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Alexza Pharmaceuticals 10-K 2008
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UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549
 
 
 
 
Form 10-K
For Annual and Transition Reports Pursuant to
 
     
þ
  ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
    For the fiscal year ended December 31, 2007
o
  TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
    For the transition period from          to          
 
Commission File Number: 000-51820
 
 
     
Delaware
(State or Other Jurisdiction of
Incorporation or Organization)
  77-0567768
(I.R.S. Employer
Identification Number)
 
2091 Stierlin Court
Mountain View, California 94043
(Address of Principal Executive Offices including Zip Code)
 
Registrant’s telephone number, including area code:
(650) 944-7000
 
Securities registered pursuant to Section 12 (b) of the Act:
 
     
Title of Each Class
 
Name of Each Exchange on Which Registered
 
Common Stock, par value $0.0001 per share   Nasdaq Global Market
 
 
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 þ
 
Indicate by check mark if the Registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.  Yes o     No þ
 
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 þ     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 Form 10-K or any amendments to this Form 10-K. þ
 
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. (Check one):
 
             
Large accelerated filer o
  Accelerated filer þ   Non-accelerated filer o
(Do not check if a smaller reporting company)
  Smaller reporting Company o
 
Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Act).  Yes o     No þ
 
The aggregate market value of the voting and non-voting stock held by non-affiliates of the Registrant was $193,805,928 based on the closing sale price of the Registrant’s common stock on The NASDAQ Global Market on June 30, 2007. Shares of the Registrant’s common stock beneficially owned by each executive officer and director of the Registrant and by each person known by the Registrant to beneficially own 10% or more of its outstanding common stock have been excluded, in that such persons may be deemed to be affiliates. This determination of affiliate status is not necessarily a conclusive determination for other purposes. The number of outstanding shares of the Registrant’s common stock as of March 1, 2008 was 31,156,728.
 
 
Portions of the registrant’s definitive Proxy Statement for the 2008 Annual Meeting of Stockholders to be filed within 120 days after the end of the Registrant’s fiscal year ended December 31, 2007 are incorporated by reference into Part III of this Annual Report on Form 10-K to the extent stated therein.
 


 

 
 
TABLE OF CONTENTS
 
                 
      Business     1  
      Risk Factors     27  
      Unresolved Staff Comments     44  
      Properties     44  
      Legal Proceedings     44  
      Submission of Matters to a Vote of Security Holders     44  
 
      Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities     44  
      Use of Proceeds from the Sale of Registered Securities     45  
      Treasury Stock     45  
      Selected Financial Data     46  
      Management’s Discussion and Analysis of Financial Condition and Results of Operations     47  
      Quantitative and Qualitative Disclosures About Market Risks     63  
      Financial Statements and Supplementary Data     64  
      Changes in and Disagreements With Accountants on Accounting and Financial Disclosure     100  
      Controls and Procedures     100  
      Other Information     101  
 
      Directors and Executive Officers of the Registrant     101  
      Executive Compensation     102  
      Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters     102  
      Certain Relationships and Related Transactions and Director Independence     102  
      Principal Accountant Fees and Services     102  
 
      Exhibits and Financial Statement Schedules     102  
    105  
    107  
 EXHIBIT 3.8
 EXHIBIT 10.36
 EXHIBIT 10.37
 EXHIBIT 10.38
 EXHIBIT 23.1
 EXHIBIT 31.1
 EXHIBIT 31.2
 EXHIBIT 32.1


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The names “Alexza” and “Staccato” are trademarks of Alexza Pharmaceuticals, Inc. We have registered the trademarks “Alexza Pharmaceuticals,” “Alexza” and “Staccato” with the U.S. Patent and Trademark Office. All other trademarks, trade names and service marks appearing in this Annual Report on Form 10-K are the property of their respective owners.
 
 
SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS
 
Some of the statements under “Business,” “Risk Factors,” “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and elsewhere in this Annual Report constitute forward-looking statements. In some cases, you can identify forward-looking statements by the following words: “may,” “will,” “could,” “would,” “should,” “expect,” “intend,” “plan,” “anticipate,” “believe,” “estimate,” “predict,” “project,” “potential,” “continue,” “ongoing” or the negative of these terms or other comparable terminology, although not all forward-looking statements contain these words. Examples of these statements include, but are not limited to, statements regarding the following: the implications of interim or final results of our clinical trials, the progress and timing of our research programs, including clinical testing, our anticipated timing for filing additional Investigational New Drug Applications with the United States Food and Drug Administration, the initiation or completion of Phase 1, Phase 2 or Phase 3 clinical testing for any of our product candidates, the extent to which our issued and pending patents may protect our products and technology, our ability to identify new product candidates using the Staccato system, the potential of such product candidates to lead to the development of safe or effective therapies, our ability to enter into collaborations, our future operating expenses, our future losses, our future expenditures for research and development, and the sufficiency of our cash resources. These statements involve known and unknown risks, uncertainties and other factors that may cause our actual results, levels of activity, performance or achievements to be materially different from the information expressed or implied by these forward-looking statements. While we believe that we have a reasonable basis for each forward-looking statement contained in this Annual Report, we caution you that these statements are based on a combination of facts and factors currently known by us and our projections of the future, about which we cannot be certain.
 
In addition, you should refer to the “Risk Factors” section of this Annual Report for a discussion of other important factors that may cause our actual results to differ materially from those expressed or implied by our forward-looking statements. As a result of these factors, we cannot assure you that the forward-looking statements in this Annual Report will prove to be accurate. Furthermore, if our forward-looking statements prove to be inaccurate, the inaccuracy may be material. In light of the significant uncertainties in these forward-looking statements, you should not regard these statements as a representation or warranty by us or any other person that we will achieve our objectives and plans in any specified time frame, or at all.
 
We undertake no obligation to publicly update any forward-looking statements, whether as a result of new information, future events or otherwise. You are advised, however, to consult any further disclosures we make on related subjects in our Quarterly Reports on Form 10-Q and Current Reports on Form 8-K.
 
Item 1.   Business
 
We are an emerging specialty pharmaceutical company focused on the development and commercialization of novel, proprietary products for the treatment of acute and intermittent conditions. We currently have six product candidates in clinical development. Our technology, the Staccato system, vaporizes excipient-free drugs to form condensation aerosols that, when inhaled, allows for rapid systemic drug delivery. Because of the particle size of the aerosol, the drug is quickly absorbed through the deep lung into the bloodstream, providing speed of therapeutic onset that is comparable to intravenous, or IV, administration but with greater ease, patient comfort and convenience.
 
We have identified approximately 200 drug compounds that have demonstrated initial vaporization feasibility for delivery with our technology. We believe that a number of these drug compounds, when delivered by the Staccato system, will have a desirable therapeutic profile for the treatment of acute and intermittent conditions. We are initially focusing on developing proprietary products by combining our Staccato system with small molecule


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drugs that have been in use for many years and are well characterized to create aerosolized forms of these drugs. We believe that we will be able to reduce the development time and risks associated with our product candidates, compared to the development of new chemical entities.
 
Our clinical-stage product candidates are:
 
  •  AZ-004 (Staccato loxapine).  We are developing AZ-004 for the treatment of acute agitation in patients with schizophrenia or bi-polar disorder. In March 2007, we announced positive initial results from a multi-center, randomized, double-blind, placebo-controlled Phase 2a clinical trial in 129 patients in an in-patient clinical setting. The 10 mg dose of AZ-004 met the primary endpoint of the clinical trial, which was a statistically significant reduction in the measure of agitation from baseline to the 2-hour post-dose time point, as compared to placebo. The 10 mg dose of AZ-004 also exhibited a rapid onset of effect, with a statistically-significant improvement in the PANSS (Positive and Negative Symptom Scale) Excited Component (PEC) scores at 20 minutes post-dose, as compared to placebo. The effectiveness of the 10 mg dose was sustained throughout the 24-hour study period, as compared to placebo. The 5 mg dose failed to achieve statistical significance. In February 2008 we initiated a Phase 3 clinical trial that is designed to enroll approximately 300 schizophrenic patients with acute agitation at 25 U.S. clinical centers. The trial is an in-clinic, multi-center, randomized, double-blind, placebo-controlled study and will test AZ-004 at two dose levels, 5 and 10 mg. Patients may receive up to 3 doses of study drug in a 24-hour period, depending on their clinical status. The primary endpoint for the study is the change from baseline in the PEC score, measured at 2 hours after the first dose. Various assessments of a patient’s agitation state will be conducted at serial time points using standard agitation scales over the first 4-hour post-dose time period, with follow-up assessments at the end of the 24-hour study period. Side effects will be recorded throughout the 24-hour period. A second Phase 3 clinical trial is projected to begin in the third quarter of 2008. The design of the second study will be similar to the first trial, except that the patient population will be patients with bipolar disease. AZ-004 has been licensed to Symphony Allegro, Inc., or Symphony Allegro, and we have the right to repurchase all rights to this product candidate.
 
  •  AZ-001 (Staccato prochlorperazine).  We are developing AZ-001 to treat patients suffering from acute migraine headaches. In March 2007, we announced positive initial results from an outpatient, multi-center, randomized, double blind, placebo-controlled Phase 2b clinical trial of AZ-001 in 400 migraine patients. All three doses of AZ-001 (5, 7.5 and 10 mg) met the primary endpoint of statistically significant pain relief 2-hours post-dose using the IHS (International Headache Society) 4-point headache pain rating scale, compared to placebo. In the two highest doses studied, AZ-001 also showed a statistically-significant difference in achieving a pain-free response at two hours, as compared with placebo. AZ-001 demonstrated rapid onset of pain relief, with statistically significant pain response in 15 minutes for the 7.5 mg dose and statistically-significant pain responses for all three doses at 30 minutes. AZ-001 also showed a sustained pain-free response, where a patient has a pain score of 0, or “no” headache, with statistically-significant elimination of pain at 24 hours post-dose at the two highest studied doses. Survival analysis for nausea, photophobia and phonophobia over the 2-hour period post-dose showed a statistically significant difference, compared to placebo. In December 2007, we completed enrollment of a thorough QT clinical trial, in which two doses of AZ-001 (5 and 10 mg) were compared to active control and to placebo. The purpose of a thorough QT study is to determine a drugs effect on cardiac rhythms. With > 40 subjects per treatment condition, we found that the active control, moxyfloxacin, produced a positive QT/QTc signal that verified the sensitivity of the clinical study. Based on a preliminary analysis of the data from the study, neither of the doses of AZ-001 produced a QT/QTc prolongation that would suggest an increased risk of cardiac arrhythmia.
 
  •  AZ-104 (Staccato loxapine).  We are developing AZ-104 to treat patients suffering from acute migraine headaches. AZ-104 is a lower dose version of AZ-004. In March 2008, we announced initial results of an in-clinic, multi-center randomized, double-blind, single administration, placebo controlled Phase 2a proof-of-concept clinical trial in 168 migraine patients with or without aura. Three doses of AZ-104 (1.25, 2.5 and 5 mg) were evaluated against placebo in the clinical trial. Using the IHS) 4-point rating scale, the primary efficacy endpoint was pain-relief response at 2 hours post-administration. AZ-104 met the primary efficacy endpoint of the clinical trial for the two highest doses of the drug compared to placebo. Statistically


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  significant improvements in pain response were observed in 76.7% of patients at the 5 mg dose (p= 0.02), 79.1% of patients at the 2.5 mg dose (p = 0.01) and 67.4% of patients at the 1.25 mg dose (p = 0.18), compared to 51.3% of patients receiving placebo. Using survival analysis for pain relief response, all three dose groups were statistically superior (p < .05) to placebo during the 4-hour post-treatment time period that the patients remained in the clinic. AZ-104 has been licensed to Symphony Allegro, and we have the right to repurchase all rights to this product candidate.
 
  •  AZ-002 (Staccato alprazolam).  We are developing AZ-002 for the acute treatment of panic attacks associated with panic disorder. In April 2006, we initiated an in-clinic, single-center, double-blind, placebo-controlled, Phase 2a proof-of-concept clinical trial in patients with panic disorder. As a result of observing greater than expected levels of sedation in the first two patients enrolled in the trial, we reduced the dose of AZ-002, modified the AZ-002 device, added an open-label portion to the clinical protocol, manufactured and released new clinical trial materials for the trial, and added two additional study sites to the study group. In April 2007, we re-initiated dosing in the 42 patient clinical trial with a lower dose of AZ-002. We have completed the open-label, lead-in segment of the clinical trial, identifying the 1 mg AZ-002 dose as an acceptable dose in terms of its safety and efficacy profile, and have initiated the randomized, double blind, placebo-controlled segment of the clinical trial. We expect to complete enrollment of this trial in the second quarter of 2008. AZ-002 has been licensed to Symphony Allegro, and we have the right to repurchase all rights to this product candidate.
 
  •  AZ-003 (Staccato fentanyl).  We are jointly developing AZ-003 with Endo Pharmaceuticals Inc., or Endo, for the treatment of breakthrough pain in cancer and non-cancer patients. Endo is responsible for regulatory, pre-clinical and clinical development, and for commercializing the product in North America. We are responsible for the development of the Staccato Electric Multiple Dose device and we have the exclusive right to manufacture the product for clinical development and commercial supply.
 
  •  AZ-007 (Staccato zaleplon).  We are developing AZ-007 for the treatment of insomnia in patients who have difficulty falling asleep, including patients who awake in the middle of the night and have difficulty falling back asleep. We filed an Investigational New Drug application, or IND, in December 2007. In February 2008, we initiated a Phase 1 clinical trial that enrolled 40 healthy volunteers at a single site. The purpose of this trial is to assess the safety, tolerability and pharmacokinetic parameters of a single dose of AZ-007. Using a double blind, randomized trial design, four doses of AZ-007 (ranging from 0.5 to 4.0 mg) are being compared to placebo. We expect to report initial results of this trial in the second quarter of 2008.
 
In order for us to initiate a clinical development program, a drug compound must exhibit technical feasibility with our Staccato system and also have the potential to serve an important unmet medical need in a large patient population. We believe that, with the current development status of our single dose device, the inherent advantages of our Staccato system will enable us to move a compound from initial screening through filing of an IND in 12 to 18 months.
 
On December 1, 2006 we entered into a transaction involving a series of related agreements providing for the financing of additional clinical and nonclinical development of AZ-002, Staccato alprazolam, and AZ-004, Staccato loxapine. Pursuant to the agreements, Symphony Capital LLC and other investors have invested $50 million to form Symphony Allegro to fund additional clinical and nonclinical development of Staccato alprazolam and Staccato loxapine. We have exclusively licensed to Symphony Allegro certain intellectual property rights related to Staccato alprazolam and Staccato loxapine. We have retained manufacturing rights to these two product candidates. We continue to be primarily responsible for the development of these two product candidates in accordance with a development plan and related development budgets. Pursuant to the agreements, we have received an exclusive purchase option that gives us the right, but not the obligation, to acquire all, but not less than all, of the equity of Symphony Allegro, and reacquire the intellectual property rights that we licensed to Symphony Allegro. This purchase option is exercisable at predetermined prices between December 1, 2007 and December 1, 2010. The purchase option exercise price may be paid for in cash or in a combination of cash and our common stock, in our sole discretion, provided that the common stock portion may not exceed 40% of the purchase option exercise price or 10% of our common stock issued and outstanding as of the purchase option closing date. If we pay a portion of the purchase option exercise price in shares of our common stock, then we will be required to register such shares


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for resale under a resale registration statement pursuant to the terms of a registration rights agreement. If we do not exercise our purchase option by December 1, 2010, then Symphony Allegro will retain its exclusive license to develop and commercialize Staccato alprazolam and Staccato loxapine for all indications, and we will manufacture and sell Staccato alprazolam and Staccato loxapine to Symphony Allegro or its sublicensee for those purposes. Pursuant to a warrant purchase agreement, we issued to Symphony Allegro Holdings, LLC a warrant with a five-year term to purchase 2,000,000 shares of our common stock at $9.91 per share, also paid a transaction structuring fee of $2.5 million, and reimbursed approximately $329,000 of Symphony Allegro transaction expenses.
 
On December 27, 2007, we entered into a license, development and supply agreement, or the license agreement, with Endo for AZ-003 (Staccato fentanyl) and the fentanyl class of molecules for North America. Under the terms of the license agreement, Endo paid us an upfront fee of $10 million, and will pay potential additional milestone payments of up to $40 million upon achievement of predetermined regulatory and clinical milestones. Endo will also pay undisclosed royalties to us on net sales of the product, from which we will pay for the cost of goods for the manufacture of the commercial version of the product. We have primary responsibility for the development and costs of the Staccato Electronic Multiple Dose device and the exclusive right to manufacture the product for clinical development and commercial supply. Endo has responsibility for future pre-clinical, clinical and regulatory development, and, if AZ-003 is approved for marketing, for commercializing the product in North America. Each party will be responsible for all internal costs and expenses incurred related to the respective area of responsibility. Generally speaking, each party will also be responsible for external development costs incurred related to the respective area of responsibility, but we agreed to pay certain external development costs incurred by Endo in excess of an agreed upon threshold, with a maximum expense to us of $20 million. We retain all rights outside of North America. Endo has the right to terminate the license agreement on 90 days written notice. Upon such termination, all rights to the product, including regulatory filings, data and clinical and non-clinical data for use with the product will revert to us.
 
We have retained all other rights to our product candidates and the Staccato system. We plan to build a United States-based specialty sales force to commercialize our product candidates which are approved for marketing and which are intended for psychiatric markets. We plan to enter into strategic partnerships with other companies to commercialize products that are intended for certain markets in the United States and for all of our product candidates in geographic territories outside the United States.
 
 
Acute and intermittent medical conditions are characterized by a rapid onset of symptoms that are temporary and severe, and that occur at irregular intervals, unlike the symptoms of chronic medical conditions that continue at a relatively constant level over time. Approved drugs for the treatment of many acute and intermittent conditions, such as antipsychotics to treat agitation, triptans to treat migraine headaches and benzodiazepines to treat anxiety, are typically delivered either in tablets or by injections. Traditional inhalation technologies are also being developed to treat these conditions. These delivery methods have the following advantages and disadvantages:
 
  •  Oral Tablets.  Oral tablets or capsules are convenient and cost effective, but they generally do not provide rapid onset of action. Oral tablets may require at least one to four hours to achieve peak plasma levels. Also, some drugs, if administered as a tablet or capsule, do not achieve adequate or consistent bioavailability due to the degradation of the drug by the stomach or liver or inability to be absorbed into the bloodstream.
 
  •  Injections.  IV injections provide a rapid onset of action and can sometimes be used to titrate potent drugs with very rapid changes in effect. Titration refers to the ability of a patient to self-administer an initial dose of medication and then determine if the medication is effective; if the medication is effective no further dosing is required. However, if the medication is not yet effective, the patient can administer another dose and repeat this process until the patient determines that the medication has had an adequate effect. However, IV injections generally are administered by trained medical personnel in a medical care setting. Other forms of injections result in an onset of action that is generally substantially slower than IV injection, although often faster than oral administration. All forms of injections are invasive, can be painful to some patients and are often expensive. In addition, many drugs are not water soluble and can be difficult to formulate in an injectable form.


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  •  Traditional Inhalation.  Traditional dry powder and aerosolized inhalation delivery systems have been designed and used primarily for local delivery of drugs to the respiratory airways, not to the deep lung for rapid systemic drug delivery. Certain recent variants of these systems, however, can provide systemic delivery of drugs, either for the purpose of rapid onset of action or to enable noninvasive delivery of drugs that are not orally bioavailable. Nevertheless, many of these systems have difficulty in generating appropriate drug particle sizes or consistent emitted doses for deep lung delivery. To achieve appropriate drug particle sizes and consistent emitted doses, most traditional inhalation systems require the use of excipients and additives such as detergents, stabilizers and solvents, which may potentially cause toxicity or allergic reactions. Many traditional inhalation devices require patient coordination to deliver the correct drug dose, leading to potentially wide variations in the drug delivered to a patient.
 
As a result of these limitations, we believe there is a significant unmet medical and patient need for products for the treatment of acute and intermittent conditions that can be delivered in precise amounts, provide rapid therapeutic onset, and are noninvasive and easy to use.
 
Our Solution: Staccato System
 
Our Staccato system rapidly vaporizes an excipient-free drug compound to form a proprietary condensation aerosol that is inhaled and rapidly achieves systemic blood circulation via deep lung absorption. The Staccato system consistently creates aerosol particles averaging one to three and one-half microns in size, which is the most appropriate size for deep lung inhalation and absorption into the bloodstream.
 
We believe our Staccato system matches delivery characteristics and product attributes to patient needs for acute and intermittent conditions, and also has the following advantages:
 
  •  Rapid Onset.  The aerosol produced with the Staccato system is designed to be rapidly absorbed through the deep lung with a speed of therapeutic onset comparable to an IV injection, generally achieving peak plasma levels of drug in two to five minutes.
 
  •  Ease of Use.  The Staccato system is breath actuated, and a patient simply inhales to administer the drug dose. Unlike injections, the Staccato system is noninvasive and does not require caregiver assistance. The aerosol produced with the Staccato system is relatively insensitive to patient inhalation rates. Unlike many other inhalation technologies, the patient does not need to learn a special breathing pattern. In addition, the Staccato device is small and easily portable.
 
  •  Consistent Particle Size and Dose.  The Staccato system uses rapid heating of the drug film to create consistent and appropriate particle sizes for deep lung inhalation and absorption into the bloodstream. The Staccato system also produces a consistent high emitted dose, regardless of the patient’s breathing pattern.
 
  •  Broad Applicability.  We have screened over 400 drugs, and approximately 200 have exhibited initial vaporization feasibility using our Staccato system. The Staccato system can deliver both water soluble and water insoluble drugs and eliminates the need for excipient and additives such as detergents, stabilizers and solvents, avoiding the side effects that may be associated with the excipient or additives.
 
  •  Design Flexibility.  The Staccato system can incorporate lockout and multiple dose features, potentially enhancing safety, convenience of patient titration and a variety of administration regimens.
 
 
We combine small molecule drugs with our Staccato system to create proprietary product candidates. We believe that the drugs we are currently using are no longer eligible for patent protection as chemical entities or have their patent protection expiring in the next several years. These drugs have been widely used, and we believe their biological activity and safety are well understood and characterized. We have received composition of matter patent protection on the Staccato aerosolized forms of these drugs. We also intend to collaborate with pharmaceutical companies to develop new chemical entities, including compounds that might otherwise not be suitable for development because of limitations of traditional delivery methods.


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Our product candidates employing Staccato system consist of three core components: (1) a heat source that includes an inert metal substrate; (2) a thin film of an excipient-free drug compound (also known as an active pharmaceutical ingredient, or API), coated on the substrate; and (3) an airway through which the patient inhales. The left panel of the illustration below depicts these core components prior to patient inhalation.
 
The right panel of the illustration below depicts the Staccato system during patient inhalation: (1) the heated substrate has reached peak temperature in less than one half second after the start of patient inhalation; (2) the thin drug film has been vaporized; and (3) the drug vapor has subsequently cooled and condensed into excipient-free drug aerosol particles that are being drawn into the patient’s lungs. The entire Staccato system actuation occurs in less than one second.
 
(CHART)
 
Five of our product candidates, AZ-004, AZ-001, AZ-002 AZ-104 and AZ-007, use the same disposable, single dose delivery device. The single dose delivery device consists of a metal substrate that is chemically heated through a battery-initiated reaction of energetic materials. In the current design, the heat package can be coated with up to 10 milligrams of API. The device is portable and easy to carry, with dimensions of approximately three inches in length, two inches in width, and three quarters of an inch in thickness. The device weighs approximately one ounce. A diagram of the single dose delivery device is shown below:
 
(CHART)


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AZ-003 uses a multiple dose delivery device consisting of a reusable controller and a disposable dose cartridge. We have designed the multiple dose delivery device to meet the specific needs of our AZ-003 product candidate. The dose cartridge currently contains 25 separate metal substrates, each coated with the API, which rapidly heat upon application of electric current from the controller. In the current design, 25 micrograms of drug compound are coated on each metal substrate. The device is portable and easy to carry, with dimensions of approximately five inches in length, two and one-half inches in width and one inch in thickness. The controller weighs approximately four ounces, and the dose cartridge weighs approximately one ounce.
 
We continue to undertake research and development efforts to improve commercial manufacturability of our single dose device and to develop future generations of the Staccato technology.
 
 
As indicated below, we have one product candidate in Phase 3 clinical testing, one product candidate that has completed Phase 2 clinical testing, two product candidates in Phase 2 clinical testing, and two product candidates in Phase 1 clinical testing.
 
                 
                Alexza
                Commercial
Product Candidate
 
API
 
Target Indication
 
Status
 
Rights
 
AZ-004
  Loxapine   Acute agitation in schizophrenia or bi-polar disorder patients   Phase 3   Out-licensed with exclusive repurchase option*
                 
AZ-001
  Prochlorperazine   Migraine headaches   Completed Phase 2   Worldwide
                 
AZ-002
  Alprazolam   Panic attacks   Phase 2   Out-licensed with exclusive repurchase option*
                 
AZ-104
  Loxapine   Migraine headaches   Phase 2   Out-licensed with exclusive repurchase option*
                 
AZ-003
  Fentanyl   Acute pain   Phase 1   Out-licensed North American commercialization rights**
                 
AZ-007
  Zaleplon   Insomnia   Phase 1   Worldwide
 
 
Licensed to Symphony Allegro
 
** Licensed to Endo
 
ACUTE AGITATION PROGRAM: AZ-004 (Staccato loxapine)
 
We are developing AZ-004 (Staccato loxapine) for the treatment of acute agitation in patients with schizophrenia or patients with bipolar disorder. Acute agitation, characterized by unpleasant arousal, tension, irritability and hostility, is one of the most common and severe symptoms of many major psychiatric disorders, including schizophrenia and bipolar disorder. According to the National Institute of Mental Health (NIMH), schizophrenia afflicts about 6.0 million adults in the United States and bipolar disease affects about 5.7 million American adults. We believe over 90% of these patients will experience agitation during their lifetime and that about 70% of those who experience agitation will have one to six episodes per year. Agitated patients are often treated in an emergency room setting, and are also treated as in-patients in psychiatric hospitals or psychiatric units in standard hospitals. We believe physicians currently treat acute agitation with intramuscular (IM) injections, rapid-dissolve tablets or standard tablets. IM injections are invasive, can be disconcerting to patients as they often require the use of restraints, and can be dangerous to the medical personnel while they attempt to inject the patient. IM injections can also take up to 60 minutes to work. Oral tablets provide convenience of dosing alternatives and have a slower onset


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of action. Market research among physicians has identified speed of onset as an important factor that affects their choice of therapy for treating acute agitation. We believe that many patients with schizophrenia or bipolar disorder disease can make informed decisions regarding their treatment in an acute agitative state and would prefer a rapid-acting, noninvasive treatment. We believe there is a significant unmet medical need for an acute agitation treatment option that will provide a fast onset of effect, that is noninvasive and safer to administer, and that allows patients to be active participants in choosing acceptable treatment options for themselves.
 
