribution agreement for
AzaSite with Biem Pharmaceuticals in Turkey. Under the terms of the agreement,
the Company granted exclusive rights to Biem Pharmaceuticals to commercialize
AzaSite for ocular bacterial infection in Turkey.





In May
2008, the Company entered into a licensing and distribution agreement for
AzaSite with Essex Bio-Technology in the People’s Republic of China. Under the
terms of the agreement, the Company granted exclusive rights to Essex to
commercialize AzaSite for ocular bacterial infection in the People’s Republic of
China.





In all of
these agreements, the licensee is responsible for obtaining regulatory approval
and will generally pay the Company a double digit royalty on net sales of
AzaSite in these countries, if approved by regulatory
authorities.  The Company will be responsible for providing AzaSite
inventory to these licensees at a fee.





On
February 15, 2007, the Company entered into a license agreement for AzaSiteTM with
Inspire under which the Company licensed to Inspire exclusive development and
commercialization rights in the United States and Canada, for topical
anti-infective products containing azithromycin as the sole active ingredient
for human ocular or ophthalmic indications. The




50




Company
also granted Inspire an exclusive sublicense under the Pfizer patent rights the
Company has licensed under the Pfizer License discussed below. Inspire has the
right to grant sublicenses under the terms of the Inspire License.





Inspire
paid the Company an upfront license fee of $13 million on February 15, 2007 and
on May 11, 2007 paid an additional $19 million upon regulatory approval by the
U.S. FDA. Inspire also pays the Company a royalty on net sales
of AzaSite in the United States and Canada. The royalty rate is 20% of
net sales in the first two years of commercialization and 25% thereafter.
Inspire is obligated to pay the Company royalties under the Inspire License for
the longer of (i) eleven years from the launch of the first product, and (ii)
the period during which a valid claim under a patent exists. For five years
after the first year of commercial sale, Inspire will pay the Company certain
tiered minimum royalties. The royalties discussed above are subject to certain
reductions in the event of patent invalidity, generic competition, uncured
material breach or in the event that Inspire is required to pay license fees to
third parties for the continued use of AzaSite.





The
Company also entered into a supply agreement, or the Supply Agreement, with
Inspire on February 15, 2007 for the active pharmaceutical ingredient
azithromycin. The Company had previously entered into a third-party supply
agreement for the production of such active ingredient.





The
Company recognized the upfront license fee and milestone payment totaling $32
million ratably over the period that the Company was required to continue to
provide services under the license agreement, which ended in April 2008, under
the contingency-adjusted performance model of revenue recognition. During the
years ended December 31, 2008 and December 31, 2007, the Company recognized $9.9
million and $22.1 million, respectively, of the license fee and milestone
payment as revenue.




In August
2007, Inspire commercially launched AzaSite in the United States.
Correspondingly, during the year ended December 31, 2007, the Company recognized
$701,000 of royalties related to sales of AzaSite by Inspire. Additionally,
during the period ended December 31, 2007, the Company recognized $980,000 of
revenue from Inspire for the sales of the active ingredient, azithromycin, under
the Supply Agreement, sales of AzaSite inventory and for contract services
provided.





On February 15, 2007, the Company
entered into a worldwide, exclusive, royalty-bearing license agreement with
Pfizer Inc. under Pfizer’s patent family titled “Method of Treating Eye
Infections with Azithromycin” for ocular anti-infective product candidates known
as AzaSite and ISV-502 (the “Pfizer License”). Under the Pfizer License, the
Company is required to pay Pfizer a low single digit royalty based on net sales
of the licensed products and to use reasonable commercial efforts to seek
regulatory approval for and market licensed products. The Pfizer License
provides the Company the right to grant sublicenses thereunder, subject to
Pfizer's prior approval, which approval shall not be unreasonably withheld.
Pfizer approved the sublicense granted to Inspire. Based on the royalty report
provided by Inspire, for the year ended December 31, 2008 and December 31, 2007,
the Company recorded third-party royalties of $629,000 and $122,000,
respectively, due primarily under the Pfizer License.





3.           Restricted
Cash





As of December 31, 2007, the Company
reserved approximately $75,000 related to a letter of credit issued as
collateral for a capital lease for a telephone system which was installed and
initiated in the first quarter of 2006.  The requirement for this
restricted cash was eliminated in 2008.





As of
December 31, 2008, the Company had no restricted cash or short-term
investments.





4.             Accounts
Receivable





Accounts
receivable primarily represent amounts due to the Company from Inspire and Shin
Poong.  The Company has not recorded a bad debt allowance related to
these accounts receivable as the amounts were deemed collectible.  The
need for a bad debt allowance is evaluated each reporting period based on our
assessment of the collectiblity of the amounts.




51




5.      
     Secured Notes Payable





In
February 2008, the Company’s wholly-owned subsidiary, Azithromycin Royalty Sub,
LLC completed a private placement of $60.0 million in aggregate principal amount
of non-convertible, non-recourse promissory notes due in 2019. Net proceeds from
the financing were approximately $55.3 million after transaction costs of
approximately $4.7 million. In addition, $5.0 million of the proceeds was set
aside for interest reserves. The annual interest rate on the notes is 16% with
interest payable quarterly in arrears beginning May 15, 2008. The notes are
secured by, and will be repaid from, royalties to be paid to the Company by
Inspire Pharmaceuticals from sales of AzaSite in the United States and Canada.
The secured notes payable are non-recourse to InSite Vision
Incorporated.  When the AzaSite royalties received for any quarter
exceed the interest payments and certain expenses due that quarter, the excess
will be applied to the repayment of principal of the notes until the notes have
been paid in full. Any shortfall of interest payments from the royalty payments
will be paid out of the interest reserves. As of December 31, 2008, no balance
remained on the interest reserve.  Further shortfalls, if any, can be
paid by the Company at their option to avoid default under the
agreement.  The notes may be redeemed at the Company’s option, subject
to the payment of a redemption premium through May 2012. As of December 31,
2008, the $60.0 million of secured notes payable is classified as
long-term.





