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ARYX THERAPEUTICS INC 10-Q 2008

Documents found in this filing:

  1. 10-Q
  2. Ex-31.1
  3. Ex-31.2
  4. Ex-32.1
  5. Ex-32.1

Table of Contents

 

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 


 

FORM 10-Q

 


 

x

Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

 

 

 

For the quarterly period ended June 30, 2008.

 

or

 

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 001-33782

 


 

ARYx THERAPEUTICS, INC.

(Exact name of registrant as specified in its charter)

 

Delaware

 

77-0456039

(State or Other Jurisdiction of
Incorporation or Organization)

 

(I.R.S. Employer
Identification No.)

 

6300 Dumbarton Circle, Fremont, California 94555

(Address of Principal Executive Offices including zip code)

 

(510) 585-2200

(Registrant’s Telephone Number, Including Area Code)

 


 

Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act 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  o    No  x

 

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

 

Large accelerated filer o

 

Accelerated filer o

 

 

 

Non-accelerated filer x  (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 Exchange Act).    Yes  o    No  x

 

As of July 31, 2008, 17,683,145 shares of the registrant’s common stock, $0.001 par value, were outstanding.

 

 

 



Table of Contents

 

ARYx THERAPEUTICS, INC.

 

FORM 10-Q FOR THE QUARTER ENDED JUNE 30, 2008

 

INDEX

 

 

Page

PART I — FINANCIAL INFORMATION

 

 

 

 

Item 1.

Financial Statements

 

 

Condensed Consolidated Balance Sheets as of June 30, 2008 and December 31, 2007

2

 

Condensed Consolidated Statements of Operations for the three and six months ended June 30, 2008 and 2007

3

 

Condensed Consolidated Statements of Cash Flow for the six months ended June 30, 2008 and 2007

4

 

Notes to Condensed Consolidated Financial Statements

5

Item 2.

Management’s Discussion and Analysis of Financial Condition and Results of Operations

12

Item 3.

Quantitative and Qualitative Disclosures About Market Risk

20

Item 4T.

Controls and Procedures

20

 

 

 

PART II — OTHER INFORMATION

 

Item 1.

Legal Proceedings

21

Item 1A.

Risk Factors

21

Item 2.

Unregistered Sales of Equity Securities and Use of Proceeds

40

Item 3.

Defaults Upon Senior Securities

40

Item 4.

Submission of Matters to a Vote of Security Holders

40

Item 5.

Other Information

40

Item 6.

Exhibits

41

 

 

 

SIGNATURE

42

 

1



Table of Contents

 

PART I — FINANCIAL INFORMATION

 

ITEM 1.  FINANCIAL STATEMENTS

 

ARYx THERAPEUTICS, INC.

 

CONDENSED CONSOLIDATED BALANCE SHEETS

 

(In thousands)

 

 

 

June 30,

 

December 31,

 

 

 

2008

 

2007

 

 

 

(unaudited)

 

(Note 1)

 

ASSETS

 

 

 

 

 

Current assets:

 

 

 

 

 

Cash and cash equivalents

 

$

34,536

 

$

55,476

 

Marketable securities

 

12,877

 

7,640

 

Restricted cash - current

 

150

 

150

 

Prepaid research and development expenses

 

1,321

 

582

 

Other prepaid, receivable, and current assets

 

835

 

1,051

 

Total current assets

 

49,719

 

64,899

 

Restricted cash

 

1,203

 

903

 

Property and equipment, net

 

3,687

 

3,655

 

Other assets

 

266

 

168

 

Total assets

 

$

54,875

 

$

69,625

 

 

 

 

 

 

 

LIABILITIES AND STOCKHOLDERS’ EQUITY

 

 

 

 

 

Current liabilities:

 

 

 

 

 

Accounts payable

 

$

415

 

$

1,369

 

Accrued compensation

 

730

 

1,055

 

Accrued research and development expenses

 

3,933

 

2,510

 

Current portion of notes payable

 

5,631

 

3,536

 

Current portion of deferred revenue

 

17,544

 

3,913

 

Other accrued liabilities

 

916

 

1,074

 

Total current liabilities

 

29,169

 

13,457

 

Deferred lease credit

 

1,617

 

1,793

 

Notes payable

 

8,838

 

3,444

 

Deferred revenue

 

 

15,584

 

Commitments and contingencies

 

 

 

 

 

Stockholders’ equity:

 

 

 

 

 

Common stock

 

18

 

18

 

Additional paid-in capital

 

159,466

 

158,053

 

Accumulated other comprehensive loss

 

(110

)

 

Accumulated deficit

 

(144,123

)

(122,724

)

Total stockholders’ equity

 

15,251

 

35,347

 

Total liabilities and stockholders’ equity

 

$

54,875

 

$

69,625

 

 

The accompanying notes are an integral part of these financial statements.

 

2



Table of Contents

 

ARYx THERAPEUTICS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(In thousands, except per share amounts)

(Unaudited)

 

 

 

Three Months Ended June 30,

 

Six Months Ended June 30,

 

 

 

2008

 

2007

 

2008

 

2007

 

Revenue:

 

 

 

 

 

 

 

 

 

Collaboration services

 

$

164

 

$

22

 

$

232

 

$

186

 

Technology license fees

 

974

 

974

 

1,948

 

1,948

 

Total revenue

 

1,138

 

996

 

2,180

 

2,134

 

 

 

 

 

 

 

 

 

 

 

Costs and expenses:

 

 

 

 

 

 

 

 

 

Cost of collaboration service revenue

 

164

 

22

 

232

 

186

 

Research and development

 

10,045

 

6,499

 

17,645

 

11,016

 

Selling, general and administrative

 

2,664

 

1,727

 

5,596

 

3,624

 

Total costs and expenses

 

12,873

 

8,248

 

23,473

 

14,826

 

Loss from operations

 

(11,735

)

(7,252

)

(21,293

)

(12,692

)

 

 

 

 

 

 

 

 

 

 

Interest and other income, net

 

308

 

543

 

857

 

1,179

 

Interest expense

 

(469

)

(311

)

(963

)

(643

)

Net loss

 

(11,896

)

(7,020

)

(21,399

)

(12,156

)

 

 

 

 

 

 

 

 

 

 

Basic and diluted net loss per share

 

$

(0.67

)

$

(6.50

)

$

(1.21

)

$

(11.41

)

Weighted average shares used to compute basic and diluted net loss per share

 

17,641

 

1,080

 

17,636

 

1,065

 

 

The accompanying notes are an integral part of these financial statements.

