**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 1934




For
                the fiscal year ended December 31, 2007ORo
            
            TRANSITION
                REPORT PURSUANT TO SECTION 13 OR 15(d) OF THESECURITIES
                EXCHANGE ACT OF 1934





Commission
      file number: 0-22332





**INSITE
      VISION INCORPORATED**


(Exact
      name of registrant as specified in its charter)




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





**(510)-865-8800**


(Registrant’s
      telephone number, including area code)




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




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




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





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





Indicate
      by check mark if the registrant is not required to file reports pursuant to
      Section 13 or Section 15(d) of the Exchange Act. Yes oNo
x




Indicate
      by check mark whether the registrant (1) has filed all reports required to
      be
      filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
      the
      preceding 12 months (or for such shorter period that the registrant was required
      to file such reports), and (2) has been subject to such filing requirements
      for
      the past 90 days.        Yes
x    No
o





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





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 o     Accelerated
      filer x


Non-accelerated
      filer o  Smaller
      reporting company o





Indicate
      by check mark whether the registrant is a shell company (as defined in Rule
      12b-2 of the Exchange Act).   Yes
oNo
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, 2007 was approximately
      $109,145,151 (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 14, 2008:
      94,585,449.




**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 proxy statement (the “Proxy Statement”) to be mailed to
      stockholders in connection with the solicitations of proxies for the
      Registrant’s 2008 annual meeting of stockholders are incorporated herein by
      reference in Part III of this Annual Report on Form 10-K to the extent stated
      herein.










**ANNUAL
      REPORT ON FORM 10-K**


**FOR
      THE FISCAL YEAR ENDED DECEMBER 31, 2007**





**TABLE
      OF CONTENTS**




PagePART
                  IItem
                  1.Business
              
              
              1Item
                  1A.Risk
                  Factors
              
              
              14Item
                  1B.Unresolved
                  Staff Comments
              
              
              26Item
                  2.Properties
              
              
              26Item
                  3.Legal
                  Proceedings
              
              
              26Item
                  4.Submission
                  of Matters to a Vote of Security Holders
              
              
              26PART
                  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
              
              
              39Item
                  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
              
              
              61PART
                  IIIItem
                  10.Directors,
                  Executive Officers and Corporate Governance
              
              
              61Item
                  11.Executive
                  Compensation
              
              
              61Item
                  12.Security
                  Ownership of Certain Beneficial Owners and Management and Related
                  Stockholder Matters
              
              
              62Item
                  13.Certain
                  Relationships and Related Transactions, and Director
                  Independence
              
              
              62Item
                  14.Principal
                  Accountant Fees and Services
              
              
              62PART
                  IVItem
                  15.Exhibits,
                  and Financial Statement Schedules
              
              
              62Signatures
              
              
              63





*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**





Historically
      we have been an ophthalmic product development company focused on ophthalmic
      pharmaceutical products based on our proprietary DuraSite® drug delivery
      technology. Beginning in 2007, we have expanded beyond ophthalmic products
      to
      other topical anti-infectives, including the treatment of ear infections. Our
      intent is to continue to solidify our franchise in ocular anti-infective topical
      therapies as well as extend our anti-infective platform to non-ocular topical
      products.





Our
      DuraSite ® sustained 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 and development and commercial efforts on the
      following topical anti-infective products that formulate the antibiotic
      azithromycin with our DuraSite® drug delivery technology.





·
            AzaSite®(azithromycin ophthalmic solution) 1% (ISV-401), a DuraSite formulation
                of
                azithromycin, was developed to serve as a broad spectrum ocular
                antibiotic; 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.


·
            AzaSite
                PlusTM
                (ISV-502), a DuraSite formulation of azithromycin and a corticosteroid
                is
                under development for ocular inflammation and infection, or
                blepharoconjunctivitis, for which there is no FDA approved indicated
                treatment; we initiated a pivotal Phase 3 trial in December
                2007.


·
            AzaSite
                OticTM (ISV-016), a DuraSite formulation of azithromycin and a
                corticosteroid, is under development for the treatment of bacterial
                infections of the middle ear (otitis media); and is in preclinical
                development.


·
            AzaSite
                XtraTM (ISV-405), a DuraSite formulation with a higher percentage of
                azithromycin, is in preclinical development for the treatment of
                ocular
                infection and is targeted at international
                markets.




*Business
      Strategy* .
      Our
      business strategy is to in-license promising product candidates and technologies
      from academic institutions and other companies and apply our formulation
      expertise to create novel differentiated product opportunities, subsequently
      conduct preclinical and clinical testing, and partner with pharmaceutical
      companies in the late stages of clinical trials to manufacture, market and
      sell
      our products. For select opportunities, we may manufacture, market or sell
      our
      own products.




We
      have
      also internally developed DuraSite-based product candidates using either
      non-proprietary drugs or compounds developed by others for non-ophthalmic
      indications. Currently we are leveraging our success with the
      DuraSite-technology product platform to develop additional ocular and non-ocular
      topical anti-infective products. As with in-licensed product candidates, we
      either have partnered, or generally plan to partner, with pharmaceutical
      companies to complete clinical development and commercialization of our own
      product candidates.





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




1




**Recent
      Event**





On
      February 21, 2008, our wholly owned subsidiary, Azithromycin Royalty Sub LLC,
      or
      our subsidiary, closed a private placement of $60 million in aggregate principal
      amount of promissory notes, or the Notes, to institutional investors. The Notes
      are secured by royalties to be paid from sales of AzaSite in the United States
      and Canada and by a pledge by us of the stock of our subsidiary. All interest
      and principal payments on the Notes will be made solely from royalties and
      other
      payments payable under the license agreement with Inspire Pharmaceuticals,
      Inc.,
      or Inspire, all of which have been transferred to our subsidiary. The Notes
      are non-recourse and non-convertible and have not been guaranteed by us. Our
      subsidiary will receive all royalties on the sales of AzaSite until the Notes
      have been repaid in full; therefore, future royalties, until the Notes are
      fully
      paid, will not be available to fund our operations.





The
      Notes
      bear interest at 16% per annum payable quarterly beginning May 15, 2008. AzaSite
      royalties received for any quarter that exceed the interest payments and
      expenses due for that quarter, will be applied to the repayment of principal
      of
      the Notes until the Notes have been paid in full. Any portion of the principal
      amount of the Notes not repaid on or before the legal final maturity date of
      May
      15, 2019, will be payable on that date. In addition, the Notes may be redeemed
      at our option on any quarterly payment date, subject to the payment of a
      redemption premium if repaid on or before February 15, 2012. After February
      15,
      2012, the Notes may be redeemed without premium. Once the Notes are repaid
      in
      full, our subsidiary will retain all future royalty and other payments due
      under
      the license agreement with Inspire.





Net
      proceeds to us from the financing were slightly over $50 million after deducting
      transaction costs and $5 million placed into an Interest Reserve Account. If
      the
      AzaSite royalties received for any quarter is not sufficient to pay all of
      the
      interest due on the Notes on or prior to February 15, 2010, the Trustee will
      withdraw funds equal to such insufficiency from the Interest Reserve Account.
      Any amount that remains in the Interest Reserve Account after February 15,
      2010
      will be applied to the repayment of principal of the Notes.





**Ophthalmic
      Anti-Infective Market**





We
      have
      concentrated most recently on the need for differentiated topical
      anti-infectives. In the ocular market we have concentrated on eye and eye-lid
      infections. Today, eye infections are treated with antibiotics as well as
      antibiotic/corticosteroid combination products. This ocular anti-infective
      market represented global sales of $1.5 billion in 2006 according to Navigant
      Consulting IMS-based data. The market is comprised of two separate product
      segments:





·
            Ocular
                antibiotic products


·
            Ocular
                antibiotic/corticosteroid combination
                products





Some
      of
      these infections are either under-treated or do not have an FDA-approved product
      specific to their 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 can be
      applied:




·
            *Acute
                bacterial conjunctivitis*(pink eye) is a common condition experienced by most people at some
                point
                in their lives, but especially prevalent among children. As it is
                contagious, immediate treatment is recommended. 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. AzaSite is targeted at treating
                this contagious disease with significantly lower dosing and a lowered
                probability of bacterial resistance due to high tissue
                concentration.


·
            *Eye-lid
                infections*.


·
            *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.




2




·
            *Blepharoconjunctivitis*occurs
                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 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, AzaSite Plus, is targeted at this unmet need by treating
                both the
                infection and inflammation.




**Otic
      Anti-Infective Market**





Direct
      application of a topical anti-infective to the site of an infection will be
      an
      improvement over systemic dosing if an appropriate biocompatible vehicle can
      deliver high concentrations of drug to infected sites and sustain the release
      of
      the antibiotic to minimize dosing frequency. Therefore we are expanding our
      azithromycin-DuraSite platform outside of ocular anti-infectives to those
      markets where azithromycin has proven itself as an effective systemic drug
      agent, but a topical azithromycin format has been unavailable.





For
      our
      first opportunity outside of the ocular market space, we are focusing on ear
      infections. According to Hygea Strategies 2007 IMS-based data, the topical
      otological drugs category is valued at approximately $600 million globally,
      with
      the U.S. accounting for 67% of this market.





The
      worldwide otological market is fragmented. Companies engaged in the otic market
      include Alcon Laboratories, Inc., Daiichi Sankyo Co. Ltd., and Monarch
      Pharmaceuticals Inc. In the U.S., Alcon’s Ciprodex, which requires a total of 56
      drops per ear infection therapy, is approximately 9% of the U.S. market and
      neomycin/steroid combination, which requires approximately 200 drops, is
      approximately 18%, while in Japan Daiichi Sankyo’s Floxin, which requires
      approximately 100 drops per therapy, is 29% of the market and in Italy the
      neomycin/steroid combination is more than 60%. Ciprodex and Floxin are not
      yet
      widely approved in international markets.





A
      key
      area where our azithromycin-DuraSite technology can be applied is for acute *otitis
      media* with
      tympanostomy tubes (AOMT). Acute *otitis
      media* is the
      most common type of ear infection and is most often seen in infants and
      children. After multiple recurrent episodes of infection within a year -- or
      fluid in the middle ear that persists for multiple months -- patients often
      have
      tympanostomy tubes temporarily implanted in their eardrums as a method to let
      air in, allowing fluid to drain more easily down the Eustachian tube. The
      duration of tube treatment is generally 6-12 months. Patients with these tubes
      have approximately 1.4 recurrent episodes of infection. In the U.S. 1 in 160
      children under the age of 3 have tympanostomy tubes. 1% of all children under
      the age of 5 have them.





Topical
      antibiotics are used to treat patients with tubes because the medication can
      easily make its way to the site of infection. Topical antibiotics are used
      when
      a patient with tubes is experiencing drainage from the tube or is experiencing
      ear pain due to inflammation. Physicians will often prescribe a systemic
      antibiotic for patients who did not respond to topical treatment alone within
      3-5 days. Severe cases are often treated both topically and systemically as
      a
      first-line defense. According to a study by Navigant Consulting, physicians
      feel
      that a corticosteroid component treats the inflammation associated with more
      severe symptoms more effectively than do antibiotics alone.





By
      using
      both azithromycin for the infection and dexamethasone for inflammation, we
      are
      developing AzaSite Otic to reduce the duration required for treatment, reduce
      the number of required doses and either maintain or increase the effectiveness
      of the topical treatment, much as we did with AzaSite for bacterial
      conjunctivitis.




3





**Products
      and Product Candidates**





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





**Principal
      Products and Product Candidates**


**Active
      Programs**




**Product**
            **Indications**
            **Anticipated
                Benefits**
            **Status****Topical
                Anti-infectives**AzaSite
              (ISV-401)
            Bacterial
                conjunctivitis (pink eye)
            Broad
                spectrum antibiotic with reduced dosing frequency
            *Approved
                and launched in US
              *NDS
                filed in CanadaAzaSite
                Plus
              (ISV-502)
            Blepharoconjunctivitis
            Reduced
                dosing frequency of a broad spectrum antibiotic combined with an
                anti-inflammatory corticosteroid
            *Pivotal
                Phase 3 trial initiatedAzaSite
                Otic
              (ISV-016)
            Ear
                infections
            Reduced
                dosing frequency of a broad spectrum antibiotic combined with an
                anti-inflammatory corticosteroid
            PreclinicalAzaSite
                Xtra
              (ISV-405)
            Eye
                infections
            Broad
                spectrum antibiotic with reduced dosing frequency for use outside
                of North
                America
            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 7-day dosing using our proprietary DuraSite technology.
      The eye drop is designed to enable superior bactericidal activity against common
      ocular pathogens and 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
      resulting in a wide spectrum of activity. Clinical studies have shown that
      AzaSite is well tolerated and efficacious.





In
      August
      2007, Inspire commercially launched AzaSite (azithromycin
      ophthalmic solution) 1% in
      the
      United States pursuant to their license of AzaSite from InSite and approval
      from
      the U.S. Food and Drug Administration, or FDA, in April 2007.





In
      the
      United States, the marketing emphasis, through our partner Inspire, will focus
      on pediatricians, general practitioners, optometrists, and ophthalmologists.
      Pediatricians and general practice physicians write more than 65% of
      prescriptions for ophthalmic antibiotics. AzaSite is positioned to compete
      favorably with the newer 4 th generation fluoroquinolones for antibacterial coverage. Further, AzaSite
      possesses the advantage of reduced dosing frequency that we believe may increase
      patient compliance and reduce the likelihood of the development of bacterial
      resistance.