The API of AZ-004 is loxapine, a generic drug belonging to the class of drugs known as antipsychotics. Loxapine is currently approved in oral and injectable (intramuscular only) formulations in the United States for the management of the manifestations of schizophrenia.
 
Development Status
 
Clinical Trials
 
 
In February 2008 we initiated a Phase 3 clinical trial that is designed to enroll approximately 300 schizophrenic patients with acute agitation at 25 U.S. clinical centers. The trial is an in-clinic, multi-center, randomized, double-blind, placebo-controlled study and will test AZ-004 at two dose levels, 5 and 10 mg. Patients may receive up to 3 doses of study drug in a 24-hour period, depending on their clinical status. The primary endpoint for the study is the change from baseline in the PEC score, measured at 2 hours after the first dose. Various assessments of a patient’s agitation state will be conducted at serial time points using standard agitation scales over the first 4-hour post-dose time period, with follow-up assessments at the end of the 24-hour study period. Side effects will be recorded throughout the 24-hour period. A second Phase 3 clinical trial is projected to begin in the third quarter of 2008. The design of the second study will be similar to the first trial, except that the patient population will be patients with bipolar disease.
 
In March 2007, we reported initial results of a Phase 2a clinical trial of AZ-004. The Phase 2a clinical trial was designed as a multi-center, randomized, double-blind, placebo-controlled study of 129 patients in an in-patient clinical setting. In the trial, two doses of AZ-004 (Staccato loxapine in 5 and 10 mg doses) and placebo (Staccato device containing no drug) were tested. The primary aim of the clinical trial was to assess the safety and efficacy of a single dose of AZ-004 in acutely treating agitation in schizophrenic patients. Assessments of a patient’s agitation state were conducted at serial time points using both standard agitation scales and objective measures of patient’s movement over a 4-hour period, with follow-up assessments for the next 20 hours. The change in the PEC score at the 2-hour post-dose time point was the primary efficacy measure for the clinical study. All results were considered statistically significant at the p < 0.05 level and all analyses were made on an intent-to-treat basis. Side effects were recorded throughout the clinical trial study period.
 
Primary Efficacy Endpoint.  The 10 mg dose of AZ-004 met the primary endpoint of the clinical trial, showing a statistically significant improvement, compared to placebo. The 5 mg dose of AZ-004 did not achieve statistical significance, compared to placebo.
 
 
                         
    Baseline
    2-hour Post-
       
Study Arms
  Mean     Dose Mean     Significance  
 
10 mg AZ-004
    17.3       8.8       p=0.0002  
5 mg AZ-004
    17.6       10.8       p=0.088  
Placebo
    17.7       12.7       na  
 
Note:  na = not applicable
 
Additional Efficacy Variables.  The 10 mg dose of AZ-004 also exhibited a rapid onset of effect. At 10 minutes post-dose, the 10 mg dose exhibited an improvement in symptoms and at 20 minutes post-dose, the 10 mg dose showed statistically significant improvement in the PEC scores, compared to placebo. The effectiveness of the 10 mg dose was sustained throughout the 24-hour study period, compared to placebo.


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Using the Behavioral Activity Rating Scale (BARS), the 10 mg dose of AZ-004 showed statistically significant improvement, compared to placebo, beginning at 30 minutes. This response was sustained throughout the 24-hour study period, compared to placebo.
 
Clinical Global Impression-Severity (CGI-S) scale ratings to measure agitation were completed at baseline, immediately prior to AZ-004 administration. At the 2-hour post-dose time point, a Clinical Global Impression-Improvement (CGI-I) evaluation was completed for each patient. Both the 10 mg and the 5 mg doses of AZ-004 showed statistically significant improvements in the CGI-I scale, compared to placebo.
 
Safety Evaluations.  Side effects were recorded throughout the clinical trial period. The administration of AZ-004 was generally safe and well tolerated. The most common side effects reported were unpleasant taste, sedation and dizziness. These side effects were generally mild to moderate in severity, and occurred in both drug and placebo dose groups. There were three serious adverse events reported associated with the trial and all occurred at least one week post dosing. None of these serious adverse events were deemed attributable to study medication.
 
 
Loxapine has been approved for marketing in oral and injectable forms. There are publicly available safety pharmacology, systemic toxicology, carcinogenicity and reproductive toxicology data we will be able to use for our regulatory filings. Therefore, our preclinical development testing is primarily focused on assessing the local tolerability of inhaled loxapine. Our two preclinical inhalation toxicology studies with loxapine have indicated that it was generally well tolerated. We continue to generate the preclinical data that will be required to submit a New Drug Application, or NDA, for AZ-004.
 
MIGRAINE HEADACHE PROGRAM: AZ-001 (Staccato procholoperazine) and AZ-104 (Staccato loxapine)
 
We are developing AZ-001 (Staccato prochlorperazine) and AZ-104 (Staccato loxapine) for the treatment of acute migraine headaches. Although there are numerous products available for the treatment of migraines, including simple analgesics such as aspirin and acetaminophen, and nonsteroidal anti-inflammatory drugs such as ibuprofen and naproxen, the prescription market is dominated by a class of orally administered medications commonly known as triptans.
 
According to the National Headache Foundation, approximately 13 million people in the United States have been diagnosed with migraine headaches and are treated with prescription medications. Acute migraine headaches occur often, usually one to four times a month. Of the estimated 29.5 million migraine sufferers (including diagnosed and undiagnosed sufferers), there are at least two groups of potential patients for whom we believe AZ-001 and AZ-104 could be effective and safe in comparison to triptans. Many migraine sufferers who do take triptans have an insufficient therapeutic response to these medications. In addition, according to the warning labels on triptans, patients with hypertension or high cholesterol, or who smoke cigarettes, are contraindicated for and should not take these medications due to potential cardiovascular and cerebrovascular health risks.
 
 
The API of AZ-001 is prochlorperazine, a generic drug belonging to the class of drugs known as phenothiazines. Prochlorperazine is currently approved in oral, injectable and suppository formulations in the United States for the treatment of several indications, including nausea and vomiting. In several published clinical studies, 10 mg of prochlorperazine administered intravenously demonstrated effective relief of migraine pain. Prochlorperazine is often administered intravenously to patients with severe migraine headaches who come to emergency departments or migraine treatment clinics. We believe the combination of prochlorperazine with our Staccato system could potentially result in a speed of therapeutic onset advantage over oral tablets and a convenience and comfort advantage over injections. In addition, AZ-001 may be appropriate for patients who do not achieve effective relief with triptans or cannot take triptans due to the cardiovascular risk sometimes associated with the administration of triptans. For patients who do not obtain adequate relief from current migraine therapies, AZ-001 may offer a new anti-migraine mechanism of action.


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Development Status
 
 
We reported initial results of a Phase 2b clinical trial in March 2007. The AZ-001 Phase 2b clinical trial was an outpatient, multi-center, randomized, double blind, placebo-controlled study. The study was designed to evaluate the treatment of a single migraine attack in each of approximately 400 migraine patients, with and without aura. In the trial, three doses of AZ-001 (Staccato prochlorperazine in 5, 7.5 and 10 mg doses) and placebo (a Staccato device containing no drug) were tested, with 100 patients assigned to each treatment group. The primary efficacy endpoint for the trial was headache pain relief at 2-hours post-dose, as defined by the IHS 4-point headache pain rating scale. Secondary efficacy endpoints for the trial included various additional measurements of pain relief, as well as effects on nausea, vomiting, phonophobia and photophobia. The clinical trial study period was 24 hours post dosing for each patient. All results were considered statistically significant at the p < 0.05 level, and all analyses were made on an intent-to-treat basis. Side effects were recorded throughout the clinical trial study period, and a safety evaluation was made at each patient’s closeout visit.
 
Primary Efficacy Endpoint.  AZ-001 met the primary efficacy endpoint of the clinical trial, which was pain relief at 2-hours post-dose using the IHS 4-point headache pain rating scale, for all three doses of the drug compared to placebo. Statistically significant improvements in pain response were observed in 66.0% of patients at the 10 mg dose (p=0.0013), 63.7% of patients at the 7.5 mg dose (p=0.0046) and 60.2% of patients at the 5 mg dose (p=0.0076), compared to 40.8% of patients receiving placebo.
 
Additional Efficacy Endpoints.  Another measure of efficacy was the achievement of a pain-free response at 2 hours, where a patient has a pain score of 0, or “no”, headache pain at the 2-hours post-dose time point. In the trial, AZ-001 showed statistically significant differences from placebo in this measure with 35.0% of patients who received the 10 mg dose achieving pain-free status (p=0.0019) and 29.7% of patients who received the 7.5 mg dose achieving pain-free status (p=0.0226). Patients receiving the 5 mg dose (21.4%) did not achieve a statistically significant pain-free response, compared to placebo. The rate of pain-free response at 2 hours in patients receiving placebo was 15.3%.
 
We believe duration of efficacy is an important consideration in developing migraine therapeutics. A commonly used measure of duration of efficacy is the sustained pain-free response, whereby a patient reports a pain-free score at the 2-hour post-dose time point and remains pain-free for the remainder of the study period (through 24 hours). The 10.0 mg and 7.5 mg doses of AZ-001 showed statistically-significant differences in sustained pain-free response, compared to placebo. Sustained pain-free outcomes through 24 hours were observed in 30.1% and 23.1% of patients in the 10.0 mg and 7.5 mg dose groups, respectively. The placebo group exhibited a sustained pain-free response in 10.2% of patients.
 
AZ-001 exhibited rapid onset of pain relief. The 7.5 mg dose showed statistically significant pain response, compared to placebo, at 15 minutes (p=0.016). At 30 minutes, all three doses of AZ-001 showed statistically significant pain response, compared to placebo; 10 mg (p=0.0056), 7.5 mg (p=0.0003) and 5 mg (p=0.0056).
 
Symptom management is an important consideration in the overall efficacy of a migraine therapy. Important symptoms to be managed in migraine patients are nausea, vomiting, photophobia (sensitivity to light) and phonophobia (sensitivity to sound). Survival analyses for nausea, photophobia and phonophobia over the 2 hour time period post-dose showed a statistically significant difference, compared to placebo. The total number of patients with vomiting were too few to make conclusions about drug effect.
 
Safety Evaluations.  Side effects were recorded throughout the clinical trial study period, and a safety evaluation was made at each patient’s closeout visit. There were no serious adverse events reported during the trial. The most common drug-related side effects reported across all three active dose groups in the clinical trial were taste (25 — 33%), throat irritation (18 — 30%), cough (16 — 30%), somnolence (6 — 10%), breathlessness (2 — 9%), and dizziness (0 — 9%). These side effects appeared to be dose related, with a lower incidence and severity of the side effects generally seen at the lower doses of AZ-001.


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We have completed several preclinical studies of AZ-001 including inhalation toxicology studies in two animal species, cardiovascular and respiratory safety studies in one species, and in vitro and in vivo studies to assess potential gene mutations. In animal toxicology studies of prochlorperazine aerosols involving prolonged daily dosing, we detected changes to, and increases in the number of, the cells in the upper airway of the test animals. The terms for these changes and increases are “squamous metaplasia” and “hyperplasia,” respectively. We also observed lung inflammation in some animals. Squamous metaplasia and hyperplasia occurred at doses that were substantially greater than those administered in our human clinical trials. In subsequent toxicology studies of AZ-001 involving intermittent dosing, we detected lower incidence and severity of squamous metaplasia and hyperplasia in the upper airway of the test animals compared to the daily dosing results. No lung inflammation was observed with intermittent dosing. We do not expect to observe these events when AZ-001 is delivered intermittently and at proportionately lower doses in future toxicology studies. We continue to conduct toxicology and other preclinical studies, including preliminary studies to prepare for potentially required longer term carcinogenicity studies, to generate the preclinical data that will be required to submit an NDA for AZ-001.
 
 
We are developing AZ-104 for the treatment of acute migraine headaches. The API of AZ-104 is loxapine, a generic drug belonging to the class of drugs known as antipsychotics. Loxapine is currently approved in oral and injectable (intramuscular only) formulations in the United States for the management of the manifestations of schizophrenia.
 
Development Status
 
 
We completed enrollment of a Phase 2a proof-of-concept clinical trial for patients with migraine headache in December 2007 and reported initial results of this trial in February 2008. The Phase 2a clinical trial was an in-clinic, multi-center, randomized, double-blind, single-administration, placebo-controlled study in approximately 160 migraine patients with or without aura. Three doses of AZ-104 (1.25, 2.5 and 5 mg) were evaluated against placebo in the clinical trial. Using the IHS 4-point rating scale, the primary efficacy endpoint was pain-relief response at 2 hours post-administration. Secondary efficacy endpoints for the trial included additional pain response assessments and other symptom assessments at various time points. Safety evaluations were made throughout the clinical trial period.
 
Primary Efficacy Endpoint.  AZ-104 met the primary efficacy endpoint of the clinical trial for two doses of the drug compared to placebo. Statistically significant improvements in pain response were observed in 76.7% of patients at the 5 mg dose (p = 0.02), 79.1% of patients at the 2.5 mg dose (p = 0.01) and 67.4% of patients at the 1.25 mg dose (p = 0.18), compared to 51.3% of patients receiving placebo. Using survival analysis for pain relief response, all three dose groups were statistically superior (p < 0.05) to placebo during the 4-hour post-treatment time period that the patients remained in the clinic.
 
                                 
    Primary Efficacy Endpoint — Pain Relief at 2-Hous Post-Dose  
          Patients
             
          Achieving
          p-value
 
Treatment
  Number of Patients     Pain Relief     Percent Pain Relief     vs. Placebo  
 
Placebo
    39       20       51.3 %     na  
1.25 mg
    43       29       67.4 %     0.18  
2.5 mg
    43       34       79.1 %     0.01 *
5 mg
    43       33       76.7 %     0.02 *
 
 
Statistically significant results
 
Additional Efficacy Endpoints.  Additional measures of efficacy included the achievement of a pain-free response, in which a patient has a post-dose pain score of 0 (or “no”) headache pain. In the trial, AZ-104 showed statistically significant differences from placebo in this measure at the 2-hour time point with 30% of patients


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achieving pain-free status at the 2.5 mg dose (p = 0.01) and 28% at the 1.25 mg dose (p = 0.02). While the 5.0 mg dose was numerically superior to placebo with 21% pain-free, this group did not achieve a statistically significant response, compared to placebo (p = 0.12). The rate of pain-free response at 2 hours in patients receiving placebo was 8%. Using survival analysis for pain free response, all three dose groups were statistically superior (p < 0.05) to placebo during the 4-hour post-treatment time period that the patients remained in the clinic.
 
A commonly used measure of duration of efficacy is the sustained pain-free response, in which a patient reports a pain-free score at the 2-hour post-dose time point and remains pain-free for the remainder of the study period (up to 24 hours). The 2.5 mg dose of AZ-104 showed a statistically significant difference in sustained pain-free response (26%, p = 0.04) compared to placebo (8%). Sustained pain-free outcomes for the 5 mg (16%) and the 1.25 mg (21%) dose groups were not statistically significant.
 
Important symptoms to be managed in migraine patients are nausea, photophobia (sensitivity to light) and phonophobia (sensitivity to sound). This proof-of-concept trial was not powered to detect differences in these measurements. AZ-104 did exhibit statistically significant improvement in nausea across all dose levels (survival analysis, p = 0.02). Positive trends were observed in the improvement of the other symptoms, but the changes were not statistically significant.
 
Safety Evaluations.  Side effects were recorded throughout the clinical trial study period. There were no serious adverse events reported during the trial. The most common drug-related side effects (incidence ³ 5% in at least one drug dose group) reported across the three drug dose groups and placebo are listed in the table below.
 
                                 
    Placebo
    1.25 mg
    2.5 mg
    5 mg
 
Side Effects
  (%)     (%)     (%)     (%)  
 
Dysgeusia
    13       19       23       37  
Somnolence
    13       5       23       23  
Fatigue
    8       0       7       14  
Oral discomfort
    3       0       2       7  
Dizziness
    5       2       7       2  
Hypoaesthesia, pharyngeal
    0       0       0       7  
Throat irritation
    0       7       0       0  
Dry mouth
    5       2       5       5  
Hypoaesthesia, oral
    0       2       5       2  
Attention disturbance
    0       5       0       2  
Hypotension
    3       0       2       5  
 
 
Loxapine has been approved for marketing in oral and injectable forms. There are publicly available safety pharmacology, systemic toxicology, carcinogenicity and reproductive toxicology data we will be able to use for our regulatory filings. Therefore, our preclinical development testing is primarily focused on assessing the local tolerability of inhaled loxapine. Our two preclinical inhalation toxicology studies with loxapine have indicated that it was generally well tolerated. We continue to conduct toxicology, including extended duration exposure testing, and other preclinical studies to generate the data that will be required to submit an NDA for AZ-104.
 
PANIC ATTACK PROGRAM: AZ-002 (Staccato alprazolam)
 
We are developing AZ-002 (Staccato alprazolam) for the acute treatment of panic attacks associated with panic disorder, a condition characterized by the frequent, unpredictable occurrence of panic attacks. Although there are several chronic treatments approved to treat panic disorder, there are currently no approved drugs to acutely treat associated panic attacks. According to the NIMH approximately 6 million people in the United States suffer from panic disorder. Approximately 60% of patients seek treatment for their panic attacks. The current leading treatments for panic disorder are selective serotonin reuptake inhibitors, or SSRIs, taken prophylactically on a daily basis. Clinical literature indicates that approximately 46% of patients suffering from anxiety disorders, including panic disorder, are also prescribed benzodiazepines to take on an “as-needed” basis, indicating a level of ineffective


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treatment with the SSRIs alone. In addition, patients initiating SSRI drug therapy often take several weeks to experience therapeutic effects and during this time may experience breakthrough panic attacks.
 
We believe some physicians may generally prescribe benzodiazepines for patients to take as needed, when they feel a panic attack coming on, or during an attack. However, because the symptoms of a panic attack typically have a rapid onset and last less than 30 minutes, we believe oral benzodiazepines often do not work fast enough to provide patients with adequate relief.
 
The API of AZ-002 is alprazolam, a generic drug belonging to the class of drugs known as benzodiazepines. Alprazolam is currently approved in oral formulations in the United States for use in the management of anxiety disorder, for the short term relief of symptoms of anxiety, for anxiety associated with depression, and for the treatment of panic disorder with or without agoraphobia, or abnormal fear of being in public places. We believe alprazolam is one of the most frequently prescribed psychoactive drugs in the United States. Alprazolam oral tablet formulations are usually prescribed for a short-duration course of therapy of a few days to a few weeks with the goal of reducing the frequency of symptoms of anxiety or panic disorder, including panic attacks. However, the oral tablet formulations are not intended to acutely treat or reduce the severity of panic attacks when they occur. We believe alprazolam’s demonstrated ability to reduce the frequency of panic attacks, coupled with the noninvasive nature and pharmacokinetic, or PK, properties of the aerosolized form of alprazolam produced by our Staccato system, make AZ-002 a viable product candidate for the acute treatment of panic attacks. Pharmacokinetics is the analysis of absorption, distribution, metabolism and excretion of a drug by the body. AZ-002 has been licensed to Symphony Allegro, and we have the right to repurchase all rights to this product candidate.
 
Development Status
 
 
In April 2006, we initiated a Phase 2a proof-of-concept clinical trial with AZ-002 in patients with panic disorder. The primary aim of the clinical trial is to assess the safety and efficacy of a single dose of AZ-002 in treating a pharmacologically-induced panic attack. Changes in the intensity and the duration of the induced panic attack, using psychological and physiological measurements, are being evaluated at multiple time points during the study. The first two patients dosed in the study exhibited a higher level of sedation than had been observed at the same dose in healthy volunteers in the AZ-002 Phase 1 clinical trial. In consultation with the clinical investigator, we modified the protocol to reduce the dose of AZ-001 and to include an open label lead-in stage of the study in which patient sedation was assessed. To facilitate patient enrollment in the clinical trial, we recruited two additional clinical sites to conduct the study. In April 2007, we re-initiated dosing in the 42 patient clinical trial with a lower dose of AZ-002. We have completed the open-label, lead-in segment of the clinical trial, identifying the 1 mg AZ-002 dose as an acceptable dose in terms of its safety and efficacy profile, and have initiated the randomized, double blind, placebo-controlled segment of the clinical trial. We expect to complete enrollment of this trial in the second quarter of 2008.
 
In the manufacture of the new dosage strengths required for the amended protocol, a higher variability of the alprazolam emitted dose was observed. Further testing showed that alprazolam aerosols are electrically charged leading to variable deposition on the internal airway housing of the device. We believe this aerosol characteristic is unique to alprazolam, and it has not been observed in our other development product candidates. Consequently, the manufacturing process for AZ-002 was modified to incorporate a conductive airway housing to reduce the effects of the electrically charged aerosol. We have manufactured AZ-002 using the new airway housing, and we believe this change has resolved the aerosol emitted dose variability.
 
 
Alprazolam has been approved for marketing in oral tablet form. There are publicly available safety pharmacology, systemic toxicology, carcinogenicity and reproductive toxicology data that we will be able to use for our regulatory filings. Therefore, our preclinical development plan is primarily focused on assessing the local tolerability of inhaled alprazolam. To date, our two preclinical inhalation toxicology studies with inhaled alprazolam have indicated that it is generally well tolerated. We continue to conduct safety assessments, including


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extended duration exposure testing in toxicology studies, to generate the preclinical data that will be required to submit an NDA for AZ-002.
 
 
We are developing our product candidate AZ-003 (Staccato fentanyl) for the treatment of breakthrough pain in cancer and non-cancer patients. Based on our analysis of industry data and clinical literature, we believe over 25 million postoperative patients experience inadequate pain relief, despite receiving some form of pain management and, according to a three month study on cancer pain by Portenoy and Hagen (1990) and a cross-sectional study on cancer pain by Caraceni (2004), approximately 65% of patients diagnosed with cancer pain experience breakthrough cancer pain. A patient controlled analgesia, or PCA, IV pump is often used directly after surgery so the patient can achieve quick pain relief as needed. The PCA pump approach generally works well, but typically requires patients to remain in the hospital with an IV line in place. Physicians generally treat cancer pain using a combination of a chronic, long-acting drug and an acute or rapid acting drug for breakthrough pain. Treating a breakthrough pain episode with an oral medication is difficult due to the slow onset of therapeutic effect. However, patients usually also find more invasive, injectable treatments undesirable. Based on preclinical testing and the results of our Phase 1 clinical trial, we believe the PK of fentanyl delivered using a Staccato system will be similar to the PK of IV fentanyl administration. We believe many patients would benefit from a noninvasive but fast acting therapy that allows them to titrate the amount of pain medication to the amount of pain relief required.
 
In December 2007, we entered into a license and development agreement with Endo, for development of AZ-003 and the fentanyl class of molecules in North America. In the partnership, we have primary responsibility for the development of the Staccato Electric Multiple Dose device and the exclusive right to manufacture the product for clinical development and commercial supply. Endo has primary responsibility for regulatory, pre-clinical and clinical development, and for commercializing the product in North America.
 
The API of AZ-003 is fentanyl, a generic drug belonging to the class of drugs known as opioid analgesics. Fentanyl is currently approved in three different formulations in the United States for the management of various types of pain: injectable, transmucosal, which deliver drugs through the mucous membranes of the mouth or nose, and transdermal, which deliver drug through the skin. Since the Staccato system can incorporate lockout and multiple dose features, we believe that AZ-003 will facilitate patient titration to the minimum effective drug dose in a safe, convenient, easy to use and simple delivery system. In addition, we believe the incorporation of patient lockout features may be a significant safety advantage and has the potential to prevent diversion, or use by individuals who have not been prescribed the drug.
 
Development Status
 
 
We completed the initial analysis of the top-line results of our Phase 1 clinical trial with AZ-003 in December 2006. The primary aims of the Phase 1 clinical trial were to evaluate the arterial PK and absolute bioavailability for AZ-003 by comparing the AZ-003 profile to that of IV fentanyl, and to examine the pharmacodynamics, tolerability and safety of AZ-003 in opioid naive healthy subjects. The trial enrolled 50 subjects and was conducted at a single clinical center in two stages. Stage 1 of the protocol was an open-label, crossover comparison of a 25 g dose of AZ-003 by a single inhalation and the same dose of fentanyl administered intravenously over five seconds. Stage 2 of the protocol was a randomized double-blind, placebo-controlled, dose escalation of AZ-003 evaluating cumulative doses of 50, 100, 150 and 300 g of fentanyl. A 25 g individual dose of fentanyl was inhaled once in Stage 1, or 2, 4 or 6 times at 4 minute intervals for the first four different cohorts in Stage 2. A fifth cohort in Stage 2 received a 150 g dosing sequence starting at time zero and then a second 150 g dosing sequence starting at 60 minutes after the first dose, for a cumulative dose of 300 g. In addition to comprehensive PK sample collection, pharmacodynamic data were generated using pupillometry, a surrogate measure used to assess the functional activity of opioids.
 
The AZ-003 PK was substantially equivalent to the IV fentanyl PK, with similar peak plasma concentration (Cmax), time to maximum plasma concentration (Tmax) and area under the curve concentration (AUC). These data suggest very high absolute bioavailability of the inhaled dose. Mean peak arterial plasma concentrations were


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observed within 30 seconds for both administration routes. In Stage 2 of the clinical trial, ascending doses of AZ-003 controlled by the Staccato device, exhibited dose-proportionality of fentanyl throughout the dosing range from 50 mcg to 300 mcg, following an AUC analysis. There were no serious adverse events attributable to AZ-003, and the results from the clinical study showed that AZ-003 was generally safe and well tolerated at all doses.
 
In October 2007, clinical data from the AZ-003 Phase 1 clinical trial were presented in four different presentations at the 2007 American Society of Anesthesiologists Annual Meeting, in San Francisco, California. The four presentations were entitled, “Pharmacokinetic Profiles of Fentanyl Delivered by Intravenous and Inhaled Thermal Aerosol Routes”, “Pharmacokinetic Profile of Multiple Doses of Fentanyl Delivered by Inhaled Thermal Aerosol Route”, “Pharmacodynamic Response to Fentanyl Delivered by Intravenous and Inhaled Thermal Aerosol Routes” and “Pharmacodynamic Response to Multiple Doses of Fentanyl Delivered by Inhaled Thermal Aerosol Route”. This clinical trial demonstrated that the pharmacokinetic profile of AZ-003 in a single breath offers a speed of onset and consistency equivalent to fentanyl administered intravenously over 5 seconds. This clinical trial also demonstrated that the pharmacodynamic profile of AZ-003 in a single breath was comparable to that of fentanyl administered by intravenous administration.
 
 
Fentanyl is approved for marketing in injectable, transdermal and transmucosal forms. We are able to use publicly available safety pharmacology, systemic toxicology and reproductive toxicology data for our regulatory filings. Therefore, our preclinical development testing was primarily focused on assessing the local tolerability of inhaled fentanyl. Our two preclinical inhalation toxicology tests in two animal species with fentanyl have indicated that it was generally well tolerated. Endo is responsible for future preclinical development of AZ-003.
 