 

3



Table of Contents

 

ARYx THERAPEUTICS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOW

(In thousands)

(Unaudited)

 

 

 

Six Months Ended June 30,

 

 

 

2008

 

2007

 

Cash flows from operating activities:

 

 

 

 

 

Net loss

 

$

(21,399

)

$

(12,156

)

Adjustments to reconcile net loss to net cash used in operating activities:

 

 

 

 

 

Depreciation and amortization

 

565

 

512

 

Amortization of warrants and revaluation to fair value

 

214

 

7

 

Stock-based compensation

 

1,137

 

479

 

Change in assets and liabilities:

 

 

 

 

 

Prepaid research and development expenses

 

(739

)

(550

)

Other prepaid, receivable, and assets

 

136

 

(147

)

Accounts payable and other accrued liabilities

 

(1,133

)

(511

)

Accrued compensation

 

(325

)

(32

)

Accrued research and development expenses

 

1,423

 

1,150

 

Deferred lease credit

 

(176

)

(163

)

Deferred revenue

 

(1,953

)

(1,912

)

Net cash used in operating activities

 

(22,250

)

(13,323

)

 

 

 

 

 

 

Cash flows from investing activities:

 

 

 

 

 

Purchases of marketable securities

 

(13,232

)

(10,474

)

Proceeds from sales of marketable securities

 

3,475

 

5,490

 

Proceeds from maturities of marketable securities

 

4,390

 

16,055

 

Increase in restricted cash

 

(300

)

(150

)

Purchases of fixed assets

 

(556

)

(236

)

Net cash (used in) provided by investing activities

 

(6,223

)

10,685

 

 

 

 

 

 

 

Cash flows from financing activities:

 

 

 

 

 

Proceeds from exercise of stock options and issuance of common stock, net of offering cost in connection with our initial public offering in November 2007

 

44

 

38

 

Proceeds from issuance of notes payable

 

9,000

 

 

Principal payments on notes payable

 

(1,511

)

(1,409

)

Net cash provided by (used in) financing activities

 

7,533

 

(1,371

)

 

 

 

 

 

 

Net increase (decrease) in cash and cash equivalents

 

(20,940

)

(4,009

)

Cash and cash equivalents at beginning of period

 

55,476

 

18,660

 

Cash and cash equivalents at end of period

 

$

34,536

 

$

14,651

 

 

The accompanying notes are an integral part of these financial statements.

 

4



Table of Contents

 

ARYx THERAPEUTICS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

 

In this report, “ARYx,” “we,” “us” and “our” refer to ARYx Therapeutics, Inc. “Common Stock” refers to ARYx’s common stock, par value $0.001 per share. “Preferred Stock” refers to ARYx’s convertible preferred stock, $0.001 per share.

 

1.  Organization and Summary of Significant Accounting Policies

 

The Company

 

ARYx is a biopharmaceutical company focused on developing a portfolio of internally discovered product candidates designed to eliminate known safety issues associated with well-established, commercially successful drugs. We use our RetroMetabolic Drug Design technology to design structurally unique molecules that retain the efficacy of these original drugs but are metabolized through a potentially safer pathway to avoid specific adverse side effects associated with these compounds. Our product candidate portfolio includes an oral anticoagulant, ATI-5923, designed to have the same therapeutic benefits as warfarin currently in Phase 2/3 clinical trials for the treatment of patients who are at risk for the formation of dangerous blood clots; an oral anti-arrhythmic agent, ATI-2042, designed to have the efficacy of amiodarone in Phase 2 clinical development for the treatment of atrial fibrillation, a form of irregular heartbeat; a novel, next-generation atypical antipsychotic agent, ATI-9242, currently in Phase 1 clinical trials for the treatment of schizophrenia and other psychiatric disorders; and an oral prokinetic agent, ATI-7505, designed to have the same therapeutic benefits as cisapride in Phase 2 clinical trials for the treatment of chronic constipation, gastroesophageal reflux disease and symptoms associated with functional dyspepsia. We have multiple product candidates in preclinical development.

 

We were incorporated in the State of California on February 28, 1997 and reincorporated in the State of Delaware on August 29, 2007. We maintain a wholly-owned subsidiary, ARYx Therapeutics Limited, with registered offices in the United Kingdom, which has had no operations since its inception in September 2004. We currently are focused on the human drug development business and operate in a single business segment with regard to the development of human pharmaceutical products.

 

Basis of Presentation

 

The accompanying unaudited condensed consolidated financial statements include the accounts of our wholly-owned subsidiary, ARYx Therapeutics, Ltd. All intercompany accounts and transactions have been eliminated. These unaudited condensed consolidated financial statements have been prepared in accordance with U.S. generally accepted accounting principles for interim financial information on the same basis as the annual financial statements and with instructions to Form 10-Q and Rule 10-01 of Regulation
S-X. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. These interim financial statements include all adjustments (consisting only of normal recurring adjustments) that management believes are necessary for the fair presentation of the balances and results for the periods presented. Interim financial results are not necessarily indicative of results to be expected for the full fiscal year or any future interim period.

 

The balance sheet data at December 31, 2007 has been derived from our audited consolidated financial statements for the year ended December 31, 2007, contained in our Annual Report on Form 10-K. The unaudited condensed consolidated financial statements and related disclosures contained in this report have been prepared with the presumption that users of the interim financial statements have read or have access to our audited financial statements for the preceding year. Accordingly, these interim financial statements should be read in conjunction with our audited financial statements and notes thereto for the year ended December 31, 2007, contained in our Annual Report on Form 10-K.

 

Use of Estimates

 

The preparation of financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts in the condensed consolidated financial statements and accompanying notes. Management bases its estimates on historical experience and on assumptions believed to be reasonable under the circumstances. Actual results could differ from those estimates.

 

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Table of Contents

 

Marketable Securities and the Adoption of SFAS 157

 

In September 2006, the Financial Accounting Standards Board (“FASB”) issued Statements of Financial Accounting Standards No. 157, Fair Value Measurements (“SFAS 157”). SFAS 157 defines fair value, establishes a framework for measuring fair value and expands fair value measurement disclosure. In February 2008, the FASB issued FASB Staff Position 157-1, Application of FASB Statement No. 157 to FASB Statement No. 13 and Other Accounting Pronouncements That Address Fair Value Measurements for Purposes of Lease Classification or Measurement under Statement 13 (“FSP 157-1”), and FASB Staff Position 157-2, Effective Date of FASB Statement No. 157 (“FSP 157-2”). FSP 157-1 amends SFAS 157 to remove certain leasing transactions from its scope. FSP 157-2 delays the effective date of SFAS 157 for all non-financial assets and non-financial liabilities, except for items that are recognized or disclosed at fair value in the financial statements on a recurring basis (at least annually), until fiscal year beginning after November 15, 2008. The measurement and disclosure requirements related to financial assets and financial liabilities became effective for us beginning in the first quarter of 2008. The adoption of SFAS 157 for financial assets and financial liabilities did not have a significant impact on our consolidated financial statements. We are currently evaluating the impact that SFAS 157 may have on our consolidated financial statements when it is applied to non-financial assets and non-financial liabilities beginning in the first quarter of 2009. SFAS 157 describes three levels of inputs that may be used to measure fair value, as follows:

 

·                  Level 1 inputs which include quoted prices in active markets for identical assets or liabilities;

 

·                  Level 2 inputs which include observable inputs other than Level 1 inputs, such as quoted prices for similar assets or liabilities; quoted prices for identical or similar assets or liabilities in markets that are not active; or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the asset or liability; and

 

·                  Level 3 inputs which include unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the underlying asset or liability.  Level 3 assets and liabilities include those whose fair value measurements are determined using pricing models, discounted cash flow methodologies or similar valuation techniques, as well as significant management judgment or estimation.