4





*AzaSite
      Plus (ISV-502)*  *in
      Phase 3 Trials for Blepharoconjunctivitis*





Our
      first
      expansion of our product candidate AzaSite into a larger franchise is the
      development of a combination of AzaSite with an anti-inflammatory corticosteroid
      (dexamethasone) for the treatment of 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, or 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 AzaSite Plus was well tolerated. 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 AzaSite Plus 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. 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 Phase 3 trials.





In
      December 2007, we initiated the first of two pivotal Phase 3 trials to evaluate
      AzaSite Plus for the treatment of blepharoconjunctivitis. The
      Phase
      3 trials will test a total of approximately 900 patients. The dosing regimen
      consists of one drop in the eye and one on the eyelid, two times a day for
      14
      days. There are three treatment arms with the objective that AzaSite Plus will
      show superiority in treating blepharoconjunctivitis over AzaSite and superiority
      over dexamethasone. The end points required for product approval include lid
      margin redness, lid swelling, conjunctival redness, ocular discharge, and
      discomfort symptoms.





*AzaSite
      Otic (ISV-016): Pre-Clinical Development for Ear Infections*





We
      are in
      the early stages of developing AzaSite Otic for ear infections.  The
      primary indication is for acute otitis media with tympanostomy tubes
      (AOMT).  AzaSite Otic combines both azithromycin and dexamethasone
      formulated with DuraSite to provide less frequent dosing while maintaining
      at
      least equivalent efficacy.





*AzaSite
      Xtra (ISV-405): Pre-clinical Development for Ocular Infections in International
      Markets*





We
      are in
      the early stages of developing AzaSite Xtra which is a product candidate with
      a
      higher percentage of azithromycin (2%) as part of the formulation than with
      AzaSite (1%). AzaSite Xtra is being developed primarily to address markets
      outside of the United States.





**DuraSite
      Sustained Delivery Technology**





At
      the
      core of our product development program is our DuraSite drug delivery
      technology. Our DuraSite sustained 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 plus proven drug products results in differentiated
      products that have increased efficacy and improved compliance through 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.





*Physical
      Properties.* DuraSite
      is composed of a cross linked polyacrylic acid polymer, water and salts. We
      have
      developed considerable know-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 3x10 7 Daltons.
      Upon the addition of water, DuraSite swells to ~100x its original
      weight.





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.




5





*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.





**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 our key agreements.





*Shin
      Poong Pharm Co., Ltd* .
      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 granted exclusive rights to Shin Poong to commercialize
      AzaSite for ocular bacterial infection in South Korea. Shin Poong will also
      be
      responsible for securing approval of AzaSite in South Korea. In exchange, Shin
      Poong will pay InSite upfront and regulatory milestone payments as well as
      double-digit royalties on net sales of AzaSite in South Korea, if approved
      by
      regulatory authorities. InSite Vision will be responsible for providing
      manufactured products to Shin Poong at cost.





*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 AzaSite Plus. Under the Pfizer License, we are required
      to
      pay Pfizer a single digit royalty based on net sales of the licensed products
      and to use reasonable commercial efforts to seek regulatory approval for and
      market licensed products. We have the right to grant sublicenses, subject to
      Pfizer’s prior approval which shall not be unreasonably withheld.





*Inspire
      Pharmaceuticals, Inc.* In
      February 2007, we entered into a license agreement, or the Inspire License,
      with
      Inspire under which we licensed to Inspire 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 its 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,
      to Inspire. We are also responsible for obtaining regulatory approval of AzaSite
      in Canada. On November 30, 2007, we filed a New Drug Submission (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 countries.




6





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
      materials 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.





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
      is
      until 2012, subject to customary termination provisions, such as termination
      for
      material breach. Either party may terminate the Supply Agreement upon 180 days
      notice to the other party. In addition, Inspire may 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.





*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. The AzaSite NDA 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
      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.




7





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. Additionally, we
      assist University of California Regents in filing patent applications seeking
      to
      protect inventions that are the subject of our agreements with that institution.
      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, seven U.S. patents have been issued. Of the patent applications
      we
      have licensed from the UC Regents, twelve U.S. patents have been issued. We
      have
      four U.S. patents on our retinal drug delivery device that have been issued.
      Three U.S. patents have been issued related to our antibiotic programs with
      four
      applications pending. Several other patent applications by us and by the UC
      Regents, relating to the foregoing and other aspects of our business and
      potential business are also pending. Foreign counterparts of our patents as
      well
      as those we have licensed from others have been filed in many
      countries.





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





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





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





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




8




**Research
      and Development**





On
      December 31, 2007, our research and development staff numbered 32 people, of
      whom 6 have Ph.D.s. Our research and development expenses for the years ended
      December 31, 2007, 2006 and 2005 were:





R&D
      Cost by Program


(in
      millions)





**Program**
            
            **2007**
            
            **2006**
            
            **2005**AzaSite
            
            $
            2.7
            
            $
            6.1
            
            $
            10.4AzaSite
                Plus
            
            
            6.0
            
            
            2.7
            
            
            0.1AzaSite
                Otic
            
            
            1.3
            
            
            -
            
            
            -AzaSite
                Xtra
            
            
            0.4
            
            
            -
            
            
            -Other
            
            
            -
            
            
            0.1
            
            
            0.2Total
            
            $
            10.4
            
            $
            8.9
            
            $
            10.7





In
      2007,
      our AzaSite program activities included producing registration batches at our
      contract manufacturing site and assembling and filing the application for
      regulatory approval in Canada. Our activities related to the AzaSite Plus
      program focused on 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 clinical trial. Our
      activities related to the AzaSite Otic program mainly consisted of preclinical
      testing to support filing of an IND. Our AzaSite Xtra activities mainly related
      to preclinical experiments.





In
      2006,
      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. Our AzaSite
      Plus activities mainly focused on preclinical testing, preparation of an IND
      and
      initiation of Phase 1 clinical trails.





In
      2005,
      our AzaSite activities were mainly focused on the conduct of our Phase 3
      clinical trials and preparation of other portions of the NDA we filed in 2006
      after the completion of the trials.





Although
      the majority of our personnel were focused on our AzaSite and AzaSite Plus
      programs in 2007, due to our limited personnel and the number of projects that
      we are developing including our AzaSite Otic program, our personnel are involved
      in a number of projects at the same time. Accordingly, the majority of our
      R&D expenses are not linked to a specific project but are allocated across
      projects, based on personnel time expended on each project. Accordingly, the
      allocated costs may not reflect the actual costs of each project.




**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.




9





**Marketing
      and Sales**





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





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





Our
      current 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 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. Shin Poong will also be
      responsible for securing approval of AzaSite in South Korea. In exchange, Shin
      Poong will pay InSite upfront and regulatory milestone payments as well as
      a
      double-digit royalty on net sales of AzaSite in South Korea, if approved by
      regulatory authorities. InSite Vision will be responsible for providing
      manufactured products.





*Inspire.* 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.




**Competition**





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





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





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





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 Inc. While there are many other large- and
      medium-sized companies participating in the ophthalmic market, it continues
      to
      be very difficult for smaller companies such as our own to successfully develop
      and market products without entering into effective collaborations with our
      direct competitors.




10





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





The
      worldwide otological market is fragmented. Companies engaged in the otic market
      include Alcon, Daiichi Sankyo, and Monarch. In the U.S., Alcon’s Ciprodex, which
      requires a total of 56 drops per therapy, is approximately 9% of the U.S. market
      and neomycin/steroid combination, which requires approximately 200 drops, is
      approximately 18%, while in Japan Daiichi Sankyo’s Floxin, which requires
      approximately 100 drops per therapy, is 29% of the market and in Italy the
      neomycin/steroid combination is more than 60%. Ciprodex and Floxin are not
      yet
      widely approved in international markets.





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


·
            submission
                to the FDA of an IND;


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


·
            the
                submission of an NDA or 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 SchoolChandler
                  R. Dawson, M.D.
              
              Emeritus
                  Professor, Department of Ophthalmology, University of California,
                  San
                  FranciscoEric
                  D. Donnenfeld, M.D.
              
              Founding
                  partner of Ophthalmic Consultants of Long Island and Connecticut;
                  Co-
                  Chairman of Cornea and External Disease at Nassau University Medical
                  Center and Surgical Director of the Lions Eye Bank for Long
                  Island.Syd
                  Gilman, Ph.D.
              
              Partner,
                  Trident Rx Consultant ServiceEdward
                  J. Holland, M.D.
              
              Director,
                  Cornea Services at the Cincinnati Eye Institute and Professor of
                  Ophthalmology at the University of Cincinnati; Member of the Board
                  of
                  Trustees for the American Academy of Ophthalmology.Ping
                  H. Hsu, Ph.D.
              
              Consultant,
                  BiostatisticsDavid
                  G. Hwang, M.D.
              
              Professor
                  of Clinical Ophthalmology, Co-Director, Cornea and Refractive Surgery
                  Service, University of California, San Francisco School of
                  MedicineHenrick
                  K. Kulmala, Ph.D.
              
              Consultant,
                  Pharmaceutical DevelopmentMichael
                  Marmor, M.D.
              
              Professor,
                  Department of Ophthalmology, Stanford University School of
                  MedicinePeter
                  Roland, M.D.
              
              Professor
                  and Chairman, Otolaryngology-Head and Neck Surgery, Professor Neurological
                  Surgery, Chief of Pediatric Otology, UT Southwestern Medical
                  CenterJames
                  G. Shook, Ph.D.
              
              President,
                  Jim Shook Research, Inc.Kerry
                  D. Solomon, M.D.
              
              Professor
                  of Ophthalmology at the Medical University of South Carolina (MUSC);
                  at
                  MUSC:
                  Director of the Cataract, Refractive and Cornea Services at Storm
                  Eye
                  Institute; Medical Director of the Magill Laser Center for Vision
                  Correction; and Director of the Magill Research
                  Center




**Employees**





As
      of
      December 31, 2007, we had 45 employees, 43 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.




13





**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.
      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 an NDA. Successful development
      of
      pharmaceutical products is highly uncertain. Products that appear promising
      in
      research or development, including AzaSite Plus, 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
                or
                competition 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;




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


·
              competitors
                  may promote their products to a greater extent or more effectively
                  than
                  ours are promoted.


Therefore,
      our research and development activities, including AzaSite Plus, 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
      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
      have
      begun our first Phase 3 clinical trial for our AzaSite Plus 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 AzaSite Plus and any other
      product candidates may take over a year to complete. Furthermore, we could
      encounter problems that 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;




14




·
            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.




***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 AzaSite
      Plus. 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;




·
            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.




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.




15




***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 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 our 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 current Phase 3 trial for AzaSite Plus, 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 and use our products***




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




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




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




·
            perceived
                benefits of competing products or
                treatments;




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




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




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




16




***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, thatwe 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
      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.




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




17




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 “Business-Recent Events” and Note 12 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 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;




·
            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;




18




·
            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 to select eye care professionals, pediatricians and primary
      care providers. However, Inspire has no prior experience calling on
      pediatricians and primary care physicians. 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 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.




19





***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 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.




20




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




We
      are
      highly dependent on Dr. S. Kumar Chandrasekaran, who is our chief
      executive officer and president, and Dr. Lyle Bowman, our vice president,
      development and operations. The loss of services from either of these key
      individuals might significantly delay or prevent the achievement of planned
      development objectives. We carry a $1.0 million life insurance policy on
      Dr. Chandrasekaran under which we are the sole beneficiary, however in the
      event of the death of Dr. Chandrasekaran such policy would be unlikely to
      fully compensate us for the hardship and expense in finding a successor. We
      do
      not carry a life insurance policy on Dr. Bowman. Furthermore, 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 our past reductions in force.
      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 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.”




21




***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 new drug
      application. 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 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.




22




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 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 approximately $13,400 and $11,800 for the years ended 2007 and 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.




23




***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, 2007, 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, 2007. 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, 2007. As a result, these two groups of stockholders, acting
      together or as individual groups, may be able to exert significant control
      on
      matters requiring approval by our stockholders, including the election of all
      or
      at least a majority of our Board of Directors, amendments to our charter, and
      the approval of business combinations and certain financing
      transactions.




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




The
      market prices for securities of biopharmaceutical and biotechnology companies,
      including ours, have been highly volatile. The market has from time to time
      experienced significant price and volume fluctuations that are unrelated to
      the
      operating performance of particular companies. In addition, future announcements
      and circumstances, 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
      fourth quarter of fiscal 2007 our closing stock price fluctuated from a high
      of
      $1.32 to a low of $0.69. 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.




24




***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 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 or the
      necessity of reclassifying current assets.  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.




25




**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.





**Item
      3. Legal Proceedings**





None





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





On
      October 15, 2007, we held our Annual Meeting of Stockholders at which the
      stockholders approved:





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


For
                  Election
              
              WithheldS.
                  Kumar Chandrasekaran, Ph.D.
              
              
              57,460,817
              
              
              9,927504Mitchell
                  H. Friedlaender, M.D.
              