INSOMNIA PROGRAM: AZ-007 (Staccato zaleplon)
 
We are developing AZ-007 for the treatment of insomnia in patients who have difficulty falling asleep, including those patients with middle of the night awakening who have difficulty falling back asleep. Insomnia is the most prevalent sleep disorder, and we believe that it affects at least 15% to 20% of the US population, with some estimates of up to 50% of Americans reporting difficulty getting a good nights’ sleep at least a few nights a week. Insomnia can be due to any variety of causes, including depression, grief or stress, menopause, age, shift work, or environmental disruption. Whatever the cause of insomnia, it can take its toll on both the afflicted and the non-afflicted. Sleep disturbances have a major negative impact on public health and economic productivity. Costs for direct healthcare associated with insomnia are estimated to be approximately $14 billion to $15 billion each year.
 
 
Insomnia is a prevalent disorder that drives almost $5 billion in worldwide sales of prescription medications each year. In a large survey conducted by the National Sleep Foundation in 2005, results showed that 54% of the respondents experienced a minimum of one symptom of insomnia at least a few nights a week. Of those, respondents complained primarily of waking up feeling unrefreshed (38%), waking up frequently during the night (32%), having difficulty falling asleep (21%), and waking up too early and not being able to get back to sleep (21%).
 
Although benzodiazepines have been the gold standard in treatment of sleep disorders for decades, issues with drug misuse and dependency are common and concerning. Other current leading treatments for insomnia include non-benzodiazepine GABA-A receptor agonists, which include Ambien® (immediate release and controlled-release tablets), Sonata®, and Lunesta®, which have less abuse potential and side effects than classical benzodiazepines and can be used for longer term treatment. Patients and physicians surveyed suggest that current oral forms of these leading insomnia medications can take from 30 — 60 minutes to work, while promotions for insomnia medications cite 20 — 30 minutes. Compounds with a longer half-life that keep patients asleep longer, or those that are dosed in the middle of the night are also those that have residual side effects that can cause a ’hangover’ feeling the next day.
 
We believe the opportunity in insomnia is achieving a balance in treating patients so they can fall asleep quickly (whether at bedtime or in the middle of the night) while enabling them to function well the next day without a groggy feeling. We believe there is a potentially significant clinical need for rapid and predictable onset of sleep in


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patients with insomnia, coupled with a predictable duration of sleep and rapid, clear awakening that can be satisfied with AZ-007.
 
Development Status
 
 
In February 2008 we initiated a single-center, randomized, dose-escalation Phase 1 clinical trial in healthy male and female subjects. The primary objectives of the study are to examine the tolerability and safety of AZ-007 in a healthy volunteer population, to establish the pharmacokinetics of zaleplon in the target therapeutic range following AZ-007 doses, and to support the dosing selection for AZ-007 to be used in the Phase 2 clinical trial of this development program. Dose selection is based on AZ-007’s pharmacokinetic, pharmacodynamic, and tolerability profiles determined in this study.
 
 
Zaleplon has been approved for marketing in oral form. There are publicly available safety pharmacology, systemic toxicology, carcinogenicity and reproductive toxicology data we will be able to use for our regulatory filings. Therefore, our preclinical development testing is primarily focused on assessing the local tolerability of inhaled zaleplon. Our two preclinical inhalation toxicology studies with zaleplon have indicated that it was generally well tolerated. We continue to conduct toxicology, including extended duration exposure testing, and other preclinical studies to generate the data that will be required to submit an NDA for AZ-007.
 
 
We believe our Staccato system is broadly applicable to a large number of medically important small molecule compounds that could be useful in the treatment of acute and intermittent conditions. Since our inception, we have undertaken technical feasibility screening of approximately 400 compounds, which has resulted in the identification of approximately 200 compounds that have demonstrated initial vaporization feasibility. We intend to continue to screen additional drug compounds for vaporization feasibility with our Staccato system.
 
Once we have established initial vaporization feasibility, we conduct experiments and activities designed to identify viable product candidates. These experiments and activities include calculation of emitted doses, analysis of whether or not the emitted dose would be therapeutic, particle size analyses, early product stability studies and comprehensive medical and market needs assessments. After completion of these experiments and activities, a formal Product Selection Advisory Board, or PSAB, composed of employees and outside experts, is convened to evaluate these data.
 
After a positive PSAB decision, we initiate preclinical pharmacology and toxicology studies, with the intent of filing an IND upon successful completion of our preclinical studies. During this preclinical period, we also manufacture toxicology study supplies and initiate the manufacturing scale-up to move the product candidate through manufacturing design verification testing and the production of clinical trial materials.
 
We believe that, with the current development status of our single dose device, we can move a compound from initial screening through filing of an IND in 12 to 18 months.
 
 
We intend to develop an extensive portfolio of products. Key elements of our strategy include:
 
  •  Focus on Acute and Intermittent Conditions.  We focus our development and commercialization efforts on product candidates based on our Staccato system that are intended to address important unmet medical and patient needs in the treatment of acute and intermittent conditions. To meet these needs, we believe that products that provide rapid onset, ease of use, noninvasive administration and, in some cases, patient titration of dosage are required.


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  •  Develop Commercialization Capabilities.  We plan to build a United States-based specialty sales force to commercialize our product candidates which are approved for marketing and which are intended for psychiatric markets.
 
  •  Establish Strategic Partnerships.  We intend to strategically partner with pharmaceutical and other companies to provide development funding or to address markets that may require a larger sales force, greater marketing resources or specific expertise to maximize the value of some product candidates. We also intend to seek international distribution partners for our product candidates. We may also enter into strategic partnerships with other pharmaceutical companies to combine our Staccato system with their proprietary compounds.
 
  •  Retain and Control Product Manufacturing.  We own all manufacturing rights to our product candidates. We intend to internally complete the final manufacture and assembly of our product candidates and any future products, potentially enabling greater intellectual property protection and economic return from our future products. We also believe controlling the final manufacture and assembly reduces the risk of supply interruptions and allows more cost effective manufacturing.
 
 
 
On December 1, 2006 we entered into a transaction involving a series of related agreements providing for the financing of additional clinical and nonclinical development of AZ-002, Staccato alprazolam, and AZ-004, Staccato loxapine. Pursuant to the agreements, Symphony Capital LLC and other investors have invested $50 million to form Symphony Allegro to fund additional clinical and nonclinical development of Staccato alprazolam and Staccato loxapine. We have exclusively licensed to Symphony Allegro certain intellectual property rights related to Staccato alprazolam and Staccato loxapine. We have retained manufacturing rights to these two product candidates. We continue to be primarily responsible for the development of these two product candidates in accordance with a development plan and related development budgets. Pursuant to the agreements, we have received an exclusive purchase option that gives us the right, but not the obligation, to acquire all, but not less than all, of the equity of Symphony Allegro, and reacquire the intellectual property rights that we licensed to Symphony Allegro. This purchase option is exercisable at predetermined prices between December 1, 2007 and December 1, 2010. The purchase option exercise price may be paid for in cash or in a combination of cash and our common stock, in our sole discretion, provided that the common stock portion may not exceed 40% of the purchase option exercise price or 10% of our common stock issued and outstanding as of the purchase option closing date. If we pay a portion of the purchase option exercise price in shares of our common stock, then we will be required to register such shares for resale under a resale registration statement pursuant to the terms of a registration rights agreement. If we do not exercise our purchase option by December 1, 2010, then Symphony Allegro will retain its exclusive license to develop and commercialize Staccato alprazolam and Staccato loxapine for all indications, and we will manufacture and sell Staccato alprazolam and Staccato loxapine to Symphony Allegro or its sublicensee for those purposes. Pursuant to a warrant purchase agreement, we issued to Symphony Allegro Holdings, LLC a warrant with a five-year term to purchase 2,000,000 shares of our common stock at $9.91 per share. We also paid a transaction structuring fee of $2.5 million, and reimbursed approximately $329,000 of Symphony Allegro transaction expenses to Symphony Allegro Holdings LLC.
 
 
On December 27, 2007, we entered into a license, development and supply agreement, or the license agreement, with Endo for AZ-003 (Staccato fentanyl) and the fentanyl class of molecules for North America. Under the terms of the license agreement, Endo paid us an upfront fee of $10 million, and will pay potential additional milestone payments of up to $40 million upon achievement of predetermined regulatory and clinical milestones. Endo will also pay undisclosed royalties to us on net sales of the product, from which we will pay for the cost of goods for the manufacture of the commercial version of the product. We have primary responsibility for the development and costs of the Staccato Electronic Multiple Dose device and the exclusive right to manufacture the product for clinical development and commercial supply. Endo has responsibility for future pre-clinical, clinical


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and regulatory development, and, if AZ-003 is approved for marketing, for commercializing the product in North America. Each party will be responsible for all internal costs and expenses incurred related to the respective area of responsibility. Generally speaking, each party will also be responsible for external development costs incurred related to the respective area of responsibility, but we agreed to pay certain external development costs incurred by Endo in excess of an agreed upon threshold, with a maximum expense to us of $20 million. We retain all rights outside of North America. Endo has the right to terminate the license Agreement on 90 days written notice. Upon such termination, all rights to the product, including regulatory filings, data and clinical and non-clinical data for use with the product will revert to us.
 
 
We manufacture our product candidates with components supplied by vendors and with parts manufactured in-house. We believe that manufacturing our product candidates will potentially enable greater intellectual property protection and economies of scale and decrease the risk of supply interruptions.
 
We outsource the production of some components of our product candidates, including the printed circuit boards and the molded plastic airways. We currently use single source suppliers for these components, as well as for the API used in each of our product candidates. We will outsource the heat packages used in the single dose version of our Staccato system device in the future. We do not carry a significant inventory of these components, and establishing additional or replacement suppliers for any of these components may not be accomplished quickly, or at all, and could cause significant additional expense. With the exception of Autoliv ASP Inc., or Autoliv, which will provide chemical heat packages as described below, our suppliers have no contractual obligations to continue to supply us with any of the components necessary to manufacture our product candidates. Any supply interruption from our vendors would limit our ability to manufacture our product candidates and could delay clinical trials for, and regulatory approval of, our product candidates.
 
On November 2, 2007, we entered into a manufacturing and supply agreement, or the supply agreement, with Autoliv relating to the commercial supply of chemical heat packages that can be incorporated into our single dose Staccato device. Autoliv had developed these chemical heat packages for us pursuant to a development agreement between Autoliv and us executed in October 2005. Under the terms of the supply agreement, Autoliv will develop a manufacturing line capable of producing 10 million chemical heat packages a year. Alexza will pay Autoliv $12 million upon the earlier of December 31, 2011 or 60 days after the approval by the FDA of an NDA filed by us. If either party terminates the supply agreement, we will be required to reimburse Autoliv for certain expenses related to the equipment and tooling used in the production and testing of the chemical heat packages up to $12 million. Upon either payment Autoliv will be required to transfer possession and ownership of such equipment and tooling to us.
 
Autoliv has agreed to manufacture, assemble and test the chemical heat packages solely for us in conformance with our specifications. We will pay Autoliv a specified purchase price, which varies based on annual quantities ordered by us, per chemical heat package delivered. The initial term of the supply agreement expires on December 31, 2012 and may be extended by written mutual consent. The supply agreement provides that during the term of the supply agreement, Autoliv will be our exclusive supplier of chemical heat packages. In addition, the supply agreement grants Autoliv the right to negotiate for the right to supply commercially any second generation chemical heat package, or a second generation product, and provides that we will pay Autoliv certain royalty payments if we manufacture second generation products ourselves or if we obtain second generation products from a third party manufacturer. Upon the expiration or termination of the supply agreement we will also be required, on an ongoing basis, to pay Autoliv certain royalty payments related to the manufacture of the chemical heat packages by us or third party manufacturers.
 
The supply agreement also contains certain provisions regarding the rights and responsibilities of the parties with respect to manufacturing specifications, forecasting and ordering, delivery arrangements, payment terms, packaging requirements, change orders, intellectual property rights confidentiality and indemnification, as well as certain other customary matters.
 
The chemical heat packages for our single dose delivery device are manufactured by coating energetic materials on the inside surface of the metal substrate. After inspection and qualification, we assemble the


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components of our product candidates and coat the exterior of the metal substrate with a thin film of API. We then place the plastic airway around the assembly and package a completed device in a pharmaceutical-grade foil pouch. The controller for our multiple dose delivery design includes the battery power source for heating the individual metal substrates, a microprocessor that directs the electric current to the appropriate metal substrate at the appropriate time, and an icon-based liquid crystal display that shows the number of doses remaining in the dose cartridge and the controller status. We may need to develop additional versions of our devices for future product candidates.
 
We believe we have developed quality assurance and quality control systems applicable to the design, manufacture, packaging, labeling and storage of our product candidates in compliance with applicable regulations. These systems include extensive requirements with respect to quality management and organization, product design, manufacturing facilities, equipment, purchase and handling of components, production and process controls, packaging and labeling controls, device evaluation, distribution and record keeping.
 
In 2007, we completed a current good manufacturing practices, or cGMP, compliant pilot manufacturing facility in our new location in Mountain View, California. In November 2007, we received a pharmaceutical manufacturing license from the California State Food and Drug Branch for this facility. We believe this pilot manufacturing facility will have sufficient capacity to manufacture materials for toxicology studies and clinical trial materials for future clinical trials. We also believe that this facility may be sufficient to manufacture early commercial-scale batches of our products. In February 2008, we completed the move from Palo Alto to our new Mountain View facilities.
 
 
We plan to build a United States based specialty sales force to commercialize any of our product candidates, which are approved for marketing and which are intended for psychiatric markets. We plan to enter into strategic partnerships with other companies to commercialize products that are intended for certain markets in the United States and for all of our product candidates in geographic territories outside the United States.
 
Government Regulation
 
The testing, manufacturing, labeling, advertising, promotion, distribution, export and marketing of our product candidates are subject to extensive regulation by governmental authorities in the United States and other countries. Our product candidates include drug compounds incorporated into our delivery device and are considered “combination products” in the United States. We have agreed with the FDA that our product candidates will be reviewed by the FDA’s Center for Drug Evaluation and Research. The FDA, under the Federal Food, Drug and Cosmetic Act, or FDCA, regulates pharmaceutical products in the United States. The steps required before a drug may be approved for marketing in the United States generally include:
 
  •  preclinical laboratory studies and animal tests;
 
  •  the submission to the FDA of an IND for human clinical testing, which must become effective before human clinical trials commence;
 
  •  adequate and well controlled human clinical trials to establish the safety and efficacy of the product;
 
  •  the submission to the FDA of an NDA;
 
  •  satisfactory completion of an FDA inspection of the manufacturing facilities at which the product is made to assess compliance with cGMP. In addition, the FDA may audit clinical trial sites that generated the data in support of the NDA; and
 
  •  FDA review and approval of the NDA.
 
The testing and approval process requires substantial time, effort and financial resources, and the receipt and timing of any approval is uncertain. Preclinical studies include laboratory evaluations of the product candidate, as well as animal studies to assess the potential safety and efficacy of the product candidate. The results of the preclinical studies, together with manufacturing information and analytical data, are submitted to the FDA as part of


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the IND, which must become effective before clinical trials may be commenced. The IND will become effective automatically 30 days after receipt by the FDA, unless the FDA raises concerns or questions about the conduct of the trials as outlined in the IND prior to that time. In this case, the IND sponsor and the FDA must resolve any outstanding concerns before clinical trials can proceed.
 
Clinical trials involve the administration of the product candidates to healthy volunteers or patients under the supervision of a qualified principal investigator. Further, each clinical trial must be reviewed and approved by an independent institutional review board, or IRB, at or servicing each institution at which the clinical trial will be conducted. The IRB will consider, among other things, ethical factors, the safety of human subjects and the possible liability of the institution.
 
Clinical trials typically are conducted in three sequential phases prior to approval, but the phases may overlap. A fourth, or post-approval, phase may include additional clinical studies. These phases generally include the following:
 
  •  Phase 1.  Phase 1 clinical trials involve the initial introduction of the drug into human subjects, frequently healthy volunteers. These studies are designed to determine the metabolism and pharmacologic actions of the drug in humans, the adverse effects associated with increasing doses and, if possible, to gain early evidence of effectiveness. In Phase 1 clinical trials, the drug is usually tested for safety, including adverse effects, dosage tolerance, absorption, distribution, metabolism, excretion and pharmacodynamics.
 
  •  Phase 2.  Phase 2 clinical trials usually involve studies in a limited patient population to (1) evaluate the efficacy of the drug for specific, targeted indications; (2) determine dosage tolerance and optimal dosage; and (3) identify possible adverse effects and safety risks. Although there are no statutory or regulatory definitions for Phase 2a and Phase 2b, Phase 2a is commonly used to describe a Phase 2 clinical trial evaluating efficacy, adverse effects and safety risks and Phase 2b is commonly used to describe a subsequent Phase 2 clinical trial that also evaluates dosage tolerance and optimal dosage.
 
  •  Phase 3.  If a compound is found to be potentially effective and to have an acceptable safety profile in Phase 2 clinical trials, the clinical trial program will be expanded to further demonstrate clinical efficacy, optimal dosage and safety within an expanded patient population at geographically dispersed clinical trial sites. Phase 3 clinical trials usually include several hundred to several thousand patients.
 
  •  Phase 4.  Phase 4 clinical trials are studies required of, or agreed to, by a sponsor that are conducted after the FDA has approved a product for marketing. These studies are used to gain additional experience from the treatment of patients in the intended therapeutic indication and to document a clinical benefit in the case of drugs approved under accelerated approval regulations. If the FDA approves a product while a company has ongoing clinical trials that were not necessary for approval, a company may be able to use the data from these clinical trials to meet all or part of any Phase 4 clinical trial requirement. These clinical trials are often referred to as Phase 3/4 post-approval clinical trials. Failure to promptly conduct Phase 4 clinical trials could result in withdrawal of approval for products approved under accelerated approval regulations.
 
In the case of products for the treatment of severe or life threatening diseases, the initial clinical trials are sometimes conducted in patients rather than in healthy volunteers. Since these patients are already afflicted with the target disease, it is possible that such clinical trials may provide evidence of efficacy traditionally obtained in Phase 2 clinical trials. These trials are referred to frequently as Phase 1/2 clinical trials. The FDA may suspend clinical trials at any time on various grounds, including a finding that the subjects or patients are being exposed to an unacceptable health risk.
 
The results of preclinical studies and clinical trials, together with detailed information on the manufacture and composition of the product, are submitted to the FDA in the form of an NDA requesting approval to market the product. Generally, regulatory approval of a new drug by the FDA may follow one of three routes. The most traditional of these routes is the submission of a full NDA under Section 505(b)(1) of the FDCA. A second route, which is possible where an applicant chooses to rely in part on the FDA’s conclusion about the safety and effectiveness of previously approved drugs is to submit a more limited NDA described in Section 505(b)(2) of the FDCA. The final route is the submission of an Abbreviated New Drug Application for products that are shown to be therapeutically equivalent to previously approved drug products as permitted under Section 505(j) of the FDCA. We


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do not expect any of our product candidates to be submitted under Section 505(j). Both Section 505(b)(1) and Section 505(b)(2) applications are required by the FDA to contain full reports of investigations of safety and effectiveness. However, in contrast to a traditional NDA submitted pursuant to Section 505(b)(1) in which the applicant submits all of the data demonstrating safety and effectiveness, we believe an application submitted pursuant to Section 505(b)(2) can rely upon findings by the FDA that the parent drug is safe and effective in that indication. As a consequence, the preclinical and clinical development programs leading to the submission of an NDA under Section 505(b)(2) may be less expensive to carry out and can be concluded in a shorter period of time than programs required for a Section 505(b)(1) application. In its review of any NDA submissions, however, the FDA has broad discretion to require an applicant to generate additional data related to safety and efficacy, and it is impossible to predict the number or nature of the studies that may be required before the FDA will grant approval. Notwithstanding the approval of many products by the FDA pursuant to Section 505(b)(2), over the last few years certain brand-name pharmaceutical companies and others have objected to the FDA’s interpretation of Section 505(b)(2). If the FDA changes its interpretation of Section 505(b)(2), this could delay or even prevent the FDA from approving any Section 505(b)(2) NDA that we submit.
 
To the extent that a Section 505(b)(2) applicant is relying on the FDA’s findings for an already-approved product, the applicant is required to certify to the FDA concerning any patents listed for the approved product in the FDA’s Orange Book publication. A certification that the new product will not infringe the already approved products’ Orange Book-listed patents or that such patents are invalid is called a paragraph IV certification, and could be challenged in court by the patent owner or holder of the application of the already approved products. This could delay the approval of any Section 505(b)(2) application we submit. In addition, any period of marketing exclusivity applicable to the already approved product might delay approval of any Section 505(b)(2) application we submit. Any Section 505(b)(1) or Section 505(b)(2) application we submit for a drug product containing a previously approved API might be eligible for three years of marketing exclusivity, provided new clinical investigations that were conducted or sponsored by the applicant are essential to the FDA’s approval of the application. Five years of marketing exclusivity is granted if FDA approves an NDA for a new chemical entity. In addition, we can list in the FDA’s Orange Book publication any of our patents claiming the drug product, drug substance or that cover an approved method-of-use. In order for a generic applicant to rely on the FDA’s approval of any NDA we submit, such generic applicant must certify to any Orange Book listed patents and might be subject to any marketing exclusivity covering our approved drug product.
 
In the NDA submissions for our product candidates that are currently undergoing clinical trials, we intend to follow the development pathway permitted under the FDCA that we believe will maximize the commercial opportunities for these product candidates. We are currently pursuing the Section 505(b)(2) application route for our product candidates. As such, we intend to engage in discussions with the FDA to determine which, if any, portions of our development program can be modified, based on previous FDA findings of a drug’s safety and effectiveness.
 
Before approving an NDA, the FDA will inspect the facilities at which the product is manufactured, whether ours or our third party manufacturers’, and will not approve the product unless the manufacturing facility complies with cGMP. The FDA reviews all NDA’s submitted before it accepts them for filing and may request additional information rather than accept an NDA for filing. Once the NDA submission has been accepted for filing, the FDA begins an in-depth review of the NDA. Under the goals and policies agreed to by the FDA under the Prescription Drug User Fee Act, or PDUFA, the FDA has 10 months in which to complete its initial review of a standard NDA and respond to the applicant, and six months for a priority NDA. The FDA does not always meet the PDUFA goal dates for standard and priority NDA’s. The review process is often significantly extended by FDA requests for additional information or clarification. The FDA may delay approval of an NDA if applicable regulatory criteria are not satisfied, require additional testing or information and/or require post-marketing testing and surveillance to monitor safety or efficacy of a product. FDA approval of any NDA submitted by us will be at a time the FDA chooses. Also, if regulatory approval of a product is granted, such approval may entail limitations on the indicated uses for which such product may be marketed. Once approved, the FDA may withdraw the product approval if compliance with pre and post-marketing regulatory requirements and conditions of approvals are not maintained or if problems occur after the product reaches the marketplace. In addition, the FDA may require post-marketing studies, referred to as Phase 4 clinical trials, to monitor the effect of approved products and may limit further marketing of the product based on the results of these post-marketing studies.


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If we obtain regulatory approval for a product, this approval will be limited to those diseases and conditions for which the product is effective, as demonstrated through clinical trials. Even if this regulatory approval is obtained, a marketed product, its manufacturer and its manufacturing facilities are subject to continual review and periodic inspections by the FDA and, in our case, the State of California. Discovery of previously unknown problems with a medicine, device, manufacturer or facility may result in restrictions on the marketing or manufacturing of an approved product, including costly recalls or withdrawal of the product from the market. The FDA has broad post-market regulatory and enforcement powers, including the ability to suspend or delay issuance of approvals, seize or recall products, withdraw approvals, enjoin violations and institute criminal prosecution.
 
In addition to regulation by the FDA and certain state regulatory agencies, the United States Drug Enforcement Administration, or DEA, imposes various registration, recordkeeping and reporting requirements, procurement and manufacturing quotas, labeling and packaging requirements, security controls and a restriction on prescription refills on certain pharmaceutical products under the Controlled Substances Act. A principal factor in determining the particular requirements, if any, applicable to a product is its actual or potential abuse profile. The DEA regulates drug substances as Schedule I, II, III, IV or V substances, with Schedule I and II substances considered to present the highest risk of substance abuse and Schedule V substances the lowest risk. Alprazolam, the API in AZ-002, is regulated as a Schedule IV substance, fentanyl, the API in AZ-003, is regulated as a Schedule II substance, and zaleplon, the API in AZ-007, is regulated as a Schedule IV substance. Each of these product candidates are subject to DEA regulations relating to manufacturing, storage, distribution and physician prescription procedures, and the DEA regulates the amount of the scheduled substance that would be available for clinical trials and commercial distribution. As a Schedule II substance, fentanyl is subject to additional controls, including quotas on the amount of product that can be manufactured and limitations on prescription refills. We have received necessary registrations from the DEA for the manufacture of AZ-002, AZ-003 and AZ-007. The DEA periodically inspects facilities for compliance with its rules and regulations. Failure to comply with current and future regulations of the DEA could lead to a variety of sanctions, including revocation, or denial of renewal, of DEA registrations, injunctions, or civil or criminal penalties, and could harm our business and financial condition.
 
The single dose design of our Staccato system uses what we refer to as “energetic materials” to generate the rapid heating necessary for vaporizing the drug while avoiding degradation. Manufacture of products containing these types of materials is controlled by the Bureau of Alcohol, Tobacco, Firearms and Explosives, or ATF, under 18 United States Code Chapter 40. Technically, the energetic materials used in our Staccato system are classified as “low explosives,” and we have been granted a license/permit by the ATF for the manufacture of such low explosives.
 
Additionally, due to inclusion of the energetic materials in our Staccato system, shipments of the single dose design of our Staccato system are regulated by the Department of Transportation, or DOT, under Section 173.56, Title 49 of the United States Code of Federal Regulations. The single dose version of our Staccato device has been granted “Not Regulated as an Explosive” status by the DOT.
 
We have received funding for one or more research projects from a funding agency of the United States government, and inventions conceived or first actually reduced to practice during the performance of the research project are subject to the rights and limitations of certain federal statutes and various implementing regulations known generally and collectively as the “Bayh-Dole Requirements.” As a funding recipient, we are subject to certain invention reporting requirements, and certain limitations are placed on assignment of the invention rights. In addition, the federal government retains a non-exclusive, irrevocable, paid-up license to practice the invention and, in exceptional cases, the federal government may seek to take title to the invention.
 
We also will be subject to a variety of foreign regulations governing clinical trials and the marketing of any future products. Outside the United States, our ability to market a product depends upon receiving a marketing authorization from the appropriate regulatory authorities. The requirements governing the conduct of clinical trials, marketing authorization, pricing and reimbursement vary widely from country to country. In any country, however, we will only be permitted to commercialize our products if the appropriate regulatory authority is satisfied that we have presented adequate evidence of safety, quality and efficacy. Whether or not FDA approval has been obtained, approval of a product by the comparable regulatory authorities of foreign countries must be obtained prior to the commencement of marketing of the product in those countries. The time needed to secure approval may be longer or


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shorter than that required for FDA approval. The regulatory approval and oversight process in other countries includes all of the risks associated with the FDA process described above.
 