 

The following table summarizes our available-for-sale securities portfolio as of June 30, 2008, and provides a reconciliation of the beginning and ending balance of our auction rate securities measured at fair value using significant other observable and unobservable inputs during the three months ended June 30, 2008:

 

 

 

 

 

Fair Value Measurements Using

 

Available-For-Sale Securities Portfolio

 

Fair Value

 

Quoted Prices in
Active Markets for
Identical Assets
(Level 1)

 

Significant Other
Observable Inputs

(Level 2)

 

Significant
Unobservable Inputs

(Level 3)

 

 

 

(in thousands)

 

Money market fund

 

$

15,205

 

$

15,205

 

$

 

$

 

U.S. government agencies debt

 

10,020

 

10,020

 

 

 

Commercial paper

 

11,171

 

11,171

 

 

 

Corporate debt securities

 

1,562

 

1,562

 

 

 

Auction rate securities:

 

 

 

 

 

 

 

 

 

Beginning balance as of March 31, 2008

 

2,020

 

 

1,200

 

820

 

Purchases

 

 

 

 

 

Sales and maturities

 

(1,200

)

 

(1,200

)

 

Unrealized losses included in other comprehensive income

 

(22

)

 

 

(22

)

Transfer in (out) between Level 2 and 3

 

 

 

 

 

Ending balance as of June 30, 2008

 

798

 

 

 

798

 

Total available-for-sale securities

 

$

38,756

 

$

37,958

 

$

 

$

798

 

 

As of June 30, 2008, we held in our marketable securities portfolio two auction rate securities with an aggregate par value of $875,000. Beginning in early 2008, market auctions for certain of the auction rate securities held in our portfolio began to fail causing those securities to become temporarily illiquid. However, during the first half of 2008 we did experience liquidity in the market for auction rate securities as all but two of our auction rate holdings were either redeemed by the original issuers or were sold at par value in the open market. Based on our recent experience with the liquidity of our own auction rate portfolio and our expectations regarding near-term market conditions, we concluded that the impairment to the fair value of our auction rate holdings as of June 30, 2008, is not other-than-temporary in accordance with guidance

 

6



Table of Contents

 

provided by FSP FAS 115-1. Accordingly, we classify our two remaining auction rate holdings as current assets as we intend to liquidate these instruments as soon as liquidity for these instruments is available to us.

 

The recent failure of some auctions and the resulting lack of liquidity require that certain of these securities be measured using Level 3 inputs in accordance with guidance provided by SFAS 157. The fair value of our two remaining auction rate securities which are classified as Level 3 instruments at June 30, 2008 was determined using a discounted cash flow model that considers inputs such as expected cash flows from the auction rate instruments, expected interest payments, market yields for similarly rated instruments, our estimates of time to liquidity for those securities, and marketability discounts. We revise our estimates for each input as of each financial statement reporting period based upon known and expected market conditions as well as specific information we have regarding each instrument. We have determined that as of June 30, 2008, the aggregate fair value of our two remaining auction rate instruments was $798,000, net of an estimated $77,000 unrealized loss representing an aggregate 8.8% reduction in the carrying value for these instruments. The reduction in carrying value is reflected in our condensed consolidate balance sheet as a component of other comprehensive loss as of June 30, 2008.

 

Comprehensive Loss

 

Comprehensive loss is comprised of net loss and other comprehensive income/loss. The only component of our other comprehensive income/loss is the unrealized gains and losses on our marketable securities. Comprehensive loss for the three months ended June 30, 2008 and 2007 was $12.0 million and $7.0 million, respectively, and for the six months ended June 30, 2008 and 2007 was $21.5 million and $12.2 million, respectively.

 

Net Loss Per Share

 

Basic net loss per share is computed by dividing net loss by the weighted average number of fully vested common shares outstanding during the period. Diluted net loss per share is computed by giving effect to all potential dilutive common shares, including outstanding stock options, warrants and convertible preferred stock. Because we are in a net loss position, our computation of diluted net loss per share excludes the effects of common stock equivalents because the inclusion would have been anti-dilutive.

 

The following table presents the calculation of historical basic and diluted net loss per share:

 

 

 

Three Months Ended 
 June 30,

 

Six Months Ended 
 June 30,

 

 

 

2008

 

2007

 

2008

 

2007

 

 

 

(In thousands, except per share amounts)

 

Numerator:

 

 

 

 

 

 

 

 

 

Net loss

 

$

(11,896

)

$

(7,020

)

$

(21,399

)

$

(12,156

)

Denominator:

 

 

 

 

 

 

 

 

 

Weighted average common shares outstanding

 

17,668

 

1,114

 

17,664

 

1,092

 

Less: Weighted average unvested restricted common shares

 

(27

)

(34

)

(28

)

(27

)

Weighted average common shares used in computing basic and diluted net loss per share

 

17,641

 

1,080

 

17,636

 

1,065

 

Basic and diluted net loss per share

 

$

(0.67

)

$

(6.50

)

$

(1.21

)

$

(11.41

)

 

For the three months ended June 30, 2008, shares and per share amounts above reflect the conversion of all of our outstanding convertible preferred stock into common stock upon the closing of our initial public offering on November 13, 2007.