At
December 31, 2008, the estimated future principal payments on the notes, based
on minimum royalty income covered by the agreement, as follows (in
thousands):





Year
      Ending December 31,2009
                        
                        $
                        -2010
                        
                        
                        -2011
                        
                        
                        3,3002012
                        
                        
                        5,5482013
                        
                        
                        8,156Thereafter
                        
                        
                        42,996Total
      secured notes payable
                        
                        
                        60,000





6.        
   Commitments and Contingencies





At December 31, 2008, the Company had
contractual obligations of approximately $157.0 million, primarily related to
the issuance of the AzaSite Notes (See Note 5) and minimum royalty payments
related to license agreements.  These contractual obligations are
reflected in the Company’s financial statements once the related goods or
services have been received or payments related to the obligations become
due.





Capital
lease obligations represent the present value of future rental payments under
capital lease agreements for telephones and telephone equipment.  At
December 31, 2008 and 2007 the Company had $71,000 of capital leased equipment
with accumulated depreciation of $38,000 and $23,000, respectively.





Future
minimum payments under capital leases are as follows:





CapitalYear
      Ending December 31,
                      
                      Leases2009
                      
                      $
                      17,6612010
                      
                      
                      17,6612011
                      
                      
                      4,7502012
                      
                      
                      -2013
                      
                      
                      -Total
      minimum lease payments
                      
                      
                      40,072Amount
      representing interest
                      
                      
                      (4,404
                      )Present
      value of net minimum lease payment
                      
                      
                      35,668Current
      Portion, in other current liabilities
                      
                      
                      (14,738
                      )Long-term
      portion
                      
                      $
                      20,930




52




The
Company conducts its operations from leased facilities in Alameda, California
under non-cancelable operating lease agreements that expire in
2013.  Lease payments include rent and the Company’s pro-rata share of
operation expenses.  For accounting purposes, the Company is
amortizing all rent payments ratably over the life of the
lease.  Future minimum lease payments under this lease and a
reconciliation of rent expense to rent paid is in the table
below.  Rent expense for the year ended December 31, 2008, 2007 and
2006, was $837,000, $695,000, and $706,000, respectively.





Operating LeaseCash PaymentsYear
      Ending December 31,
                      
                      Required2009
                      
                      $
                      754,1322010
                      
                      
                      775,1752011
                      
                      
                      798,4832012
                      
                      
                      821,7902013
                      
                      
                      847,5282014
      and thereafter
                      
                      
                      -Total
      minimum lease payments
                      
                      $
                      3,997,108





7.           Income
Taxes





The
provision of income taxes is determined using an estimated annual effective tax
rate. The Company’s effective tax rate may be subject to fluctuations during the
year as new information is obtained, which may affect the assumptions management
uses to estimate the annual effective tax rate. The effective income tax rate
was 0.0% for the period ended December 31, 2008 due to the use of previously
generated net operating losses.  There was no provision for income
taxes for the period ended December 31, 2006 and 2007 due to the Company’s net
operating losses.





Significant
components of the Company’s deferred tax assets for federal and state income
taxes as of December 31, 2008 and 2007 are as follows (in
thousands):





2008
                            
                            
                            2007Deferred
      tax assets:Net
      operating loss carryforwards
                            
                            $
                            38,150
                            
                            
                            $
                            37,786Tax
      credit carryforwards
                            
                            
                            6,520
                            
                            
                            
                            5,637Capitalized
      research and development
                            
                            
                            14,546
                            
                            
                            
                            10,208Depreciation
                            
                            
                            345
                            
                            
                            
                            381Other
                            
                            
                            252
                            
                            
                            
                            300Total
      deferred tax assets
                            
                            
                            59,813
                            
                            
                            
                            54,312Valuation
      allowance
                            
                            
                            (59,813
                            )
                            
                            
                            (54,312
                            )Net
      deferred tax assets
                            
                            $
                            -
                            
                            
                            $
                            -





During the year ended December 31,
2008, the valuation allowance increased by $5.5 million. During the year ended
December 31, 2007, the valuation decreased by $5.5 million.  During
the year ended December 31, 2006, the valuation allowance increased by $6.6
million.





At December 31, 2008, the Company had
net operating loss carryforwards for federal income tax purposes of
approximately $98.2 million, which expire in the years 2009 through 2028 and
federal tax credits of approximately $2.7 million, which expire in the years
2009 through 2028.  At December 31, 2008, the Company also has net
operating loss carryforwards for state income tax purposes of approximately
$79.2 million which expire in the years 2009 through 2028 and state research and
development tax credits of approximately $3.7 million which carryforward
indefinitely.




53


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.





The Company files income tax returns in
the U.S. federal and California jurisdictions. The Company is no longer
subject to tax examinations for years before 2006 for federal returns and 2005
for California returns, except to the extent that it utilizes net operating
losses or tax credit carryforwards that originated before those
years.  The Company is not currently under audit by any major tax
jurisdiction nor has it been in the past.





8.           Stockholders’
Equity (Deficit)





In 2008,
the Company received approximately $28,000 from the issuance of 96,169 shares
acquired under the employee stock purchase plan





In 2007,
the Company received approximately $403,000, net of approximately $10,000 of
fees, from the exercise of warrants to purchase 568,211 shares of Common Stock
issued as part of private placements. In addition, warrants to purchase 921,328
shares of Common Stock were exercised as cashless warrant exercises resulting in
the issuance of 573,287 net shares. The Company also received approximately
$70,000 from the exercise of 96,192 options issued to employees and
approximately $39,000 from the issuance of 62,825 shares acquired under the
employee stock purchase plan.