 
In both domestic and foreign markets, our ability to commercialize successfully and attract strategic partners for our product candidates depends in significant part on the availability of adequate coverage and reimbursement from third-party payors, including, in the United States, governmental payors such as the Medicare and Medicaid programs, managed care organizations, and private health insurers. Third-party payors are increasingly challenging prices charged for medical products and services and examining their cost effectiveness, in addition to their safety and efficacy. We may need to conduct expensive pharmacoeconomic studies in order to demonstrate the cost effectiveness of any future products. Even with studies, our product candidates may be considered less safe, less effective or less cost effective than existing products, and third-party payors therefore may not provide coverage and reimbursement for our product candidates, in whole or in part.
 
Political, economic and regulatory influences are subjecting the healthcare industry in the United States to fundamental changes. There have been, and we expect there will continue to be, a number of legislative and regulatory proposals to change the healthcare system in ways that could significantly affect our business. We anticipate that Congress, state legislatures and the private sector will continue to consider and may adopt healthcare policies intended to curb rising healthcare costs. These cost containment measures include:
 
  •  controls on government funded reimbursement for medical products and services;
 
  •  controls on healthcare providers;
 
  •  challenges to the pricing of medical products and services or limits or prohibitions on reimbursement for specific products and therapies through other means;
 
  •  reform of drug importation laws; and
 
  •  expansion of use of managed care systems in which healthcare providers contract to provide comprehensive healthcare for a fixed cost per person.
 
We are unable to predict what additional legislation, regulations or policies, if any, relating to the healthcare industry or third-party coverage and reimbursement may be enacted in the future or what effect such legislation, regulations or policies would have on our business. Any cost containment measures, including those listed above, or other healthcare system reforms that are adopted could have a material adverse effect on our ability to operate profitably.
 
 
We actively seek to patent the technologies, inventions and improvements we consider important to the development of our business. In addition, we rely on trade secrets and contractual arrangements to protect our proprietary information. Some areas for which we seek patent protection include:
 
  •  the Staccato system and its components;
 
  •  methods of using the Staccato system;
 
  •  the aerosolized form of drug compounds produced by the Staccato system; and
 
  •  methods of making and using the drug containing aerosols, including methods of administering the aerosols to a patient.
 
As of February 1, 2008, we held over 95 issued and allowed U.S. and international patents. Most of our patents are directed to compositions for delivery of an aerosol comprising drugs other than our lead product candidates described below, and cover the process for producing these aerosols using the Staccato system. As of that date, we held over 55 additional pending patent applications in the United States. We also hold over 125 pending corresponding foreign patent applications or Patent Cooperation Treaty applications that will permit us to pursue additional patents outside of the United States. The claims in these various patents and patent applications are


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directed to various aspects of our drug delivery devices and their components, methods of using our devices, drug containing aerosol compositions and methods of making and using such compositions.
 
 
One of our issued U.S. patents covers compositions for delivery of a condensation aerosol comprising loxapine and covers the process for producing such condensation aerosol using the Staccato system technology. This patent will not expire until 2022. Counterparts to this patent are pending in a number of foreign jurisdictions, including Europe. We also have three other U.S. patents directed to condensation aerosol compositions for delivery of loxapine, kits containing devices for forming such compositions and methods of administering such compositions.
 
 
One of our issued U.S. patents covers compositions for delivery of a condensation aerosol comprising prochlorperazine and covers the process for producing such condensation aerosol using the Staccato system technology. This patent will not expire until 2022. Counterparts to this patent are pending in a number of foreign jurisdictions, including Europe. We also have three other U.S. patents directed to condensation aerosol compositions for delivery of prochlorperazine, kits containing devices for forming such compositions, and methods of administering such compositions.
 
 
One of our issued U.S. patents covers compositions for delivery of a condensation aerosol comprising alprazolam and covers the process for producing such condensation aerosol using the Staccato system technology. This patent will not expire until 2022. Counterparts to this patent are pending in a number of foreign jurisdictions, including Europe. We also have three other U.S. patents directed to condensation aerosol compositions for delivery of alprazolam, kits containing devices for forming such compositions, and methods of administering such compositions.
 
 
One of our issued U.S. patents covers compositions for delivery of a condensation aerosol comprising fentanyl and covers the process for producing such condensation aerosol using the Staccato system technology. This patent will not expire until 2022. Counterparts to this patent are pending in a number of foreign jurisdictions, including Europe. We also have three other U.S. patents directed to condensation aerosol compositions for delivery of fentanyl, kits containing devices for forming such compositions, and methods of administering such compositions.
 
 
One of our issued U.S. patents covers compositions for delivery of a condensation aerosol comprising zaleplon and covers the process for producing such condensation aerosol using the Staccato system technology. This patent will not expire until 2022. Counterparts to this patent are pending in a number of foreign jurisdictions, including Europe. We also have three other U.S. patents directed to condensation aerosol compositions for delivery of zaleplon, kits containing devices for forming such compositions, and methods of administering such compositions.
 
 
The pharmaceutical and biotechnology industries are intensely competitive. Many pharmaceutical companies, biotechnology companies, public and private universities, government agencies and research organizations are actively engaged in research and development of products targeting the same markets as our product candidates. Many of these organizations have substantially greater financial, research, drug development, manufacturing and marketing resources than we have. Large pharmaceutical companies in particular have extensive experience in clinical testing and obtaining regulatory approvals for drugs. Our ability to compete successfully will depend largely on our ability to:
 
  •  develop products that are superior to other products in the market;


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  •  attract and retain qualified scientific, product development and commercial personnel;
 
  •  obtain patent and/or other proprietary protection covering our future products and technologies;
 
  •  obtain required regulatory approvals; and
 
  •  successfully collaborate with pharmaceutical and biotechnology companies in the development and commercialization of new products.
 
We expect any future products we develop to compete on the basis of, among other things, product efficacy and safety, time to market, price, extent of adverse side effects experienced and convenience of treatment procedures. One or more of our competitors may develop products based upon the principles underlying our proprietary technologies earlier than we do, obtain approvals for such products from the FDA more rapidly than we do or develop alternative products or therapies that are safer, more effective and/or more cost effective than any future products developed by us. In addition, our ability to compete may be affected if insurers and other third-party payors encourage the use of generic products through other routes of administration, making our pulmonary delivery products less attractive from a cost perspective.
 
Any future products developed by us would compete with a number of alternative drugs and therapies, including the following:
 
  •  AZ-004 would compete with the injectable form of loxapine (Loxitane®) and other antipsychotic drugs, such as Zyprexa® Geodon® and Abilify®;
 
  •  AZ-001 and AZ-104 would compete with available triptan drugs, such as Imitrex®, Zomig® and Maxalt®, and IV prochlorperazine;
 
  •  AZ-002 would compete with the oral tablet form of alprazolam and other benzodiazepines and antidepressant drugs, such as Klonopin®, Paxil®, Prozac® and Effexor®;
 
  •  AZ-003 would compete with injectable and other forms of fentanyl and various generic oxycodone, hydrocodone and morphine products; and
 
  •  AZ-007 would compete with non-benzodiazepine GABA-A receptor agonists, which include Ambien® (immediate release and controlled-release tablets), Sonata®, and Lunesta®.
 
Many of these existing drugs have substantial current sales and long histories of effective and safe use. As patent protection expires for these drugs, we will also compete with their generic versions. In addition to currently marketed drugs and their generic versions, we believe there are a number of drug candidates in clinical trials that, if approved in the future, would compete with any future products we may develop.
 
 
As of March 1, 2008, we had 144 full time employees, 27 of whom held Ph.D. or M.D. degrees and 110 of whom were engaged in full time research and development activities. We plan to continue to expand our product candidate development programs and hire additional staff to facilitate this growth. We continue to search for qualified individuals with interdisciplinary training to address the various aspects and applications of our development candidates and our technologies. None of our employees is represented by a labor union, and we consider our employee relations to be good.
 
 
We were incorporated in the state of Delaware on December 19, 2000 as FaxMed, Inc. In June 2001, we changed our name to Alexza Corporation and in December 2001 we became Alexza Molecular Delivery Corporation. In July 2005, we changed our name to Alexza Pharmaceuticals, Inc.


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Our website address is www.alexza.com; however, information found on, or that can be accessed through, our website is not incorporated by reference into this Annual Report. We file electronically with the SEC our Annual Report, quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934. We make available free of charge on or through our website copies of these reports as soon as reasonably practicable after we electronically file such material with, or furnish it to, the SEC. The SEC maintains an internet site that contains reports, proxy and information statements and other information regarding our filings at www.sec.gov. You may also read and copy any of our materials filed with the SEC at the SEC’s Public References Room at 100 F Street, NW, Washington, DC 20549. Information regarding the operation of the Public Reference Room can be obtained by calling the SEC at 1-800-SEC-0330.


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Item 1A.   Risk Factors
 
 
Investing in our common stock involves a high degree of risk. You should carefully consider the risks described below, together with all of the other information included in this Annual Report, before deciding whether to invest in shares of our common stock. Additional risks and uncertainties not presently known to us or that we currently deem immaterial also may impair our business operations. The occurrence of any of the following risks could harm our business, financial condition or results of operations. In such case, the trading price of our common stock could decline, and you may lose all or part of your investment.
 
Risks Relating to Our Business
 
 
We are not profitable and have incurred significant net losses in each year since our inception, including net losses of $45.1 million, $41.8 million, and $32.4 million for the years ended December 31, 2007, 2006 and 2005, respectively. As of December 31, 2007, we had a deficit accumulated during development stage of $164.1 million. We expect our expenses to increase as we expand our product candidate and manufacturing development programs and add the necessary infrastructure to support operating as a public company. As a result, we expect to incur substantial and increasing net losses and negative cash flow for the foreseeable future. These losses and negative cash flows have had, and will continue to have, an adverse effect on our stockholders’ equity (deficit) and working capital.
 
Because of the numerous risks and uncertainties associated with pharmaceutical product development, we are unable to accurately predict the timing or amount of increased expenses or when, or if, we will be able to achieve or maintain profitability. Currently, we have no products approved for commercial sale, and to date we have not generated any product revenue. We have financed our operations primarily through the sale of equity securities, capital lease and equipment financing and government grants. The size of our future net losses will depend, in part, on the rate of growth of our expenses and the rate of growth, if any, of our revenues. Revenues from strategic partnerships are uncertain because we may not enter into any additional strategic partnerships, and we do not expect any revenue in 2008 from our partnership with Endo. If we are unable to develop and commercialize one or more of our product candidates or if sales revenue from any product candidate that receives marketing approval is insufficient, we will not achieve profitability. Even if we do achieve profitability, we may not be able to sustain or increase profitability.
 
 
You must evaluate us in light of the uncertainties and complexities affecting a development stage pharmaceutical company. We have not completed Phase 3 clinical trials for any of our product candidates. Each of our product candidates is at an early stage of development and will be unsuccessful if it:
 
  •  does not demonstrate acceptable safety and efficacy in preclinical studies and clinical trials or otherwise does not meet applicable regulatory standards for approval;
 
  •  does not offer therapeutic or other improvements over existing or future drugs used to treat the same or similar conditions;
 
  •  is not capable of being produced in commercial quantities at an acceptable cost, or at all; or
 
  •  is not accepted by patients, the medical community or third party payors.
 
Our ability to generate product revenue in the future is dependent on the successful development and commercialization of our product candidates. We have not proven our ability to develop and commercialize products. Problems frequently encountered in connection with the development and utilization of new and


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unproven technologies and the competitive environment in which we operate might limit our ability to develop commercially successful products. We do not expect any of our current product candidates to be commercially available before 2011, if at all. If we are unable to make our product candidates commercially available, we will not generate product revenues, and we will not be successful.
 
 
We will need to raise additional capital to fund our operations, to develop our product candidates and to develop our manufacturing capabilities. Our future capital requirements will be substantial and will depend on many factors including:
 
  •  the scope, rate of progress, results and costs of our preclinical studies, clinical trials and other research and development activities, and our manufacturing development and commercial manufacturing activities;
 
  •  the amount and timing of payments from Symphony Allegro related to the development of Staccato alprazolam and Staccato loxapine;
 
  •  the amount and timing of any payments to Symphony Allegro related to the repurchase of rights to Staccato alprazolam and Staccato loxapine;
 
  •  the amount and timing of any milestone and royalty payments from Endo related to the development and commercialization of Staccato fentanyl;
 
  •  the cost, timing and outcomes of regulatory proceedings;
 
  •  the cost and timing of developing sales and marketing capabilities;
 
  •  the cost and timing of developing sales and marketing capabilities prior to receipt of any regulatory approval of our product candidates;
 
  •  the cost and timing of developing manufacturing capacity;
 
  •  revenues received from any future products;
 
  •  payments received under any future strategic partnerships;
 
  •  the filing, prosecution and enforcement of patent claims;
 
  •  the costs associated with building out and moving to our new facilities in 2007 and 2008; and
 
  •  the costs associated with commercializing our product candidates, if they receive regulatory approval.
 
We anticipate that existing cash, cash equivalents and marketable securities, along with interest earned thereon, funding available under our equipment financing arrangements, expected payments from Symphony Allegro, expected proceeds from stock option exercises and purchases under our Employee Stock Purchase Plan, will enable us to maintain our currently planned operations through the middle of 2009. Changing circumstances may cause us to consume capital significantly faster than we currently anticipate. We may be unable to raise sufficient additional capital on terms favorable to us, or at all. If we fail to raise sufficient funds, we will have to delay development programs or reduce or cease operations, or we may be required to enter into a strategic partnership at an earlier stage of development than currently anticipated. Our estimates of future capital use are uncertain, and changes in our development plans, payments received from Symphony Allegro, partnering activities, regulatory requirements and other developments may increase our rate of spending and decrease the amount of time our available resources will fund our operations.
 
We may never be able to generate a sufficient amount of product revenue to cover our expenses. Until we do, we expect to finance our future cash needs through public or private equity offerings, debt financings, strategic partnerships or licensing arrangements, as well as interest income earned on cash and marketable securities balances and proceeds from stock option exercises and purchases under our Employee Stock Purchase Plan. Any financing transaction may contain unfavorable terms. If we raise additional funds by issuing equity securities, our stockholders’ equity will be diluted. If we raise additional funds through strategic partnerships, we may be required


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to relinquish rights to our product candidates or technologies, or to grant licenses on terms that are not favorable to us.
 
 
To obtain regulatory approval to market and sell any of our product candidates, we must satisfy the FDA and other regulatory authorities abroad, through extensive preclinical studies, that our product candidates are safe. Our Staccato system creates condensation aerosols from drug compounds, and there currently are no approved products that use a similar method of drug delivery. Companies developing other inhalation products have not defined or successfully completed the types of preclinical studies we believe will be required for submission to regulatory authorities as we seek approval to conduct our clinical trials. We may not conduct the types of preclinical testing eventually required by regulatory authorities, or the preclinical tests may indicate that our product candidates are not safe for use in humans. Preclinical testing is expensive, can take many years and have an uncertain outcome. In addition, success in initial preclinical testing does not ensure that later preclinical testing will be successful. We may experience numerous unforeseen events during, or as a result of, the preclinical testing process, which could delay or prevent our ability to develop or commercialize our product candidates, including:
 
  •  our preclinical testing may produce inconclusive or negative safety results, which may require us to conduct additional preclinical testing or to abandon product candidates that we believed to be promising;
 
  •  our product candidates may have unfavorable pharmacology, toxicology or carcinogenicity; and
 
  •  our product candidates may cause undesirable side effects.
 
Any such events would increase our costs and could delay or prevent our ability to commercialize our product candidates, which could adversely impact our business, financial condition and results of operations.
 
 
In our daily dosing animal toxicology studies of prochlorperazine, the active pharmaceutical ingredient, or API, in AZ-001, we detected changes to, and increases of, the cells in the upper airway of the test animals. The terms for these changes and increases are “squamous metaplasia” and “hyperplasia,” respectively. We also observed lung inflammation in some animals. These findings occurred in daily dosing studies at doses that were proportionately substantially greater than any dose we expect to continue to develop or commercialize. In subsequent toxicology studies of AZ-001 involving intermittent dosing consistent with its intended use, we detected lower incidence and severity of the changes to, and increases of, the cells in the upper airway of the test animals compared to the daily dosing results. We did not observe any lung inflammation with intermittent dosing. These findings suggest that the delivery of the pure drug compound of AZ-001 at the proportionately higher doses used in daily dosing toxicology studies may cause adverse consequences if we were to administer prochlorperazine chronically for prolonged periods of time. If we observe these findings in our clinical trials of AZ-001, it could prevent further development or commercialization of AZ-001.
 
 
To date, we have not completed all the clinical trials necessary to support an application with the FDA for approval to market any of our product candidates. Current and planned clinical trials may be delayed or terminated as a result of many factors, including:
 
  •  delays or failure in reaching agreement on acceptable clinical trial contracts or clinical trial protocols with prospective sites;
 
  •  regulators or institutional review boards may not authorize us to commence a clinical trial;
 
  •  regulators or institutional review boards may suspend or terminate clinical research for various reasons, including noncompliance with regulatory requirements or concerns about patient safety;


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  •  we may suspend or terminate our clinical trials if we believe that they expose the participating patients to unacceptable health risks;
 
  •  we may experience slower than expected patient enrollment or lack of a sufficient number of patients that meet the enrollment criteria for our clinical trials;
 
  •  patients may not complete clinical trials due to safety issues, side effects, dissatisfaction with the product candidate, or other reasons;
 
  •  we may have difficulty in maintaining contact with patients after treatment, preventing us from collecting the data required by our study protocol;
 
  •  product candidates may demonstrate a lack of efficacy during clinical trials;
 
  •  we may experience governmental or regulatory delays, failure to obtain regulatory approval or changes in regulatory requirements, policy and guidelines; and
 
  •  we may experience delays in our ability to manufacture clinical trial materials in a timely manner as a result of ongoing process and design enhancements to our Staccato system and the move to a new facility in late 2007 and early 2008.
 
Any delay in commencing or completing clinical trials for our product candidates would delay commercialization of our product candidates and harm our business, financial condition and results of operations. It is possible that none of our product candidates will successfully complete clinical trials or receive regulatory approval, which would severely harm our business, financial condition and results of operations.
 
 
Our clinical studies to date for our AZ-004, AZ-001, AZ-104, AZ-002 and AZ-007 product candidates have been completed using a version of our single dose Staccato device we refer to as the chemical single dose, or CSD, device. We are developing a version of the CSD which is intended to cost less to manufacture than the current version of CSD. We refer to the newer version of this single dose device as the commercial production device, or CPD, version. The CPD incorporates the same basic chemical heat package and electronics as the CSD. We plan to conduct a bioequivalence study in normal volunteers in the second half of 2008 using the CSD and the CPD versions of the device to determine if the drug dose dispensed by the two devices is bioequivalent. If the results of the planned bioequivalence study and the available analytical data do not support the bioequivalency or if the FDA or foreign regulatory authorities determine the CPD is unacceptable for any other reason, we may be required to conduct an additional Phase 3 clinical trial for AZ-004 with the CPD version of the device. Conducting an additional Phase 3 clinical trial would delay the filing of an NDA which would also delay any potential marketing approval in the United States. We may also decide to file an NDA for AZ-004 using the current version of the CSD, which we anticipate would cost more to produce and may limit market adoption of the product if and when it is approved.
 
 
Our product candidates are in preclinical and clinical development and have not received regulatory approval from the FDA or any foreign regulatory authority. The clinical development and regulatory approval process is extremely expensive and takes many years. The timing of any approval cannot be accurately predicted. If we fail to obtain regulatory approval for our current or future product candidates, we will be unable to market and sell them and therefore may never be profitable.
 
As part of the regulatory process, we must conduct clinical trials for each product candidate to demonstrate safety and efficacy to the satisfaction of the FDA and other regulatory authorities abroad. The number and design of clinical trials that will be required varies depending on the product candidate, the condition being evaluated, the trial results and regulations applicable to any particular product candidate.


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Prior clinical trial program designs and results are not necessarily predictive of future clinical trial designs or results. Initial results may not be confirmed upon full analysis of the detailed results of a trial. Product candidates in later stage clinical trials may fail to show the desired safety and efficacy despite having progressed through initial clinical trials with acceptable endpoints. Prior clinical trial program designs and results are not necessarily predictive of future clinical trial designs or results.
 
 
Device failure rates higher than we anticipate may result in clinical trials that do not meet their specific efficacy endpoints. Device failures or improper device use by patients may impact the results of future trials. The design of our clinical trials is based on many assumptions about the expected effect of our product candidates, and if those assumptions prove incorrect, the clinical trials may not produce statistically significant results. In addition, because we are developing AZ-002 for a novel indication, and may develop future product candidates for other novel indications, and because our Staccato system is not similar to other approved drug delivery methods, there is no clear precedent for the application of detailed regulatory requirements to our product candidates. We cannot assure you that the design of, or data collected from, the clinical trials of our product candidates will be sufficient to support the FDA and foreign regulatory approvals.
 
 
The FDA and other foreign regulatory agencies can delay, limit or deny marketing approval for many reasons, including:
 
  •  a product candidate may not be considered safe or effective;
 
  •  the manufacturing processes or facilities we have selected may not meet the applicable requirements; and
 
  •  changes in their approval policies or adoption of new regulations may require additional work on our part.
 
Any delay in, or failure to receive or maintain, approval for any of our product candidates could prevent us from ever generating meaningful revenues or achieving profitability.
 
Our product candidates may not be approved even if they achieve their endpoints in clinical trials. Regulatory agencies, including the FDA, or their advisors may disagree with our trial design and our interpretations of data from preclinical studies and clinical trials. Regulatory agencies may change requirements for approval even after a clinical trial design has been approved. Regulatory agencies also may approve a product candidate for fewer or more limited indications than requested or may grant approval subject to the performance of post-marketing studies. In addition, regulatory agencies may not approve the labeling claims that are necessary or desirable for the successful commercialization of our product candidates.
 
 
Even if we receive regulatory approval to market a particular product candidate, the FDA or a foreign regulatory authority could condition approval on conducting additional costly post-approval studies or could limit the scope of our approved labeling. Moreover, the product may later cause adverse effects that limit or prevent its widespread use, force us to withdraw it from the market or impede or delay our ability to obtain regulatory approvals in additional countries. In addition, we will continue to be subject to FDA review and periodic inspections to ensure adherence to applicable regulations. After receiving marketing approval, the FDA imposes extensive regulatory requirements on the manufacturing, labeling, packaging, adverse event reporting, storage, advertising, promotion and record keeping related to the product.


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If we fail to comply with the regulatory requirements of the FDA and other applicable U.S. and foreign regulatory authorities or previously unknown problems with any future products, suppliers or manufacturing processes are discovered, we could be subject to administrative or judicially imposed sanctions, including:
 
  •  restrictions on the products, suppliers or manufacturing processes;
 
  •  warning letters or untitled letters;
 
  •  civil or criminal penalties or fines;
 
  •  injunctions;
 
  •  product seizures, detentions or import bans;
 
  •  voluntary or mandatory product recalls and publicity requirements;
 
  •  suspension or withdrawal of regulatory approvals;
 
  •  total or partial suspension of production; and
 
  •  refusal to approve pending applications for marketing approval of new drugs or supplements to approved applications.
 
 
Our Staccato system based product candidates contain electronic and other components in addition to the active pharmaceutical ingredients. As a result of the cost of developing and producing these components, the cost to produce our product candidates, and any approved products, will likely be higher per dose than the cost to produce intravenous or oral tablet products. This increased cost of goods may prevent us from ever selling any products at a profit. In addition, we are developing single dose and multiple dose versions of our Staccato system. Developing multiple versions of our Staccato system may reduce or eliminate our ability to achieve manufacturing economies of scale. In addition, developing multiple versions of our Staccato system reduces our ability to focus development resources on each version, potentially reducing our ability to effectively develop any particular version. We expect to continue to modify each of our product candidates throughout their clinical development to improve their performance, dependability, manufacturability and quality. Some of these modifications may require additional regulatory review and approval, which may delay or prevent us from conducting clinical trials. The development and production of our technology entail a number of technical challenges, including achieving adequate dependability, that may be expensive or time consuming to solve. Any delay in or failure to develop and manufacture any future products in a cost effective way could prevent us from generating any meaningful revenues and prevent us from becoming profitable.
 
 
We do not have the ability to conduct preclinical studies or clinical trials independently for our product candidates. We must rely on third parties, such as contract research organizations, medical institutions, academic institutions, clinical investigators and contract laboratories, to conduct our preclinical studies and clinical trials. We are responsible for confirming that our preclinical studies are conducted in accordance with applicable regulations and that each of our clinical trials is conducted in accordance with its general investigational plan and protocol. The FDA requires us to comply with regulations and standards, commonly referred to as good laboratory practices, or GLP, for conducting and recording the results of our preclinical studies and good clinical practices for conducting, monitoring, recording and reporting the results of clinical trials, to assure that data and reported results are accurate and that the clinical trial participants are adequately protected. Our reliance on third parties does not relieve us of these responsibilities. If the third parties conducting our clinical trials do not perform their contractual duties or obligations, do not meet expected deadlines, fail to comply with the FDA’s good clinical practice regulations, do not adhere to our clinical trial protocols or otherwise fail to generate reliable clinical data, we may need to enter into new arrangements with alternative third parties and our clinical trials may be extended, delayed or terminated or


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may need to be repeated, and we may not be able to obtain regulatory approval for or commercialize the product candidate being tested in such trials.
 
 
We do not currently own or operate manufacturing facilities for clinical or commercial production of the API used in any of our product candidates. We have no experience in drug manufacturing, and we lack the resources and the capability to manufacture any of the APIs used in our product candidates, on either a clinical or commercial scale. As a result, we rely on third parties to supply the API used in each of our product candidates. We expect to continue to depend on third parties to supply the API for our lead product candidates and any additional product candidates we develop in the foreseeable future.
 
An API manufacturer must meet high precision and quality standards for that API to meet regulatory specifications and comply with regulatory requirements. A contract manufacturer is subject to ongoing periodic unannounced inspection by the FDA and corresponding state and foreign authorities to ensure strict compliance with current good manufacturing practice, or cGMP, and other applicable government regulations and corresponding foreign standards. Additionally, a contract manufacturer must pass a pre-approval inspection by the FDA to ensure strict compliance with cGMP prior to the FDA’s approval of any product candidate for marketing. A contract manufacturer’s failure to conform with cGMP could result in the FDA’s refusal to approve or a delay in the FDA’s approval of a product candidate for marketing. We are ultimately responsible for confirming that the APIs used in our product candidates are manufactured in accordance with applicable regulations.
 
Our third party suppliers may not carry out their contractual obligations or meet our deadlines. In addition, the API they supply to us may not meet our specifications and quality policies and procedures. If we need to find alternative suppliers of the API used in any of our product candidates, we may not be able to contract for such supplies on acceptable terms, if at all. Any such failure to supply or delay caused by such contract manufacturers would have an adverse effect on our ability to continue clinical development of our product candidates or commercialize any future products.
 