 

The following common stock equivalent shares related to our convertible preferred stock, warrants and stock options were excluded from the computation of diluted net loss per share for the periods presented because including them would have had an antidilutive effect:

 

 

 

Three Months Ended 
June 30,

 

Six Months Ended 
June 30,

 

 

 

2008

 

2007

 

2008

 

2007

 

 

 

(In thousands)

 

Series A convertible preferred stock (as if converted)

 

 

126

 

 

126

 

Series B convertible preferred stock (as if converted)

 

 

105

 

 

105

 

Series C convertible preferred stock (as if converted)

 

 

2,826

 

 

2,826

 

Series D convertible preferred stock (as if converted)

 

 

5,539

 

 

5,539

 

 

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Table of Contents

 

 

 

Three Months Ended 
June 30,

 

Six Months Ended 
June 30,

 

 

 

2008

 

2007

 

2008

 

2007

 

 

 

(In thousands)

 

Series E convertible preferred stock (as if converted)

 

 

2,819

 

 

2,819

 

Warrants to purchase Series C convertible preferred stock (as if exercised and converted)

 

 

11

 

 

11

 

Warrants to purchase Series D convertible preferred stock (as if exercised and converted)

 

 

101

 

 

101

 

Warrants to purchase common stock (as if exercised)

 

190

 

 

190

 

 

Outstanding common stock options

 

2,354

 

1,793

 

2,354

 

1,793

 

 

 

2,544

 

13,320

 

2,544

 

13,320

 

 

Income Taxes

 

We utilize the liability method of accounting for income taxes. Under this method, deferred tax assets and liabilities are determined based on differences between financial reporting bases and the tax bases of assets and liabilities and are measured using the enacted tax rates and laws that will be in effect when the differences are expected to reverse. Based on known factors, our management cannot currently conclude that it will be more likely than not that the deferred tax assets will be utilized. Accordingly, the deferred tax assets have been fully offset by a valuation allowance.

 

As permitted under the provisions of FIN 48, we will classify interest and penalties related to unrecognized tax benefits as part of our income tax provision, although there have been no such interest or penalties recognized to-date.

 

Recent Accounting Pronouncements

 

In December 2007, the FASB ratified EITF 07-1, “Accounting for Collaborative Arrangements” (“EITF 07-1”). EITF 07-1 defines collaborative arrangements and establishes reporting requirements for transactions between participants in a collaborative arrangement and between participants in the arrangement and third parties. EITF 07-1 also establishes the appropriate income statement presentation and classification for joint operating activities and payments between participants, as well as the sufficiency of the disclosures related to these arrangements. EITF 07-1 is effective for fiscal years beginning after December 15, 2008. We are currently evaluating the impact of EITF 07-1 on our consolidated financial position, results of operations and cash flows.

 

2.  Revenue Recognition

 

On June 30, 2006, we entered into a collaboration agreement with Procter & Gamble Pharmaceuticals, Inc., or P&G, pursuant to which P&G would develop and commercialize ATI-7505, our product candidate for the treatment of gastrointestinal disorders such as chronic constipation, functional dyspepsia, gastroesophageal reflux disease, gastroparesis and irritable bowel syndrome with constipation. In connection with the collaboration agreement, P&G paid us a $25.0 million nonrefundable upfront license fee. As of July 2, 2008, the collaboration agreement with P&G was terminated. See Note 6 – Subsequent Event for further discussion.

 

In accordance with our revenue recognition policy, the $25.0 million nonrefundable upfront license fee was deferred upon receipt, as objective evidence of the fair value of the undelivered elements under the agreement could not be established. This fee is being recognized as revenue on a straight-line basis over our estimated obligatory performance period under the terms of the collaboration agreement. As of June 30, 2008, a cumulative total of $7.5 million of the $25.0 million upfront payment had been recognized as revenue.  In connection with the termination of the collaboration agreement, the obligatory performance period has effectively ended and accordingly, we classify the remaining $17.5 million deferred revenue as a current liability.

 

Under the collaboration agreement, we were obligated to provide certain transitional services to P&G which were fully reimbursable to ARYx by P&G. These transitional services represented the pass through of actual costs billed to us by third party vendors, were standard support services for the biopharmaceutical industry and were readily available from multiple vendors. We were also entitled to compensation from P&G for certain pre-determined development services, such as formulation, development and manufacturing of drug substance and products, as well as other activities related to the licensed technology. As of June 30, 2008, we have recognized a cumulative total of $2.6 million as collaboration service revenue since the commencement of our collaboration arrangement with P&G and costs associated with these services are included in the cost of collaboration service revenue.

 

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3.  Debt Financing

 

In March 2005, we entered into a loan agreement with Lighthouse Capital Partners V, L.P. (“Lighthouse”) that was amended on October 19, 2007. The original agreement provided for up to $10.0 million in debt financing. The amended agreement provides for up to $9.0 million in additional financing for a total of $19.0 million made available over the life of the facility. We issued two warrants to Lighthouse in connection with the original agreement and the amended agreement. As of June 30, 2008, these warrants are exercisable for an aggregate of 100,704 shares of our common stock at an exercise price of $9.93 per share and 83,332 shares of our common stock at an exercise price of $10.80.

 

In February 2008, we borrowed the additional $9.0 million available to us under the loan facility pursuant to the terms of the amended loan agreement dated October 19, 2007. The amended loan agreement provides for a seven-month interest-only period and a 36 month repayment term which will begin on October 1, 2008. The related promissory note provides for monthly cash payments of principal and interest at an interest rate equal to the higher of 7.75% or the prime rate plus 200 basis points per annum to be fixed as of October 1, 2008, and a balloon interest payment of $675,000 to be made in September 2011. The loan agreement allows for prepayment of principal with respect to the promissory note whereupon the $675,000 terminal interest payment is accelerated and due at the time of prepayment of the loan balance.

 

4.  Warrants

 

Upon completion of our initial public offering in November 2007, all outstanding warrants to purchase our convertible preferred stock were converted into warrants to purchase our common stock in accordance with their original terms.

 

As of June 30, 2008, the following warrants were issued and outstanding:

 

 

 

 

 

 

 

 

 

 

 

Exercise

 

 

 

 

 

 

 

 

 

 

 

Shares

 

Price

 

Expiration

 

Warrant Holder

 

Issue Date

 

In Connection With

 

Warrant to Purchase

 

(in thousands)

 

(per share)

 

Date

 

ATEL(1)

 

12/23/2002

 

Leasing arrangement

 

Common stock

 

6

 

$

8.91

 

 

(1)

Lighthouse-Warrant 1(2)

 

3/28/2005

 

Debt financing

 

Common stock

 

101

 

$

9.93

 

 

(2)

Lighthouse-Warrant 2(3)

 

10/19/2007

 

Debt financing

 

Common stock

 

83

 

$

10.80

 

 

(3)

 

 

 

 

 

 

 

 

190

 

 

 

 

 

 


(1)

Exercisable, in whole or in part, until the earlier of the 10th anniversary of the issue date or the 5th anniversary of the closing of an initial public offering.

(2)

Exercisable, in whole or in part, prior to or upon the closing of an initial public offering, a merger, change in control, or sale of substantially all of our assets; expires at the earlier of (i) the close of business on March 28, 2012, (ii) two years following the effective date of an initial public offering, or (iii) the effective date of a merger, as defined in the agreement.

(3)

Exercisable, in whole or in part, at anytime at the option of the holder or deemed to have been automatically exercised in full immediately prior to the expiration of the warrant; expires at the earlier of (i) the close of business on October 19, 2014, or (ii) the effective date of a merger, as defined in the agreement.