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





Warrants
      issued as part of:
                        
                        Exercise
                          Price
                        
                        
                        Net
      Cash
                          Received
                        
                        
                        Fees
                          Incurred
                        
                        
                        Warrants
                          Exercised
                        
                        
                        Shares of
                          Common Stock
                          IssuedMarch
      2004 private placement
                        
                        $
                        0.75
                        
                        
                        $
                        5,256,000
                        
                        
                        $
                        162,000
                        
                        
                        
                        7,223,763
                        
                        
                        
                        7,223,763Placement
      agent warrants related to the March 2004 private placement, cashless
      exercise
                        
                        $
                        0.55
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        29,077
                        
                        
                        
                        17,719May
      2005 private placement
                        
                        $
                        0.63
                        
                        
                        
                        345,000
                        
                        
                        
                        -
                        
                        
                        
                        545,451
                        
                        
                        
                        545,451May
      2005 private placement, cashless exercise
                        
                        $
                        0.63
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        436,361
                        
                        
                        
                        274,074Legal
      settlement
                        
                        $
                        0.50
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        922,800
                        
                        
                        
                        565,1252003
      services provided
                        
                        $
                        0.50
                        
                        
                        
                        25,000
                        
                        
                        
                        -
                        
                        
                        
                        50,000
                        
                        
                        
                        50,000Total
                        
                        
                        
                        
                        
                        $
                        5,626,000
                        
                        
                        $
                        162,000
                        
                        
                        
                        9,207,452
                        
                        
                        
                        8,676,132





54





The
following table shows the detail of outstanding warrants as of December 31,
2008.  All of the outstanding warrants, except for those issued in
March and June, 2004, with an exercise price of $0.75, have cashless exercise
provisions.





Date
      Issued
                                
                                Warrants
                                  Shares
                                
                                
                                Exercise
                                  Price
                                
                                Expiration
      Date
                                
                                Cash
      if
                                  ConvertedMarch
      26, 2004
                                
                                
                                989,401
                                
                                
                                
                                0.75
                                
                                March
      25, 2009
                                
                                
                                742,051June
      14, 2004
                                
                                
                                7,414,569
                                
                                
                                
                                0.75
                                
                                June
      13, 2009
                                
                                
                                5,560,927June
      14, 2004
                                
                                
                                351,640
                                
                                
                                
                                0.55
                                
                                June
      13, 2009
                                
                                
                                193,402May
      26, 2005
                                
                                
                                3,818,175
                                
                                
                                
                                0.63
                                
                                May
      25, 2010
                                
                                
                                2,414,996May
      26, 2005
                                
                                
                                366,136
                                
                                
                                
                                0.63
                                
                                May
      25, 2010
                                
                                
                                231,581December
      30, 2005
                                
                                
                                860,000
                                
                                
                                
                                0.82
                                
                                December 29, 2010
                                
                                
                                705,200December
      30, 2005
                                
                                
                                100,000
                                
                                
                                
                                0.82
                                
                                December
      29, 2010
                                
                                
                                82,000January
      11, 2006
                                
                                
                                400,000
                                
                                
                                
                                0.82
                                
                                January
      10, 2011
                                
                                
                                328,000August
      16, 2006
                                
                                
                                958,015
                                
                                
                                
                                1.51
                                
                                August
      15, 2011
                                
                                
                                1,446,603Total
                                
                                
                                15,257,936
                                
                                
                                
                                
                                
                                
                                
                                
                                11,704,760Weighted-average
      exercise price per share
                                
                                
                                
                                $
                                0.77





In August
2006, the Company received, net of placement fees, approximately $5.8 million
from a private placement pursuant to which it issued 4,790,076 shares of Common
Stock and warrants to purchase 958,015 shares of Common Stock at an exercise
price of $1.51 per share.  These warrants were valued using a
Black-Scholes option pricing model, assuming no dividend yield, with the
following assumptions:  risk-free interest rate of 5.1%, volatility of
78.8% and an expected life of 5 years, resulting in the recording of a stock
issue cost of approximately $1.0 million for the warrants issued to the
investors.





9.
            Employee
      Stock-based Compensation





The
Company accounts for stock-based compensation in accordance with the provisions
of SFAS No. 123(R).  SFAS No. 123(R) establishes
accounting for stock-based awards exchanged for employee services. Accordingly,
stock-based compensation cost is measured at the grant date, based on the fair
value of the award, and is recognized as expense over the requisite service
period. All of the Company’s stock compensation is accounted for as an equity
instrument.





The
effect of recording stock-based compensation for the year ended December 31,
2008, 2007 and 2006 was as follows (in thousands):





Year
      Ended December 31,2008
                            
                            
                            2007
                            
                            
                            2006Stock-based
      compensation expense by type of award:Employee
      stock options
                            
                            $
                            950
                            
                            
                            $
                            936
                            
                            
                            $
                            780Employee
      stock purchase plan
                            
                            
                            68
                            
                            
                            
                            43
                            
                            
                            
                            24Non-employee
      stock options
                            
                            
                            12
                            
                            
                            
                            22
                            
                            
                            
                            6Total
      stock-based compensation
                            
                            $
                            1,030
                            
                            
                            $
                            1,001
                            
                            
                            $
                            810





Employee Stock-based
Compensation





During
the year ended December 31, 2008 and December 31, 2007, respectively, the
Company granted options to purchase 630,250 and 1,071,001 shares of common stock
with an estimated total grant date fair value of $0.2 million and $1.0
million. Based on the Company’s historical experience of option pre-vesting
cancellations and estimates of future forfeiture rates, the Company has assumed
an annualized forfeiture rate of 10% for its options for all periods disclosed.
Accordingly, for the year ended December 31, 2008 and December 31, 2007, the
Company estimated that the stock-based compensation for the




55




awards
not expected to vest was less than $0.1 million and $0.2 million, respectively.
During the year ended December 31, 2008 December 31, 2007, and December 31,
2006, the Company recorded employee stock-based compensation related to all
stock options of $950,000, $936,000, and $780,000, respectively.