              
              58,396,307
              
              
              8,992,014John
                  L. Mattana
              
              
              57,021,350
              
              
              10,366,971Jon
                  S. Saxe
              
              
              58,183,582
              
              
              9,204,739Anders
                  P. Wiklund
              
              
              57,721,204
              
              
              9,667,117





(2)  Adoption
      of 2007 Performance Incentive Plan, or the 2007 Plan. Our stockholders voted
      to
      approve the proposed adoption of the 2007 Plan. The 2007 Plan provides for
      grants of stock options and other equity-based awards to employees and
      consultants that provide services to us and our subsidiaries and to our
      non-employee directors. No increase was made to the total number of shares
      of
      common stock available for issuance under the 2007 Plan. Such proposal received
      16,284,261 votes for the 2007 Plan, 8,206,171 votes against the 2007 Plan,
      91,547 votes abstaining, and 42,806,342 broker non-votes.





(3)
      Adoption of the Amended and Restated 1994 Employee Stock Purchase Plan, or
      the
      Purchase Plan. The amendments extended the term of the Purchase Plan until
      August 8, 2017 and made various other changes to conform the Purchase Plan
      with
      current market practice. The Purchase Plan provides eligible employees with
      an
      opportunity to acquire shares of our common stock on a periodic basis by means
      of payroll deductions. No increase was made to the total number of shares of
      common stock available for issuance under the Purchase Plan. Such proposal
      received 19,050,970 votes for the Purchase Plan, 5,302,532 votes against the
      Purchase Plan, 228,477 votes abstaining, and 42,806,342 broker
      non-votes.




(4)
      The
      ratification of our audit committee’s appointment of Burr, Pilger & Mayer
      LLP as our independent public accountants for the fiscal year ending December
      31, 2007. Such proposal received 65,885,872 votes for ratification, 1,045,632
      votes against ratification and 456,817 abstentions.




26




**Executive
      Officers of the Company**





As
      of
      March 14, 2008, our executive officers were as follows:


**Name**
              
              **Age**
              
              **Title**S.
                  Kumar Chandrasekaran, Ph.D.
              
              65
              
              Chairman
                  of the Board, President, and Chief Executive OfficerLyle
                  M. Bowman, Ph.D.
              
              59
              
              Vice
                  President, Development and OperationsLouis
                  Drapeau
              
              64
              
              Vice
                  President and Chief Financial OfficerKamran
                  Hosseini, M.D., Ph.D.
              
              43
              
              Vice
                  President, Clinical Affairs and Chief MedicalOfficerDavid
                  F. Heniges
              
              64
              
              Vice
                  President and General Manager, CommercialOpportunitiesSandra
                  C. Heine
              
              46
              
              Vice
                  President, Finance and
                  Administration





S.
      Kumar
      Chandrasekaran joined us in September 1987 as Vice President, Development.
      From
      1988 to 1989, Dr. Chandrasekaran served as Vice President, Research and
      Development. From 1989 to 1993, he served as President and Chief Operating
      Officer. Since August 1993, Dr. Chandrasekaran has served as Chairman of
      the Board of Directors, President and Chief Executive Officer from January
      1999
      to October 2007, he also served as Chief Financial Officer.
      Dr. Chandrasekaran holds a Ph.D. in Chemical Engineering from the
      University of California, Berkeley.





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





Louis
      Drapeau joined us on October 1, 2007 as Vice President and Chief Financial
      Officer. 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.





Kamran
      Hosseini joined us on February 11, 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 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.




David
      Heniges joined us in July 2002 as Vice President and General Manager, Commercial
      Opportunities. From 1998 to 2001, Mr. Heniges served as General
      Manager-Europe/Africa/Middle East for Kera Vision, Inc., a manufacturer of
      implantable ophthalmic devices and equipment. From 1996 to 1998 he was Vice
      President, Global Marketing for the cardiovascular group at Baxter Healthcare
      Corporation. From 1982 to 1995 he served in various managerial positions,
      including Director, Product Management and International Marketing, Vice
      President, Marketing, and Vice President, Worldwide Business Development, at
      IOLAB Corporation, a Johnson & Johnson company, which manufactured
      ophthalmic devices, equipment and pharmaceuticals. Mr. Heniges spent 23 years
      in
      total with Johnson and Johnson in various sales, marketing, and business
      development positions. Mr. Heniges holds a B.S. in Sociology with a minor in
      science from Oregon State University.




27





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





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.





**PART
      II**





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





**Market
      Information**





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




**2007**
              
              **High**
              
              **Low**First
                  Quarter
              
              1.73
              
              1.42Second
                  Quarter
              
              1.79
              
              1.42Third
                  Quarter
              
              1.49
              
              1.04Fourth
                  Quarter
              
              1.32
              
              0.69**2006**
              
              **High**
              
              **Low**First
                  Quarter
              
              2.17
              
              0.90Second
                  Quarter
              
              2.69
              
              1.53Third
                  Quarter
              
              1.90
              
              1.26Fourth
                  Quarter
              
              1.88
              
              1.27
  **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**





For
      information regarding securities authorized for issuance under our equity
      compensation plans, please see Note 9 in the Notes to the Consolidated
      Financial Statements contained in this Annual Report on Form 10-K.





As
      of
      March 12, 2008, we had approximately 210 stockholders of record of our Common
      Stock. On March 12, 2008, the last sale price reported on The American Stock
      Exchange for our common stock was $0.65 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, 2002 through December
      31, 2007 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, 2002 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
                BIOTECH12/31/02
            
            
            100
            
            
            100
            
            
            10012/31/03
            
            
            80
            
            
            142
            
            
            17512/31/04
            
            
            124
            
            
            174
            
            
            14012/31/05
            
            
            117
            
            
            213
            
            
            17512/31/06
            
            
            218
            
            
            249
            
            
            19412/31/07
            
            
            106
            
            
            292
            
            
            202





*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. The following
      table sets forth selected consolidated financial data for us for the five years
      ended December 31, 2007 (in thousands except per share amounts):


**Year Ended December 31,**(in thousands, except per share data)
              
              **2007**
              
              **2006**
              
              **2005**
              
              **2004**
              
              **2003****Consolidated
                  Statements of Operations Data**Revenues
              
              $
              23,761
              
              $
              2
              
              $
              4
              
              $
              542
              
              $
              134Cost
                  of revenues
              
              
              982
              
              
              28
              
              
              14
              
              
              14
              
              
              20Operating
                  expenses:Research
                  and development
              
              
              10,384
              
              
              8,890
              
              
              10,690
              
              
              6,788
              
              
              4,007General
                  and administrative
              
              
              6,760
              
              
              6,182
              
              
              4,510
              
              
              3,826
              
              
              3,450Total
                  expenses
              
              
              17,144
              
              
              15,072
              
              
              15,200
              
              
              10,614
              
              
              7,457Gain
                  on sale of assets
              
              
              -
              
              
              -
              
              
              -
              
              
              4,616
              
              
              1,153Interest
                  (expense) and other income, net
              
              
              (100
              )
              
              (1,513
              )
              
              (5
              )
              
              (44
              )
              
              (561
              )Net
                  income (loss)
              
              
              5,535
              
              
              (16,611
              )
              
              (15,215
              )
              
              (5,514
              )
              
              (6,751
              )Non
                  cash preferred dividend
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              221Net
                  income (loss) applicable to common stockholders
              
              $
              5,535
              
              $
              (16,611
              )
              $
              (15,215
              )
              $
              (5,514
              )
              $
              (6,972
              )Net
                  income (loss) per share:Earnings
                  (loss) per share - basic
              
              $
              0.06
              
              $
              (0.19
              )
              $
              (0.21
              )
              $
              (0.11
              )
              $
              (0.27
              )Earnings
                  (loss) per share - diluted
              
              $
              0.06
              
              $
              (0.19
              )
              $
              (0.21
              )
              $
              (0.11
              )
              $
              (0.27
              )Weighted
                  average shares used in per-share calculation:-
                  basic
              
              
              94,168
              
              
              88,339
              
              
              72,647
              
              
              47,984
              
              
              25,767-
                  diluted
              
              
              100,110
              
              
              88,339
              
              
              72,647
              
              
              47,984
              
              
              25,767
 **As
                    of December 31,**(in thousands)
                
                **2007**
                
                **2006**
                
                **2005**
                
                **2004**
                
                **2003****Consolidated
                    Balance Sheet Data:**Cash
                    and cash equivalents
                
                $
                11,532
                
                $
                986
                
                $
                4,027
                
                $
                5,351
                
                $
                1,045Working
                    capital, exclusive of deferred revenue
                
                
                9,589
                
                
                (6,836
                )
                
                (3,424
                )
                
                3,515
                
                
                (6,434
                )Total
                    assets
                
                
                15,012
                
                
                2,439
                
                
                5,079
                
                
                5,696
                
                
                1,405Long-term
                    Notes Payable
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                16Accumulated
                    deficit
                
                
                (147,527
                )
                
                (153,062
                )
                
                (136,451
                )
                
                (121,236
                )
                
                (115,722
                )Total
                    stockholders’ equity (deficit)
                
                $
                746
                
                $
                (6,302
                )
                $
                (2,545
                )
                $
                3,601
                
                $
                (6,200
                )


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**





Historically
      we have been an ophthalmic product development company focused on ophthalmic
      pharmaceutical products based on our proprietary DuraSite® drug delivery
      technology. Beginning in 2007, we have expanded beyond ophthalmic products
      to
      other topical anti-infectives, including the treatment of ear infections. Our
      intent is to continue to solidify our franchise in ocular anti-infective topical
      therapies as well as extend our anti-infective platform to non-ocular topical
      products.





Our
      DuraSite ® sustained 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 and development and commercial efforts on the
      following topical anti-infective products that formulate the antibiotic
      azithromycin with our DuraSite® drug delivery technology.





·
            AzaSite®(azithromycin ophthalmic solution) 1% (ISV-401), a DuraSite formulation of
                azithromycin, was developed to serve as a broad spectrum ocular
                antibiotic; 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.


·
            AzaSite
                PlusTM (ISV-502), a DuraSite formulation of azithromycin and a
                corticosteroid is under development for ocular inflammation and infection,
                or blepharoconjunctivitis, for which there is no FDA approved indicated
                treatment; we initiated a pivotal Phase 3 trial in December
                2007.


·
            AzaSite
                OticTM (ISV-016), a DuraSite formulation of azithromycin and a
                corticosteroid, is under development for the treatment of bacterial
                infections of the middle ear (otitis media); and is in preclinical
                development.


·
            AzaSite
                XtraTM (ISV-405), a DuraSite formulation with a higher percentage of
                azithromycin, is in preclinical development for the treatment of
                ocular
                infection and is targeted at international
                markets.





**Major
      Developments in 2007**





In
      2007
      our primary developments were related to our AzaSite product and
      included:





·
            receipt
                of $13.0 million from Inspire upon the February 15, 2007 licensing
                to
                Inspire of the manufacturing, sales and marketing and future development
                rights to AzaSite for the United States and
                Canada;


·
            NDA
                approval of AzaSite by the FDA on April 27, 2007, which triggered
                a $19.0
                million milestone payment from Inspire;


·
            launch
                of AzaSite in the United States by Inspire in August 2007 and recognition
                of our first royalties in the third quarter of 2007;
                and


·
            entrance
                into our first international licensing agreement for AzaSite with
                Shin
                Poong in December 2007.





In
      2007
      we also continued our development of several additional product candidates
      that
      incorporate our DuraSite sustained delivery technology and azithromycin,
      including:





·
            successful
                completion of a Phase 1 clinical trial for our AzaSite Plus product
                candidate;


·
            initiation
                of an AzaSite Plus pivotal Phase 3 trial in December 2007;
                and


·
            preclinical
                development activities for the AzaSite Otic product
                candidate.





31


**Business
      Strategy**





Our
      business strategy is to in-license promising product candidates and technologies
      from academic institutions and other companies and apply our formulation
      expertise to create novel differentiated product opportunities, subsequently
      conduct preclinical and clinical testing, and partner with pharmaceutical
      companies in the late stages of clinical trials to manufacture, market and
      sell
      our products. For select opportunities, we may manufacture, market and sell
      our own products.





We
      also
      have internally developed DuraSite-based product candidates using either
      non-proprietary drugs or compounds developed by others for non-ophthalmic
      indications. Currently we are leveraging our success with the
      DuraSite-azithromycin product platform to develop additional ocular and
      non-ocular topical anti-infective products. As with in-licensed product
      candidates, we either have partnered or generally plan to partner with
      pharmaceutical companies to complete clinical development and commercialization
      of our product candidates.





**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.





Revenues
      related to sales of the Ocu G ene
      glaucoma genetic test, were recognized when all related services had been
      rendered and collectibility was reasonably assured. Accordingly, revenues for
      sales of Ocu G ene
      may
      have been recognized in a later period than the associated recognition of costs
      of the services provided, especially during the initial launch of the product.





Inventory .
      Our
      inventories are stated at the lower of cost or market. The cost of the inventory
      is based on the first-in first-out method. If the cost of the inventory exceeds
      the expected market value, a provision is recorded for the difference between
      cost and market.




32





Income
      Taxes.  Effective
      January 1, 2007, we 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. FIN 48 clarifies the accounting for uncertainty in income
      taxes recognized in an enterprise’s financial statements in accordance with
      SFAS No. 109, *Accounting
      for Income Taxes* ,
      or
      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.