If our third party drug suppliers fail to achieve and maintain high manufacturing standards in compliance with cGMP regulations, we could be subject to certain product liability claims in the event such failure to comply resulted in defective products that caused injury or harm.
 
 
We outsource the manufacturing of some of the components of our Staccato system, including the printed circuit boards and the plastic airways, and we will outsource the manufacturing of the chemical heat packages to be used in our commercial single dose device. We have no experience in the manufacturing of components (other than our current chemical heat packages), and we currently lack the resources and the capability to manufacture them, on either a clinical or commercial scale. As a result, we rely on third parties to supply these components. We expect to continue to depend on third parties to supply these components for our current product candidates and any devices based on the Staccato system we develop in the foreseeable future.
 
The third party suppliers of the components of our Staccato system must meet high precision and quality standards for those components to comply with regulatory requirements. A contract manufacturer is subject to ongoing periodic unannounced inspection by the FDA and corresponding state and foreign authorities to ensure strict compliance with the FDA’s Quality System Regulation, or QSR, which sets forth the FDA’s current good manufacturing practice requirements for medical devices and their components, and other applicable government regulations and corresponding foreign standards. We are ultimately responsible for confirming that the components used in the Staccato system are manufactured in accordance with the QSR or other applicable regulations.
 
Our third party suppliers may not comply with their contractual obligations or meet our deadlines, or the components they supply to us may not meet our specifications and quality policies and procedures. If we need to find alternative suppliers of the components used in the Staccato system, we may not be able to contract for such


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components on acceptable terms, if at all. Any such failure to supply or delay caused by such contract manufacturers would have an adverse affect on our ability to continue clinical development of our product candidates or commercialize any future products.
 
In addition, the heat packages used in the single dose version of our Staccato system are manufactured using certain energetic, or highly combustible, materials that are used to generate the rapid heating necessary for vaporizing the drug compound while avoiding degradation. Manufacture of products containing these types of materials is regulated by the U.S. government. We currently manufacture the heat packages that are being used in the devices used in our clinical trials. We have entered into a supply agreement with Autoliv. for the manufacture of the heat packages in the commercial design of our single dose version of our Staccato system. If we are unable to manufacture the heat packages used in our ongoing clinical trials or if in the future Autoliv is unable to manufacture the heat packages to our specifications, or does not carry out its contractual obligations to supply our heat packages or to supply them to us, our clinical trials may be delayed, suspended or terminated while we seek additional suitable manufacturers of our heat packages, which may prevent us from commercializing our product candidates that utilize the single dose version of the Staccato system.
 
 
A key element of our business strategy is our intent to selectively partner with pharmaceutical, biotechnology and other companies to obtain assistance for the development and potential commercialization of our product candidates. In December, 2006, we entered into such a development relationship with Symphony Allegro and in December 2007, we entered into a license and development agreement with Endo related to AZ-003 (Staccato fentanyl). We intend to enter into additional strategic partnerships with third parties to develop and commercialize our product candidates that are intended for larger markets, and we may enter into strategic partnerships for product candidates that are targeted toward specialty markets. To date, other than Symphony Allegro and Endo, we have not entered into any strategic partnerships for any of our product candidates. We face significant competition in seeking appropriate strategic partners, and these strategic partnerships can be intricate and time consuming to negotiate and document. We may not be able to negotiate strategic partnerships on acceptable terms, or at all. We are unable to predict when, if ever, we will enter into any additional strategic partnerships because of the numerous risks and uncertainties associated with establishing strategic partnerships. If we are unable to negotiate additional strategic partnerships for our product candidates we may be forced to curtail the development of a particular candidate, reduce or delay its development program or one or more of our other development programs, delay its potential commercialization, reduce the scope of our sales or marketing activities or undertake development or commercialization activities at our own expense. In addition, we will bear all the risk related to the development of that product candidate. If we elect to increase our expenditures to fund development or commercialization activities on our own, we may need to obtain additional capital, which may not be available to us on acceptable terms, or at all. If we do not have sufficient funds, we will not be able to bring our product candidates to market and generate product revenue.
 
 
Due to our relationship with Symphony Allegro and Endo we are, and for any additional strategic partnerships with pharmaceutical or biotechnology companies we will be, subject to a number of risks, including:
 
  •  we may not be able to control the amount and timing of resources that our strategic partners devote to the development or commercialization of product candidates;
 
  •  strategic partners may delay clinical trials, provide insufficient funding, terminate a clinical trial or abandon a product candidate, repeat or conduct new clinical trials or require a new version of a product candidate for clinical testing;


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  •  strategic partners may not pursue further development and commercialization of products resulting from the strategic partnering arrangement or may elect to discontinue research and development programs;
 
  •  strategic partners may not commit adequate resources to the marketing and distribution of any future products, limiting our potential revenues from these products;
 
  •  disputes may arise between us and our strategic partners that result in the delay or termination of the research, development or commercialization of our product candidates or that result in costly litigation or arbitration that diverts management’s attention and consumes resources;
 
  •  strategic partners may experience financial difficulties;
 
  •  strategic partners may not properly maintain or defend our intellectual property rights or may use our proprietary information in a manner that could jeopardize or invalidate our proprietary information or expose us to potential litigation;
 
  •  business combinations or significant changes in a strategic partner’s business strategy may also adversely affect a strategic partner’s willingness or ability to complete its obligations under any arrangement;
 
  •  strategic partners could independently move forward with a competing product candidate developed either independently or in collaboration with others, including our competitors; and
 
  •  strategic partners could terminate the arrangement or allow it to expire, which would delay the development and may increase the cost of developing our product candidates.
 
We have exclusively licensed certain intellectual property rights to Staccato alprazolam and Staccato loxapine in connection with our Symphony Allegro arrangement and will not receive material future royalties or revenues with respect to this intellectual property unless we exercise an option to repurchase the rights to the programs in the future through the acquisition of Symphony Allegro. We may not obtain sufficient clinical data in order to determine whether we should exercise this option prior to the expiration of the development period, and even if we decide to exercise the option, we may not have the financial resources to exercise it in a timely manner.
 
In December 2006, we entered into a transaction providing for the financing of additional clinical and nonclinical development of Staccato alprazolam, our AZ-002 program, and Staccato loxapine, our AZ-004 and AZ-104 programs. Pursuant to the agreements, Symphony Capital LLC and its investors have invested $50 million to form Symphony Allegro, to fund additional clinical and nonclinical development of Staccato alprazolam and Staccato loxapine. We have exclusively licensed to Symphony Allegro certain intellectual property rights related to Staccato alprazolam and Staccato loxapine. We have retained manufacturing rights to these two product candidates. As part of the arrangement, we received an option granting us the exclusive right, but not the obligation, to acquire the licensed programs at specified points in time at specified prices during the term of the development period through the acquisition of Symphony Allegro. The development programs under the arrangement are jointly managed by Symphony Allegro and us, and there can be no assurance that we will agree on various decisions that will enable us to successfully develop the potential products, or even if we are in agreement on the development plans, that the development efforts will result in sufficient clinical data to make a fully informed decision with respect to the exercise of our option. If we do not exercise our purchase option by December 1, 2010, then Symphony Allegro will retain its exclusive license to develop and commercialize Staccato alprazolam and Staccato loxapine for all indications, and we will manufacture and sell Staccato alprazolam and Staccato loxapine to Symphony Allegro or its sublicensee for those purposes.
 
If we elect to exercise the purchase option, we will be required to make a payment estimated to be $104 million in the fourth quarter of 2009, which at our election may be paid partially in shares of our common stock. As a result, in order to exercise the option, we will be required to make a substantial payment of cash and possibly issue a substantial number of shares of our common stock. We do not currently have the resources to exercise the option, and we may be required to enter into a financing arrangement or license arrangement with one or more third parties, or some combination of these, in order to exercise the option, even if we paid a portion of the purchase price with our common stock. There can be no assurance that any financing or licensing arrangement will be available or even if


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available, that the terms would be favorable to us and our stockholders. In addition, the exercise of the purchase option may require us to record a significant charge to earnings and may adversely impact future operating results.
 
 
The Staccato system is a fundamentally new method of drug delivery. Any future product based on our Staccato system may not gain market acceptance among physicians, patients, third-party payors and the medical community. If these products do not achieve an adequate level of acceptance, we will not generate sufficient product revenues to become profitable. The degree of market acceptance of any of our product candidates, if approved for commercial sale, will depend on a number of factors, including:
 
  •  demonstration of efficacy and safety in clinical trials;
 
  •  the existence, prevalence and severity of any side effects;
 
  •  potential or perceived advantages or disadvantages compared to alternative treatments;
 
  •  perceptions about the relationship or similarity between our product candidates and the parent drug compound upon which each product candidate is based;
 
  •  the timing of market entry relative to competitive treatments;
 
  •  the ability to offer any future products for sale at competitive prices;
 
  •  relative convenience, product dependability and ease of administration;
 
  •  the strength of marketing and distribution support;
 
  •  the sufficiency of coverage and reimbursement of our product candidates by governmental and other third-party payors; and
 
  •  the product labeling or product insert required by the FDA or regulatory authorities in other countries.
 
 
The current versions of the Staccato system cannot deliver large molecule drugs, such as peptides and proteins. In addition, the physical size of the metal substrates in the single dose and multiple dose versions of the Staccato system limits their use to drugs that require dose amounts less than 10 to 15 milligrams and 100 to 200 micrograms, respectively. Further, approximately 200 of the 400 small molecule compounds we have screened for initial vaporization feasibility did not form drug aerosols with the 97% purity we use as an internal standard for further development. There are also many drug compounds that are covered by composition of matter patents that prevent us from developing the compound in the Staccato system without a license from the patent owner, which may not be available on acceptable terms, if at all. If we are not able to identify additional drug compounds that can be developed with the Staccato system, we may not develop enough products to develop a sustainable business.
 
 
The API in AZ-001, prochlorperazine, was approved by the FDA in 1956 for the treatment of severe nausea and vomiting. At that time, the FDA did not require the carcinogenicity testing that is now generally required for marketing approval. It is unclear whether we will be required to perform such testing prior to filing our application for marketing approval of AZ-001 or whether we will be allowed to perform such testing after we file an application. Such carcinogenicity testing will be expensive and require significant additional resources to complete and may delay approval to market AZ-001. We may encounter similar requirements with other product candidates incorporating drugs that have not undergone carcinogenicity testing. Any carcinogenicity testing we are required to complete will increase the costs to develop a particular product candidate and may delay or halt the development of such product candidate.


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If some or all of our patents expire, are invalidated or are unenforceable, or if some or all of our patent applications do not yield issued patents or yield patents with narrow claims, competitors may develop competing products using our or similar intellectual property and our business will suffer.
 
Our success will depend in part on our ability to obtain and maintain patent and trade secret protection for our technologies and product candidates both in the United States and other countries. We do not know whether any patents will issue from any of our pending or future patent applications. In addition, a third party may successfully circumvent our patents. Our rights under any issued patents may not provide us with sufficient protection against competitive products or otherwise cover commercially valuable products or processes.
 
The degree of protection for our proprietary technologies and product candidates is uncertain because legal means afford only limited protection and may not adequately protect our rights or permit us to gain or keep our competitive advantage. For example:
 
  •  we might not have been the first to make the inventions covered by each of our pending patent applications and issued patents;
 
  •  we might not have been the first to file patent applications for these inventions;
 
  •  others may independently develop similar or alternative technologies or duplicate any of our technologies;
 
  •  it is possible that none of our pending patent applications will result in issued patents;
 
  •  the claims of our issued patents may be narrower than as filed and not sufficiently broad to prevent third parties from circumventing them;
 
  •  we may not develop additional proprietary technologies or drug candidates that are patentable;
 
  •  our patent applications or patents may be subject to interference, opposition or similar administrative proceedings;
 
  •  any patents issued to us or our potential strategic partners may not provide a basis for commercially viable products or may be challenged by third parties in the course of litigation or administrative proceedings such as reexaminations or interferences; and
 
  •  the patents of others may have an adverse effect on our ability to do business.
 
 
Our and our potential strategic partners’ ability to obtain patents is uncertain because, to date, some legal principles remain unresolved, there has not been a consistent policy regarding the breadth or interpretation of claims allowed in patents in the United States, and the specific content of patents and patent applications that are necessary to support and interpret patent claims is highly uncertain due to the complex nature of the relevant legal, scientific and factual issues. Furthermore, the policies governing pharmaceutical and medical device patents outside the United States may be even more uncertain. Changes in either patent laws or interpretations of patent laws in the United States and other countries may diminish the value of our intellectual property or narrow the scope of our patent protection.
 
Even if patents are issued regarding our product candidates or methods of using them, those patents can be challenged by our competitors who can argue that our patents are invalid and/or unenforceable. Third parties may challenge our rights to, or the scope or validity of, our patents. Patents also may not protect our product candidates if competitors devise ways of making these or similar product candidates without legally infringing our patents. The Federal Food, Drug and Cosmetic Act and the FDA regulations and policies provide incentives to manufacturers to challenge patent validity or create modified, non-infringing versions of a drug or device in order to facilitate the approval of generic substitutes. These same types of incentives encourage manufacturers to submit new drug applications that rely on literature and clinical data not prepared for or by the drug sponsor.
 
We also rely on trade secrets to protect our technology, especially where we do not believe that patent protection is appropriate or obtainable. However, trade secrets are difficult to protect. The employees, consultants,


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contractors, outside scientific collaborators and other advisors of our company and our strategic partners may unintentionally or willfully disclose our confidential information to competitors. Enforcing a claim that a third party illegally obtained and is using our trade secrets is expensive and time consuming and the outcome is unpredictable. Failure to protect or maintain trade secret protection could adversely affect our competitive business position.
 
Our research and development collaborators may have rights to publish data and other information in which we have rights. In addition, we sometimes engage individuals or entities to conduct research that may be relevant to our business. The ability of these individuals or entities to publish or otherwise publicly disclose data and other information generated during the course of their research is subject to certain contractual limitations. These contractual provisions may be insufficient or inadequate to protect our trade secrets and may impair our patent rights. If we do not apply for patent protection prior to such publication or if we cannot otherwise maintain the confidentiality of our technology and other confidential information, then our ability to receive patent protection or protect our proprietary information may be jeopardized.
 
 
Our commercial success depends in part on not infringing patents and proprietary rights of third parties. Others have filed, and in the future are likely to file, patent applications covering products that are similar to our product candidates, as well as methods of making or using similar or identical products. If these patent applications result in issued patents and we wish to use the claimed technology, we would need to obtain a license from the third party. We may not be able to obtain these licenses at a reasonable cost, if at all.
 
In particular, we are aware of at least one pending U.S. patent application and foreign counterparts filed by a biopharmaceutical company relating to the use of drugs, including alprazolam which is the API in AZ-002, for treating disorders of the central nervous system by pulmonary delivery. In addition, we are aware of another pending U.S. patent application and foreign counterparts, filed by another biopharmaceutical company, that claims a method of making a vapor medicament under specific manufacturing conditions. We do not currently have a license to these patent applications. If these patent applications were to result in issued patents as originally filed, the relevant patent holders at that time may assert that we require licenses.
 
If these patent applications issue as originally filed, we believe we have valid defenses against any assertions that our product candidates are infringing. We do not know whether a court would determine that our defenses are valid. If we decide to pursue a license to one or more of these patent applications, or patents issued therefrom, we do not know that we will be able to obtain such a license on commercially reasonable terms, or at all.
 
In addition, administrative proceedings, such as interferences and reexaminations before the U.S. Patent and Trademark Office, could limit the scope of our patent rights. We may incur substantial costs and diversion of management and technical personnel as a result of our involvement in such proceedings. In particular, our patents and patent applications may be subject to interferences in which the priority of invention may be awarded to a third party. We do not know whether our patents and patent applications will be entitled to priority over patents or patent applications held by such a third party. Our issued patents may also be subject to reexamination proceedings. We do not know whether our patents would survive reexamination in light of new questions of patentability that may be raised following their issuance.
 
Third parties may assert that we are employing their proprietary technology or their proprietary products without authorization. In addition, third parties may already have or may obtain patents in the future and claim that use of our technologies or our products infringes these patents. We could incur substantial costs and diversion of management and technical personnel in defending our self against any of these claims. Furthermore, parties making claims against us may be able to obtain injunctive or other equitable relief, which could effectively block our ability to further develop, commercialize and sell any future products and could result in the award of substantial damages against us. In the event of a successful claim of infringement against us, we may be required to pay damages and obtain one or more licenses from third parties. We may not be able to obtain these licenses at a reasonable cost, if at all. In that event, we could encounter delays in product introductions while we attempt to develop alternative methods or products. In the event we cannot develop alternative methods or products, we may be effectively


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blocked from developing, commercializing or selling any future products. Defense of any lawsuit or failure to obtain any of these licenses would be expensive and could prevent us from commercializing any future products.
 
We review from time to time publicly available information concerning the technological development efforts of other companies in our industry. If we determine that these efforts violate our intellectual property or other rights, we intend to take appropriate action, which could include litigation. Any action we take could result in substantial costs and diversion of management and technical personnel in enforcing our patents or other intellectual property rights against others. Furthermore, the outcome of any action we take to protect our rights may not be resolved in our favor.
 
 
We face competition from established as well as emerging pharmaceutical and biotechnology companies, as well as from academic institutions, government agencies and private and public research institutions. Our commercial opportunity will be reduced or eliminated if our competitors develop and commercialize products that are safer, more effective, have fewer side effects or are less expensive than any future products that we may develop and commercialize. In addition, significant delays in the development of our product candidates could allow our competitors to bring products to market before us and impair our ability to commercialize our product candidates.
 
We anticipate that, if approved, AZ-004 would compete with the available intramuscular, or IM, injectable form and oral forms of loxapine for the treatment of agitation, and other forms of available antipsychotic drugs.
 
We anticipate that, if approved, AZ-001 and AZ-104 would compete with currently marketed triptan drugs and with other migraine headache treatments, including intravenous, or IV, delivery of prochlorperazine, the API in AZ-001. In addition, we are aware of at least 14 product candidates for the treatment of migraines, including triptan products and a sumatriptan/naproxen combination product.
 
We anticipate that, if approved, AZ-002 would compete with the oral tablet form of alprazolam and several other approved anti-depressant drugs. In addition, we are aware of two product candidates in early stage clinical development for the treatment of acute panic attacks.
 
We anticipate that, if approved, AZ-003 would compete with some of the available forms of fentanyl, including injectable fentanyl, oral transmucosal fentanyl formulations and ionophoretic transdermal delivery of fentanyl. We are also aware of at least 20 products in Phase 2 and Phase 3 clinical trial development for acute pain, five of which are fentanyl products. Two of these fentanyl products are inhaled versions. In addition, if approved, AZ-003 would compete with various generic opioid drugs, such as oxycodone, hydrocodone and morphine, or combination products including one or more of such drugs.
 
We anticipate that, if approved, AZ-007 would compete with non-benzodiazepine GABA-A receptor agonists, which include Ambien® (immediate release and controlled-release tablets), Sonata®, and Lunesta®.
 
Many of our competitors have significantly greater financial resources and expertise in research and development, manufacturing, preclinical testing, conducting clinical trials, obtaining regulatory approvals and marketing approved products than we do. Established pharmaceutical companies may invest heavily to discover quickly and develop novel compounds or drug delivery technology that could make our product candidates obsolete. Smaller or early stage companies may also prove to be significant competitors, particularly through strategic partnerships with large and established companies. In addition, these third parties compete with us in recruiting and retaining qualified scientific and management personnel, establishing clinical trial sites and patient registration for clinical trials, as well as in acquiring technologies and technology licenses complementary to our programs or advantageous to our business. Accordingly, our competitors may succeed in obtaining patent protection, receiving FDA approval or discovering, developing and commercializing products before we do. If we are not able to compete effectively against our current and future competitors, our business will not grow and our financial condition will suffer.


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We do not have a sales and marketing organization and have no experience in the sales, marketing and distribution of pharmaceutical products. There are risks involved with establishing our own sales and marketing capabilities, as well as entering into arrangements with third parties to perform these services. Developing an internal sales force is expensive and time consuming and could delay any product launch. On the other hand, if we enter into arrangements with third parties to perform sales, marketing and distribution services, our product revenues or the profitability of these product revenues are likely to be lower than if we market and sell any products that we develop ourselves.
 
We may establish our own specialty sales force and/or engage pharmaceutical or other healthcare companies with existing sales and marketing organization and distribution systems to sell, market and distribute any future products. We may not be able to establish a specialty sales force or establish sales and distribution relationships on acceptable terms. Factors that may inhibit our efforts to commercialize any future products without strategic partners or licensees include:
 
  •  our inability to recruit and retain adequate numbers of effective sales and marketing personnel;
 
  •  the inability of sales personnel to obtain access to or persuade adequate numbers of physicians to prescribe any future products;
 
  •  the lack of complementary products to be offered by sales personnel, which may put us at a competitive disadvantage relative to companies with more extensive product lines; and
 
  •  unforeseen costs and expenses associated with creating an independent sales and marketing organization.
 
Because the establishment of sales and marketing capabilities depends on the progress towards commercialization of our product candidates and because of the numerous risks and uncertainties involved with establishing our own sales and marketing capabilities, we are unable to predict when, if ever, we will establish our own sales and marketing capabilities. However, we do not anticipate establishing sales and marketing capabilities until at least 2010. If we are not able to partner with a third party and are unsuccessful in recruiting sales and marketing personnel or in building a sales and marketing infrastructure, we will have difficulty commercializing our product candidates, which would adversely affect our business and financial condition.
 
 
We are highly dependent on our President and Chief Executive Officer, Thomas B. King, the loss of whose services might adversely impact the achievement of our objectives. In addition, recruiting and retaining qualified clinical, scientific and engineering personnel to manage clinical trials of our product candidates and to perform future research and development work will be critical to our success. There is currently a shortage of skilled executives in our industry, which is likely to continue. As a result, competition for skilled personnel is intense and the turnover rate can be high. Although we believe we will be successful in attracting and retaining qualified personnel, competition for experienced management and clinical, scientific and engineering personnel from numerous companies and academic and other research institutions may limit our ability to do so on acceptable terms. In addition, we do not have employment agreements with any of our employees, and they could leave our employment at will. We have change of control agreements with our executive officers and vice presidents that provide for certain benefits upon termination or a change in role or responsibility in connection with a change of control of our company. We do not maintain life insurance policies on any employees. Failure to attract and retain personnel would prevent us from developing and commercializing our product candidates.
 
 
We expect to experience substantial growth in our business over the next few years. We expect to substantially increase our number of employees to service our internal programs and planned strategic partnering arrangements. This growth will place a strain on our human and capital resources. If we are unable to manage this growth


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effectively, our losses could increase. Our need to manage our operations and growth effectively requires us to continue to expend funds to improve our operational, financial and management controls, reporting systems and procedures, to attract and retain sufficient numbers of talented employees and to manage our facility requirements. If we are unable to implement improvements to our management information and control systems successfully in an efficient or timely manner, or if we encounter deficiencies in existing systems and controls, then management may receive inadequate information to manage our day to day operations.
 
 
We face an inherent risk of product liability as a result of the clinical testing of our product candidates in clinical trials and will face an even greater risk if we commercialize any products. We may be held liable if any product we develop causes injury or is found otherwise unsuitable during product testing, manufacturing, marketing or sale. Regardless of merit or eventual outcome, liability claims may result in decreased demand for any product candidates or products that we may develop, injury to our reputation, withdrawal of clinical trials, costs to defend litigation, substantial monetary awards to clinical trial participants or patients, loss of revenue and the inability to commercialize any products that we develop. We have product liability insurance that covers our clinical trials up to a $10 million aggregate annual limit. We intend to expand product liability insurance coverage to include the sale of commercial products if we obtain marketing approval for any products that we may develop. However, this insurance may be prohibitively expensive, or may not fully cover our potential liabilities. Inability to obtain sufficient insurance coverage at an acceptable cost or otherwise to protect against potential product liability claims could prevent or delay the commercialization of our product candidates. If we are sued for any injury caused by any future products, our liability could exceed our total assets.
 
 
The Controlled Substances Act imposes various registration, recordkeeping and reporting requirements, procurement and manufacturing quotas, labeling and packaging requirements, security controls and a restriction on prescription refills on certain pharmaceutical products. A principal factor in determining the particular requirements, if any, applicable to a product is its actual or potential abuse profile. The U.S. Drug Enforcement Administration, or DEA, regulates chemical compounds as Schedule I, II, III, IV or V substances, with Schedule I substances considered to present the highest risk of substance abuse and Schedule V substances the lowest risk. Alprazolam, the API in AZ-002, is regulated as a Schedule IV substance, fentanyl, the API in AZ-003, is regulated as a Schedule II substance, and zaleplon, the API in AZ-007, is regulated as a Schedule IV substance. Each of these product candidates is subject to DEA regulations relating to manufacture, storage, distribution and physician prescription procedures, and the DEA regulates the amount of the scheduled substance that would be available for clinical trials and commercial distribution. As a Schedule II substance, fentanyl is subject to more stringent controls, including quotas on the amount of product that can be manufactured as well as a prohibition on the refilling of prescriptions without a new prescription from the physician. The DEA periodically inspects facilities for compliance with its rules and regulations. Failure to comply with current and future regulations of the DEA could lead to a variety of sanctions, including revocation, or denial of renewal, or of DEA registrations, injunctions, or civil or criminal penalties and could harm our business, financial condition and results of operations.
 
 
The single dose version of our Staccato system uses energetic materials to generate the rapid heating necessary for vaporizing the drug, while avoiding degradation. Manufacture of products containing energetic materials is controlled by the U.S. Bureau of Alcohol, Tobacco, Firearms and Explosives, or ATF. Technically, the energetic materials used in our Staccato system are classified as “low explosives,” and the ATF has granted us a license/permit for the manufacture of such low explosives. Additionally, due to inclusion of the energetic materials in our Staccato system, the Department of Transportation, or DOT, regulates shipments of the single dose version of our Staccato


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system. The DOT has granted the single dose version of our Staccato system “Not Regulated as an Explosive” status. Failure to comply with the current and future regulations of the ATF or DOT could subject us to future liabilities and could harm our business, financial condition and results of operations. Furthermore, these regulations could restrict our ability to expand our facilities or construct new facilities or could require us to incur other significant expenses in order to maintain compliance.
 
 
Our research and development processes involve the controlled use of hazardous materials, including chemicals. We also use energetic materials in the manufacture of the chemical heat packages that are used in our single dose devices. Our operations produce hazardous waste products. We cannot eliminate the risk of accidental contamination or discharge or injury from these materials. Federal, state and local laws and regulations govern the use, manufacture, storage, handling and disposal of these materials. We could be subject to civil damages in the event of an improper or unauthorized release of, or exposure of individuals to, hazardous materials. In addition, claimants may sue us for injury or contamination that results from our use or the use by third parties of these materials and our liability may exceed our total assets. We maintain insurance for the use of hazardous materials in the aggregate amount of $1 million, which may not be adequate to cover any claims. Compliance with environmental and other laws and regulations may be expensive, and current or future regulations may impair our research, development or production efforts.
 