As of
December 31, 2008 and 2007, unrecorded deferred stock-based compensation balance
related to stock options was $0.5 million and $1.8 million, respectively, and
will be recognized over an estimate weighted-average amortization period of
1 year and 2.3 years, respectively.





Valuation
Assumptions





The
Company estimates the fair value of stock options using a Black-Scholes
valuation model, consistent with the provisions of SFAS No. 123 (R),
Securities and Exchange Commission Staff Accounting Bulletin No. 107. The
fair value of each option grant is estimated on the date of grant using the
Black-Scholes option valuation model and the graded-vesting method with the
following weighted-average assumptions:





Year endedDecmeber
      31,2008
                        
                        
                        2007Risk-free
      interest rate
                        
                        
                        2.6% - 3.3%
                        
                        
                        
                        3.3% - 4.6%Expected
      term(years)
                        
                        
                        5%
                        
                        
                        
                        5%Expected
      dividends
                        
                        
                        0.0%
                        
                        
                        
                        0.0%Volatility
                        
                        
                        76.6%
                        
                        
                        
                        74.8%





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





Equity Incentive
Program





Prior to
October 15, 2007, the Company granted options under a stock option plan adopted
in 1994 and amended thereafter (the “1994 Plan”), that allowed for the granting
of non-qualified stock options, incentive stock options and stock purchase
rights to the Company’s employees, directors, and consultants.  On
October 15, 2007, the Company’s stockholders approved a new equity incentive
plan, the 2007 Performance Incentive Plan (the “2007 Plan”), that provides for
grants of options and other equity-based awards to the Company’s employees,
directors and consultants.  The Company’s authority to grant new
awards under the 1994 Plan terminated upon stockholder approval of the 2007
Plan.  Options granted under these plans expire 10 years after the
date of grant and become exercisable at such times and under such conditions as
determined by the Company’s Board of Directors or a committee appointed by the
Board (generally with 25% vesting after one year and the balance vesting on a
daily basis over the next three years of service).  Upon termination
of the optionee’s service, unvested options terminate, and vested options
generally expire at the end of three months. Only nonqualified stock
options have been granted under these plans to date.  On January 1 of
each calendar year during the term of the 2007 Plan, the shares of Common Stock
available for issuance will be increased by the lesser of 2% of the total
outstanding shares of Common Stock on December 31 of the preceding calendar
year, or 3,000,000 shares.  The followings is a summary of activity
under these plans for the indicated periods:




56




Number
      of
                          shares
                        
                        
                        Weighted-Average
                          Exercise
      Price
                        
                        
                        Weighted-Average
                          Remaining Contractual
                          Term
      (Years)
                        
                        
                        Aggregate
                          Intrinsic
      Value
                          (in
      thousands)Outstanding
      at December 31, 2005
                        
                        
                        5,554,990
                        
                        
                        $
                        1.15
                        
                        
                        
                        7.24
                        
                        
                        $
                        639Granted
                        
                        
                        1,628,200
                        
                        
                        
                        1.52Exercised
                        
                        
                        (136,257
                        )
                        
                        
                        0.68Canceled
                        
                        
                        (464,055
                        )
                        
                        
                        2.01Outstanding
      at December 31, 2006
                        
                        
                        6,582,878
                        
                        
                        
                        1.19
                        
                        
                        
                        7.08
                        
                        
                        
                        3,597Granted
                        
                        
                        1,071,001
                        
                        
                        
                        1.43Exercised
                        
                        
                        (96,192
                        )
                        
                        
                        0.73Canceled
                        
                        
                        (553,832
                        )
                        
                        
                        3.07Outstanding
      at December 31, 2007
                        
                        
                        7,003,855
                        
                        
                        
                        1.09
                        
                        
                        
                        6.84
                        
                        
                        
                        349Granted
                        
                        
                        630,250
                        
                        
                        
                        0.47Exercised
                        
                        
                        -
                        
                        
                        
                        0.00Canceled
                        
                        
                        (1,420,079
                        )
                        
                        
                        1.19Outstanding
      at December 31, 2008
                        
                        
                        6,214,026
                        
                        
                        $
                        1.00
                        
                        
                        
                        3.67
                        
                        
                        $
                        0Options
      vested and exerciseable and expected to be exercisable at December 31,
      2008
                        
                        
                        6,058,685
                        
                        
                        $
                        1.00
                        
                        
                        
                        3.55
                        
                        
                        $
                        0Options
      vested and exerciseable at December 31, 2008
                        
                        
                        5,287,717
                        
                        
                        $
                        1.04
                        
                        
                        
                        2.74
                        
                        
                        $
                        0




At
December 31, 2008, the Company had 4,671,043 shares of Common Stock available
for grant of issuance under its 2007 Plan. The weighted average grant date fair
value of options granted during the years ended December 31, 2008, 2007 and 2006
were $0.26, $0.91 and $1.52, respectively.  The total intrinsic value
of options exercised during the years ended December 31, 2007 and 2006 were
$75,000 and $157,000, respectively.