We
      have
      generated net losses through the year ended December 31, 2006 and,
      accordingly, did not record a provision for 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. As of December 31, 2007, our
      total deferred tax assets were $54.3 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. In 2007
      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) approved in October 2007. 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 as of
      January 1, 2006 (the effective date). Prior to the effective date, we did
      not recognize any compensation cost in our income statements for stock-based
      awards granted with an option price equal to the fair market value of our common
      stock on the date of grant or employee stock purchase rights as we accounted
      for
      them under the recognition and measurement principles of APB Opinion
      No. 25, “Accounting for Stock Issued to Employees” (APB 25) and its related
      interpretations and adopted the disclosure only provisions of Statement of
      Financial Accounting Standards No. 123, “Stock-Based Compensation” (SFAS
      123).





For
      the
      year ended December 31, 2007, we recognized $1.0 million of compensation
      expense for employee stock options and purchase rights. At December 31,
      2007, we had $1.8 million in unrecognized compensation cost related to employee
      stock options remaining, which is expected to be recognized over a weighted
      average period of 2.3 years.





We
      estimate the fair value of share-based awards on the date of grant using the
      Black-Scholes option-pricing method (Black-Scholes method), which was also
      used
      for the proforma information required to be disclosed under SFAS 123. 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.




33





For
      stock-based awards issued during the year ended December 31, 2007, 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. 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.
      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.





**Results
      of Operations**





*Revenues.*





We
      had
      total revenues of $23.8 million, $2,000, and $4,000 for the years ended December
      31, 2007, 2006 and 2005, respectively. $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 and 2005 were from
      sales of Ocu G ene.





*Cost
      of revenues.*





Our
      cost
      of revenues was $1.0 million, $28,000 and $14,000 for 2007, 2006 and 2005,
      respectively. 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 and 2005 reflected
      the cost of Ocu G ene
      tests
      performed as well as the cost of sample collection kits distributed for use.





*Research
      and development (R & D).*





Our
      R&D activities can be separated into two major segments, research and
      clinical development. Research includes activities involved in evaluating a
      potential product, related 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 2007, 2006 and 2005 (in thousands):


**As
                  of December 31,****2007**
              
              **2006**
              
              **2005**Research
              
              $
              4,372
              
              $
              3,291
              
              $
              2,142Clinical
                  development
              
              
              6,012
              
              
              5,599
              
              
              8,548Total
                  research and development
              
              $
              10,384
              
              $
              8,890
              
              $
              10,690




Research
      and development expenses increased to $10.4 million in 2007 from $8.9 million
      in
      2006. In
      2007
      our activities primarily included production of AzaSite process validation
      batches, expenses related to the AzaSite Canadian NDS filing, AzaSite Plus
      preclinical activities, Phase 1 clinical trial data evaluation, pilot study,
      Phase 3 clinical trial design and initiation and preclinical work on AzaSite
      Otic and AzaSite Xtra. Our R&D personnel costs were higher in 2007 due to
      success bonuses related to the successful FDA approval of AzaSite. In 2006,
      our
      activities had been primarily related to the AzaSite clinical trials,
      preparation of the related NDA and the FDA filing fee.




34





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





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 $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. These increases were partially offset by the decrease in the
      deferred debt issuance costs related to the short-term Senior Secured Notes
      which were repaid in February 2007.





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





*Interest,
      other income (expenses), net.*





Interest
      expense and other income was an expense of $100,000, $1.5 million and $5,000
      in
      2007, 2006 and 2005, respectively. In February 2007, our Senior Secured Notes
      were repaid in full and, correspondingly, interest expense decreased compared
      to
      2006 when these notes were outstanding for the full period. The increased
      expense in 2006 mainly reflects accrued interest payable on our short-term
      Senior Secured Notes issued in December 2005 and January 2006 and the accretion
      of the value of the debt discount related to the warrants issued as part of
      the
      note financing.





Interest
      paid in the future will increase and the amount will be dependent on the
      repayment of the notes issued in February 2008 secured by royalties received
      from Inspire for the sales of AzaSite. Interest earned will be dependent on
      prevailing interest rates and the amount of funds we use for our operating
      activities.




**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. At
      December 31, 2007, our unrestricted cash and cash equivalents were $11.5
      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, 2007, cash provided by operating activities was $17.6
      million, primarily due to $32.0 million of license and milestone payments from
      the February 2007 license of AzaSite to Inspire. For the years ended December
      31, 2006 and 2005, cash used for operating activities was $16.2 million and
      $13.4 million, respectively.




35





Cash
      used
      in investing activities was $1.0 million, $322,000 and $137,000, for 2007,
      2006
      and 2005, respectively, primarily related to cash outlays for additions to
      laboratory and other equipment. ****





Cash
      used
      in financing activities was $6.1 million for the year ended December 31, 2007,
      primarily due to the repayment of short-term notes payable in February 2007.
      Cash provided by financing activities was $13.5 million and $12.2 million for
      the years ending December 31, 2006 and 2005, respectively, principally due
      to
      warrant and option exercises, private placement equity offerings and debt
      issuances.





The
      tables below set forth the amount of cash that we raised for fiscal years 2005
      through 2007 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
                Proceeds**2007
            
            $
            512,0002006
            
            $
            5.8
                million2005
            
            $
            536,000




*Cash
      Received from Private Placements of Equity Securities*





**Date**
            
            **Net
                Proceeds**
            
            **Shares
                of Common Stock Issued**August
                2006
            
            $5.8
                million
            
            4.8
                million plus warrants to purchase 1.0 million sharesMay
                2005
            
            $8.1
                million
            
            16.4
                million plus warrants to purchase 4.9 million
                shares





*Cash
      Received from Private Placement of Notes*





**Date**
            
            **Net
                Proceeds**
            
            **Type
                of Notes**
            
            **Interest
                Rates and Terms**
            
            **Maturity
                Date**January
                2006
            
            $1.8
                million
            
            Short-Term
                Senior Secured Notes
            
            10%
                through July 10, 2006, 12% from July 11, 2006 through February 15,
                2007
            
            February
                15, 2007*December
                2005
            
            $3.8
                million
            
            Short-Term
                Senior Secured Notes
            
            10%
                through June 30, 2006, 12% from July 1, 2006 through February 15,
                207
            
            February
                15, 2007*





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





In
      addition to the above, in 2005 we repaid $73,000 of short-term notes payable
      to
      directors, members of senior management and other stockholders, with interest
      at
      rates from 2% to 12% and which matured on March 31, 2007. We received payments
      on a note from a stockholder of $168,000 and $19,000 in 2006 and 2005,
      respectively.





Our
      future capital expenditures and requirements will depend on numerous factors,
      including the progress of our clinical testing, research and development
      programs and preclinical testing, the time and costs involved in obtaining
      regulatory approvals, our ability to **** successfully
      commercialize AzaSite, AzaSite Plus, OcuGene 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 2008. 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.





See
      -
      Subsequent Event for discussion of our February 21, 2008, issuance of $60.0
      million of notes.




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, 2007 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)Total
              
              Less
                    than
                  1
                    year
              
              1-3
                  years
              
              3-5
                  Years
              
              More
                    than
                  5
                    yearsCapital
                Lease Obligations (1)
              
              $
              58
              
              $
              18
              
              $
              35
              
              $
              5
              
              $
              -Facilities
                Lease Obligations (2)
              
              
              4,728
              
              
              731
              
              
              1,529
              
              
              1,620
              
              
              848Purchase
                obligations (3)
              
              
              11,007
              
              
              8,460
              
              
              2,547
              
              
              -
              
              
              -Licensing
                agreement obligations (4)
              
              
              9,475
              
              
              20
              
              
              2,175
              
              
              4,520
              
              
              2,760Total
                commitments
              
              $
              25,268
              
              $
              9,229
              
              $
              6,286
              
              $
              6,145
              
              $
              3,608




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




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




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




(4)
            We
                have entered into certain license agreements that require us to make
                minimum royalty payments for the life of the licensed patents. The
                life of
                the patents 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.





**Subsequent
      Event**





In
      February 2008, our wholly-owned subsidiary issued $60.0 million
      in aggregate principal amount of non-convertible, non-recourse promissory notes
      due in 2019. The notes are secured by, and will be repaid from, royalties to
      be
      paid to us by Inspire Pharmaceuticals from sales of AzaSite in the United States
      and Canada. The annual cash coupon rate on the notes is 16% with interest
      payable quarterly in arrears beginning May 15, 2008. Net proceeds to InSite
      from
      the financing were slightly over $50.0 million after deducting transaction
      costs
      and setting aside $5.0 million as interest reserves. This interest reserve
      will
      be reflected as restricted cash on our balance sheets commencing March 31,
      2008.





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. The notes
      may
      be redeemed at our option, subject to the payment of a redemption premium
      through May 2012. After that date they may be redeemed without a
      premium.





**Recent
      Accounting Pronouncements**





In
      September 2006, the FASB issued Statement of Financial Accounting Standards
      No. 157, or SFAS No. 157, “Fair Value Measurements.”
SFAS No. 157 provides guidance for using fair value to measure assets
      and liabilities. It also responds to investors’ request for expanded information
      about the extent to which companies measure assets and liabilities at fair
      value, the information used to measure fair value, and the effect of fair valued
      measurements on earnings. SFAS No. 157 applies whenever standards
      require (or permit) assets or liabilities to be measured at fair value, and
      does
      not expand the use of fair value in any new circumstances.
      SFAS No. 157 is effective for financial statements issued for fiscal
      years beginning after November 15, 2007, and interim periods within those
      fiscal years, with early adoption permitted, except for the impact of FASB
      Staff
      Position (FSP) 157-2. FSP 157-2 deferred the adoption of SFAS 157 for non
      financial assets and liabilities until years ended after November 15, 2008.
      The
      Company must adopt these requirements no later than the first quarter of
      2008. We do not anticipate the adoption of SFAS No. 157 will have a
      material effect on our consolidated financial position, results of operations
      or
      liquidity.




37





In
      February 2007, the FASB issued SFAS No. 159, “The Fair Value Option
      for Financial Assets and Financial Liabilities — Including an amendment of
      FASB Statement No. 115,” or SFAS No. 159. SFAS No. 159
      expands the use of fair value accounting but does not affect existing standards
      that require assets or liabilities to be carried at fair value. Under
      SFAS No. 159, a company may elect to use fair value to measure
      accounts and loans receivable, available-for-sale and held-to-maturity
      securities, equity method investments, accounts payable, guarantees and issued
      debt. Other eligible items include firm commitments for financial instruments
      that otherwise would not be recognized at inception and non-cash warranty
      obligations where a warrantor is permitted to pay a third party to provide
      the
      warranty goods or services. If the use of fair value is elected, any upfront
      costs and fees related to the item must be recognized in earnings and cannot
      be
      deferred (e.g., debt issue costs). The fair value election is irrevocable and
      generally made on an instrument-by-instrument basis, even if a company has
      similar instruments that it elects not to measure based on fair value. At the
      adoption date, unrealized gains and losses on existing items for which fair
      value has been elected are reported as a cumulative adjustment to beginning
      retained earnings. Subsequent to the adoption of SFAS No. 159, changes
      in fair value are recognized in earnings. SFAS No. 159 is effective
      for fiscal years beginning after November 15, 2007. We are currently
      determining whether fair value accounting is appropriate for any of our eligible
      items and cannot estimate the impact, if any, that SFAS No. 159 will
      have on our consolidated financial position, results of operations or liquidity.




In
      November 2007, the FASB ratified Issue No. EITF 07-1, “Accounting for
      Collaborative Agreements Related to the Development and Commercialization of
      Intellectual Property,” or EITF Issue No. 07-1. EITF Issue No. 07-1
      defines collaborative agreements as a contractual arrangement in which the
      parties are active participants to the arrangement and are exposed to the
      significant risks and rewards that are dependent on the ultimate commercial
      success of the endeavor. Additionally, it requires that revenue generated and
      costs incurred on sales to third parties as it relates to a collaborative
      agreement be recognized as gross or net based on EITF Issue No. 99-19,
“Reporting Revenue Gross as a Principal versus Net as an Agent.” It also
      requires payments between participants to be accounted for in accordance with
      already existing generally accepted accounting principles, unless none exist,
      in
      which case a reasonable, rational, consistent method should be used. EITF Issue
      No. 07-1 is effective for fiscal years beginning after December 15,
      2008 for all collaborative arrangements existing as of that date, with
      retrospective application to all periods. We do not anticipate the adoption
      of
      EITF Issue No. 07-1 will have a material effect on our financial position,
      results of operations or liquidity.




In
      June
      2007, the FASB ratified Emerging Issues Task Force Issue No. 07-3,
“Accounting for Non-Refundable Payments for Goods or Services Received for Use
      in Future Research and Development Activities,” or EITF Issue No. 07-3.
      EITF Issue No. 07-3 requires that nonrefundable advance payments for goods
      or services that will be used or rendered for future research and development
      activities be deferred and capitalized and recognized as an expense as the
      goods
      are delivered or the related services are performed. EITF Issue No. 07-3 is
      effective, on a prospective basis, for fiscal years beginning after
      December 15, 2007. We do not anticipate the adoption of EITF Issue
      No. 07-3 will have a material effect on our consolidated financial
      position, results of operations or liquidity.





In
      December 2007, the FASB issued SFAS No. 141(R), “Business
      Combinations,” or SFAS No. 141(R). SFAS No. 141(R) changes
      the requirements for an acquirer’s recognition and measurement of the assets
      acquired and liabilities assumed in a business combination, including the
      treatment of contingent consideration, pre-acquisition contingencies,
      transaction costs, in-process research and development and restructuring costs.
      In addition, under SFAS No. 141(R), changes in an acquired entity’s
      deferred tax assets and uncertain tax positions after the measurement period
      will impact income tax expense. This statement is effective with respect to
      business combination transactions for which the acquisition date is after
      December 31, 2008.