Certain of our suppliers are working with these types of hazardous and highly combustible materials in connection with our component manufacturing agreements. In the event of a lawsuit or investigation, we could be held responsible for any injury caused to persons or property by exposure to, or release of, these hazardous and highly combustible materials. Further, under certain circumstances, we have agreed to indemnify our suppliers against damages and other liabilities arising out of development activities or products produced in connection with these agreements.
 
 
The laws and regulations affecting public companies, including the provisions of the Sarbanes-Oxley Act of 2002, or Sarbanes-Oxley, and rules enacted and proposed by the U.S. Securities and Exchange Commission, or SEC, and by the Nasdaq Global Market, will result in increased costs to us as we continue to undertake efforts to comply with rules and respond to the requirements applicable to public companies. The rules make it more difficult and costly for us to obtain certain types of insurance, including director and officer liability insurance, and we may be forced to accept reduced policy limits and coverage or incur substantially higher costs to obtain the same or similar coverage as compared to the polices previously available to public companies. The impact of these events could also make it more difficult for us to attract and retain qualified persons to serve on our board of directors or our board committees or as executive officers.
 
As a public company, we need to comply with Sarbanes-Oxley and the related rules and regulations of the SEC, including expanded disclosure, accelerated reporting requirements and more complex accounting rules. Compliance with Section 404 of Sarbanes-Oxley and other requirements will continue to increase our costs and require additional management resources. We have been upgrading our finance and accounting systems, procedures and controls and will need to continue to implement additional finance and accounting systems, procedures and controls as we grow to satisfy new reporting requirements. We currently do not have an internal audit group. In addition, we may need to hire additional legal and accounting staff with appropriate experience and technical knowledge, and we cannot assure you that if additional staffing is necessary that we will be able to do so in a timely fashion.


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Our facilities are located in the San Francisco Bay Area near known earthquake fault zones and, therefore, are vulnerable to damage from earthquakes. We are also vulnerable to damage from other types of disasters, such as power loss, fire, floods and similar events. If any disaster were to occur, our ability to operate our business could be seriously impaired. We currently may not have adequate insurance to cover our losses resulting from disasters or other similar significant business interruptions, and we do not plan to purchase additional insurance to cover such losses due to the cost of obtaining such coverage. Any significant losses that are not recoverable under our insurance policies could seriously impair our business, financial condition and results of operations.
 
 
 
Our common stock price has experienced large fluctuations since our initial public offering in March 2006. In addition, the trading prices of life science and biotechnology company stocks in general have experienced extreme price fluctuations in recent years. The valuations of many life science companies without consistent product revenues and earnings are extraordinarily high based on conventional valuation standards, such as price to revenue ratios. These trading prices and valuations may not be sustained. Any negative change in the public’s perception of the prospects of life science or biotechnology companies could depress our stock price regardless of our results of operations. Other broad market and industry factors may decrease the trading price of our common stock, regardless of our performance. Market fluctuations, as well as general political and economic conditions such as terrorism, military conflict, recession or interest rate or currency rate fluctuations, also may decrease the trading price of our common stock. In addition, our stock price could be subject to wide fluctuations in response to various factors, including:
 
  •  actual or anticipated results and timing of our clinical trials;
 
  •  actual or anticipated regulatory approvals of our product candidates or competing products;
 
  •  changes in laws or regulations applicable to our product candidates;
 
  •  changes in the expected or actual timing of our development programs, including delays or cancellations of clinical trials for our product candidates;
 
  •  period to period fluctuations in our operating results;
 
  •  announcements of new technological innovations or new products by us or our competitors;
 
  •  changes in financial estimates or recommendations by securities analysts;
 
  •  conditions or trends in the life science and biotechnology industries;
 
  •  changes in the market valuations of other life science or biotechnology companies;
 
  •  developments in domestic and international governmental policy or regulations;
 
  •  announcements by us or our competitors of significant acquisitions, strategic partnerships, joint ventures or capital commitments;
 
  •  additions or departures of key personnel;
 
  •  disputes or other developments relating to proprietary rights, including patents, litigation matters and our ability to obtain patent protection for our technologies;
 
  •  sales of our common stock by us; and
 
  •  sales and distributions of our common stock by our stockholders.


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In the past, stockholders have often instituted securities class action litigation after periods of volatility in the market price of a company’s securities. If a stockholder files a securities class action suit against us, we would incur substantial legal fees, and our management’s attention and resources would be diverted from operating our business in order to respond to the litigation.
 
Item 1B.   Unresolved Staff Comments
 
None.
 
Item 2.   Properties
 
We lease two buildings with an aggregate of 106,894 square feet of office, manufacturing, and laboratory facilities in Mountain View, California, which we began to occupy in the fourth quarter of 2007. We currently occupy 87,560 square feet of these facilities and will gain access to the remaining 19,334 square feet on or about June 1, 2008. The lease for both facilities expires on March 31, 2018, and we have two options to extend the lease for five years each. We believe that the Mountain View facilities are sufficient for our office, manufacturing and laboratory needs through approximately the end of 2010 and that future growth thereafter can be accommodated by leasing additional space near the Mountain View facilities.
 
The leases on our two recently vacated facilities in Palo Alto, California expire on March 31, 2008 and June 30, 2008, during which time we will complete the decommissioning of the facilities to return to the landlord in accordance with the terms of the lease.
 
Item 3.   Legal Proceedings
 
None
 
Item 4.   Submission of Matters to a Vote of Security Holders
 
None.
 
 
Item 5.   Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
 
On March 8, 2006, our common stock began to trade on the NASDAQ Global Market under the symbol “ALXA.” The following table sets forth, for the periods indicated, the high and low sales prices of our common stock.
 
                 
2007
  High     Low  
 
First Quarter
  $ 15.80     $ 8.52  
Second Quarter
    12.80       7.86  
Third Quarter
    10.10       7.11  
Fourth Quarter
    9.72       7.00  
 
                 
2006
  High     Low  
 
March 8, 2006-March 31, 2006
  $ 10.59     $ 8.00  
Second Quarter
    10.00       6.51  
Third Quarter
    8.35       6.12  
Fourth Quarter
    12.09       7.29  
 
As of December 31, 2007, there were 211 holders of record of our common stock. We have not paid cash dividends on our common stock since our inception, and we do not anticipate paying any in the foreseeable future.


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Item 5B.   Use of Proceeds from the Sale of Registered Securities
 
March 2006 Initial Public Offering
 
Our initial public offering of common stock was effected through a Registration Statement on Form S-1 (File No. 333-130644), that was declared effective by the SEC on March 8, 2006. We registered 6,325,000 shares of our common stock, including the full underwriters’ over-allocation, with a proposed maximum aggregate offering price of $50.6 million, of which we sold 6,325,000 shares at $8.00 per share and an aggregate offering price of $50.6 million. The offering was completed after the sale of 6,325,000 shares. Piper Jaffray & Co. and Pacific Growth Equities, LLC were the joint book-running managing underwriters of our initial public offering and RBC Capital Markets and JMP Securities, acted as co-managers.
 
Of this amount, $3.5 million was paid in underwriting discounts and commissions, and an additional $2.2 million of expenses were incurred. None of the expenses were paid, directly or indirectly, to directors, officers or persons owning 10% or more of our common stock, or to our affiliates. As of December 31, 2007, we had applied the aggregate net proceeds of $44.9 million from our initial public offering as follows:
 
  •  approximately $41.5 million was used for working capital; and
 
  •  the remainder of the net proceeds from the offering, approximately $3.4 million, remain invested in cash, cash equivalents and marketable securities.
 
The foregoing amounts represent our best estimate of our use of proceeds for the period indicated. No payments were made to directors, officers or persons owning ten percent or more of our common stock or to their associates, or to our affiliates, other than payments in the ordinary course of business to officers for salaries and to non-employee directors as compensation for board or board committee service.
 
May 2007 Public Offering
 
Our follow-on public offering of common stock was effected through a shelf Registration Statement on Form S-3 (File No. 333-141739), that was declared effective by the SEC on April 16, 2007. We registered to sell common stock, preferred stock, debt securities and/or warrants, either individually or in units, with a total value of up to $150,000,000. We may also offer common stock or preferred stock upon conversion of debt securities, common stock upon conversion of preferred stock or common stock, preferred stock or debt securities upon the exercise of warrants. On May 2, 2007, we sold 6,900,000 shares at $10.25 per share and an aggregate offering price of $70.7 million. The offering was completed after the sale of 6,900,000 shares. Merrill Lynch, Pierce, Fenner & Smith Incorporated and Morgan Stanley & Co. Incorporated were the joint book-running managing underwriters of our public offering and Pacific Growth Equities and RBC Capital Markets, acted as co-managers.
 
Of this amount, $4.2 million was paid in underwriting discounts and commissions, and an additional $0.5 million of expenses were incurred. None of the expenses were paid, directly or indirectly, to directors, officers or persons owning 10% or more of our common stock, or to our affiliates. As of December 31, 2007, the aggregate net proceeds of $66.0 million from our public offering remained invested in cash, cash equivalents and marketable securities.
 
The foregoing amounts represent our best estimate of our use of proceeds for the period indicated. No payments were made to directors, officers or persons owning ten percent or more of our common stock or to their associates, or to our affiliates, other than payments in the ordinary course of business to officers for salaries and to non-employee directors as compensation for board or board committee service.
 
Item 5C.   Treasury Stock
 
None


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Item 6.   Selected Financial Data
 
The data set forth below should be read in conjunction with Management’s Discussion and Analysis of Financial Condition and Results of Operations and the consolidated financial statements and related notes included elsewhere herein.
 
                                                 
                                  Period from
 
                                  December 19,
 
                                  2000
 
                                  (Inception) to
 
    Year Ended December 31,     December 31,
 
    2007     2006     2005     2004     2003     2007  
    (In thousands, except per share data)  
 
Consolidated Statement of Operations Data:
                                               
Revenue
  $     $ 1,028     $ 2,230     $ 2,436     $ 1,002     $ 6,945  
Operating expenses:
                                               
Research and development(1)
    45,645       36,494       26,235       15,147       11,487       143,118  
General and administrative(1)
    14,888       9,969       9,654       4,155       4,213       45,063  
Acquired in-process research and development
                                  3,916  
                                     
                                                 
Total operating expenses(1)
    60,533       46,463       35,889       19,302       15,700       192,097  
                                                 
Loss from operations
    (60,533 )     (45,435 )     (33,659 )     (16,866 )     (14,698 )     (185,152 )
Interest and other income and interest expense, net
    4,623       1,909       1,257       241       370       8,546  
                                                 
Loss before noncontrolling interest in Symphony Allegro, Inc. 
    (55,910 )     (43,526 )     (32,402 )     (16,625 )     (14,328 )     (176,606 )
Loss attributed to noncontrolling interest in Symphony Allegro, Inc. 
    10,791       1,720                         12,511  
                                                 
                                     
Net loss
  $ (45,119 )   $ (41,806 )   $ (32,402 )   $ (16,625 )   $ (14,328 )   $ (164,095 )
                                                 
Basic and diluted net loss per common share
  $ (1.58 )   $ (2.13 )   $ (18.98 )   $ (11.41 )   $ (10.81 )        
                                                 
Shares used to compute basic and diluted net loss per common share
    28,605       19,584       1,707       1,457       1,325          
                                                 
 
 
(1) Includes stock-based compensation as follows:
 
                                                 
                                  Period from
 
                                  December 19,
 
                                  2000
 
                                  (Inception) to
 
    Year Ended December 31,     December 31,
 
    2007     2006     2005     2004     2003     2007  
    (In thousands)  
 
Research and development
  $ 1,885     $ 1,770     $ 167     $ 59     $ 32     $ 3,926  
General and administrative
    1,531       447       874                   2,852  
                                                 
Total
  $ 3,416     $ 2,217     $ 1,041     $ 59     $ 32     $ 6,778  
                                                 


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During the year ended December 31, 2005, we recorded compensation expense in relation to the extinguishment of officer notes receivable, representing $875,000 of research and development expense and $3.1 million of general and administrative expense.
 
                                         
    December 31,
    2007   2006   2005   2004   2003
    (In thousands)
 
Consolidated Balance Sheet Data:
                                       
Cash, cash equivalents and marketable securities
  $ 69,391     $ 42,623     $ 38,369     $ 62,294     $ 28,387  
Investments held by Symphony Allegro, Inc. 
    39,449       49,956                    
Working capital
    106,092       79,649       30,760       60,027       27,144  
Total assets
    149,125       105,766       47,405       69,280       34,477  
Noncurrent portion of equipment financing obligations
    6,317       5,865       5,155       1,840       1,551  
Convertible preferred stock
                107,194       107,194       57,414  
Deficit accumulated during development stage
    (164,095 )     (118,976 )     (77,170 )     (44,768 )     (28,143 )
Total stockholders’ equity (deficit)
    75,991       49,774       (74,385 )     (43,396 )     (26,982 )
 
Item 7.   Management’s Discussion and Analysis of Financial Condition and Results of Operations
 
The following Management’s Discussion and Analysis of Financial Condition and Results of Operations contains forward-looking statements that are based upon current expectations. In some cases, you can identify forward-looking statements by terminology such as “may,” “will,” “should,” “expect,” “plan,” “anticipate,” “believe,” “estimate,” “predict,” “intend,” “potential” or “continue” or the negative of these terms or other comparable terminology. Forward-looking statements involve risks and uncertainties. Our actual results and the timing of events could differ materially from those discussed in our forward-looking statements as a result of many factors, including those set forth under “Risk Factors” and elsewhere in this Annual Report on Form 10-K.
 
 
We are an emerging specialty pharmaceutical company focused on the development and commercialization of novel, proprietary products for the treatment of acute and intermittent conditions. We currently have six product candidates in clinical development. Our technology, the Staccato system, vaporizes an excipient-free drug to form a condensation aerosol that, when inhaled, allows for rapid systemic drug delivery. Because of the particle size of the aerosol, the drug is quickly absorbed through the deep lung into the bloodstream, providing speed of therapeutic onset that is comparable to IV administration but with greater ease, patient comfort and convenience.
 
We have identified approximately 200 drug compounds that have demonstrated initial vaporization feasibility for delivery with our technology. We believe that a number of these drug compounds, when delivered by the Staccato system, will have a desirable therapeutic profile for the treatment of acute and intermittent conditions. We are initially focusing on developing proprietary products by combining our Staccato system with small molecule drugs that have been in use for many years and are well characterized to create aerosolized forms of these drugs. We believe that we will be able to reduce the development time and risks associated with our product candidates, compared to the development of new chemical entities.
 
Our clinical-stage product candidates are:
 
  •  AZ-004 (Staccato loxapine).  We are developing AZ-004 for the treatment of acute agitation in patients with schizophrenia or bi-polar disorder. In March 2007, we announced positive initial results from a multi-center, randomized, double-blind, placebo-controlled Phase 2a clinical trial in 129 patients in an in-patient clinical setting. The 10 mg dose of AZ-004 met the primary endpoint of the clinical trial, which was a statistically significant reduction in the measure of agitation from baseline to the 2-hour post-dose time point, as compared to placebo. The 10 mg dose of AZ-004 also exhibited a rapid onset of effect, with a statistically-significant improvement in the PANSS (Positive and Negative Symptom Scale) Excited Component (PEC) scores at 20 minutes post-dose, as compared to placebo. The effectiveness of the


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  10 mg dose was sustained throughout the 24-hour study period, as compared to placebo. The 5 mg dose failed to achieve statistical significance. In February 2008 we initiated a Phase 3 clinical trial that is designed to enroll approximately 300 schizophrenic patients with acute agitation at 25 U.S. clinical centers. The trial is an in-clinic, multi-center, randomized, double-blind, placebo-controlled study and will test AZ-004 at two dose levels, 5 and 10 mg. Patients may receive up to 3 doses of study drug in a 24-hour period, depending on their clinical status. The primary endpoint for the study is the change from baseline in the PEC score, measured at 2 hours after the first dose. Various assessments of a patient’s agitation state will be conducted at serial time points using standard agitation scales over the first 4-hour post-dose time period, with follow-up assessments at the end of the 24-hour study period. Side effects will be recorded throughout the 24-hour period. A second Phase 3 clinical trial is projected to begin in the third quarter of 2008. The design of the second study will be similar to the first trial, except that the patient population will be patients with bipolar disease. AZ-004 has been licensed to Symphony Allegro, Inc., or Symphony Allegro, and we have the right to repurchase all rights to this product candidate.
 
  •  AZ-001 (Staccato prochlorperazine).  We are developing AZ-001 to treat patients suffering from acute migraine headaches. In March 2007, we announced positive initial results from an outpatient, multi-center, randomized, double blind, placebo-controlled Phase 2b clinical trial of AZ-001 in 400 migraine patients. All three doses of AZ-001 (5, 7.5 and 10 mg) met the primary endpoint of statistically significant pain relief 2-hours post-dose using the IHS (International Headache Society) 4-point headache pain rating scale, compared to placebo. In the two highest doses studied, AZ-001 also showed a statistically-significant difference in achieving a pain-free response at two hours, as compared with placebo. AZ-001 demonstrated rapid onset of pain relief, with statistically significant pain response in 15 minutes for the 7.5 mg dose and statistically-significant pain responses for all three doses at 30 minutes. AZ-001 also showed a sustained pain-free response, where a patient has a pain score of 0, or “no” headache, with statistically-significant elimination of pain at 24 hours post-dose at the two highest studied doses. Survival analysis for nausea, photophobia and phonophobia over the 2-hour period post-dose showed a statistically significant difference, compared to placebo. In December 2007, we completed enrollment of a thorough QT clinical trial, in which two doses of AZ-001 (5 and 10 mg) were compared to active control and to placebo. The purpose of a thorough QT study is to determine a drugs effect on cardiac rhythms. With > 40 subjects per treatment condition, we found that the active control, moxyfloxacin, produced a positive QT/QTc signal that verified the sensitivity of the clinical study. Based on a preliminary analysis of the data from the study, neither of the doses of AZ-001 produced a QT/QTc prolongation that would suggest an increased risk of cardiac arrhythmia.
 
  •  AZ-104 (Staccato loxapine).  We are developing AZ-104 to treat patients suffering from acute migraine headaches. AZ-104 is a lower dose version of AZ-004. In March 2008, we announced initial results of an in-clinic, multi-center randomized, double-blind, single administration, placebo controlled Phase 2a proof-of-concept clinical trial in 168 migraine patients with or without aura. Three doses of AZ-104 (1.25, 2.5 and 5 mg) were evaluated against placebo in the clinical trial. Using the IHS) 4-point rating scale, the primary efficacy endpoint was pain-relief response at 2 hours post-administration. AZ-104 met the primary efficacy endpoint of the clinical trial for the two highest doses of the drug compared to placebo. Statistically significant improvements in pain response were observed in 76.7% of patients at the 5 mg dose (p= 0.02), 79.1% of patients at the 2.5 mg dose (p = 0.01) and 67.4% of patients at the 1.25 mg dose (p = 0.18), compared to 51.3% of patients receiving placebo. Using survival analysis for pain relief response, all three dose groups were statistically superior (p < .05) to placebo during the 4-hour post-treatment time period that the patients remained in the clinic. AZ-104 has been licensed to Symphony Allegro, and we have the right to repurchase all rights to this product candidate.
 
  •  AZ-002 (Staccato alprazolam).  We are developing AZ-002 for the acute treatment of panic attacks associated with panic disorder. In April 2006, we initiated an in-clinic, single-center, double-blind, placebo-controlled, Phase 2a proof-of-concept clinical trial in patients with panic disorder. As a result of observing greater than expected levels of sedation in the first two patients enrolled in the trial, we reduced the dose of AZ-002, modified the AZ-002 device, added an open-label portion to the clinical protocol, manufactured and released new clinical trial materials for the trial, and added two additional study sites to the study group.


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  In April 2007, we re-initiated dosing in the 42 patient clinical trial with a lower dose of AZ-002. We have completed the open-label, lead-in segment of the clinical trial, identifying the 1 mg AZ-002 dose as an acceptable dose in terms of its safety and efficacy profile, and have initiated the randomized, double blind, placebo-controlled segment of the clinical trial. We expect to complete enrollment of this trial in the second quarter of 2008. AZ-002 has been licensed to Symphony Allegro, and we have the right to repurchase all rights to this product candidate.
 
  •  AZ-003 (Staccato fentanyl).  We are jointly developing AZ-003 with Endo Pharmaceuticals Inc., or Endo, for the treatment of breakthrough pain in cancer and non-cancer patients. Endo is responsible for regulatory, pre-clinical and clinical development, and for commercializing the product in North America. We are responsible for the development of the Staccato Electric Multiple Dose device and we have the exclusive right to manufacture the product for clinical development and commercial supply.
 
  •  AZ-007 (Staccato zaleplon).  We are developing AZ-007 for the treatment of insomnia in patients who have difficulty falling asleep, including patients who awake in the middle of the night and have difficulty falling back asleep. We filed an Investigational New Drug application, or IND, in December 2007. In February 2008, we initiated a Phase 1 clinical trial that enrolled 40 healthy volunteers at a single site. The purpose of this trial is to assess the safety, tolerability and pharmacokinetic parameters of a single dose of AZ-007. Using a double blind, randomized trial design, four doses of AZ-007 (ranging from 0.5 to 4.0 mg) are being compared to placebo. We expect to report initial results of this trial in the second quarter of 2008.
 
We were incorporated December 19, 2000. We have funded our operations primarily through the sale of equity securities, capital lease and equipment financings and government grants. We have generated $6.9 million in revenue from inception through December 31, 2007, substantially all of which was earned through United States Small Business Innovation Research grants. We did not have any revenues in 2007, and we do not expect any material product revenue until at least 2011.
 
From inception through 2003, we focused on the development of our technology, the selection and preclinical testing of product candidates and the manufacture of clinical trial supplies. In 2004, we expanded our activities to include the clinical development of our product candidates. The continued development of our product candidates will require significant additional expenditures, including expenses for preclinical studies, clinical trials, research and development, manufacturing development and seeking regulatory approvals. We rely on third parties to conduct a portion of our preclinical studies and all of our clinical trials, and we expect these expenditures to increase in future years as we continue development of our product candidates. In 2008, we intend to conduct several clinical trials, including our on-going Phase 3 clinical trial for AZ-004, and an additional Phase 3 clinical trial for AZ-004. With our partner Endo, we intend to continue device development and manufacturing of AZ-003. These clinical trials and development efforts will result in higher expenditures than in previous years. If these product candidates continue to progress, expenses for future clinical trials will be significantly higher than those incurred to date.
 
In 2007, we completed a current good manufacturing practice pilot manufacturing facility in Mountain View, California and completed the move of our operations to the new facility in the first quarter of 2008. We intend the pilot manufacturing facility to be capable of manufacturing materials for toxicology studies and clinical trial materials for future clinical trials. Facility lease payments will decrease in the second and third quarters of 2008 as the leases on our Palo Alto, California facilities expire.
 
On December 1, 2006 we entered into a transaction involving a series of related agreements providing for the financing of additional clinical and nonclinical development of AZ-002, Staccato alprazolam, and AZ-004/104, Staccato loxapine. Pursuant to the agreements, Symphony Capital LLC, a wholly owned subsidiary of Symphony Holdings LLC, and its investors have invested $50 million to form Symphony Allegro to fund additional clinical and nonclinical development of Staccato alprazolam and Staccato loxapine. We have exclusively licensed to Symphony Allegro certain intellectual property rights related to Staccato alprazolam and Staccato loxapine. We have retained manufacturing rights to these two product candidates. We continue to be primarily responsible for the development of these two product candidates in accordance with a development plan and related development budgets, and we have incurred and may continue to incur expenses that are not funded by Symphony Allegro. Pursuant to the agreements, we have received an exclusive purchase option that gives us the right, but not the obligation, to acquire all, but not less than all, of the equity of Symphony Allegro, and reacquire the intellectual property rights that we


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licensed to Symphony Allegro. This purchase option is exercisable at predetermined prices between December 1, 2007 and December 1, 2010. The purchase option exercise price may be paid for in cash or in a combination of cash and our common stock, in our sole discretion, provided that the common stock portion may not exceed 40% of the purchase option exercise price or 10% of our common stock issued and outstanding as of the purchase option closing date. If we pay a portion of the purchase option exercise price in shares of our common stock, then we will be required to register such shares for resale under a resale registration statement pursuant to the terms of a registration rights agreement. If we do not exercise our purchase option by December 1, 2010, then Symphony Allegro will retain its exclusive license to develop and commercialize Staccato alprazolam and Staccato loxapine for all indications, and we will manufacture and sell Staccato alprazolam and Staccato loxapine to Symphony Allegro or its sublicensee for those purposes.
 
On December 27, 2007, we entered into a license, development and supply agreement, or the license agreement, with Endo for AZ-003 (Staccato fentanyl) and the fentanyl class of molecules for North America. Under the terms of the license agreement, Endo paid us an upfront fee of $10 million, and will pay potential additional milestone payments of up to $40 million upon achievement of predetermined regulatory and clinical milestones. Endo will also pay undisclosed royalties to us on net sales of the product, from which we will pay for the cost of goods for the manufacture of the commercial version of the product. We have primary responsibility for the development and costs of the Staccato Electronic Multiple Dose device and the exclusive right to manufacture the product for clinical development and commercial supply. Endo has responsibility for future pre-clinical, clinical and regulatory development, and, if AZ-003 is approved for marketing, for commercializing the product in North America. Each party will be responsible for all internal costs and expenses incurred related to the respective area of responsibility. Generally speaking, each party will also be responsible for external development costs incurred related to the respective area of responsibility, but we agreed to pay certain external development costs incurred by Endo in excess of an agreed upon threshold, with a maximum expense to us of $20 million. We and Endo have established a joint steering committee and a joint development committee to oversee the development of AZ-003. We have the right, but not the obligation to participate on each of the committees. We retain all rights outside of North America. Endo has the right to terminate the license agreement on 90 days written notice. Upon such termination, all rights to the product, including regulatory filings, data and clinical and non-clinical data for use with the product will revert to us. We will recognize expense related to the agreement when incurred.
 
As our activities have expanded, we have consistently increased the number of our employees. We expect that we will add a significant number of employees during the remainder of 2008 to support our expanded operations.
 
We have incurred significant losses since our inception. As of December 31, 2007, our deficit accumulated during development stage was $164.1 million and total stockholders’ equity was $76.0 million. We recognized net losses of $45.1 million, $41.8 million, and $32.4 million, in 2007, 2006 and 2005, respectively. We expect our net losses to increase as we continue our existing and planned preclinical studies and clinical trials, expand our research and development efforts, continue our manufacturing development, begin commercialization development, and add infrastructure to support these expanded operations.
 