The
following table summarizes information concerning outstanding and exercisable
options as of December 31, 2008:




Option
      Outstanding
                  
                  
                  Options
      Vested and ExercisableWeighted-AverageRange
      of Exercise Prices
                  
                  Number
                    Outstanding
                  
                  
                  Contractual
                    Life
                  
                  
                  Exercise
      Price
                  
                  
                  Number
                    Exerisable
                  
                  
                  Weighted-
                    Average
                    Exercise
      Price$0.36  -  $0.52
                  
                  
                  635,000
                  
                  
                  
                  8.02
                  
                  
                  $
                  0.42
                  
                  
                  
                  155,000
                  
                  
                  $
                  0.41$0.56  -  $0.60
                  
                  
                  81,692
                  
                  
                  
                  8.63
                  
                  
                  
                  0.60
                  
                  
                  
                  6,690
                  
                  
                  
                  0.59$0.63  -  $0.63
                  
                  
                  1,784,382
                  
                  
                  
                  3.09
                  
                  
                  
                  0.63
                  
                  
                  
                  1,734,421
                  
                  
                  
                  0.63$0.64  -  $0.85
                  
                  
                  700,820
                  
                  
                  
                  3.88
                  
                  
                  
                  0.75
                  
                  
                  
                  629,134
                  
                  
                  
                  0.76$0.88  -  $1.13
                  
                  
                  806,272
                  
                  
                  
                  1.91
                  
                  
                  
                  1.01
                  
                  
                  
                  783,172
                  
                  
                  
                  1.01$1.20  -  $1.46
                  
                  
                  263,778
                  
                  
                  
                  3.65
                  
                  
                  
                  1.35
                  
                  
                  
                  225,493
                  
                  
                  
                  1.37$1.50  -  $1.50
                  
                  
                  1,240,420
                  
                  
                  
                  3.31
                  
                  
                  
                  1.50
                  
                  
                  
                  1,132,515
                  
                  
                  
                  1.50$1.56  -  $1.57
                  
                  
                  15,891
                  
                  
                  
                  4.68
                  
                  
                  
                  1.56
                  
                  
                  
                  11,385
                  
                  
                  
                  1.56$1.59  -  $1.59
                  
                  
                  630,000
                  
                  
                  
                  3.17
                  
                  
                  
                  1.59
                  
                  
                  
                  554,136
                  
                  
                  
                  1.59$1.63  -  $5.88
                  
                  
                  55,771
                  
                  
                  
                  1.70
                  
                  
                  
                  3.60
                  
                  
                  
                  55,771
                  
                  
                  
                  3.606,214,026
                  
                  
                  
                  3.67
                  
                  
                  $
                  1.00
                  
                  
                  
                  5,287,717
                  
                  
                  $
                  1.05





At December 31, 2007 and 2006 options
to purchase 4,629,501 and 3,720,567 shares of Common Stock were exercisable at
weighted-average exercise prices of $1.01 and $1.25, per share,
respectively.





57


Employee Stock Purchase
Plans
 The
Company currently maintains an employee stock purchase plan, adopted in 1994 and
amended thereafter (the “Purchase Plan”).  The Purchase Plan operates
in 24-month “offering periods” that are each divided into four six-month
“purchase periods.”  The Purchase Plan allows eligible employees to
purchase Common Stock at 85% of the lower of the fair market value of the Common
Stock on the first day of the applicable offering period or the fair market
value of the Common Stock on the last day of the applicable purchase
period.  Purchases are limited to 10% of each employee’s eligible
compensation, subject to certain Internal Revenue Service
restrictions.  All of the Company’s employees are eligible to
participate in the Purchase Plan after certain service periods are
met.  The number of shares available for issuance under the Purchase
Plan is automatically increased on the first trading day in January each
calendar year, 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.  The fair value of shares purchased under the Purchase
Plan is estimated using the Black-Scholes option valuation model and the
graded-vesting method with the following weighted-average assumptions for the
year ended December 31, 2008 and December 31, 2007,
respectively:  risk-free interest rate of 3.0% and 3.7%; volatility
factor of 73.8% and 74.4%; and an expected life of 1.5 years. During
the year ended December 31, 2008 and December 31, 2007, the compensation cost in
connection with the Purchase Plan was $68,000 and $43,000,
respectively. During the year ended December 31, 2008 and December 31,
2007, 96,169 and 62,825 shares were issued under the Purchase Plan. As
of December 31, 2008 and December 31, 2007, 571,965 and 543,134 shares were
reserved for issuance under the Purchase Plan.  As of December 31,
2008, the unrecorded deferred stock-based compensation balance related to the
employee stock purchase plan was $29,000 and will be recognized over an
estimated weighted average amortization period of 1.5 years.





10.           Restructuring
Charge





During
the year ended December 31, 2008, the Company announced a corporate
restructuring plan to focus on the Company’s growth opportunities and conserve
resources.  The restructuring plan decreased the Company’s personnel
by 20 employees.  In 2008, when the affected employees were notified
of their termination, the Company estimated that severance related costs would
total approximately $1.9 million which is recorded as severance expense in the
Consolidated Statement of Operations.   As of December 31, 2008,
$1.5 million of the severance has been paid and $0.2 million is a non-cash
transaction related to the accelerated vesting of employee stock
options.  The remaining liability of $0.2 million, which is recorded
accrued compensation and related expense in the Consolidated Balance Sheets,
will be paid in 2009.





11.           Legal
Proceedings





The Company is
subject to various claims and legal actions during the ordinary course of our
business. We believe that there are currently no claims or legal actions that
would have a material adverse impact on our financial position, operations or
potential performance.


58





12.           Quarterly
Results (Unaudited)





The following table is a summary of the
quarterly results of operations for the years ended December 31, 2008 and
December 31, 2007.  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.