In
      December 2007, the FASB issued SFAS No. 160, “Noncontrolling Interests
      in Consolidated Financial Statements (an amendment of Accounting Research
      Bulletin, or ARB, No. 51),” or SFAS No. 160.
      SFAS No. 160 requires that noncontrolling (minority) interests be
      reported as a component of equity, that net income attributable to the parent
      and to the non-controlling interest be separately identified in the income
      statement, that changes in a parent’s ownership interest while the parent
      retains its controlling interest be accounted for as equity transactions, and
      that any retained noncontrolling equity investment upon the deconsolidation
      of a
      subsidiary be initially measured at fair value. This statement is effective
      for
      fiscal years beginning after December 31, 2008, and shall be applied
      prospectively. However, the presentation and disclosure requirements of
      SFAS No. 160 are required to be applied retrospectively for all
      periods presented. The retrospective presentation and disclosure requirements
      of
      this statement will be applied to any prior periods presented in financial
      statements for the fiscal year ending December 31, 2009, and later periods
      during which we have a consolidated subsidiary with a noncontrolling interest.
      As of December 31, 2007, we do not have any consolidated subsidiaries in
      which there is a noncontrolling interest.




38




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





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





We
      invest
      our excess cash in investment grade, interest-bearing securities. At December
      31, 2007, we had $11.5 million invested in interest bearing operating accounts.
      While a hypothetical decrease in market interest rates by 10 percent from the
      December 31, 2007 levels would cause a decrease in interest income, it would
      not
      result in a loss of the principal. Additionally, the decrease in interest income
      would not be material. **** The
      current uncertain credit markets may affect the liquidity of such money market
      funds or other cash investments.





**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, 2007 and 2006
              
              
              41Consolidated
                  Statements of Operations for the Years Ended December 31, 2007,
                  2006 and
                  2005
              
              
              42Consolidated
                  Statements of Stockholders’ Equity (Deficit) for the Years ended December
                  31, 2007, 2006 and 2005
              
              
              43Consolidated
                  Statements of Cash Flows for the Years Ended December 31, 2007,
                  2006 and
                  2005
              
              
              44Notes
                  to the Consolidated Financial Statements
              
              
              45
                  - 60




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, 2007
      and 2006, 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, 2007. These consolidated financial statements are the
      responsibility of the Company’s management. Our responsibility is to express an
      opinion on these consolidated financial statements based on our
      audits.





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





In
      our
      opinion, the consolidated financial statements referred to above present fairly,
      in all material respects, the financial position of InSite Vision Corporation
      as
      of December 31, 2007 and 2006, and the results of their operations and
      their cash flows for each of the three years in the period ended
      December 31, 2007, in conformity with accounting principles generally
      accepted in the United States of America.





As
      discussed in Note 1 and Note 9 to the consolidated financial statements, on
      January 1, 2006 the Company changed its method of accounting for stock-based
      compensation as a result of adopting Statement of Financial Accounting Standards
      No. 123 (revised 2004), “Share-Based Payment” applying the modified prospective
      method.





We
      also
      have audited, in accordance with the standards of the Public Company Accounting
      Oversight Board (United States), the effectiveness of the Company’s internal
      control over financial reporting as of December 31, 2007, based on criteria
      established in *Internal
      Control — Integrated Framework* issued
      by
      the Committee of Sponsoring Organizations of the Treadway Commission and our
      report dated March 17, 2008 expressed an unqualified opinion
      thereon.




/s/
      Burr,
      Pilger & Mayer LLP


Palo
      Alto, California


March 17,
      2008




40


**INSITE
      VISION INCORPORATED**


**CONSOLIDATED
      BALANCE SHEETS**




**December
                  31,**(in
                  thousands, except share and per share amounts)
              
              **2007**
              
              **2006****ASSETS**Current
                  assets:Cash
                  and cash equivalents
              
              $
              11,532
              
              $
              986Restricted
                  cash and cash equivalents
              
              
              75
              
              
              75Accounts
                  receivable
              
              
              719
              
              
              -Deferred
                  debt issuance cost
              
              
              -
              
              
              22Prepaid
                  deal expenses
              
              
              538
              
              
              -Prepaid
                  expenses and other current assets
              
              
              810
              
              
              795Total
                  current assets
              
              
              13,674
              
              
              1,878Property
                  and equipment, at cost:Laboratory
                  and other equipment
              
              
              1,210
              
              
              580Leasehold
                  improvements
              
              
              289
              
              
              5Furniture
                  and fixtures
              
              
              160
              
              
              771,659
              
              
              662Accumulated
                  depreciation
              
              
              321
              
              
              1011,338
              
              
              561Total
                  assets
              
              $
              15,012
              
              $
              2,439**LIABILITIES
                  AND STOCKHOLDERS’ EQUITY (DEFICIT)**Current
                  liabilities:Short-term
                  notes payable to related parties, unsecured
              
              $
              -
              
              $
              35Short-term
                  notes payable to related parties, secured
              
              
              -
              
              
              231Short-term
                  notes payable, secured
              
              
              -
              
              
              6,300Accrued
                  interest
              
              
              -
              
              
              702Accounts
                  payable
              
              
              2,196
              
              
              377Accrued
                  liabilites
              
              
              862
              
              
              381Accrued
                  compensation and related expense
              
              
              979
              
              
              648Deferred
                  revenue
              
              
              10,145
              
              
              -Other
                  current liabilities
              
              
              48
              
              
              18Total
                  current liabilities
              
              
              14,230
              
              
              8,692Capital
                  lease obligation, less current portion
              
              
              36
              
              
              49Total
                  liabilities
              
              
              14,266
              
              
              8,741Commitments
                and contingencies (Note 6)Stockholders’
                  equity (deficit):Preferred
                  stock, $0.01 par vlue, 5,000,000 shares authorized, none issued
                  and
                  outstanding at December 31, 2007 and December 31, 2006
              
              
              -
              
              
              -Common
                  stock, $0.01 par vlue, 240,000,0000 shares authorized; 94,585,449
                  issued
                  and outstanding at December 31, 2007 and 93,284,934 issued and
                  outstanding
                  at December 31, 2006
              
              
              946
              
              
              933Additional
                  paid-in capital
              
              
              147,327
              
              
              145,827Accumulated
                  deficit
              
              
              (147,527
              )
              
              (153,062
              )Stockholders’
                  equity (deficit)
              
              
              746
              
              
              (6,302
              )Total
                  liabilities and stockholders’ equity (deficit)
              
              $
              15,012
              
              $
              2,439







*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)
              
              **2007**
              
              **2006**
              
              **2005**Revenues:Licensing
                  fee and milestone amortization
              
              $
              22,080
              
              $
              2
              
              $
              4Royalties
              
              
              701
              
              
              -
              
              
              -Other
                  product and service revenue
              
              
              980
              
              
              -
              
              
              -Total
              
              
              23,761
              
              
              2
              
              
              4Cost
                  of revenues
              
              
              982
              
              
              28
              
              
              14Gross
                  margin
              
              
              22,779
              
              
              (26
              )
              
              (10
              )Operating
                  expenses:Research
                  and development(a)
              
              
              10,384
              
              
              8,890
              
              
              10,690General
                  and administrative(a)
              
              
              6,760
              
              
              6,182
              
              
              4,510Total
              
              
              17,144
              
              
              15,072
              
              
              15,200Income
                  (loss) from operations
              
              
              5,635
              
              
              (15,098
              )
              
              (15,210
              )Interest
                  (expense) and other income, net
              
              
              (100
              )
              
              (1,513
              )
              
              (5
              )Net
                  income (loss)
              
              $
              5,535
              
              $
              (16,611
              )
              $
              (15,215
              )Net
                  income (loss) per share:Earnings
                  (loss) per share - basic
              
              $
              0.06
              
              $
              (0.19
              )
              $
              (0.21
              )Earnings
                  (loss) per share - diluted
              
              $
              0.06
              
              $
              (0.19
              )
              $
              (0.21
              )Weighted
                  average shares used in per-share calculation:-
                  Basic
              
              
              94,168
              
              
              88,339
              
              
              72,647-
                  Diluted
              
              
              100,110
              
              
              88,339
              
              
              72,647(a)
                  Includes the following amounts related to stockbased
                  compensation:Research
                  and development
              
              $
              282
              
              $
              245
              
              $
              -General
                  and administrative
              
              
              719
              
              
              565
              
              
              -





*See
      accompanying notes to consolidated financial statements.*




42





**INSITE
      VISION INCORPORATED**


**CONSOLIDATED
      STATEMENTS OF STOCKHOLDER’ EQUITY (DEFICIT)**


**Notes**
                
                **Retained**
                
                **Total****Receivable**
                
                **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, 2004**
                
                
                -
                
                $
                -
                
                
                62,381,808
                
                $
                624
                
                $
                124,400
                
                $
                (187
                )
                $
                (121,236
                )
                $
                3,601Issuance
                    costs related to 2004 private placement
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                (262
                )
                
                -
                
                
                -
                
                
                (262
                )Issuance
                    of common stock from exercise of options and employee stock purchase
                    plan
                
                
                -
                
                
                -
                
                
                65,647
                
                
                -
                
                
                33
                
                
                -
                
                
                -
                
                
                33Issuance
                    of common stock from exercise of warrants
                
                
                -
                
                
                -
                
                
                803,725
                
                
                8
                
                
                495
                
                
                -
                
                
                -
                
                
                503Issuance
                    of common stock from private placement
                
                
                -
                
                
                -
                
                
                16,363,626
                
                
                164
                
                
                7,978
                
                
                -
                
                
                -
                
                
                8,142Non-employee
                    stock compensation
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                14
                
                
                -
                
                
                -
                
                
                14Loan
                    payment from stockholder
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                
                
                
                19
                
                
                -
                
                
                19Issuance
                    of warrants in connection with private placement of notes
                    payable
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                620
                
                
                -
                
                
                -
                
                
                620Net
                    loss
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                
                
                
                -
                
                
                (15,215
                )
                
                (15,215
                )**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 warrants
                
                
                -
                
                
                -
                
                
                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
                
                
                5,535**Balances,
                    December 31, 2007**
                
                
                -
                
                $
                -
                
                
                94,585,449
                
                $
                946
                
                $
                147,327
                
                $
                -
                
                $
                (147,527
                )
                $
                746







*See
      accompanying notes consolidated financial statements.*




43


**INSITE
      VISION INCORPORATED**


**CONSOLIDATED
      STATEMENTS OF CASH FLOWS**


**(in
      thousands)**


Year
                      Ended December 31,2007
                  
                  2006
                  
                  2005OPERATING
                      ACTIVITIES:Net
                      income (loss)
                  
                  $
                  5,535
                  
                  $
                  (16,611
                  )
                  $
                  (15,215
                  )Adjustment
                      to reconcile net income (loss) to net cash provided by(used
                      in) operating activities:Depreciation
                      and amortization
                  
                  
                  236
                  
                  
                  97
                  
                  
                  57Gain
                      on sale of assets
                  
                  
                  (1
                  )
                  
                  -
                  
                  
                  (4
                  )Amortization
                      of deferred debt issuance costs
                  
                  
                  22
                  
                  
                  809
                  
                  
                  -Accretion
                      of debt discount
                  
                  
                  -
                  
                  
                  798
                  
                  
                  -Stock-based
                      compensation
                  
                  
                  1,001
                  
                  
                  810
                  
                  
                  14Changes
                      in operating assets and liabilities:Accounts
                      receivable
                  
                  
                  (719
                  )
                  
                  -
                  
                  
                  -Prepaid
                      expenses and other current assets
                  
                  
                  (553
                  )
                  
                  (697
                  )
                  
                  (9
                  )Accounts
                      payable
                  
                  
                  1,819
                  
                  
                  (1,564
                  )
                  
                  1,367Accrued
                      interest
                  
                  
                  (702
                  )
                  
                  699
                  
                  
                  -Deferred
                      revenue
                  
                  
                  10,145
                  
                  
                  -
                  
                  
                  -Accrued
                      liabilities
                  
                  
                  481
                  
                  
                  (786
                  )
                  
                  380Accrued
                      compensation and related expense, and other current liabilities
                  
                  
                  360
                  
                  
                  216
                  
                  
                  46Net
                      cash provided by (used in) operating activities
                  
                  
                  17,624
                  
                  
                  (16,229
                  )
                  
                  (13,364
                  )INVESTING
                      ACTIVITIES:Purchase
                      of property and equipment
                  
                  
                  (1,013
                  )
                  
                  (322
                  )
                  
                  (236
                  )Proceeds
                      from sale of asset
                  
                  
                  1
                  
                  
                  -
                  
                  
                  4Restricted
                      cash decrease
                  
                  
                  -
                  
                  
                  -
                  
                  
                  95Net
                      cash used in investing activities
                  
                  
                  (1,012
                  )
                  
                  (322
                  )
                  
                  (137
                  )FINANCING
                      ACTIVITIES:Issuance
                      of common stock from exercise of options, employeepurchase
                      plan and warrants, net of issuance costs
                  
                  
                  512
                  
                  
                  5,759
                  
                  
                  536Issuance
                      of common stock from private placement, net of issuance costs
                  