 

We follow guidance under SFAS 150, and EITF 96-18 prior, to measure the fair value of these warrants on the date of issuance using the Black-Scholes option valuation model with the following assumptions: risk-free interest rate ranging from 3.27% to 4.10%, contractual life according to the remaining terms of the arrangements, no dividend yield and volatility of 73%. The fair value of the warrant issued to ATEL was fully amortized as of December 31, 2005. The fair value of the first warrant issued to Lighthouse was recorded in three separate tranches as debt issuance cost with the first tranche amortized to interest expense over the funding commitment period ended December 31, 2005, and the remainder amortized to interest expense over the duration of the interest-only period plus the term of the loan over 42 months. The fair value of the second warrant issued to Lighthouse was recorded in two separate tranches as debt issuance cost with the first tranche amortized to interest expense over the funding commitment period ended March 1, 2008, and the remainder amortized to interest expense over the duration of the interest-only period plus the term of the loan over 36 months. Amortization of the fair value of the warrants was charged to interest expense as follows:

 

 

 

Three Months Ended 
June 30,

 

Six Months Ended
 June 30,

 

 

 

2008

 

2007

 

2008

 

2007

 

 

 

(In thousands)

 

Lighthouse – Warrant 1

 

$

23

 

$

23

 

$

47

 

$

47

 

Lighthouse – Warrant 2

 

16

 

 

167

 

 

 

 

$

39

 

$

23

 

$

214

 

$

47

 

 

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The warrants may be exercised using the net exercise method. Under this method, the number of shares issued upon exercise is reduced by an amount equal to the product of the number of shares subject to the exercise and the exercise price per share, divided by the fair value of convertible preferred stock on the date of the exercise. The number of shares issued upon exercise of the warrants, and the exercise price per share, are adjustable in the event of stock splits, dividends and similar fundamental changes. No warrant was exercised during the three and six month periods ended June 30, 2008.  In June 2007, Life Science Group, Inc. exercised their first warrant on a net exercise basis which resulted in the issuance of 1,055 shares of our Series C convertible preferred stock prior to the conversion to an equal number of common shares.

 

Before conversion of the convertible preferred stock warrants into common stock warrants, we followed guidance under SFAS 150 and re-measured the fair value of these warrants on each subsequent balance sheet date until the date of conversion using the Black-Scholes option valuation model with the following assumptions: risk-free interest rate between 3.78% and 4.96%, contractual life according to the remaining terms of the arrangements, no dividend yield and volatility of 73%. Accordingly, we recorded interest and other income of $21,000 and $40,000 to reflect the decrease in fair value of the then preferred stock warrant liability for the three and six months ended June 30, 2007, respectively, before the conversion of the warrants.

 

5.  Stock-Based Compensation

 

We account for employee stock-based compensation under SFAS No. 123(R), Share-Based Payment (“SFAS 123R”), which requires compensation expense related to stock-based payments, including stock options and awards granted to employees and directors, to be measured based on grant date fair value and recognized as expense in the financial statements over the requisite service period. We estimate the fair value of our share-based award to employees and directors using the Black-Scholes option valuation model. Option valuation models require the input of highly subjective assumptions and these assumptions can vary over time. Due to the fact that we are a newly public company, there is limited historical information available to support our estimate of expected volatility required to value our stock-based awards. We, therefore, follow guidance discussed in SAB No. 107 basing our estimate of expected volatility on the expected volatility of a group of similar entities whose stock prices are publicly available. We will continue to consistently apply this process using the similar entities until a sufficient amount of historical information regarding the volatility of our own stock price becomes available. The fair value of our stock-based awards was estimated at the date of grant using the following assumptions:

 

 

 

Three Months Ended 
June 30,

 

Six Months Ended 
June 30,

 

 

 

2008

 

2007

 

2008

 

2007

 

Expected volatility

 

73

%

73

%

73

%

73

%

Expected term (in years)

 

4.6

 

4.0

 

4.6

 

4.1

 

Weighted-average risk-free interest rate

 

3.27

%

4.44

%

2.66

%

4.63

%

Expected dividends

 

 

 

 

 

Weighted-average grant date fair value per share

 

$

3.83

 

$

1.88

 

$

4.35

 

$

1.90

 

 

SFAS 123R requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from estimates. Forfeitures are estimated based on our historical experience and separate groups of employees that have similar historical forfeiture behavior are separately considered for expense recognition.

 

Total compensation cost that has been recorded in the statement of operations, which includes stock-based compensation expense under SFAS 123R and the value of options issued to non-employees for services rendered, are allocated as follows:

 

 

 

Three Months Ended
 June 30,

 

Six Months Ended 
June 30,

 

 

 

2008

 

2007

 

2008

 

2007

 

 

 

(In thousands)

 

Research and development:

 

 

 

 

 

 

 

 

 

Officer compensation

 

$

84

 

$

42

 

$

160

 

$

77

 

Employee and consultant compensation

 

161

 

71

 

332

 

128

 

Selling, general and administrative:

 

 

 

 

 

 

 

 

 

Director and officer compensation

 

279

 

92

 

555

 

245

 

Employee and consultant compensation

 

48

 

16

 

90

 

29

 

 

 

$

572

 

$

221

 

$

1,137

 

$

479

 

 

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As of June 30, 2008, total compensation cost related to unvested stock options not yet recognized was $2.7 million, which is expected to be allocated to expense over a weighted-average period of 1.45 years. As a result of stock option exercises, we issued 16,278 shares and 8,360 shares of common stock during the three months ended June 30, 2008 and 2007, respectively, and 27,343 shares and 21,771 shares of common stock during the six months ended June 30, 2008 and 2007, respectively.

 

6.  Subsequent Event

 

On July 2, 2008, we received notice from P&G that it elected to exercise its option to terminate the collaboration agreement between P&G and ARYx, effective July 2, 2008. In connection with the termination of the collaboration agreement, the obligatory performance period has effectively ended and pursuant to the terms of the collaboration agreement, we are under no obligation to return any portion of the $25 million upfront license fee to P&G. Accordingly, we classify the remaining $17.5 million deferred revenue as a current liability. In addition, effective with P&G’s notice of termination, we no longer provide support services to P&G for the development of ATI-7505 and therefore those services will no longer be a source of revenue for us.