2008First
                    
                    
                    Second
                    
                    
                    Third
                    
                    
                    Fourth(In
      thousands, except per share amounts)
                    
                    Quarter
                    
                    
                    Quarter
                    
                    
                    Quarter
                    
                    
                    QuarterRevenues
                    
                    $
                    7,931
                    
                    
                    $
                    3,305
                    
                    
                    $
                    960
                    
                    
                    $
                    1,510Cost
      of revenues
                    
                    
                    67
                    
                    
                    
                    142
                    
                    
                    
                    167
                    
                    
                    
                    254Income
      (loss) from operations
                    
                    
                    1,872
                    
                    
                    
                    (3,442
                    )
                    
                    
                    (5,625
                    )
                    
                    
                    (6,131
                    )Net
      income/(loss)
                    
                    
                    970
                    
                    
                    
                    (5,762
                    )
                    
                    
                    (7,950
                    )
                    
                    
                    (8,568
                    )-
      basic
                    
                    $
                    0.01
                    
                    
                    $
                    (0.06
                    )
                    
                    $
                    (0.08
                    )
                    
                    $
                    (0.09
                    )-
      diluted
                    
                    $
                    0.01
                    
                    
                    $
                    (0.06
                    )
                    
                    $
                    (0.08
                    )
                    
                    $
                    (0.09
                    )
 
 2007First
                    
                    
                    Second
                    
                    
                    Third
                    
                    
                    FourthQuarter
                    
                    
                    Quarter
                    
                    
                    Quarter
                    
                    
                    QuarterRevenues
                    
                    $
                    929
                    
                    
                    $
                    6,617
                    
                    
                    $
                    8,271
                    
                    
                    $
                    7,944Cost
      of revenues
                    
                    
                    3
                    
                    
                    
                    260
                    
                    
                    
                    450
                    
                    
                    
                    269Income
      (loss) from operations
                    
                    
                    (2,475
                    )
                    
                    
                    2,163
                    
                    
                    
                    3,577
                    
                    
                    
                    2,370Net
      income/(loss)
                    
                    
                    (2,575
                    )
                    
                    
                    2,159
                    
                    
                    
                    3,575
                    
                    
                    
                    2,376-
      basic
                    
                    $
                    (0.03
                    )
                    
                    $
                    0.02
                    
                    
                    $
                    0.04
                    
                    
                    $
                    0.03-
      diluted
                    
                    $
                    (0.03
                    )
                    
                    $
                    0.02
                    
                    
                    $
                    0.04
                    
                    
                    $
                    0.02





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





None





Item9A.Controls and
Procedures





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




59




control
over financial reporting is also separately evaluated on an annual basis for
purposes of providing the management report which is set forth
below.





Report of
Management on Internal Control Over Financial
Reporting.Our management is responsible for
establishing and maintaining adequate internal control over our financial
reporting. A company’s internal control over financial reporting is a process
designed to provide reasonable assurance regarding the reliability of financial
reporting and the preparation of financial statements for external purposes in
accordance with generally accepted accounting principles.





There are
inherent limitations in the effectiveness of any system of internal control,
including the possibility of human error and the circumvention or overriding of
controls. Accordingly, even effective internal controls can provide only
reasonable assurances with respect to financial statement preparation. Further,
because of changes in conditions, the effectiveness of internal control may vary
over time.





Our
management assessed the effectiveness of our internal control over financial
reporting as of December 31, 2008. In making this assessment, our
management used the criteria set forth by the Committee of Sponsoring
Organizations (COSO) of the Treadway Commission in Internal
Control — Integrated Framework. Based on its assessment using those
criteria, our management concluded that, as of December 31, 2008, our
internal control over financial reporting was effective.





Changes in
Internal Control Over Financial Reporting.   There were no
changes in our internal control over financial reporting (as defined in Exchange
act Rule 13a-15(f)) during the quarter ended December 31, 2008 that have
materially affected, or are reasonably likely to materially affect, our internal
control over financial reporting.





Item 9B.  Other
Information





Not
applicable.





PART
III





Item
10.  Directors, Executive Officers and Corporate
Governance





(a)
Information regarding our executive officers appears under the heading
“Executive Officers of the Company” in Item 1 of Part I of this Annual Report on
Form 10-K.





(b) The
remaining information required by this Item will appear under the headings
labeled “Nominees for Directors,” “Board Committees and Meetings,” “Audit
Committee Matters,” “Corporate Governance” and “Section 16(a) Beneficial
Ownership Reporting Compliance” of our Proxy Statement and such required
information is incorporated herein by reference.





Item
11.  Executive Compensation





The
information required by this Item will appear under the headings labeled
“Director Compensation for 2008,” “Compensation, Discussion and Analysis,”
“Compensation of Named Executive Officers,” “Summary Compensation Table for
2008,” “Grants of Plan Based Awards in 2008,” “Outstanding Equity Awards at
Fiscal 2008 Year End,” “ Option Exercises and Stock Vested in 2008,”
“Non-Qualified Deferred Compensation for 2008,” “Compensation Committee
Interlocks and Insider Participation” and “Compensation Committee Report” of our
Proxy Statement and such required information is incorporated herein by
reference.





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





The
information required by this Item will appear under the headings labeled “Equity
Compensation Plans” and “Beneficial Ownership of Principal Stockholders,
Directors and Management” of our Proxy Statement and such required information
is incorporated herein by reference.


60





Item
13.  Certain Relationships and Related Transactions, and Director
Independence





The
information required by this Item will appear under the headings labeled
“Certain Relationships and Related Persons Transactions” and “Director
Independence” of our Proxy Statement and such required information is
incorporated herein by reference.





Item
14.  Principal Accounting Fees and Services





Audit
Fees





The
information required by this Item will appear under the headings labeled “Audit
Committee Matters” and “Principal Accounting Fees and Services” of our Proxy
Statement and such required information is incorporated herein by
reference.