                  
                  -
                  
                  
                  5,810
                  
                  
                  8,142Issuance
                      costs related ot 2004 equity private placement
                  
                  
                  -
                  
                  
                  -
                  
                  
                  (262
                  )Note
                      payment received from stockholder
                  
                  
                  -
                  
                  
                  168
                  
                  
                  19Issuance
                      of short-term notes payable, net of issuance costs
                  
                  
                  -
                  
                  
                  1,783
                  
                  
                  3,815Repayments
                      of borrowings
                  
                  
                  (6,300
                  )
                  
                  -
                  
                  
                  -Payments
                      of notes payable to related parties
                  
                  
                  (266
                  )
                  
                  -
                  
                  
                  (73
                  )Payment
                      of capital lease obligation
                  
                  
                  (12
                  )
                  
                  (10
                  )
                  
                  -Net
                      cash (used in) provided by financing activities
                  
                  
                  (6,066
                  )
                  
                  13,510
                  
                  
                  12,177Net
                      increase (decrease) in cash and cash equivalents
                  
                  
                  10,546
                  
                  
                  (3,041
                  )
                  
                  (1,324
                  )Cash
                      and cash equivalents at beginning of period
                  
                  
                  986
                  
                  
                  4,027
                  
                  
                  5,351Cash
                      and cash equivalents at end of period
                  
                  $
                  11,532
                  
                  $
                  986
                  
                  $
                  4,027Supplemental
                      disclosure of cash flow information:Cash
                      paid:Interest
                  
                  $
                  809
                  
                  $
                  16
                  
                  $
                  2Income
                      taxes
                  
                  $
                  1
                  
                  $
                  1
                  
                  $
                  1Non-cash
                      investing and financing activities:Issuance
                      of warrants to lenders in connection with notes payable
                  
                  $
                  -
                  
                  $
                  307
                  
                  $
                  491Issuance
                      of warrants to placement agent in connection with notes payable
                  
                  $
                  -
                  
                  $
                  -
                  
                  $
                  129Acquisition
                      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, 2007




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




Basis
      of Presentation .
      The
      accompanying consolidated financial statements include the accounts of InSite
      Vision, Inc. and its wholly-owned subsidiaries. InSite Vision (the “Company” or
“InSite Vision”) 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.





**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, Prepaid expenses and other current assets. At
      December 31, 2007, prepaid deal expenses included $538,000 of expenses incurred
      related to the financing completed in February 2008. See Note 15, “Subsequent
      Event” for further discussion of this transaction. At December 31, 2006, prepaid
      expenses included a receivable from the FDA of the $767,000. This receivable
      represents the filing fee the Company paid in June 2006 when it filed its
      AzaSite New Drug Application. The FDA subsequently determined the fee would
      be
      waived and it was refunded to the Company.





Inventory .
      The
      Company’s inventories are stated at the lower of cost or market. The cost of the
      inventory is based on the first-in first-out method. If the cost of the
      inventory exceeds the expected market value, a provision is recorded for the
      difference between cost and market.





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,
      2007, 2006 and 2005 were $236,000, $97,000 and $57,000,
      respectively.




45





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.





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 Ocu G ene
      glaucoma genetic test were recognized when all related services had been
      rendered and collectibility was reasonably assured.





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





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





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.




46





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





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 9, “Employee Stock-Based Compensation”
for further discussion of employee stock-based compensation.





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





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





The
      fair
      value for these options was estimated at the date of grant using a Black-Scholes
      option pricing model with the following weighted-average assumptions for 2005,
      risk-free interest rates ranging from 4.3% to 4.4%; volatility factors for
      the
      expected market price of our common stock of 103%; expected life of 4 years;
      and
      an expected dividend rate of 0%.





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


Year
                    EndedDecember 31,
                2005Net
                  loss - as reported
              
              $
              (15,215
              )Deduct:
                  Total stock-based employee compensation expense determined under
                  fair
                  value method for all awards
              
              
              (524
              )Net
                  loss-pro forma
              
              $
              (15,739
              )Loss
                  per share:Basic
                  and diluted-as reported
              
              $
              (0.21
              )Basic
                  and diluted-pro forma
              
              $
              (0.22
              )




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 $22,000, $6,000 and $14,000 during the
      years ended 2007, 2006 and 2005, 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 2006 and 2005 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)
              
              **2007**
              
              **2006**
              
              **2005**Numerator:Net
                  income (loss)
              
              $
              5,535
              
              $
              (16,611
              )
              $
              (15,215
              )Denominator:Weighted-average
                  shares outstanding
              
              
              94,168
              
              
              88,339
              
              
              72,647Effect
                  of dilutive securities:Stock
                  options and warrants
              
              
              5,942
              
              
              -
              
              
              -Weighted-average
                  shares outstanding for diluted income(loss)
              
              
              100,110
              
              
              88,339
              
              
              72,647Net
                  income (loss) per share:Basic
              
              $
              0.06
              
              $
              (0.19
              )
              $
              (0.21
              )Diluted
              
              $
              0.06
              
              $
              (0.19
              )
              $
              (0.21
              )





For
      the
      year ended 2006 and 2005, 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, 2007, 2006 and 2005, 1,016,957,
      23,412,320 and 30,253,869 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 .




Effective
      January 1, 2007, 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. 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 in 2007 were from our two AzaSite licensees.
      The Company is entitled to receive royalty revenue from net sales of AzaSite
      under the terms of its agreements with Inspire and Shin Poong, 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
      September 2006, the Financial Accounting Standards Board (“FASB”)
 issued SFAS No. 157, “Fair Value Measurements”
(“SFAS No. 157”). SFAS No. 157 provides guidance for using
      fair value to measure assets and liabilities. It also responds to investors’
request for expanded information about the extent to which companies measure
      assets and liabilities at fair value, the information used to measure fair
      value, and the effect of fair valued measurements on earnings.
      SFAS No. 157 applies whenever standards require (or permit) assets or
      liabilities to be measured at fair value, and does not expand the use of fair
      value in any new circumstances. SFAS No. 157 is effective for
      financial statements issued for fiscal years beginning after November 15,
      2007, and interim periods within those fiscal years, with early adoption
      permitted, except for the impact of FASB Staff Position (FSP) 157-2. FSP 157-2
      deferred the adoption of SFAS 157 for non financial assets and liabilities
      until
      years ended after November 15, 2008. The Company must adopt these requirements
      no later than the first quarter of 2008. The Company does not anticipate the
      adoption of SFAS No. 157 will have a material effect on its
      consolidated financial position, results of operations or
      liquidity.




49





In
      February 2007, the FASB issued SFAS No. 159, “The Fair Value Option
      for Financial Assets and Financial Liabilities — Including an amendment of
      FASB Statement No. 115” (“SFAS No. 159”). SFAS No. 159
      expands the use of fair value accounting but does not affect existing standards
      that require assets or liabilities to be carried at fair value. Under
      SFAS No. 159, a company may elect to use fair value to measure
      accounts and loans receivable, available-for-sale and held-to-maturity
      securities, equity method investments, accounts payable, guarantees and issued
      debt. Other eligible items include firm commitments for financial instruments
      that otherwise would not be recognized at inception and non-cash warranty
      obligations where a warrantor is permitted to pay a third party to provide
      the
      warranty goods or services. If the use of fair value is elected, any upfront
      costs and fees related to the item must be recognized in earnings and cannot
      be
      deferred (e.g., debt issue costs). The fair value election is irrevocable and
      generally made on an instrument-by-instrument basis, even if a company has
      similar instruments that it elects not to measure based on fair value. At the
      adoption date, unrealized gains and losses on existing items for which fair
      value has been elected are reported as a cumulative adjustment to beginning
      retained earnings. Subsequent to the adoption of SFAS No. 159, changes
      in fair value are recognized in earnings. SFAS No. 159 is effective
      for fiscal years beginning after November 15, 2007. The Company is
      currently determining whether fair value accounting is appropriate for any
      of
      its eligible items and cannot estimate the impact, if any, that
      SFAS No. 159 will have on its consolidated financial position, results
      of operations or liquidity.





In
      November 2007, the FASB ratified EITF Issue No. 07-1, “Accounting for
      Collaborative Agreements Related to the Development and Commercialization of
      Intellectual Property” (“EITF Issue No. 07-1”). EITF Issue No. 07-1
      defines collaborative agreements as a contractual arrangement in which the
      parties are active participants to the arrangement and are exposed to the
      significant risks and rewards that are dependent on the ultimate commercial
      success of the endeavor. Additionally, it requires that revenue generated and
      costs incurred on sales to third parties as it relates to a collaborative
      agreement be recognized as gross or net based on EITF Issue No. 99-19,
“Reporting Revenue Gross as a Principal versus Net as an Agent.” It also
      requires payments between participants to be accounted for in accordance with
      already existing generally accepted accounting principles, unless none exist,
      in
      which case a reasonable, rational, consistent method should be used. EITF Issue
      No. 07-1 is effective for fiscal years beginning after December 15,
      2008 for all collaborative arrangements existing as of that date, with
      retrospective application to all periods. The Company does not anticipate the
      adoption of EITF Issue No. 07-1 will have a material effect on its
      financial position, results of operations or liquidity.





In
      June
      2007, the FASB ratified EITF Issue No. 07-3, “Accounting for Non-Refundable
      Payments for Goods or Services Received for Use in Future Research and
      Development Activities” (“EITF Issue No. 07-3”). EITF Issue No. 07-3
      requires that nonrefundable advance payments for goods or services that will
      be
      used or rendered for future research and development activities be deferred
      and
      capitalized and recognized as an expense as the goods are delivered or the
      related services are performed. EITF Issue No. 07-3 is effective, on a
      prospective basis, for fiscal years beginning after December 15, 2007. The
      Company does not anticipate the adoption of EITF Issue No. 07-3 will have a
      material effect on its consolidated financial position, results of operations
      or
      liquidity.




In
      December 2007, the FASB issued SFAS No. 141(Revised 2007), “Business
      Combinations” (“SFAS No. 141(R)”). SFAS No. 141(R) changes
      the requirements for an acquirer’s recognition and measurement of the assets
      acquired and liabilities assumed in a business combination, including the
      treatment of contingent consideration, pre-acquisition contingencies,
      transaction costs, in-process research and development and restructuring costs.
      In addition, under SFAS No. 141(R), changes in an acquired entity’s
      deferred tax assets and uncertain tax positions after the measurement period
      will impact income tax expense. This statement is effective for the Company
      with
      respect to business combination transactions for which the acquisition date
      is
      after December 31, 2008.





In
      December 2007, the FASB issued SFAS No. 160, “Non-controlling
      Interests in Consolidated Financial Statements (an amendment of Accounting
      Research Bulletin No. 51)” (“SFAS No. 160”).
      SFAS No. 160 requires that non-controlling (minority) interests be
      reported as a component of equity, that net income attributable to the parent
      and to the non-controlling interest be separately identified in the income
      statement, that changes in a parent’s ownership interest while the parent
      retains its controlling interest be accounted for as equity transactions, and
      that any retained non-controlling equity investment upon the deconsolidation
      of
      a subsidiary be initially measured at fair value. This statement is effective
      for fiscal years beginning after December 31, 2008, and shall be applied
      prospectively. However, the presentation and disclosure requirements of
      SFAS No. 160 are required to be applied retrospectively for all
      periods presented. The retrospective presentation and disclosure requirements
      of
      this statement will be applied to any prior periods presented in financial
      statements for the fiscal year ending December 31, 2009, and later periods
      during which the Company had a consolidated subsidiary with a non-controlling
      interest. As of December 31, 2007, the Company does not have any
      consolidated subsidiaries in which there is a non-controlling interest.




50





**2.**   **License
      Agreements**





In
      December 2007, the Company entered into an international licensing and
      distribution agreement for AzaSite with Shin Poong Pharm, Seoul, South Korea.
      Under the terms of the agreement, the Company granted exclusive rights to Shin
      Poong to commercialize AzaSite for ocular bacterial infection in South Korea.
      Shin Poong will also be responsible for securing approval of AzaSite in South
      Korea. In exchange, Shin Poong will pay the Company upfront and regulatory
      milestone payments as well as a double-digit royalty on net sales of AzaSite
      in
      South Korea, if approved by regulatory authorities. The Company will be
      responsible for providing manufactured products at cost to Shin
      Poong.





On
      February 15, 2007, the Company entered into a license agreement for
      AzaSite TM 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 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, or (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 is recognizing the upfront license fee and milestone payment totaling
      $32 million ratably over the period that the Company is required to continue
      to
      provide services under the license agreement, which is expected to be until
      the
      second quarter of 2008, under the contingency-adjusted performance model of
      revenue recognition. During the year ended December 31, 2007, the Company
      recognized $22.1 million 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 AzaSite Plus TM (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 period ended
      December 31, 2007, the Company recorded third-party royalties of $122,000 due
      primarily under the Pfizer License which was recorded in cost revenues within
      the consolidated statements of operations.





51





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





In
      December 2005, the Company reserved approximately $75,000 related to a letter
      of
      credit issued as collateral for a capital lease for a telephone system which
      was
      installed and initiated in the first quarter of 2006. The Company anticipates
      that the requirement for this restricted cash will be eliminated in
      2008.





**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 at December 31,
      2007.
      The need for a bad debt allowance is evaluated each reporting period based
      on
      our assessment of the collectiblity of the amounts.