 

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ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

The following discussion of our financial condition and the results of operations should be read in conjunction with the condensed consolidated financial statements and notes to condensed consolidated  financial statements included elsewhere in this quarterly report on Form 10-Q. This discussion contains forward looking statements that involve risks and uncertainties. When reviewing the discussion below, you should keep in mind the substantial risks and uncertainties that characterize our business. In particular, we encourage you to review the risks and uncertainties described in Part II - Item 1A. “RISK FACTORS” elsewhere in this report. These risks and uncertainties could cause actual results to differ materially from those projected in forward-looking statements contained in this report or implied by past results and trends. Forward-looking statements are statements that attempt to forecast or anticipate future developments in our business; we encourage you to review the examples of our forward-looking statements under the heading “Cautionary Note Regarding Forward-Looking Statements” that appears at the end of this discussion. These statements, like all statements in this report, speak only as of their date (unless another date is indicated), and we undertake no obligation to update or revise these statements in light of future developments.

 

Overview

 

ARYx Therapeutics, Inc. is a biopharmaceutical company focused on developing a portfolio of internally discovered product candidates designed to eliminate known safety issues associated with well-established, commercially successful drugs. We were incorporated in the State of California on February 28, 1997 and reincorporated in the State of Delaware on August 29, 2007. We maintain a wholly-owned subsidiary, ARYx Therapeutics Limited, with registered offices in the United Kingdom, which has had no operations since its inception in September 2004 and was established to serve as a legal entity in support of our clinical trial activities conducted in Europe.

 

We use our RetroMetabolic Drug Design technology to design structurally unique molecules that retain the efficacy of these original drugs but are metabolized through a potentially safer pathway to avoid specific adverse side effects associated with these compounds. The following is a summary of our product candidates that are currently in clinical development:

 

ATI-5923

 

ATI-5923 is an oral anticoagulant in Phase 2/3 clinical trials for the treatment of patients who are at risk for the formation of dangerous blood clots, such as those with atrial fibrillation or those at risk of venous thromboembolism. ATI-5923 was designed to have the same therapeutic benefits as the drug warfarin, which for over 50 years has been the treatment of choice as an oral anticoagulant. Despite its widespread use, warfarin has several significant limitations. It is metabolized by CYP450 and has many drug-drug interactions that often lead to serious side effects. We designed ATI-5923 to be metabolized through the esterase pathway, eliminating metabolism through CYP450 and avoiding drug-drug interactions. Warfarin also has a very steep dose response curve which means that a small change in dose may lead to a substantial change in the anticoagulation status of the patient. This can put patients at risk for either life-threatening clotting or bleeding. In preclinical testing, it appears that ATI-5923 may have a more predictable rate of anticoagulation than warfarin, although confirmation of this observation will require substantial additional clinical data. We completed a Phase 2 clinical trial with ATI-5923 involving 66 patients. In this study, ATI-5923 achieved a significant improvement in the maintenance of these patients at the targeted level of anticoagulation and also demonstrated a significant reduction in the occurrence of dangerously low levels of anticoagulation compared to these patients’ historical levels of anticoagulation when on warfarin. We have also completed a pilot study of 50 patients to prepare for a recently-initiated large Phase 2/3 trial. In the pilot trial, we successfully established the trial methodologies for the blinded Phase 2/3 trial, and, even though the primary purpose of the pilot trial was not to measure the effectiveness of ATI-5923 in achieving the patient’s target INR, the efficacy results essentially matched those of the earlier 66 patient study. In June 2008, we initiated a double-blinded, placebo-controlled Phase 2/3 clinical trial involving approximately 600 patients that will study the efficacy of ATI-5923 in a head-to-head comparison to warfarin. In preliminary discussions, the U.S. Food and Drug Administration, or FDA, indicated that the standardized measurement of anticoagulation status known as the International Normalized Ratio, or INR, will likely be an acceptable surrogate and primary endpoint for ATI-5923’s clinical development. Using INR as a surrogate and primary endpoint should reduce both the size of and time to complete our planned clinical trials for ATI-5923 compared to clinical trials based on survival rates or other outcomes. Based upon other discussions with the FDA, we will request that the FDA consider the current Phase 2/3 trial part of the patient population needed to seek commercial approval in order to qualify it as a Phase 3 trial.

 

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ATI-2042

 

ATI-2042 is an oral anti-arrhythmic agent in Phase 2 clinical development for the treatment of patients with atrial fibrillation. ATI-2042 was designed to have the efficacy of amiodarone, a drug that has been used for many years, despite its adverse side effects, because physicians consider it to be the most effective drug for treating patients with atrial fibrillation. Amiodarone accumulates in many different organs and can only be metabolized by CYP450, potentially leading to serious side effects that are not immediately reversible upon withdrawal of the drug. Since ATI-2042 is predominantly metabolized through the esterase pathway, accumulation in the organs and drug-drug interactions are expected to be reduced. We have completed a Phase 2 clinical trial with ATI-2042 involving six atrial fibrillation patients with implanted recordable pacemakers who failed previous drug therapy. ATI-2042 quickly reduced the amount of time these patients were in atrial fibrillation by up to 87%. We are conducting an additional Phase 2 clinical trial to further demonstrate the efficacy of ATI-2042 in patients with atrial fibrillation. Enrollment in this trial is complete and we currently expect to have top-line efficacy results by the end of 2008.

 

ATI-9242

 

ATI-9242 is a novel antipsychotic agent in Phase 1 clinical development for the treatment of schizophrenia and other psychiatric disorders. ATI-9242’s receptor profile is targeted at the treatment of both the positive and the negative symptoms of schizophrenia as well as the improvement of cognitive function. To date, preclinical work has supported this profile. ATI-9242 is also designed to avoid certain drug-drug interactions by avoiding CYP450 enzymes for metabolism, as well as reduce certain metabolic problems associated with this class of therapy, including weight gain and type 2 diabetes. We received clearance from the FDA to initiate a Phase 1 clinical trial for ATI-9242 in April 2008, which is designed to test ATI-9242’s safety and tolerability. We currently expect to complete this clinical trial by the end of 2008.

 

ATI-7505

 

ATI-7505 is an oral prokinetic drug or an agent that speeds up the motion of contents through the gut, which has successfully completed Phase 2 clinical trials for the treatment of multiple gastrointestinal disorders including gastroesophageal reflux disease, or GERD, and functional dyspepsia. ATI-7505 was designed to have the same therapeutic benefits as cisapride, a drug marketed by Johnson & Johnson as Propulsid in the United States. Launched in 1993, cisapride reached sales of over $1.0 billion before it was withdrawn from the market in 2000 due to serious cardiovascular side effects. These side effects occurred as blood levels of the drug rose significantly when CYP450 clearance was blocked because of the presence of other drugs cleared by the same metabolic pathway. We designed ATI-7505 to be metabolized through the esterase pathway, eliminating metabolism through CYP450 as well as off-target cardiovascular effects. We have treated more than 500 patients with ATI-7505 as part of our clinical trial program, including three Phase 2 trials. Based upon the data generated in these clinical trials, in June 2006 we entered into a collaboration agreement with Procter & Gamble Pharmaceuticals, Inc., or P&G, to develop and commercialize ATI-7505.  On July 2, 2008, we announced the overall successful results of a QT study (TQT) on ATI-7505, which we believe support the favorable cardiac safety profile of the agent. On July 2, 2008, we received notice from P&G that it elected to exercise its option to terminate the collaboration agreement between P&G and ARYx, effective July 2, 2008. Upon termination of the agreement by P&G, all rights to ATI-7505 reverted to ARYx. We intend to submit the results of the TQT study to the FDA and subsequently seek a new collaboration partner for ATI-7505.