PART
IV





Item
15.  Exhibits and 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 Part II of this Annual Report on Form 10-K.





(2)       Financial Statement
Schedules





The information required under this
Item appears in the Financial Statements or notes thereto included in Item 8 of
Part II 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





The information required under this
Item appears under the heading  “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.





Dated:
March 13, 2009


INSITE
      VISION INCORPORATEDBy:
                      /s/ Louis C. DrapeauLouis
      C. DrapeauChief
      Financial Officer(Principal
      Financial Officer)





POWER
OF ATTORNEY





KNOW ALL PEOPLE BY THESE PRESENTS, that
each person whose signature appears below constitutes and appoints Louis C.
Drapeau, his or her attorneys in fact and agent, with the power of substitution
and resubstition, for him or her and in his or her name, place and stead, in any
and all capacities, to sign any amendments to this Annual Report on Form 10-K,
and to file the same, with all exhibits thereto and other documents in
connection therewith, with the Securities and Exchange Commission, granting
authority to do and perform each and every act and thing requisite or necessary
to be done in and about the premises, as fully to all intents and purposes as he
or she might or could do in person, hereby ratifying and confirming all that
said attorneys in fact, or his or her substitutes or agents, each acting alone,
may do or cause to be done by virtue thereof.





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





Name
              
              Capacity
              
              Date/s/ Louis C. Drapeau
              
              Interim
      Chief Executive Officer
              
              March
      13, 2009Louis
      C. Drapeau
              
              and
      Chief Financial Officer(Principal
      Executive Officer andPrincipal
      Financial Officer)/s/ Rick D. Anderson
              
              Director
              
              March
      13, 2009Rick
      D. Anderson/s/ Timothy P. Lynch
              
              Director
              
              March
      13, 2009Timothy
      P. Lynch/s/ Timothy McInerney
              
              Director
              
              March
      13, 2009Timothy
      McInerney/s/ Evan S. Melrose, M.D.
              
              Director
              
              March
      13, 2009Evan
      S. Melrose, M.D./s/  Robert
    O’Holla
              
              Director
              
              March
      13, 2009Robert
      O’Holla/s/  Anthony J.
    Yost
              
              Director
              
              March
      13, 2009Anthony
      J. Yost


62


EXHIBIT
INDEX





Number
              
              Exhibit Table3.11
              
              Restated
      Certificate of Incorporation, as amended on October 23,
    2006.3.22
              
              Certificate
      of Designations, Preferences and Rights of Series A Convertible Preferred
      Stock as filed with the Delaware Secretary of State on September 11,
      1997.3.32
              
              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, 1997.3.43
              
              Certificate
      of Designations, Preferences and Rights of Series A-1 Preferred Stock as
      filed with the Delaware Secretary of State on July 3,
  2002.3.54
              
              Certificate
      of Amendment to Restated Certificate of Incorporation as filed with the
      Delaware Secretary of State on June 3, 1994.3.65
              
              Certificate
      of Amendment to Restated Certificate of Incorporation as filed with the
      Delaware Secretary of State on July 20, 2000.3.75
              
              Certificate
      of Amendment to Restated Certificate of Incorporation as filed with the
      Delaware Secretary of State on June 1, 2004.3.86
              
              Certificate
      of Amendment to Restated Certificate of Incorporation as filed with the
      Delaware Secretary of State on October 23, 20063.97
              
              Amended
      and Restated Bylaws, as amended through August 8, 2006.4.1
              
              Reference
      is made to Exhibits 3.1 through 3.9.10.18
              
              InSite
      Vision Incorporated Amended and Restated Employee Stock Purchase Plan
      adopted October 15, 2007.10.29HH
              
              InSite
      Vision Incorporated 1994 Stock Option Plan (Amended and Restated as of
      June 8, 1998).10.38HH
              
              InSite
      Vision Incorporated 2007 Performance Incentive Plan.10.48
              
              Form
      of Nonqualified Stock Option Agreement (2007).10.58
              
              Form
      of Incentive Stock Option Agreement (2007).10.610
              
              Form
      of Indemnification Agreement between the Company and its directors and
      officers.10.711
              
              Form
      of Employee's Proprietary Information and Inventions
      Agreement.10.812H
              
              License
      Agreement dated as of October 9, 1991 by and between the Company and
      CIBA Vision Corporation, as amended October 9,
  1991.10.913
              
              Facilities
      Lease, dated September 1, 1996, between the Registrant and Alameda
      Real Estate Investments.10.1014H
              
              Timolol
      Development Agreement dated July 18, 1996 by and between the Company
      and Bausch & Lomb Pharmaceuticals, Inc.10.112H
              
              License
      Agreement, dated July 1, 1997, by and between the University of
      Connecticut Health Center and the Company.10.122H
              
              License
      Agreement, dated August 19, 1997, by and between the University of
      Rochester and the Company.10.1315
              
              Amendment
      No. 1 to Marina Village Office Tech Lease, dated July 20, 2001 and
      effective January 1, 2002.10.1416H
              
              License
      Agreement, dated December 21, 2001 by and between the Company and The
      University of Connecticut Health
Center.