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





In
      2005
      and 2006, the Company issued a total of $6,300,000 of short-term senior secured
      notes payable and warrants to purchase 1,260,000 shares of Common Stock at
      an
      exercise price of $0.82 per share. The Company also issued warrants to purchase
      200,000 shares of Common Stock at an exercise price of $0.82 per share to the
      placement agent engaged for such financing.





These
      notes, and the senior secured notes described in Note 11, were secured by a
      lien
      on all of the assets of the Company, including the Company’s intellectual
      property. These notes bore interest at a rate of ten percent (10%) and had
      an
      original maturity date of June 30, 2006, which maturity date was extended for
      an
      additional six months at an interest rate of twelve percent (12%). In February
      2007, these notes were repaid in full.





**6.**  **Commitments
      and Contingencies**





At
      December 31, 2007, the Company had purchase commitments and contractual
      obligations of approximately $25.2 million, primarily related to its AzaSite
      Plus Phase 3 study, future royalty payments, minimum license fees and consultant
      costs. These purchase commitments and contractual obligations are reflected
      in
      the Company’s financial statements once the related goods or services have been
      received or payments related to the obligations become due.





Capital
      lease obligations represent the present value of future rental payments under
      capital lease agreements for telephones and telephone equipment. At December
      31,
      2007 and 2006 the Company had $71,000 of capital leased equipment with
      accumulated depreciation of $23,000 and $7,000, respectively.





Future
      minimum payments under capital leases are as follows:


CapitalYear
                  Ending December 31,
              
              Leases2008
              
              $
              17,6612009
              
              
              17,6612010
              
              
              17,6612011
              
              
              4,7502012
              
              
              -Total
                  minimum lease payments
              
              
              57,733Amount
                  representing interest
              
              
              (8,713
              )Present
                  value of net minimum lease payment
              
              
              49,020Current
                  Portion, in other current liabilities
              
              
              (13,352
              )Long-term
                  portion
              
              $
              35,668




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, 2007, 2006 and 2005, was $695,000, $706,000,
      and
      $719,000, respectively.


Operating
                  LeaseCash
                  PaymentsYear
                  Ending December 31,
              
              Required2008
              
              $
              730,8242009
              
              
              754,1322010
              
              
              775,1752011
              
              
              798,4832012
              
              
              821,7902013
                  and thereafter
              
              
              847,528Total
                  minimum lease payments
              
              $
              4,727,932





**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, 2007 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 2005 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, 2007 and 2006 are as follows (in
      thousands):


2007
              
              2006Deferred
                  tax assets:Net
                  operating loss carryforwards
              
              $
              37,786
              
              $
              40,614Tax
                  credit carryforwards
              
              
              5,637
              
              
              6,456Capitalized
                  research and development
              
              
              10,208
              
              
              12,263Depreciation
              
              
              381
              
              
              398Other
              
              
              300
              
              
              95Total
                  deferred tax assets
              
              $
              54,312
              
              
              59,826Valuation
                  allowance
              
              
              (54,312
              )
              
              (59,826
              )Net
                  deferred tax assets
              
              $
              -
              
              $
              -





The
      valuation allowance decreased by $5.5 million, during the year ended December
      31, 2007 and increased by $6.6 million and $4.4 million during the years ended
      December 31, 2006 and 2005, respectively.





At
      December 31, 2007, the Company had net operating loss carryforwards for federal
      income tax purposes of approximately $98.8 million, which expire in the years
      2007 through 2026 and federal tax credits of approximately $2.3 million, which
      expire in the years 2007 through 2026. At December 31, 2007, the Company also
      has net operating loss carryforwards for state income tax purposes of
      approximately $70.0 million which expire in the years 2007 through 2016, and
      state research and development tax credits of approximately and $3.3 million
      which carryforward indefinitely.





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




53





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 2005 for federal returns and 2004 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.**  **Common
      Stockholders’ Equity (Deficit)**





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:


Exercise
              
              Net
                  Cash
              
              Fees
              
              Warrants
              
              Shares
                  of
                CommonWarrants
                  issued as part of:
              
              Price
              
              Received
              
              Incurred
              
              Exercised
              
              StockIssuedMarch
                  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





The
      following table shows the detail of outstanding warrants as of December 31,
      2007. 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
                ConvertedSeptember
                  22, 2003
              
              
              81,967
              
              $
              0.61
              
              
              September
                  21, 2008
              
              $
              50,000March
                  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
              
              
              15,339,903
              
              
              
              
              
              
              
              $
              11,754,760Weighted-average
                  exercise price per share
              
              
              
              
              
              
              
              
              
              
              $
              0.77
  54





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





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





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





In
      2005,
      the Company received approximately $308,000, from the exercise of warrants
      to
      purchase 410,206 shares of Common Stock issued as part of the March 2004 private
      placement. In December 2005, the Company received approximately $145,000 from
      the exercise of warrants to purchase 268,519 shares of Common Stock issued
      in
      December 2003. In January 2005, the Company received approximately $50,000
      from
      the exercise of warrants to purchase 125,000 shares of Common Stock issued
      in
      November 2003. In August 2005, the Company received approximately $10,000 from
      the exercise of an employee stock option to purchase 25,000 shares of Common
      Stock.





**9.** **Employee
        Stock-based Compensation**





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





The
      effect of recording stock-based compensation for the year ended December 31,
      2007, 2006 and 2005 was as follows (in thousands):


Year
                  Ended December 31,2007
              
              2006
              
              2005Stock-based
                  compensation expense by type of award:Employee
                  stock options
              
              $
              936
              
              $
              780
              
              $
              -Employee
                  stock purchase plan
              
              
              43
              
              
              24
              
              
              -Non-employee
                  stock options
              
              
              22
              
              
              6
              
              
              14Total
                  stock-based compensation
              
              $
              1,001
              
              $
              810
              
              $
              14




55




Employee
      Stock-based Compensation





During
      the year ended December 31, 2007 and December 31, 2006, respectively, the
      Company granted options to purchase 1,071,001 and 1,628,200 shares of common
      stock with an estimated total grant date fair value of $1.0 million and $1.6
      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, of the $1.0 million and $1.6 million, the Company estimated that
      the stock-based compensation for the awards not expected to vest was $0.2
      million and $0.3 million, respectively. During the year ended December 31,
      2007
      and December 31, 2006, the Company recorded employee stock-based compensation
      related to all stock options of $936,000 and $780,000,
      respectively.





As
      of
      December 31, 2007 and 2006, unrecorded deferred stock-based compensation balance
      related to stock options was $1.8 million and $1.8 million, respectively, and
      will be recognized over an estimate weighted-average amortization period of
      2.3
      years and 1.2 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 and
      the Company’s prior period pro forma disclosures of net loss, including
      stock-based compensation (determined under a fair value method as prescribed
      by
      SFAS No. 123). The fair value of each option grant is estimated on the date
      of grant using the Black-Scholes option valuation model and the graded-vesting
      method with the following weighted-average assumptions:


Year
                  endedDecmeber
                  31,2007
              
              2006Risk-free
                  interest rate
              
              
              3.3%
                  - 4.6
              %
              
              4.4%
                  -5.1
              %Expected
                  term(years)
              
              
              5
              
              
              5Expected
                  dividends
              
              
              0.0
              %
              
              0.0
              %Volatility
              
              
              74.8
              %
              
              78.0
              %





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




56





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:


Number
                  of shares
              
              Weighted-Average
                  Exercise Price
              
              Weighted-Average
                  Remaining Contractual Term (Years)
              
              Aggregate
                  Intrinsic Value (in thousands)Outstanding
                  at December 31, 2004
              
              
              3,835,736
              
              $
              1.58
              
              
              6.28
              
              $
              326Granted
              
              
              2,175,000
              
              
              0.65Exercised
              
              
              (25,000
              )
              
              0.41Canceled
              
              
              (430,746
              )
              
              2.40Outstanding
                  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
              
              $
              349Options
                  vested and exerciseable and expected to be exercisable at December
                  31,
                  2007
              
              
              
              
              
              
              
              
              6.726,474,688
              
              $
              1.08
              
              
              
              
              $
              331Options
                  vested and exerciseable at December 31, 2007
              
              
              4,629,501
              
              $
              1.01
              
              
              6.00
              
              $
              280




At
      December 31, 2007, the Company had 1,995,074 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, 2007, 2006 and
      2005
      were $0.91, $1.52 and $0.65, respectively. The total intrinsic value of options
      exercised during the years ended December 31, 2007, 2006 and 2005 were $75,000
      and $157,000 and $2,000, respectively.




The
      following table summarizes information concerning outstanding and exercisable
      options as of December 31, 2007:


Option
                  Outstanding
              
              Options
                  Vested and ExercisableWeighted-AverageRange
                  of Exercise Prices
              
              Number
                  Outstanding
              
              Contractual
                  Life
              
              Exercise
                  Price
              
              Number
                  Exerisable
              
              Weighted-Average
                  Exercise Price$0.41
                  - $0.60
              
              
              280,750
              
              
              5.97
              
              $
              0.41
              
              
              279,473
              
              $
              0.41$0.63
                  - $0.63
              
              
              1,958,829
              
              
              7.26
              
              
              0.63
              
              
              1,399,899
              
              
              0.63$0.64
                  - $0.84
              
              
              726,726
              
              
              6.23
              
              
              0.73
              
              
              664,452
              
              
              0.73$0.85
                  - $0.93
              
              
              830,510
              
              
              6.49
              
              
              0.89
              
              
              667,790
              
              
              0.90$1.02
                  - $1.45
              
              
              817,414
              
              
              3.40
              
              
              1.19
              
              
              668,282
              
              
              1.20$1.46
                  - $1.46
              
              
              20,001
              
              
              9.25
              
              
              1.46
              
              
              10,002
              
              
              1.46$1.50
                  - $1.50
              
              
              1,352,668
              
              
              8.07
              
              
              1.50
              
              
              642,455
              
              
              1.50$1.56
                  - $1.59
              
              
              719,707
              
              
              9.30
              
              
              1.59
              
              
              8,167
              
              
              1.56$1.63
                  - $5.25
              
              
              287,250
              
              
              5.30
              
              
              2.65
              
              
              278,981
              
              
              2.68$5.88
                  - $5.88
              
              
              10,000
              
              
              2.73
              
              
              5.88
              
              
              10,000
              
              
              5.887,003,855
              
              
              6.84
              
              $
              1.09
              
              
              4,629,501
              
              $
              1.01




At
        December 31, 2006 and 2005 options to purchase 3,720,567 and 3,173,607 shares
        of
        common stock were exercisable at weighted-average exercise prices of $1.25
        and
        $1.51, 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, 2007 and December 31, 2006, respectively: risk-free interest rate
      of 3.7% and 5.1%; volatility factor of 74.4% and 78.2%; and an expected life
      of
      1.5 years. During the year ended December 31, 2007 and December 31, 2006, the
      compensation cost in connection with the Purchase Plan was $43,000 and $24,000,
      respectively. During the year ended December 31, 2007 and December 31, 2006,
      62,825 and 67,663 shares were issued under the Purchase Plan. As of December
      31,
      2007 and December 31, 2006, 543,134 and 605,959 shares were reserved for
      issuance under the Purchase Plan. As of December 31, 2007, the unrecorded
      deferred stock-based compensation balance related to the employee stock purchase
      plan was $41,000 and will be recognized over an estimated weighted average
      amortization period of 1.5 years.





**10.**  **Legal
      Proceedings**





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





**11.**  **Related
      Party**





In
      May
      2000, the Company issued loans to the Company’s President, Chief Executive
      Officer and Chairman of the Board, related to his exercise of 126,667 shares
      of
      options to acquire common stock. The loans were full recourse and had an
      interest rate of 7% per annum. In January 2006, these notes, which had a balance
      of $168,000 at December 31, 2005, were repaid in full.




The
      Company had $35,000 of short-term unsecured notes payable to related parties
      as
      of December 31, 2006. In 2003, the Company issued a series of short-term
      unsecured notes payable to members of the Board of Directors, senior management
      and other employees of the Company for cash. These notes bore interest at a
      rate
      of two percent (2%) per anum. In February 2007, these notes were repaid in
      full.





The
      Company had $231,000 of short-term secured notes payable to related parties
      as
      of December 31, 2006. In 2003, the Company issued short-term senior secured
      notes payable to an officer who is also a member of the Board of Directors
      and
      to an affiliate of a member of senior management for cash. (Also described
      in
      Note 5) The note was secured by a lien on substantially all of the assets of
      the
      Company, including the Company’s intellectual property, other than certain
      equipment secured by the lessor of such equipment. In February 2007, these
      notes
      were repaid in full.




**12.**  **Subsequent
      Event**





In
      February 2008, the Company’s wholly-owned subsidiary, Azithromycin Royalty Sub,
      LLC, issued $60.0 million
      in aggregate principal amount of non-convertible, non-recourse promissory notes
      due in 2019. The notes are secured by, and will be repaid from, royalties to
      be
      paid to us by Inspire Pharmaceuticals from sales of AzaSite in the United States
      and Canada. The annual cash coupon rate on the notes is 16% with interest
      payable quarterly in arrears beginning May 15, 2008. Net proceeds from the
      financing were approximately $50.0 million after transaction costs and $5.0
      million of interest reserves.




58





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. The notes
      may
      be redeemed at our option, subject to the payment of a redemption premium
      through May 2012.