The process of conducting preclinical studies and clinical trials necessary to obtain FDA approval is costly and time consuming. We consider the development of our product candidates to be crucial to our long term success. If we do not complete development of our product candidates and obtain regulatory approval to market one or more of these product candidates, we may be forced to cease operations. The probability of success for each product candidate may be impacted by numerous factors, including preclinical data, clinical data, competition, device development, manufacturing capability, regulatory approval and commercial viability. Our strategy includes entering into strategic partnerships with third parties to participate in the development and commercialization of some of our product candidates, such as our Symphony Allegro and Endo relationships. Endo has control over future preclinical and clinical development of AZ-003. If in the future we enter into additional partnerships, third parties could have control over preclinical development or clinical trials for some of our product candidates. Accordingly, the progress of such product candidate would not be under our control. We cannot forecast with any degree of certainty which of our product candidates, if any, will be subject to any future partnerships or how such arrangements would affect our development plans or capital requirements.


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As a result of the uncertainties discussed above, the uncertainty associated with clinical trial enrollments, and the risks inherent in the development process, we are unable to determine the duration and completion costs of the current or future clinical stages of our product candidates or when, or to what extent, we will generate revenues from the commercialization and sale of any of our product candidates. Development timelines, probability of success and development costs vary widely. While we are currently focused on developing our product candidates, we anticipate that we and our partners, will make determinations as to which programs to pursue and how much funding to direct to each program on an ongoing basis in response to the scientific and clinical success of each product candidate, as well as an ongoing assessment as to the product candidate’s commercial potential. We anticipate developing additional product candidates, which will also increase our research and development expenses in future periods. We do not expect any of our current product candidates to be commercially available before 2011, if at all. We anticipate that existing cash, cash equivalents and marketable securities, along with interest earned thereon, funding available under our equipment financing arrangements, expected payments from Symphony Allegro, expected proceeds from stock option exercises and purchases under our Employee Stock Purchase Plan, will enable us to maintain our currently planned operations through the middle of 2009
 
Critical Accounting Estimates and Judgments
 
Our management’s discussion and analysis of our financial condition and results of operations is based on our financial statements, which have been prepared in accordance with U.S. generally accepted accounting principles. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements, as well as reported revenues and expenses during the reporting periods. On an ongoing basis, we evaluate our estimates and judgments related to development costs. We base our estimates on historical experience and on various other factors that we believe are reasonable under the circumstances, the results of which form the basis for making assumptions about the carrying value of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.
 
While our significant accounting policies are more fully described in Note 2 of the notes to consolidated financial statements appearing elsewhere in this Annual Report, we believe the following accounting policies are critical to the process of making significant estimates and judgments in preparation of our financial statements.
 
 
We estimate our preclinical study and clinical trial expenses based on our estimates of the services received pursuant to contracts with multiple research institutions and clinical research organizations that conduct and manage preclinical studies and clinical trials on our behalf. The financial terms of these agreements vary from contract to contract and may result in uneven payment flows. Preclinical study and clinical trial expenses include the following:
 
  •  fees paid to contract research organizations in connection with preclinical studies;
 
  •  fees paid to contract research organizations and other clinical sites in connection with clinical trials; and
 
  •  fees paid to contract manufacturers in connection with the production of components and drug materials for preclinical studies and clinical trials.
 
We record accruals for these preclinical study and clinical trial costs based upon the estimated amount of work completed. All such costs are charged to research and development expenses based on these estimates. Costs related to patient enrollment in clinical trials are accrued as patients are entered in the trial. We monitor patient enrollment levels and related activities to the extent possible through internal reviews, correspondence and discussions with research institutions and organizations. However, if we have incomplete or inaccurate information, we may underestimate or overestimate activity levels associated with various preclinical studies and clinical trials at a given point in time. In this event, we could record significant research and development expenses in future periods when the actual activity level becomes known. To date, we have not made any material adjustments to our estimates of preclinical study and clinical trial costs. We make good faith estimates which we believe to be accurate, but the actual costs and timing of clinical trials are highly uncertain, subject to risk and may change depending upon a


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number of factors, including our clinical development plan. With the start of our Phase 3 clinical trial in the first quarter of 2008 and future Phase 3 clinical trials, the process of estimating clinical trial costs will become more difficult as the trials will involve larger numbers of patients and clinical sites.
 
Stock-Based Compensation
 
 
On January 1, 2006, we adopted the fair value recognition provisions of Statement of Financial Accounting Standard No. 123R, Share-Based Payment, or SFAS 123R. As required, we adopted SFAS 123R using the prospective transition method. Under this transition method, beginning January 1, 2006, compensation cost recognized includes: (a) compensation cost for share-based payments granted prior to, but not yet vested as of December 31, 2005 related to (i) employees, based on the intrinsic value in accordance with the provisions of Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees, or APB 25, and (ii) non-employees based on the options fair value in accordance with the provisions of SFAS 123, and (b) compensation cost for all share-based payments granted or modified subsequent to December 31, 2005, based on the grant-date fair value estimated in accordance with the provisions of SFAS 123R.
 
We currently use the Black-Scholes option pricing model to determine the fair value of stock options and purchase rights issued under the employee stock purchase plan. The determination of the fair value of share-based payment awards on the date of grant using an option-pricing model is affected by our stock price as well as assumptions regarding a number of complex and subjective variables. These variables include our expected stock price volatility over the term of the awards, actual and projected employee stock option exercise behaviors, risk-free interest rates and expected dividends.
 
The estimated fair value of restricted stock unit awards is calculated based on the market price of our common stock on the date of grant, reduced by the present value of dividends expected to be paid on our common stock prior to vesting of the restricted stock unit. Our current estimate assumes no dividends will be paid prior to the vesting of the restricted stock unit.
 
Through 2007, we estimated the expected term of options using the “simplified” method, as illustrated in SAB 107. Beginning in 2008, we will estimate the expected term of our options based on historical option activity. As we have been operating as a public company for a period of time that is significantly shorter than our estimated expected option term, we are unable to use actual price volatility data. Therefore, we estimate the volatility of our common stock based on volatility of similar entities. We base the risk-free interest rate that we use in the option pricing model on U.S. Treasury zero-coupon issues with remaining terms similar to the expected term on the options. We do not anticipate paying any cash dividends in the foreseeable future and therefore use an expected dividend yield of zero in the option pricing model.
 
We are required to estimate forfeitures at the time of grant and revise those estimates in subsequent periods if actual forfeitures differ from those estimates. We use historical data to estimate pre-vesting option forfeitures and record share-based compensation expense only for those awards that are expected to vest. All share based payment awards are amortized on a straight-line basis over the requisite service periods of the awards, which are generally the vesting periods.
 
If factors change and we employ different assumptions for estimating share-based compensation expense in future periods or if we decide to use a different valuation model, the expenses in future periods may differ significantly from what we have recorded in the current period and could materially affect our operating loss, net loss and net loss per share.
 
See Note 2 to the consolidated financial statements for further information regarding the SFAS 123R disclosures.
 
 
Prior to January 1, 2006, we used the intrinsic value recognition method for equity incentive awards issued to employees in accordance with APB 25. During the year ended December 31, 2005, we granted options to employees


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to purchase a total of 777,492 shares of common stock at exercise prices ranging from $1.10 to $6.88 per share. We did not obtain contemporaneous valuations from an unrelated valuation specialist during this period. Instead, we relied on our board of directors, the members of which have extensive experience in the life sciences industry and all but one of whom are non-employee directors, to determine a reasonable estimate of the then current value of our common stock. Given the absence of an active market for our common stock during 2005, our board of directors determined the estimated fair value of our common stock on the date of grant based on several factors.
 
In connection with the preparation of our financial statements in connection with our initial public offering in March 2006, we reassessed the estimated fair value of our common stock in light of the expected completion of the offering. In reassessing the fair value of our common stock during 2005 for purposes of computing the stock-based compensation expense, we reassessed the fair value of the common stock assuming the successful completion of our initial public offering and then determined the reassessed fair value at previous points in time. In determining the reassessed fair value of our common stock during 2005, we established $9.90 as the reassessed fair value at December 31, 2005 (90% of the midpoint of the estimated price range of the initial public offering) and applied it over the prior 12 month period using a straight line basis. We also considered other material factors in reassessing fair value for financial reporting purposes as of the respective option grant dates, including the completion of our Phase 1 clinical trial of AZ-002 in September 2005, the completion of our Phase 1 clinical trial of AZ-004 in November 2005, the results of our Phase 2a clinical trial of AZ-001, valuations of existing comparable publicly traded companies, the state of the public offering market for development stage life sciences companies and our decision to pursue an initial public offering. We believe this approach was consistent with valuation methodologies applied by other life science companies pursuing an initial public offering. The reassessed fair value used to compute the stock-based compensation expense may not be reflective of the fair market value that would result from the application of other valuation methods, including accepted valuation methods for tax purposes.
 
Based upon the reassessment discussed above, we determined that the reassessed fair value of the options to purchase 777,492 shares of common stock ranged from $2.04 to $9.90 per share during the year ended December 31, 2005. We took into account the factors identified above in determining the reassessed fair value of the common stock as of each grant date. Share-based compensation resulting from this reassessment equals the difference between the reassessed fair value per share of our common stock on the date of grant and the exercise price per share and is being amortized over the vesting period of the underlying options, generally four years.
 
As a result of the reassessed fair value of options granted, we recorded deferred stock-based compensation relative to these options of approximately $3.3 million during the year ended December 31, 2005, which is being amortized over the vesting period of the applicable options on a straight-line basis. During the years ended December 31, 2007, 2006 and 2005, we amortized $577,000, $727,000 and $404,000, respectively, of deferred stock-based compensation. At December 31, 2007 we have $739,000 of deferred stock compensation to be amortized in future periods as follows: $471,000 in 2008 and $268,000 in 2009.
 
In addition, we had three officer stock option grants that were subject to variable accounting treatment. See Note 2 to the consolidated financial statements. With the variable options, we measured additional compensation each period based on the incremental difference between the reassessed fair value of the shares and the exercise price of the stock options and recorded compensation expense on a graded vesting basis in accordance with FIN 28, Accounting for Stock Appreciation Rights and other Variable Stock Option or Award Plans. As a result of the reassessed fair value, we recorded $442,000 of stock-based compensation expense during the year ended December 31, 2005. As a result of changes in our stock price, we recorded a $442,000 reduction in compensation expense during the first quarter of 2006. As the exercise price was fixed in March 2006, the contingency was resolved and variable accounting for these options ceased.
 
In December 2005, we extinguished the housing loans that were made to the three officers having a total principal value of $2.3 million and we agreed to pay $1.7 million of taxes related to the extinguishment on the officers’ behalf. We recognized compensation expense of $4.0 million in the quarter ended December 31, 2005 as a result of the extinguishments of the officers’ notes and related taxes. In connection with the loan extinguishment agreements, we settled the loan extinguishment by reducing the aggregate intrinsic value of their stock options as described below. As a result, variable stock-based compensation expense was reduced by an amount equal to the $4.0 million loan extinguishment and related taxes in the quarter ended December 31, 2005.


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In settlement for the extinguishment of the officer notes receivable, we increased the exercise price of certain options to purchase common stock held by these officers such that the aggregate intrinsic value of their stock option awards was reduced by an amount equal to the amounts of the loans extinguished and related taxes paid on their behalf. We settled this transaction based on our initial public offering price of $8.00 per share.
 
 
On December 1, 2006 we entered into a transaction involving a series of related agreements with Symphony Capital LLC, or Symphony Capital, Symphony Allegro Holdings LLC, or Holdings, and Holdings’ wholly owned subsidiary Symphony Allegro, Inc., or Allegro, to fund the clinical development of AZ-002, Staccato alprazolam, and AZ-004/104, Staccato loxapine, or the Programs. Symphony Capital and other investors, together referred to as Symphony, invested $50 million in Holdings, which then invested the $50 million in Allegro. Pursuant to the agreements, Allegro agreed to invest up to the full $50 million to fund the clinical development of the Programs, and we licensed to Allegro certain intellectual property rights related to these Programs. We have retained manufacturing rights to these two product candidates. Pursuant to the agreements, we continue to be primarily responsible for all preclinical, clinical and device development efforts as well as maintenance of the intellectual property portfolio for the Programs. We and Allegro have established a development committee to oversee the programs. We participate in the development committee and have the right to appoint one of the five board of director seats of Allegro. We have incurred and may continue to incur expenses related to the Programs that are not funded by Allegro. Pursuant to the agreements, we have received an exclusive purchase option, or the Purchase Option, that gives us the right, but not the obligation, to acquire all, but not less than all, of the equity of Allegro, and reacquire the intellectual property rights that we licensed to Allegro. The Purchase Option is exercisable at predetermined prices that increase over time and range from $67.5 million starting December 31, 2007 to $122.5 million through November 30, 2010. The Purchase Option exercise price may be paid for in cash or in a combination of cash and our common stock, in our sole discretion, provided that the common stock portion may not exceed 40% of the purchase option exercise price or 10% of our common stock issued and outstanding as of the purchase option closing date. If we pay a portion of the Purchase Option exercise price in shares of our common stock, then we will be required to register such shares for resale under a resale registration statement pursuant to the terms of a registration rights agreement. If we do not exercise the Purchase Option by December 1, 2010, then Allegro will retain its exclusive license to develop and commercialize Staccato alprazolam and Staccato loxapine for all indications, and, if they are ultimately commercialized, we will manufacture and sell Staccato alprazolam and Staccato loxapine to Allegro or its sublicensee for those purposes. In consideration for the Purchase Option, we issued to Holdings a five-year warrant to purchase 2,000,000 shares of our common stock at $9.91 per share and paid $2.85 million for structuring fees and related expenses to Symphony Capital.
 
Under FASB Interpretation No. 46 (FIN 46R), Consolidation of Variable Interest Entities, a variable interest entity (VIE) is (1) an entity that has equity that is insufficient to permit the entity to finance its activities without additional subordinated financial support, or (2) an entity that has equity investors that cannot make significant decisions about the entity’s operations or that do not absorb their proportionate share of the expected losses or do not receive the expected residual returns of the entity. FIN 46R requires a VIE to be consolidated by the party that is deemed to be the primary beneficiary, which is the party that has exposure to a majority of the potential variability in the VIE’s outcomes. The application of FIN 46R to a given arrangement requires significant management judgment.
 
We have consolidated the financial position and results of operations of Allegro in accordance with FIN 46R. We believe Allegro is by design a VIE because we have a purchase option to acquire its outstanding voting stock at prices that are fixed based upon the date the option is exercised. The fixed nature of the purchase option price limits Symphony’s returns, as the investor in Allegro.
 
FIN 46R deems parties to be de facto agents if they cannot sell, transfer, or encumber their interests without the prior approval of an enterprise. Symphony is considered to be a de facto agent of the Company pursuant to this provision, and because we and Symphony, as a related party group, absorb a majority of Allegro’s variability, we evaluated whether, pursuant to FIN 46R’s requirements, we are most closely associated with Allegro. We concluded that we are most closely associated with Allegro and should consolidate Allegro because (1) we originally developed the technology that was assigned to Allegro, (2) we will continue to oversee and monitor the development program, (3) our employees will continue to perform substantially all of the development work,


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(4) we significantly influenced the design of the responsibilities and corporate structure of Allegro, (5) Allegro’s operations are substantially similar to our activities, and (6) through the Purchase Option, we have the ability to meaningfully participate in the benefits of a successful development effort.
 
Symphony will be required to absorb the development risk for its equity investment in Allegro. Pursuant to FIN 46R’s requirements, Symphony’s equity investment in Allegro is classified as noncontrolling interest in our consolidated balance sheets. The noncontrolling interest held by Symphony has been reduced by the $10.7 million fair value of the warrant it received in consideration for the Purchase Option and $2.85 million of fees we immediately paid to Symphony upon the transaction’s closing because the total consideration provided by us to Symphony effectively reduces Symphony’s at-risk equity investment in Allegro. While we perform the research and development on behalf of Allegro, our development risk is limited to the consideration we provided to Symphony (the warrant and fees).
 
Losses incurred by Allegro are charged to the noncontrolling interest until that balance has been reduced to zero, at which point our net loss will be increased for the research and development expenses incurred subsequent to that date. Net losses incurred by Allegro and charged to the noncontrolling interest were $10.8 million and $1.7 million for the years ended December 31, 2007 and 2006, respectively. At December 31, 2007, the noncontrolling interest balance was $24.0 million. We currently expect the noncontrolling interest to be exhausted by the end of 2009. As of December 31, 2007, the investments held by Allegro were $39.4 million, which we expect to spend through the term of the collaboration in 2011.
 
If we do not exercise the Purchase Option, we would expect to recognize losses incurred after the noncontrolling interest in Allegro is reduced to zero. Furthermore, if the Purchase Option expires unexercised, we would then be required to deconsolidate Allegro. That potential deconsolidation would not be expected to impact our earnings because the carrying value of the net assets of Allegro would be expected to be zero.
 
In contrast, if we exercise the Purchase Option, we will retain control of Allegro. As such, we would expect to record the exercise of the Purchase Option as a return to the noncontrolling interest. We do not expect to recognize an asset for the Purchase Option payment to be made to Symphony. Instead, the payment is expected to be accounted for as a capital transaction (that is, a return to the noncontrolling interest) that would not affect our net income or loss. However, because the exercise of the Purchase Option will be accounted for as a capital transaction, it will be treated as a deemed dividend for purposes of reporting earnings per share, increasing loss per share or decreasing income per share, as the case may be, in the period we exercise the Purchase Option. If the Programs are successful and the resources are available, we expect to exercise the Purchase Option.
 
Results of Operations
 
 
Revenue.  We had no revenues in 2007 and had $1.0 million of revenues in 2006. In 2006, we recognized approximately $1.0 million of government grant revenue and $30,000 of revenue from drug compound feasibility screening. We do not expect additional grant revenue in 2008, as we place greater emphasis on strategic partnerships and allocate fewer resources to obtaining grants. We do not expect to generate significant, if any, revenues from drug compound feasibility screening in future periods.


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Share-based compensation expenses had varying degrees of impact on our comparative operating expenses for the years ended December 31, 2007, 2006 and 2005. Our operating expenses for the years ended December 31, 2007, 2006 and 2005 are as follows (in thousands):
 
                         
    Year Ended December 31,  
    2007     2006     2005  
 
Non share-based compensation expenses:
                       
Research and development
  $ 43,760     $ 34,724     $ 26,067  
General and administrative
    13,357       9,522       8,781  
                         
Total non share-based compensation expenses
    57,117       44,246       34,848  
Share-based compensation expenses:
                       
Research and development
    1,885       1,770       167  
General and administrative
    1,531       447       874  
                         
Total share-based compensation expenses
    3,416       2,217       1,041  
                         
Total operating expenses
  $ 60,533     $ 46,463     $ 35,889  
                         
 
Research and Development Expenses.  Research and development expenses consist of costs associated with research activities, as well as costs associated with our product development efforts, conducting preclinical studies and clinical trials and manufacturing development efforts. All research and development costs, including those funded by third parties, are expensed as incurred. Research and development expenses include:
 
  •  external research and development expenses incurred under agreements with third party contract research organizations and investigational sites where a substantial portion of our preclinical studies and all of our clinical trials are conducted;
 
  •  third party supplier, consultant and employee related expenses, which include salary and benefits;
 
  •  facilities, depreciation and other allocated expenses, which include direct and allocated expenses for rent and maintenance of facilities, depreciation of leasehold improvements and equipment and laboratory and other supplies; and
 
  •  in 2006 and 2005, certain incremental charges related to officer loan extinguishments and non-cash stock-based compensation expense.


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The table below sets forth our research and development expenses since January 1, 2003 and cumulative expenses for each of our lead product candidates based on our internal records and estimated allocations of employee time and related expenses:
 
                                                 
    Year Ended December 31,  
Preclinical and Clinical Development:
  2007     2006     2005     2004     2003     Total  
    (In thousands)  
 
AZ-004/104
  $ 15,524     $ 6,073     $ 3,187     $ 119     $     $ 24,903  
AZ-001
    8,163       9,535       6,369       8,640       5,514       38,221  
AZ-002
    3,795       3,094       3,803       1,930       490       13,112  
AZ-003
    1,474       3,687       5,021       1,706       936       12,824  
AZ-007
    8,214       2,384                         10,598  
Other preclinical programs
          3,243                         3,243  
                                                 
Total preclinical and clinical development
    37,170       28,016       18,380       12,395       6,940       102,901  
Research
    8,475       8,478       7,855       2,752       4,547       40,217  
                                                 
Total research and development
  $ 45,645     $ 36,494     $ 26,235     $ 15,147     $ 11,487     $ 143,118  
                                                 
 
 
Research and development expenses increased 25% to $45.6 million in 2007 from $36.5 million in 2006. The increases were due primarily to:
 
  •  increased spending on our AZ-004/104 and AZ-002 product candidates as we continued development of these product candidates under the Symphony Allegro agreement, including the launch of a Phase 2a clinical trial of AZ-104 at the end of the second quarter of 2007, and
 
  •  the increased spending on our AZ-007 product candidate.
 
These increased efforts were partially offset by decreased spending on:
 
  •  our AZ-001 product candidate due to the completion of the Phase 2b clinical trial in the first quarter of 2007,
 
  •  our AZ-003 product candidate, as we significantly reduced development on this program until we obtained a developmental partner, and
 
  •  our other preclinical development as we focused our efforts on our AZ-007 product candidate.
 
We expect to continue to devote substantial resources to research and development to support the continued development of our product candidates and core technology, and to expand our manufacturing development. We expect that research and development expenses for clinical trials will continue to increase as we conduct additional and later-stage clinical trials for our product candidates. We also expect that research and development expense for development for our multiple dose technology applicable to our AZ-003 program, which is partnered with Endo Pharmaceuticals, will increase in 2008 and 2009. In addition, we expect to incur additional non-cash stock-based compensation expense as future employee stock options granted are recorded at fair value and existing grants continue to be expensed.
 
General and Administrative Expenses.  General and administrative expenses consist principally of salaries and related costs for personnel in executive, finance, accounting, business development, legal and human resources functions. Other general and administrative expenses include facility and information technology costs not otherwise included in research and development expenses, patent related costs and professional fees for legal, consulting and accounting services.
 
General and administrative expenses increased 49% to $14.9 million in 2007 from $10.0 million in 2006. The increase was primarily due to expanding legal and accounting staff, adding infrastructure and incurring additional costs related to operating as a public company, investor relations programs, increased director fees, increased professional fees and non-cash stock-based compensation expense.


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We expect that our general and administrative expenses will increase as we continue to add infrastructure to support the expected increase in operations and as we continue to meet our obligations as a public company. In addition, we expect to incur additional non-cash stock-based compensation expense as future employee stock options granted are recorded at fair value and existing grants continue to be expensed.
 
Interest and Other Income, Net.  Interest and other income, net, primarily represents income earned on our cash, cash equivalents, marketable securities balances, and marketable securities held by Symphony Allegro. Interest and other income, net was $5.6 million for 2007 and $2.7 million for 2006. The increase was primarily due to higher average cash, cash equivalent and marketable securities balances due to our public stock offering in May 2007, and the addition of investments held by Symphony Allegro, Inc in December 2006. We expect interest income to decrease in future periods as we expect our cash, cash equivalent and marketable securities balances to decrease as we continue to incur net losses, and we expect to earn lower interest rates on such balances due to current market conditions.
 
Interest Expense.  Interest expense represents interest on our equipment loans and was $1.0 million in 2007 and $0.8 million in 2006. The increase was primarily due to increases in our equipment loan borrowings. We expect interest expense to continue to increase as we anticipate additional borrowings under our equipment financing agreements.
 
Loss Attributed to Noncontrolling Interest in Symphony Allegro.  Pursuant to the agreements that we entered into with Symphony Allegro, Inc. in December 2006, we consolidate Symphony Allegro’s financial condition and results of operations in accordance with FASB Interpretation No. 46R, Consolidation of Variable Interest Entities an Interpretation of Accounting Research Bulletin No. 51 (“FIN 46R”). Accordingly, we have deducted the losses attributable to the noncontrolling interest from our net loss in the consolidated statement of operations, and we have also reduced the noncontrolling interest holders’ ownership interest in Symphony Allegro, Inc. in the consolidated balance sheet by the loss attributed to the noncontrolling interests in Symphony Allegro, Inc. The losses attributed to the noncontrolling interest holders was $10.8 million in 2007 and $1.7 million in 2006. The increase was primarily due to a full year of Symphony Allegro losses in 2007 compared to one month of losses in 2006 and the timing of expenses incurred on the AZ-004 and AZ-104 clinical trials.
 
 
Revenue.  Our revenue for 2006 and 2005 was $1.0 million and $2.2 million, respectively. In 2006, we recognized approximately $1.0 million of government grant revenue and $30,000 of revenue from drug compound feasibility screening. In 2005, we recognized approximately $2.0 million of government grant revenue and $155,000 of revenue from drug compound feasibility screening. The decrease of $1.0 million of government grant revenue was due to the expiration of existing government grants.
 
 
Research and Development Expenses.  Research and development expenses increased 39% to $36.5 million in 2006 from $26.2 million in 2005. The increase was due primarily to increased spending on clinical trials for AZ-001 and AZ-004 product candidates, additional spending on new preclinical programs, increased staffing and other personnel related costs to support our preclinical studies and clinical trials and additional internal research efforts and increased share-based compensation expense.
 
General and Administrative Expenses.  General and administrative expenses increased 3% to $10.0 million in 2006 from $9.7 million in 2005. Expenses in 2005 include $3.1 million related to the extinguishment of the officer notes and related taxes paid on behalf of the officers. Excluding this expense, general and administrative expenses increased $3.4 million (35%) which was primarily due to expanding legal and accounting staff, adding infrastructure and incurring additional costs related to operating as a public company, including directors’ and officers’ insurance, investor relations programs, increased director fees, increased professional fees and non-cash stock-based compensation expense. In 2005, we also incurred certain incremental charges resulting from the extinguishment of officer notes.


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Interest and Other Income and Interest Expense, Net.  Interest and other income and interest expense, primarily represents income earned on our cash, cash equivalents and marketable securities balances net of interest expense on our equipment loans. Interest and other income and interest expense, net was $1.9 million for 2006 and $1.3 million for 2005. This increase was primarily due to substantially increased average cash balances in 2006 due to the closing of our initial public offering in March 2006, to a lesser extent the additional interest income from Symphony Allegro cash and investment balances in December 2006, and higher interest rates earned on such balances.
 
Loss Attributed to Noncontrolling Interest in Symphony Allegro.  For the year ended December 31, 2006, the losses attributed to the noncontrolling interest holders was $1.7 million. There were no such losses in 2005.
 
 
Since inception, we have financed our operations primarily through private placements and public offerings of equity securities, receiving aggregate net proceeds from such sales totaling $215.6 million, revenues primarily from government grants totaling $6.9 million and funding from Symphony Allegro. We have received additional funding from equipment financing obligations, interest earned on investments, as described below, and funds received upon exercises of stock options and exercises of purchase rights under our Employee Stock Purchase Plan. As of December 31, 2007, we had $69.4 million in cash, cash equivalents and marketable securities, $39.4 million of marketable securities held by Symphony Allegro, and $3.6 million available under an equipment financing line of credit. The marketable securities held by Symphony Allegro are used to fund the development of AZ-002, AZ-004 and AZ-104 and are not available for general corporate expenses. Our cash and marketable security balances are held in a variety of interest bearing instruments, including obligations of United States government agencies, high credit rating corporate borrowers and money market accounts. Investments held by Symphony Allegro consist of investments in a money market fund that invests primarily in domestic commercial paper, securities issued or guaranteed by the U.S. government or its agencies, U.S. and Yankee bank obligations and fully collateralized repurchase agreements. Cash in excess of immediate requirements is invested with regard to liquidity and capital preservation.
 