 

Since our inception, we have incurred significant net losses, and we expect to continue to incur net losses for the next several years as we develop, acquire or in-license additional products or product candidates, conduct clinical trials, manufacture materials for use in nonclinical studies and clinical trials, expand our research and development activities, seek regulatory approvals and engage in commercialization preparation activities. It is very expensive to gain approval of and launch a pharmaceutical product, and many expenses are incurred before revenue is received. We are unable to predict the extent of any future losses or when we will become profitable, if at all.

 

Revenue

 

  In connection with our collaboration agreement with P&G, we received a $25.0 million nonrefundable upfront license fee in August 2006. The $25.0 million payment was recorded in our balance sheet as deferred revenue upon receipt and recognized in our consolidated statement of operations as revenue on a straight-line basis over the performance and service period. Upon termination of the collaboration agreement on July 2, 2008, the performance and service period effectively ended and pursuant to the terms of the collaboration agreement, we are under no obligation to return any portion of the upfront license fee to P&G. As of June 30, 2008, we have recognized a cumulative total of $7.5 million of the $25.0 million

 

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nonrefundable upfront license fee. Following the termination of the collaboration agreement, the remaining $17.5 million is deemed fully earned and we expect that we will recognize the remaining deferred revenue in the third quarter of 2008.

 

Under the terms of the collaboration agreement, we were obligated to provide certain transitional services to P&G. These transitional services represented the pass through of actual costs billed to ARYx by third party vendors, were standard support services for the biopharmaceutical industry and were readily available from multiple vendors. We were also entitled to compensation from P&G for specified development services provided by us. These services included product formulation and manufacturing, patent filing and maintenance, and other development services related to the ATI-7505 program. Reimbursements we received for these services have been recorded as collaboration service revenue. As of June 30, 2008, we have recognized a cumulative total of $2.6 million as collaboration service revenue since the beginning of our collaboration with P&G. Effective with P&G’s notice of termination on July 2, 2008, we no longer provide support services to P&G for the development of ATI-7505 and therefore those services will no longer be a source of revenue for us.

 

Revenue generated from the P&G agreement was our only source of revenue. While we intend to seek partners for each of the four product candidates in our portfolio, there is no assurance that partnering arrangements will be available to us or on terms acceptable to us. See Part II – Item 1A.Risk Factors of this report for further discussion.

 

Cost of Collaboration Service Revenue

 

We incurred costs for certain services provided to P&G, including costs for pharmaceutical development, patent filing and maintenance and other activities related to the ATI-7505 program, which are related to the service revenue we generated in connection with our collaboration agreement with P&G. These expenses are reported separately in our income statement as cost of collaboration service revenue. As of June 30, 2008, we have recorded a cumulative total of $2.6 million of expense related to these activities since the commencement of our collaboration arrangement with P&G in June 2006.

 

Research and Development

 

Our research and development expense consists of expenses incurred in identifying, testing and developing our product candidates. These expenses consist primarily of fees paid to contract research organizations and other third parties to assist us in managing, monitoring and analyzing our clinical trials, clinical trial costs paid to sites and investigators’ fees, costs of nonclinical studies including toxicity studies in animals, costs of contract manufacturing services, costs of materials used in clinical trials and nonclinical studies, laboratory related expenses, research and development support costs including certain regulatory, quality assurance, project management and administration, allocated expenses such as facilities and information technology that are used to support our research and development activities and related personnel expenses, including stock-based compensation. Research and development costs are expensed as incurred.

 

Clinical trial costs are a significant component of our research and development expense. Currently, we conduct our clinical trials primarily through coordination with contract research organizations and other third-party service providers. We recognize research and development expense for these activities based upon a variety of factors, including actual and estimated patient enrollment, clinical site initiation activities, direct pass-through costs and other activity-based factors.

 

The following table summarizes our research and development expense for the three and six months ended June 30, 2008 and 2007:

 

 

 

Three Months Ended
 June 30,

 

Six Months Ended
 June 30,

 

 

 

2008

 

2007

 

2008

 

2007

 

 

 

(In thousands)

 

Direct research and development expense by program:

 

 

 

 

 

 

 

 

 

ATI-5923

 

$

4,494

 

1,027

 

$

6,081

 

$

1,494

 

ATI-2042

 

1,389

 

1,435

 

3,338

 

2,099

 

ATI-9242

 

546

 

645

 

1,092

 

952

 

ATI-7505

 

57

 

19

 

133

 

8

 

Other research programs

 

394

 

173

 

648

 

246

 

Total direct research and development program expense

 

6,880

 

3,299

 

11,292

 

4,799

 

Personnel, administrative and other expense

 

3,178

 

3,207

 

6,392

 

6,347

 

Less: Research and development portion of the cost of collaboration service revenue

 

(13

)

(7

)

(39

)

(130

)

Total research and development expense

 

$

10,045

 

$

6,499

 

$

17,645

 

$

11,016

 

 

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From our inception through June 30, 2008, we incurred total research and development expense of approximately $120.0 million. During the period from our inception through June 30, 2008, we estimate that approximately $20.8 million was directly incurred for our ATI-5923 program, approximately $20.9 million was directly incurred for our ATI-2042 program, approximately $4.8 million was directly incurred for our ATI-9242 program, approximately $22.3 million was directly incurred for our ATI-7505 program, and approximately $51.2 million was incurred (including internal and external activities) for our other research and development program expense, personnel, administrative and other expense.

 

We designate development programs to which we have allocated significant research and development resources with the term “ATI” and a unique number. All of the product candidates designated with “ATI” are currently in development. The expenditures summarized in the above table reflect costs directly attributable to each development candidate and to our other research programs. We do not allocate salaries, employee benefits, or other indirect costs to our development candidates or other research programs and have included those expenses in “Personnel, administrative and other expense” in the above table. The portion of our research and development expense that is identified as cost of collaboration service revenue is included within a separate category of expense in our condensed consolidated financial statements and is subtracted from total expenses in the above table to derive total research and development expense as reported in our condensed consolidated financial statements.