**13.**  **Quarterly
      Results (Unaudited)**





The
      following table is a summary of the quarterly results of operations for the
      years ended December 31, 2007 and December 31, 2006. 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.


**2007****First**
              
              **Second**
              
              **Third**
              
              **Fourth**(In
                  thousands, except per share amounts)
              
              **Quarter**
              
              **Quarter**
              
              **Quarter**
              
              **Quarter**Revenues
              
              $
              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


**2006****First**
              
              **Second**
              
              **Third**
              
              **Fourth****Quarter**
              
              **Quarter**
              
              **Quarter**
              
              **Quarter**Revenues
              
              $
              1
              
              $
              -
              
              $
              1
              
              $
              -Cost
                  of revenues
              
              
              3
              
              
              3
              
              
              20
              
              
              2Income
                  (loss) from operations
              
              
              (4,811
              )
              
              (4,570
              )
              
              (3,061
              )
              
              (2,626
              )Net
                  income/(loss)
              
              
              (5,321
              )
              
              (5,139
              )
              
              (3,337
              )
              
              (2,824
              )-
                  basic
              
              
              (0.06
              )
              
              (0.06
              )
              
              (0.04
              )
              
              (0.03
              )-
                  diluted
              
              $
              (0.06
              )
              $
              (0.06
              )
              $
              (0.04
              )
              $
              (0.03
              )




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





None





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





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




59





***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, 2007. 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, 2007, our
      internal control over financial reporting is effective.





The
      effectiveness of our internal control over financial reporting as of
      December 31, 2007 has been audited by Burr, Pilger & Mayer LLP, an
      independent registered public accounting firm, as stated in their report
      appearing below.





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





***Changes
      in Internal Control over Financial Reporting.*** There
      were no changes in our internal control over financial reporting (as defined
      in
      Exchange Act Rule 13a-15(f)) during the quarter ended December 31, 2007
      that have materially affected, or are reasonably likely to materially affect,
      our internal control over financial reporting.





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





**REPORT
      OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**





To
      the
      Board of Directors and Stockholders of InSite Vision Incorporated





We
      have
      audited the internal control over financial reporting of InSite Vision
      Incorporated and its subsidiaries (the “Company”) as of December 31, 2007,
      based on criteria established in Internal Control — Integrated
      Framework issued by the Committee of Sponsoring Organizations of the Treadway
      Commission (COSO). The Company’s management is responsible for maintaining
      effective internal control over financial reporting and for its assessment
      of
      the effectiveness of internal control over financial reporting included in
      the
      accompanying Report of Management on Internal Control Over Financial
      Reporting. Our responsibility is to express an opinion on the effectiveness
      of
      the Company’s internal control over financial reporting based on our
      audit.





We
      conducted our audit in accordance with the standards of the Public Company
      Accounting Oversight Board (United States). Those standards require that we
      plan
      and perform the audit to obtain reasonable assurance about whether effective
      internal control over financial reporting was maintained in all material
      respects. Our audit included obtaining an understanding of internal control
      over
      financial reporting, assessing the risk that a material weakness exists, testing
      and evaluating the design and operating effectiveness of internal control based
      on the assessed risk, and performing such other procedures as we considered
      necessary in the circumstances. We believe that our audit provides a reasonable
      basis for our opinion.





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




60





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





In
      our
      opinion, InSite Vision Incorporated and its subsidiaries maintained, in all
      material respects, effective internal control over financial reporting as of
      December 31, 2007, based on the COSO criteria.





We
      also
      have audited, in accordance with the standards of the Public Company Accounting
      Oversight Board (United States), the consolidated balance sheets of InSite
      Vision Incorporated and its subsidiaries as of December 31, 2007 and 2006,
      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, 2007 and our report dated March 17, 2008 expressed an
      unqualified opinion on those consolidated financial statements.





/s/ 
      Burr, Pilger & Mayer LLP





Palo
      Alto, California


March 17,
      2008





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





Not
      applicable.




**PART
      III**





**Item
      10. Directors, Executive Officers and Corporate Governance**





(a)
      Certain information required by this Item is contained under the heading
“Executive Officers of the Company” in Part I of this Annual Report on Form
      10-K.





(b)
      Other
      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 in connection with the 2008 Annual
      Meeting of Stockholders are incorporated herein by reference.





**Item
      11. Executive Compensation**





The
      information required by this Item will appear under the headings labeled
“Director Compensation for 2007,” “Compensation, Discussion and Analysis,”
“Compensation of Named Executive Officers,” “Summary Compensation Table for
      2007,” “Grants of Plan Based Awards in 2007,” “Outstanding Equity Awards at
      Fiscal 2007 Year End,” “ Option Exercises and Stock Vested in 2007,”
“Non-Qualified Deferred Compensation for 2007,” “Compensation Committee
      Interlocks and Insider Participation” and “Compensation Committee Report” of our
      Proxy Statement and are incorporated herein by reference.




61





**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 are incorporated herein by
      reference.





**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 are incorporated herein by reference.





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





**Audit
      Fees**





The
      information required by this Item will appear under the headings labeled “Audit
      Committee Matters” and “Principal Accountant Fees and Services” of our Proxy
      Statement and are 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 this Annual Report on Form 10-K.





(2)  Financial
      Statement Schedules





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





(3)  Exhibits





See
      Exhibit Index on page 65 of this Annual Report on Form 10-K.




62





**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 17,
              2008INSITE
                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 each of S. Kumar Chandrasekaran and Louis C. Drapeau,
      his or her attorneys in fact, each with the power of substitution, for him
      or
      her in any and all capacities, to sign any amendments to this Annual Report
      on
      Form 10-K, and to file the same, with exhibits thereto and other documents
      in
      connection therewith, with the Securities and Exchange Commission, hereby
      ratifying and confirming all that each of said attorneys in fact, or his or
      her
      substitutes, may do or cause to be done by virtue thereof.





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


Name
              
              Capacity
              
              Date/s/
                  S. Kumar Chandrasekaran, Ph.D.
              
              Chairman
                  of the Board, President,
              
              March
                  17, 2008S.
                  Kumar Chandrasekaran, Ph.D.
              
              and
                  Chief Executive Officer (Principal Executive Officer)/s/
                  Louis C. Drapeau
              
              Chief
                  Financial Officer
              
              March
                  17, 2008Louis
                  C. Drapeau
              
              (Principal
                  Financial Officer)/s/
                  Francis Wen-Hou Chen
              
              Director
              
              March
                  17, 2008Francis
                  Wen-Hou Chen/s/
                  Mitchell H. Friedlaender, M.D.
              
              Director
              
              March
                  17, 2008Mitchell
                  H. Friedlaender, M. D./s/
                  John L. Mattana
              
              Director
              
              March
                  17, 2008John
                  L. Mattana/s/
                  Jon S. Saxe
              
              Director
              
              March
                  17, 2008Jon
                  S. Saxe/s/
                  Anders P. Wiklund
              
              Director
              
              March
                  17, 2008Anders
                  P. Wiklund




63




**EXHIBIT
      INDEX**




**Number**
            
            **Exhibit
                Table**3.11
            
            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
            
            Amended
                Bylaws.4.1
            
            Reference
                is made to Exhibits 3.1, 3.2, 3.3 and 3.4.10.15
            
            InSite
                Vision Incorporated Amended and Restated Employee Stock Purchase
                Plan
                adopted October 15, 2007.10.26HH
            
            InSite
                Vision Incorporated 1994 Stock Option Plan (Amended and Restated
                as of
                June 8, 1998).10.35HH
            
            InSite
                Vision Incorporated 2007 Performance Incentive Plan.10.45
            
            Form
                of Nonqualified Stock Option Agreement (2007).10.55
            
            Form
                of Incentive Stock Option Agreement (2007).10.67
            
            Form
                of Indemnification Agreement between the Company and its directors
                and
                officers.10.78
            
            Form
                of Employee’s Proprietary Information and Inventions
                Agreement.10.89H
            
            License
                Agreement dated as of October 9, 1991 by and between the Company and
                CIBA Vision Corporation, as amended October 9,
                1991.10.910
            
            Facilities
                Lease, dated September 1, 1996, between the Registrant and Alameda
                Real Estate Investments.10.1011H
            
            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.10.1312
            
            Amendment
                No. 1 to Marina Village Office Tech Lease, dated July 20, 2001 and
                effective January 1, 2002.10.1413H
            
            License
                Agreement, dated December 21, 2001 by and between the Company and
                The
                University of Connecticut Health Center.10.1514H
            
            ISV-403
                Asset Purchase Agreement, dated December 19, 2003, between the Company
                and
                Bausch & Lomb, Inc.10.1615
            
            Form
                of Class A Warrants issued under Subscription Agreement dated March
                26,
                2004.10.1715
            
            Form
                of Class B Warrants issued under Subscription Agreement dated March
                26,
                2004.10.1815
            
            Form
                of Placement Warrant issued pursuant to Placement Agreement dated
                February
                12, 2004.10.1916
            
            Form
                of Common Stock Warrant issued under Subscription Agreement dated
                May 26,
                2005.10.2016
            
            Form
                of Placement Agent Warrant, dated as of May 9, 2005.




64




**Number**
            
            **Exhibit
                Table**10.2117
            
            Warrant,
                dated as of October 10, 2005, for the purchase of 922,800 shares
                of Common
                Stock of the Company.10.2218
            
            Form
                of Warrant, dated as of January 11, 2006.10.2318
            
            Form
                of Placement Agent Warrant, dated as of January 11,
                2006.10.2419
            
            Form
                of Warrant, dated as of August 15, 2006.10.2520
            
            Amendment
                No. 3 to Marina Village Office Tech Lease, dated November 28,
                2006.10.2621H
            
            Exclusive
                License Agreement, dated as of February 15, 2007, by and between
                the
                Company and Pfizer, Inc. and Pfizer Products, Inc.10.2721H
            
            License
                Agreement, dated as of February 15, 2007, by and between the Company
                and
                Inspire Pharmaceuticals, Inc.10.2821H
            
            Trademark
                License Agreement, dated as of February 15, 2007, by and between
                the
                Company and Inspire Pharmaceuticals, Inc.10.2921H
            
            Supply
                Agreement, dated as of February 15, 2007, by and between the Company
                and
                Inspire Pharmaceuticals, Inc.10.3021HH
            
            Change
                in Control Agreement for S. Kumar Chandrasekaran adopted by InSite
                Vision
                Incorporated on May 2, 2007.23.1
            
            Consent
                of Burr, Pilger & Mayer LLP, Independent Registered Public Accounting
                Firm.31.1
            
            Certification
                of Chief Executive Officer pursuant to Rules 13a-14(a) and 15d-14(a)
                promulgated under the Securities Exchange Act of 1934, as
                amended.31.2
            
            Certification
                of Chief Financial Officer pursuant to Rules 13a-14(a) and 15d-14(a)
                promulgated under the Securities Exchange Act of 1934, as
                amended.32.1
            
            Certification
                of Chief Executive Officer and Chief Financial Officer pursuant to
                18
                U.S.C. Section 1350, as adopted pursuant to Section 906 of the
                Sarbanes-Oxley Act of 2002.







1.
              Incorporated
                  by reference to exhibits in the Company’s Annual Report on Form 10-K for
                  the year ended December 31, 1993 and the Company’s Annual Report on Form
                  10-K for the year ended December 31,
                  2006.




2.
              Incorporated
                  by reference to exhibits in the Company’s Registration Statement on Form
                  S-3 (RegistrationNo.
                  333-36673) as filed with the Securities and Exchange Commission
                  on
                  September 29, 1997.




3.
              Incorporated
                  by reference to an exhibit to the Company’s Quarterly Report on Form 10-Q
                  for the quarter ended September 30,
                  2002.




4.
              Incorporated
                  by reference to an exhibit to the Company’s Quarterly Report on Form 10-Q
                  for the quarter ended June 30,
                  2006.




5.
              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.




6.
              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.
  65




7.
              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.




8.
              Incorporated
                  by reference to an exhibit in the Company’s Annual Report on Form 10‐K for
                  the year ended December 31,
                  1993.




9.
              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.




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




11.
              Incorporated
                  by reference to an exhibit to the Company’s Quarterly Report on Form 10-Q
                  for the quarter ended June 30,
                  1996.




12.
              Incorporated
                  by reference to an exhibit to the Company’s Quarterly Report on Form 10-Q
                  for the quarter ended September 30,
                  2001.




13.
              Incorporated
                  by reference to an exhibit to the Company’s Annual Report of Form 10-K for
                  the year ended December 31,
                  2001.




14.
              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.




15.
              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.




16.
              Incorporated
                  by reference to an exhibit to the Company’s Registration Statement on Form
                  S-3 filed with the Securities and Exchange Commission on June 23,
                  2005
                  (File Number 333-126084).




17.
              Incorporated
                  by reference to an exhibit to the Company’s Current Report on Form 8-K
                  filed with the Securities and Exchange Commission on October 11,
                  2005
                  (File Number 001-14207).




18.
              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).




19.
              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).




20.
              Incorporated
                  by reference to an exhibit to the Company’s Annual Report of Form 10-K for
                  the year ended December 31,
                  2006.




21.
              Incorporated
                  by reference to an exhibit to the Company’s Quarterly Report on Form 10-Q
                  for the quarter ended March 31,
                  2007.




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


HH
            Management
                contract or compensatory plan.




66