Net cash used in operating activities was $35.8 million, $33.3 million, and $22.0 million in 2007, 2006 and 2005, respectively. The net cash used in each of these periods primarily reflects net loss for these periods, offset in part by depreciation, non-cash stock-based compensation, loss attributed to noncontrolling interests, extinguishment of officer notes receivable and non-cash changes in operating assets and liabilities. In 2007, the large increase in other receivables was affected by a receivable of $10.0 million from Endo related to the license agreement signed in December 2007 and a $2.1 million receivable related to the reimbursement of leasehold improvements from the landlord of our Mountain View facility. In 2007, the increase in other liabilities is primarily due to $10.0 million of deferred revenues related to the Endo license agreement, and the effects of $14.3 million of leasehold improvement reimbursements from the Mountain View landlord in 2007 recorded as deferred rent in 2007.
 
Net cash provided by (used in) investing activities was $(20.0) million, $(61.4) million, and $15.9 million in 2007, 2006 and 2005, respectively. Investing activities consist primarily of purchases and maturities of marketable securities and capital purchases. During 2007 and 2006 we purchased $11.4 million and $2.9 million of marketable securities, net of maturities, respectively. In 2006, we also had net purchases of $50.0 million of investments by Symphony Allegro. In 2005 we sold $21.6 million of marketable securities, net of purchases. Purchases of property and equipment were $19.1 million, $8.1 million, and $5.6 million in 2007, 2006 and 2005, respectively, of which $16.5 million of property and equipment purchases in 2007 related to the build out of our leased facility in Mountain View, California. A significant portion of the increased purchase of property and equipment in 2005 related to our expansion into a second leased facility in Palo Alto, California. We expect to continue to make significant investments in the purchase of property and equipment to support our expanding operations; however, we expect overall purchase of property and equipment to be lower in 2008 as compared to 2007 as we do not expect to make any significant modification to our facilities in 2008.
 
Net cash provided by financing activities was $70.1 million, $94.9 million, and $4.1 million in 2007, 2006 and 2005, respectively. Financing activities consist primarily of proceeds from the sale of our common and preferred stock, issuance of a noncontrolling interest, and equipment financing arrangements. In 2007 and 2006, we received


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net proceeds from the issuance of common stock of $67.8 million and $46.0 million, respectively. In 2006, we received net proceeds of $47.2 from purchase of noncontrolling interests by preferred shareholders in Symphony Allegro, net of fees. Proceeds from equipment financing arrangements, net of payments, were $2.3 million, $1.8 million, and $3.7 million during 2007, 2006 and 2005, respectively.
 
We anticipate that existing cash, cash equivalents and marketable securities, along with interest earned thereon, funding available under our equipment financing arrangements, expected payments from Symphony Allegro, expected proceeds from stock option exercises and purchases under our Employee Stock Purchase Plan, will enable us to maintain our currently planned operations through the middle of 2009. Changing circumstances may cause us to consume capital significantly faster than we currently anticipate. We have based this estimate on assumptions that may prove to be wrong, and we could utilize our available financial resources sooner than we currently expect. The key assumptions underlying this estimate include:
 
  •  expenditures related to continued preclinical and clinical development of our lead product candidates during this period within budgeted levels;
 
  •  the timing and amount of payments from Symphony Allegro;
 
  •  no unexpected costs related to the development of our manufacturing capability; and
 
  •  the hiring of a number of new employees at salary levels consistent with our estimates to support our continued growth during this period.
 
Our forecast of the period of time that our financial resources will be adequate to support operations is a forward-looking statement and involves risks and uncertainties, and actual results could vary as a result of a number of factors, including the factors discussed in “Risk Factors.” In light of the numerous risks and uncertainties associated with the development and commercialization of our product candidates and the extent to which we enter into strategic partnerships with third parties to participate in their development and commercialization, we are unable to estimate the amounts of increased capital outlays and operating expenditures associated with our current and anticipated clinical trials. Our future funding requirements will depend on many factors, including:
 
  •  the scope, rate of progress, results and costs of our preclinical studies, clinical trials and other research and development activities;
 
  •  the terms and timing of any distribution, strategic partnerships or licensing agreements that we may establish;
 
  •  the cost, timing and outcomes of regulatory approvals;
 
  •  the number and characteristics of product candidates that we pursue;
 
  •  the cost and timing of establishing manufacturing, marketing and sales capabilities;
 
  •  the cost of establishing clinical and commercial supplies of our product candidates;
 
  •  the cost of preparing, filing, prosecuting, defending and enforcing any patent claims and other intellectual property rights; and
 
  •  the extent to which we acquire or invest in businesses, products or technologies, although we currently have no commitments or agreements relating to any of these types of transactions.
 
We will need to raise additional funds to support our operations, and such funding may not be available to us on acceptable terms, or at all. If we are unable to raise additional funds when needed, we may not be able to continue development of our product candidates or we could be required to delay, scale back or eliminate some or all of our development programs and other operations. We may seek to raise additional funds through public or private financing, strategic partnerships or other arrangements. Any additional equity financing may be dilutive to stockholders and debt financing, if available, may involve restrictive covenants. If we raise funds through collaborative or licensing arrangements, we may be required to relinquish, on terms that are not favorable to us, rights to some of our technologies or product candidates that we would otherwise seek to develop or


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commercialize ourselves. Our failure to raise capital when needed may harm our business, financial condition and results of operations.
 
 
We lease two buildings with an aggregate of 106,894 square feet of manufacturing, office and laboratory facilities in Mountain View, California, which we began to occupy in the fourth quarter of 2007. We currently occupy 87,560 square feet of these facilities and will gain access to the remaining 19,334 square feet on or about June 1, 2008. The lease for both facilities expires on March 31, 2018, and we have two options to extend the lease for five years each. We lease two buildings with an aggregate of 65,143 square feet of office and laboratory facilities in Palo Alto, California. The lease on one facility expires on March 31, 2008, and the lease on the second facility expires on June 30, 2008.
 
We finance a portion of our equipment purchases through various equipment financing agreements. Under the agreements, equipment advances are to be repaid in 36 to 48 installments of principal and interest. The interest rate, which is fixed for each draw, is based on the U.S. Treasuries of comparable maturities and ranges from 9.2% to 10.6%. The equipment purchased under the equipment financing agreement is pledged as security.
 
Our future contractual obligations for equipment financing and operating leases, including financing costs, at December 31, 2007 were as follows:
 
                                         
    Payments Due by Period  
          Less Than
                   
Contractual Obligations
  Total     1 Year     1-3 Years     3-5 Years     Thereafter  
    (In thousands)  
 
Equipment financing obligations
  $ 12,323     $ 5,448     $ 6,509     $ 366     $  
Operating lease obligations
    49,991       4,424       9,627       10,253       25,687  
                                         
Total
  $ 62,314     $ 9,872     $ 16,136     $ 10,619     $ 25,687  
                                         
 
On November 2, 2007, we entered into a manufacturing and supply agreement, or the supply agreement, with Autoliv relating to the commercial supply of chemical heat packages that can be incorporated into our Staccato device. Autoliv had developed these chemical heat packages for us pursuant to a development agreement between Autoliv and us executed in October 2005. Under the terms of the supply agreement, Autoliv has agreed to manufacture, assemble and test the chemical heat packages solely for us in conformance with our specifications. We will pay Autoliv a specified purchase price, which varies based on annual quantities ordered by us, per chemical heat package delivered. The initial term of the supply agreement expires on December 31, 2012 and may be extended by written mutual consent.
 
On December 27, 2007, we entered into a license, development and supply agreement with Endo. Pursuant to the agreement, Endo obtained a license to develop and commercialize AZ-003 (Staccato fentanyl) in North America and to obtain a supply of AZ-003 from us. Endo is responsible for regulatory, pre-clinical and clinical development, and for commercializing the product. We are responsible for the development of the Staccato Electric Multiple Dose commercial device and we have the exclusive right to manufacture the product for clinical development and commercial supply. Both Alexza and Endo will be responsible for all internal costs and expenses incurred related to their area of responsibility.
 
 
 
In September 2006, the FASB issued SFAS No. 157, Fair Value Measurements (“SFAS 157”). SFAS 157 defines fair value, establishes a framework for measuring fair value in accordance with generally accepted accounting principles, and expands disclosures about fair value measurements. The provisions of SFAS 157 are effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. We are currently evaluating the impact of the provisions of SFAS 157 on our financial position, results of operations and cash flows but do not believe the impact of the adoption will be material.


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In February 2007, the FASB issued SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities (“SFAS 159”). SFAS 159 permits entities to choose to measure many financial instruments and certain other items at fair value. The provisions of SFAS 159 are effective for financial statements issued for fiscal years beginning after November 15, 2007. We are currently evaluating the impact of electing to adopt the provisions of SFAS 159 on our financial position, results of operations and cash flows and, the impact of adoption is unknown at this time.
 
 
In December 2007, the FASB issued SFAS No. 160, Noncontrolling Interests in Consolidated Financial Statements — An Amendment of ARB No. 51 (“SFAS 160”). SFAS 160 will require that noncontrolling interests in subsidiaries be reported as a component of stockholders’ equity in the consolidated balance sheet. SFAS 160 also requires that earnings or losses attributed to the noncontrolling interests be reported as part of consolidated earnings and not as a separate component of income or expense, as well as requires disclosure of the attribution of consolidated earnings to the controlling and noncontrolling interests on the face of the consolidated statement of operations. SFAS 160 is effective for fiscal years beginning after December 15, 2008. We are currently evaluating the impact of SFAS 160 on our consolidated financial statements.
 
 
In November 2007, the Emerging Issues Task Force (“EITF”) ratified EITF Issue No. 07-1 (“EITF 07-1”), Accounting for Collaborative Agreements Related to the Development and Commercialization of Intellectual Property. EITF 07-1 addresses the accounting for participants in collaborative arrangements that are conducted without the creation of a separate legal entity and requires participants in a collaboration to make separate disclosures regarding the nature and purpose of an arrangement, their rights and obligations under the arrangement, the accounting policy for the arrangement and the income statement classification and amounts arising from the arrangement between participants for each period a statement of operations is presented. The provisions of EITF 07-1 are effective for fiscal years beginning after December 15, 2008 We are currently evaluating the impact of the provisions of EITF 07-1 on our financial position, results of operations and cash flows.
 
 
In June 2007, the EITF ratified EITF Issue No. 07-3 (“EITF 07-3”), Accounting for Nonrefundable Advance Payments for Goods or Services to Be Used in Future Research and Development Activities. The scope of EITF 07-3 is limited to nonrefundable advance payments for goods and services to be used or rendered in future research and development activities pursuant to an executory contractual arrangement. This issue provides that nonrefundable advance payments for goods or services that will be used or rendered for future research and development activities should be deferred and capitalized. Such amounts should be recognized as an expense as the related goods are delivered or the related services are performed. EITF 07-3 is effective for fiscal years beginning after December 15, 2007 and earlier application is not permitted. We are currently evaluating the impact of the provisions of EITF 07-3 on our financial position, results of operations and cash flows but do not believe the impact of the adoption will be material.
 
 
In July, 2006, FASB issued Interpretation No. 48, Accounting for Uncertainty in Income Taxes — An Interpretation of FASB Statement No. 109 (“FIN 48”). FIN 48 clarifies the accounting for uncertainty in income taxes recognized in an entity’s financial statements in accordance with FASB Statement No. 109, Accounting for Income Taxes and prescribes a recognition threshold and measurement attributes for financial statement disclosure of tax positions taken or expected to be taken on a tax return. Under FIN 48, the impact of an uncertain income tax position on the income tax return must be recognized at the largest amount that is more-likely-than-not to be sustained upon audit by the relevant taxing authority. An uncertain income tax position will not be recognized if it


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has less than a 50% likelihood of being sustained. Additionally, FIN 48 provides guidance on de-recognition, classification, interest and penalties, accounting in interim periods, disclosure and transition.
 
Our adoption of the provisions of FIN 48 on January 1, 2007 did not have a material impact on our financial statements. We adopted the accounting policy that interest recognized in accordance with Paragraph 15 of FIN 48 and penalties recognized in accordance with Paragraph 16 of FIN 48 are classified as part of our income tax provision. We have not incurred any interest or penalties as of December 31, 2007. We do not anticipate any significant change within 12 months of this reporting date of our uncertain tax positions. We do not anticipate any events which could cause the change to these uncertainties. We are subject to taxation in the US and various states jurisdictions. There are no ongoing examinations by taxing authorities at this time. Our various tax years starting with 2000 to 2006 remain open in various taxing jurisdictions.
 
 
None.
 
Item 7A.   Quantitative and Qualitative Disclosures About Market Risk
 
Our exposure to market risk is confined to our cash, cash equivalents, which have maturities of less than three months, and marketable securities. The primary objective of our investment activities is to preserve our capital to fund operations. We also seek to maximize income from our investments without assuming significant risk. To achieve our objectives, we maintain a portfolio of cash equivalents and marketable securities in a variety of securities of high credit quality. As of December 31, 2007, we had cash, cash equivalents and marketable securities of $69.4 million and investments held by Symphony Allegro of $39.4 million. The securities in our investment portfolio are not leveraged, are classified as available for sale and are, due to their very short-term nature, subject to minimal interest rate risk. We currently do not hedge interest rate exposure. Because of the short-term maturities of our investments, we do not believe that an increase in market rates would have a material negative impact on the realized value of our investment portfolio. We actively monitor changes in interest rates. In the third and fourth quarters of 2007, we performed a review of our investment portfolio and believe we have minimal exposure related to mortgage and other asset backed securities and no exposure to auction rate securities.


63


 

Item 8.   Financial Statements and Supplementary Data
 
ALEXZA PHARMACEUTICALS, INC.
 
 
         
    65  
    66  
    67  
    68  
    75  
    76  


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The Board of Directors and Stockholders
Alexza Pharmaceuticals, Inc.
 
We have audited the accompanying consolidated balance sheets of Alexza Pharmaceuticals, Inc. (a development stage company) (the “Company”) as of December 31, 2007 and 2006 and the related consolidated statements of operations, convertible preferred stock and stockholders’ equity (deficit), and cash flows for each of the three years in the period ended December 31, 2007 and for the period from December 19, 2000 (inception) to December 31, 2007. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.
 
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated 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 financial statements referred to above present fairly, in all material respects, the consolidated financial position of Alexza Pharmaceuticals, Inc. (a development stage company) at December 31, 2007 and 2006 and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 2007 and for the period from December 19, 2000 (inception) to December 31, 2007, in conformity with U.S. generally accepted accounting principles.
 
As discussed in Note 2 to the consolidated financial statements, the Company changed its method of accounting for share-based compensation as of January 1, 2006.
 
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), Alexza Pharmaceuticals, Inc.’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 11, 2008 expressed an unqualified opinion thereon.
 
/s/  Ernst & Young LLP
 
Palo Alto, California
March 11, 2008


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ALEXZA PHARMACEUTICALS, INC
(a development stage company)
 
CONSOLIDATED BALANCE SHEETS
 
                 
    December 31,  
    2007     2006  
    (In thousands, except share and per share amounts)  
 
ASSETS
Current assets:
               
Cash and cash equivalents
  $ 31,337     $ 17,032  
Marketable securities
    38,054       25,591  
Investments held by Symphony Allegro, Inc. 
    39,449       49,956  
Other receivables
    12,055        
Prepaid expenses and other current assets
    1,377       1,263  
                 
Total current assets
    122,272       93,842  
Property and equipment, net
    26,156       11,136  
Restricted cash
    604       604  
Employee notes receivable, net of unamortized discount
          83  
Other assets
    93       101  
                 
Total assets
  $ 149,125     $ 105,766  
                 
 
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
               
Accounts payable
  $ 5,206     $ 5,933  
Accrued clinical trial liabilities
    1,301       1,641  
Other accrued liabilities
    5,087       3,849  
Current portion of equipment financing obligations
    4,586       2,770  
                 
Total current liabilities
    16,180       14,193  
Deferred rent
    16,685       1,191  
Deferred revenue
    10,000        
Noncurrent portion of equipment financing obligations
    6,317       5,865  
Non controlling interest in Symphony Allegro, Inc. 
    23,952       34,743  
Commitments
               
Stockholders’ equity:
               
Preferred stock, $0.0001 par value, 5,000,000 shares authorized at December 31, 2007 and 2006; no shares issued and outstanding at December 31, 2007 or 2006
           
Common stock, $0.0001 par value; 100,000,000 shares authorized at December 31, 2007 and 2006; 31,137,851 and 23,819,313 shares issued and outstanding at December 31, 2007 and 2006, respectively
    3       2  
Additional paid-in capital
    240,681       170,442  
Deferred stock compensation
    (739 )     (1,703 )
Other comprehensive income
    141       9  
Deficit accumulated during development stage
    (164,095 )     (118,976 )
                 
Total stockholders’ equity
    75,991       49,774  
                 
Total liabilities and stockholders’ equity
  $ 149,125     $ 105,766  
                 
 
See accompanying notes.


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                      Period from
 
                      December 19,
 
                      2000 (Inception)
 
    Year Ended December 31,     to December 31,
 
    2007     2006     2005     2007  
    (In thousands, except per share amounts)  
 
Revenue
  $     $ 1,028     $ 2,230     $ 6,945  
Operating expenses:
                               
Research and development
    45,645       36,494       26,235       143,118  
General and administrative
    14,888       9,969       9,654       45,063  
Acquired in-process research and development
                      3,916  
                                 
Total operating expenses
    60,533       46,463       35,889       192,097  
                                 
Loss from operations
    (60,533 )     (45,435 )     (33,659 )     (185,152 )
Interest and other income, net
    5,626       2,687       1,615       11,192  
Interest expense
    (1,003 )     (778 )     (358 )     (2,646 )
                                 
Loss before non controlling interest in Symphony Allegro, Inc. 
    (55,910 )     (43,526 )     (32,402 )     (176,606 )
Loss attributed to non controlling interest in Symphony Allegro, Inc. 
    10,791       1,720             12,511  
                                 
Net loss
  $ (45,119 )   $ (41,806 )   $ (32,402 )   $ (164,095 )
                                 
Basic and diluted net loss per common share
  $ (1.58 )   $ (2.13 )   $ (18.98 )        
                                 
Shares used to compute basic and diluted net loss per common share
    28,605       19,584       1,707          
                                 
 
See accompanying notes.


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ALEXZA PHARMACEUTICALS, INC.
(a development stage company)
 
CONSOLIDATED STATEMENT OF CONVERTIBLE PREFERRED STOCK AND STOCKHOLDERS’ EQUITY (DEFICIT)
 
                                                                                                 
                                                                Deficit
       
                                                                Accumulated
    Total
 
    Convertible
                            Additional
    Stockholder
    Deferred
    Other
    During the
    Stockholders’
 
    Preferred Stock     Preferred Stock     Common Stock     Paid-In
    Note
    Stock
    Comprehensive
    Development
    Equity
 
    Shares     Amount     Shares     Amount     Shares     Amount     Capital     Receivable     Compensation     (Loss) Income     Stage     (Deficit)  
    (In thousands, except share and per share amounts)  
 
Issuance of common stock to founders at $0.22 per share in December 2000 in exchange for technology and cash of $8
        $           $       454,536     $     $ 100     $     $     $     $     $ 100  
Issuance of Series A preferred stock for cash at $0.40 per share in July 2001, net of issuance costs of $9
    2,500,000       991                                                              
Issuance of Series A1 preferred stock at $1.55 per share in December 2001, in connection with merger
    1,610,250       2,496                                                              
Issuance of Series B preferred stock for cash at $1.40 per share in December 2001, net of issuance costs of $71
    6,441,000       8,946                                                              
Issuance of common stock in connection with merger at $1.10 per share in December 2001
                            868,922             956                               956  
Warrants assumed in merger transaction
                                        10                               10  
Issuance of common stock for cash at $0.22 per share upon exercise of options in December 2001
                            9,090             2                               2  
Compensation expense related to consultant stock options
                                        3                               3  
Net loss and comprehensive loss
                                                                (5,652 )     (5,652 )
                                                                                                 
Balance at December 31, 2001 (carried forward)
    10,551,250     $ 12,433           $       1,332,548     $     $ 1,071     $     $     $     $ (5,652 )   $ (4,581 )
 
See accompanying notes.


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ALEXZA PHARMACEUTICALS, INC.
(a development stage company)
 
CONSOLIDATED STATEMENT OF CONVERTIBLE PREFERRED STOCK AND STOCKHOLDERS’ EQUITY (DEFICIT) — (Continued)
 
                                                                                                 
                                                                Deficit
       
                                                                Accumulated
    Total
 
    Convertible
                            Additional
    Stockholder
    Deferred
    Other
    During the
    Stockholders’
 
    Preferred Stock     Preferred Stock     Common Stock     Paid-In
    Note
    Stock
    Comprehensive
    Development
    Equity
 
    Shares     Amount     Shares     Amount     Shares     Amount     Capital     Receivable     Compensation     (Loss) Income     Stage     (Deficit)  
    (In thousands, except share and per share amounts)  
 
Balance at December 31, 2001 (brought forward)
    10,551,250     $ 12,433           $       1,332,548     $     $ 1,071     $     $     $     $ (5,652 )   $ (4,581 )
Issuance of common stock for cash at $0.22 per share upon exercise of options in February 2002
                            10,606             3                               3  
Issuance of warrants to purchase Series B preferred stock in March 2002, in connection with equipment financing loan
          27                                                              
Issuance of common stock for cash at $0.22 per share upon exercise of options in July 2002
                            2,180                                            
Issuance of common stock to stockholder at $0.99 per share in exchange for promissory note in July 2002
                            53,156             53       (53 )                        
Issuance of Series C preferred stock for cash at $1.56 per share in September 2002, net of issuance costs of $108
    28,870,005       44,892                                                              
Repurchase of common stock for cash at $1.05 per share in October 2002
                            (2,634 )           (3 )                             (3 )
Issuance of common stock for cash at $1.05 per share for services upon exercise of warrants in December 2002
                            9,368             10                               10  
Compensation expense related to consultant stock options
                                        10                               10  
Unrealized gain on investments
                                                          51             51  
Net loss
                                                                (8,163 )     (8,163 )
                                                                                                 
Comprehensive loss
                                                                      (8,112 )
                                                                                                 
Balance at December 31, 2002 (carried forward)
    39,421,255     $ 57,352           $       1,405,224     $     $ 1,144     $ (53 )   $     $ 51     $ (13,815 )   $ (12,673 )
 
See accompanying notes.


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ALEXZA PHARMACEUTICALS, INC.
(a development stage company)
 
CONSOLIDATED STATEMENT OF CONVERTIBLE PREFERRED STOCK AND STOCKHOLDERS’ EQUITY (DEFICIT) — (Continued)
 
                                                                                                 
                                                                Deficit
       
                                                                Accumulated
    Total
 
    Convertible
                            Additional
    Stockholder
    Deferred
    Other
    During the
    Stockholders’
 
    Preferred Stock     Preferred Stock     Common Stock     Paid-In
    Note
    Stock
    Comprehensive
    Development
    Equity
 
    Shares     Amount     Shares     Amount     Shares     Amount     Capital     Receivable     Compensation     (Loss) Income     Stage     (Deficit)  
    (In thousands, except share and per share amounts)  
 
Balance at December 31, 2002 (brought forward)
    39,421,255     $ 57,352           $       1,405,224     $     $ 1,144     $ (53 )   $     $ 51     $ (13,815 )   $ (12,673 )
Issuance of common stock for cash at $0.22, $0.99 and $1.10 per share upon exercise of options
                            74,903             47                               47  
Issuance of warrants to purchase Series C preferred stock in connection with equipment financing loan in January 2003
          35                                                              
Issuance of warrants to purchase Series C preferred stock in connection with equipment financing loan in September 2003
          27                                                              
Repurchase of common stock for cash at $1.05 per share in January 2003
                            (1,172 )           (1 )                             (1 )
Repurchase of common stock for cash at $0.22 per share in November 2003
                            (14,772 )           (3 )                             (3 )
Compensation expense related to consultant stock options
                                        31                               31  
Deferred stock compensation expense related to modification of consultant stock option
                                        1             (1 )                  
Unrealized loss on investments
                                                          (55 )           (55 )
Net loss
                                                                (14,328 )     (14,328 )
                                                                                                 
Comprehensive loss
                                                                      (14,383 )
                                                                                                 
Balance at December 31, 2003 (carried forward)
    39,421,255     $ 57,414           $       1,464,183     $     $ 1,219     $ (53 )   $ (1 )   $ (4 )   $ (28,143 )   $ (26,982 )
 
See accompanying notes.


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ALEXZA PHARMACEUTICALS, INC.
(a development stage company)
 
CONSOLIDATED STATEMENT OF CONVERTIBLE PREFERRED STOCK AND STOCKHOLDERS’ EQUITY (DEFICIT) — (Continued)
 
                                                                                                 
                                                                Deficit
       
                                                                Accumulated
    Total
 
    Convertible
                            Additional
    Stockholder
    Deferred
    Other
    During the
    Stockholders’
 
    Preferred Stock     Preferred Stock     Common Stock     Paid-In
    Note
    Stock
    Comprehensive
    Development
    Equity
 
    Shares     Amount     Shares     Amount     Shares     Amount     Capital     Receivable     Compensation     (Loss) Income     Stage     (Deficit)  
    (In thousands, except share and per share amounts)  
 
Balance at December 31, 2003 (brought forward)
    39,421,255     $ 57,414           $       1,464,183     $     $ 1,219     $ (53 )   $ (1 )   $ (4 )   $ (28,143 )   $ (26,982 )
Cancellation of unvested common stock at $0.99 per share in March 2004
                            (24,365 )           (24 )     24                          
Repayment of vested portion of stockholder note receivable for cash
                                              29                         29  
Issuance of warrants to purchase Series C preferred stock in connection with equipment financing loan in April 2004
          20                                                              
Issuance of common stock for cash at $0.22, $0.99 and $1.10 per share upon exercise of options
                            100,192             72                               72  
Repurchase of common stock for cash at $1.05 per share in September 2004
                            (404 )                                          
Issuance of Series D preferred stock at $1.29 per share in November and December 2004, net of issuance costs of $2,239
    40,435,448       49,760                                                              
Issuance of warrants to purchase common stock in connection with Series D financing in November 2004
                                        91                               91  
Compensation expense related to consultant stock options
                                        40                               40  
Compensation expense related to employee stock option modifications
                                        19                               19  
Amortization of deferred stock compensation
                                                    1                   1  
Unrealized loss on investments
                                                          (41 )           (41