63




Number
              
              Exhibit Table10.1517H
              
              ISV-403
      Asset Purchase Agreement, dated December 19, 2003, between the Company and
      Bausch & Lomb, Inc.10.1618
              
              Form
      of Class A Warrants issued under Subscription Agreement dated March 26,
      2004.10.1718
              
              Form
      of Class B Warrants issued under Subscription Agreement dated March 26,
      2004.10.1818
              
              Form
      of Placement Warrant issued pursuant to Placement Agreement dated February
      12, 2004.10.194
              
              Form
      of Common Stock Warrant issued under Subscription Agreement dated May 26,
      2005.10.204
              
              Form
      of Placement Agent Warrant, dated as of May 9, 2005.10.2119
              
              Warrant,
      dated as of October 10, 2005, for the purchase of 922,800 shares of Common
      Stock of the Company.10.2220
              
              Form
      of Warrant, dated as of January 11, 2006.10.2320
              
              Form
      of Placement Agent Warrant, dated as of January 11,
  2006.10.2421
              
              Form
      of Warrant, dated as of August 15, 2006.10.255
              
              Amendment
      No. 3 to Marina Village Office Tech Lease, dated November 28,
      2006.10.2622H
              
              Exclusive
      License Agreement, dated as of February 15, 2007, by and between the
      Company and Pfizer, Inc. and Pfizer Products, Inc.10.2722H
              
              License
      Agreement, dated as of February 15, 2007, by and between the Company and
      Inspire Pharmaceuticals, Inc.10.2822H
              
              Trademark
      License Agreement, dated as of February 15, 2007, by and between the
      Company and Inspire Pharmaceuticals, Inc.10.2922H
              
              Supply
      Agreement, dated as of February 15, 2007, by and between the Company and
      Inspire Pharmaceuticals, Inc.10.3022HH
              
              Change
      in Control Agreement for S. Kumar Chandrasekaran adopted by InSite Vision
      Incorporated on May 2, 2007.10.3123
              
              Purchase
      and Sale Agreement, dated as of February 21, 2008, by and between
      Azithromycin Royalty Sub LLC and the Company.10.3223
              
              Note
      Purchase Agreement, dated as of February 21, 2008, by and among
      Azithromycin Royalty Sub LLC, the Company and the purchasers named
      therein.10.3323
              
              Indenture,
      dated as of February 21, 2008, by and between Azithromycin Royalty Sub LLC
      and U.S. Bank National Association.10.3423
              
              Pledge
      and Security Agreement made by the Company to U.S. Bank National
      Association, as Trustee, dated February 21, 2008.10.3523
              
              Residual
      License Agreement by and between Azithromycin Royalty Sub LLC and the
      Company dated February 21, 2008.10.3624
              
              InSite
      Vision Incorporated Annual Bonus Plan.22.1
              
              List
      of Subsidiaries.23.1
              
              Consent
      of Burr, Pilger & Mayer LLP, Independent Registered Public Accounting
      Firm.24.1
              
              Reference
      is hereby made to the Power of Attorney included on the signature page to
      this Annual Report on Form 10-K.31.1
              
              Certification
      of Principal Executive Officer and Principal Financial Officer pursuant to
      Rules 13a-14(a) and 15d-14(a) promulgated under the Securities Exchange
      Act of 1934, as amended.


64





Number
            
            Exhibit Table32.1
            
            Certification
      of Principal Executive Officer and Principal 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 exhibits in the Company's Annual Report on Form 10-K for
      the year ended December 31, 1993.




2.
              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.




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 to the Company’s Registration Statement on Form
      S-3 (file Number 333-126084) as filed with the Securities and Exchange
      Commission on June 23, 2005.




5.
            Incorporated
      by reference to an exhibit in the Company’s Annual Report on Form 10-K for
      the year ended December 31, 2006.




6.
            Incorporated
      by reference to an exhibit to the Company’s Quarterly Report on Form 10-Q
      for the quarter ended September 30,
2006.




7.
            Incorporated
      by reference to an exhibit in the Company's Quarterly Report on Form 10-Q
      for the quarter ended June 30,
2006.




8.
            Incorporated
      by reference to an exhibit in the Company's Current Report on Form 8-K
      filed with the Securities and Exchange Commission on October 19,
      2007.




9.
            Incorporated
      by reference to exhibits to 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.




10.
            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.




11.
            Incorporated
      by reference to an exhibit in the Company's Annual Report on Form 10-K for
      the year ended December 31,
1993.




12.
            Incorporated
      by reference to an exhibit to 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.




13.
            Incorporated
      by reference to an exhibit to the Company's Annual Report on Form 10-K for
      the year ended December 31, 1996.




14.
            Incorporated
      by reference to an exhibit to the Company's Quarterly Report on Form 10-Q
      for the quarter ended June 30,
1996.




15.
            Incorporated
      by reference to an exhibit to the Company’s Quarterly Report on Form 10-Q
      for the quarter ended September 30,
2001.


65




16.
            Incorporated
      by reference to an exhibit to the Company’s Annual Report of Form 10-K for
      the year ended December 31, 2001.




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 January 14,
      2004.




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 March 29,
      2004.




19.
            Incorporated
      by reference to an exhibit to the Company’s Current Report on Form 8-K
      filed with the Securities and Exchange Commission on October 11, 2005
      (File Number 001-14207).




20.
            Incorporated
      by reference to an exhibit to the Company’s Registration Statement on Form
      S-3 filed with the Securities and Exchange Commission on February 10, 2006
      (File Number 333-131774).




21.
            Incorporated
      by reference to an exhibit to the Company’s Registration Statement on Form
      S-3 filed with the Securities and Exchange Commission on October 13, 2006
      (File Number 333-137994).




22.
            Incorporated
      by reference to an exhibit to the Company’s Quarterly Report on Form 10-Q
      for the quarter ended March 31,
2007.




23.
            Incorporated
      by reference to an exhibit to the Company’s Quarterly Report on Form 10-Q
      for the quarter ended March 31,
2008.




24.
            Incorporated
      by reference to an exhibit to the Company’s Quarterly Report on Form 10-Q
      for the quarter ended June 30,
2008.




H
            Confidential
      treatment has been granted with respect to certain portions of this
      agreement.


HH           Management
contract or compensatory plan.


66