 

At this time, due to the risks inherent in the clinical trial process and given the various stages of development of our product candidates, we are unable to estimate with any certainty the costs we will incur in the continued development of our product candidates. Clinical development timelines, the probability of success and development costs can differ materially from expectations. While we are currently focused on advancing each of our product development programs, our future research and development expense will depend on the clinical success of each product candidate, as well as ongoing assessments as to each product candidate’s commercial potential. In addition, we cannot forecast with any degree of certainty which product candidates will be subject to future collaborations, when such arrangements will be secured, if at all, and to what degree such arrangements would affect our development plans and capital requirements.

 

The process of developing and obtaining FDA approval of products is costly and time consuming. Development activities and clinical trials can take years to complete, and failure can occur at any time during the development and clinical trial process. In addition, the results from early clinical trials may not be predictive of results obtained in subsequent and larger clinical trials, and product candidates in later stages of clinical trials may fail to show the desired safety and efficacy despite having progressed successfully through initial clinical testing. Although our program for identifying and developing new product candidates is designed to mitigate risk, the successful development of our product candidates is highly uncertain. Further, even if our product candidates are approved for sale, they may not be successfully commercialized and therefore the future revenue we anticipate may not materialize.

 

If we fail to complete the development of any of our product candidates in a timely manner, it could have a material effect on our operations, financial position and liquidity. In addition, any failure by us or our partners to obtain, or any delay in obtaining, regulatory approvals for our product candidates could have a material effect on our results of operations. A further discussion of the risks and uncertainties associated with completing our programs on schedule, or at all, and certain consequences of failing to do so are discussed further in the “Risk Factors” section of this report.

 

Critical Accounting Policies and Significant Estimates

 

The discussion of our financial condition and results of operations is based upon our condensed consolidated 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, judgments and assumptions that affect the reported amount of assets, liabilities, revenues and expenses. On an ongoing basis, we evaluate our estimates. These estimates, assumptions and judgments about future events and their effects on our results cannot be determined with certainty, and are made based upon our historical experience and on other assumptions that are believed to be reasonable under the circumstances. Different estimates that we could have used, or changes in the estimates that are reasonably likely to occur, may have a material impact on our financial condition or results of operations. Management has discussed the development, selection and disclosure of these estimates with the audit committee of our board of directors. Our actual results may differ from these estimates under different assumptions or conditions.

 

Our critical accounting policies are more fully described in Note 1 of the audited consolidated financial statements for the year ended December 31, 2007, which are included in our Annual Report on Form 10-K filed with the Securities and Exchange Commission on March 17, 2008. There have been no material changes in our critical accounting policies and significant estimates during the three and six months ended June 30, 2008 except for the fair value estimates on our auction rate securities as discussed below.

 

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Fair Value Estimates of Auction Rate Securities

 

In September 2006, the Financial Accounting Standards Board (“FASB”) issued Statements of Financial Accounting Standards No. 157, Fair Value Measurements (“SFAS 157”). SFAS 157 defines fair value, establishes a framework for measuring fair value and expands fair value measurement disclosure. The measurement and disclosure requirements related to financial assets and financial liabilities became effective for us beginning in the first quarter of 2008. Accordingly, we began to measure the fair value of financial assets in our available-for-sale securities portfolio beginning in the first quarter of 2008 and began to value our auction rate securities using significant other observable and unobservable inputs.

 

In early 2008, market auctions for certain of the auction rate securities held in our portfolio began to fail causing those securities to become temporarily illiquid. We believe that the failed auctions are the result of temporary credit market conditions. During the first half of 2008, we did experience liquidity in the auction rate market as all but two of our auction rate holdings were either redeemed by the original issuers or were sold at par value in the open market. Based on our recent experience with the liquidity of our own auction rate portfolio and our expectations regarding near-term market conditions, we concluded that the impairment to the fair value of our auction rate holdings as of June 30, 2008, is not other-than-temporary in accordance with guidance provided by FSP FAS 115-1. Accordingly, we classify our two remaining auction rate holdings as current assets as we intend to liquidate these instruments as soon as liquidity for these instruments is available to us and due to our expectation that there is a greater likelihood than not that liquidity will be made available to us in these instruments within a twelve month period. However, in future reporting periods, if we see that market conditions are such that we determine it to be less likely than not that these instruments will become liquid to us within a twelve month period, we may be required to classify these instruments as non-current assets.

 

The fair value of our two remaining auction rate securities which are classified as Level 3 instruments at June 30, 2008 was determined using a discounted cash flow model that considers inputs such as expected cash flows from the auction rate instruments including expected interest payments, market yields for similarly rated instruments, our estimates of time to liquidity for those securities, and marketability discounts. We revise our estimates for each input as of each financial statement reporting period based upon known and expected market conditions as well as specific information we have regarding each instrument. We have determined that as of June 30, 2008, the aggregate fair value of our two remaining auction rate instruments was $798,000, net of an estimated $77,000 unrealized loss representing an aggregate 8.8% reduction in the carrying value for these instruments. The two remaining auction rate securities in our portfolio reset every 28 days with recent interest payment reset rates ranging from 3.46% to 4.23% and final maturities in 2030 and 2045, respectively. As of June 30, 2008, our auction rate instruments were current with respect to their interest payment obligations. The estimates and assumptions used in determining the fair values of our auction rate securities are made based upon our recent experiences in the market and other assumptions that are believed to be reasonable under current market conditions. Different estimates that we could have used, or changes in the estimates that are reasonably likely to occur, may have a material impact on our financial condition or results of operations.

 

Results of Operations

 

Comparison of Three and Six Months Ended June 30, 2008 and 2007

 

Revenue

 

 

 

Three Months Ended

 

 

 

 

 

Six Months Ended

 

 

 

 

 

 

 

June 30,

 

Change

 

June 30,

 

Change

 

 

 

2008

 

2007

 

$

 

%

 

2008

 

2007

 

$

 

%

 

 

 

(In thousands, except %)

 

Collaboration service revenue

 

$

164

 

$

22

 

$

142

 

645%

 

$

232

 

$

186

 

$

46

 

25%

 

Technology license fees

 

974

 

974

 

 

 

1,948

 

1,948

 

 

 

Total revenue

 

$

1,138

 

$

996

 

$

142

 

14%

 

$

2,180

 

$

2,134

 

$

46

 

2%

 

 

Revenue for the three months ended June 30, 2008, as compared to the same period in 2007, increased by $142,000, or 14%.  Revenue for the six months ended June 30, 2008, as compared to the same period in 2007, increased by $46,000, or 2%.  The increase to the three and six month periods was due to third party pass-through costs billed to P&G primarily related to ATI-7505 patent filings and maintenance that were partially offset by a reduction in manufacturing activities for the program.

 

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Cost of Collaboration Service Revenue

 

 

 

Three Months Ended

 

 

 

 

 

Six Months Ended

 

 

 

 

 

 

 

June 30,

 

Change

 

June 30,

 

Change

 

 

 

2008

 

2007

 

$

 

%

 

2008

 

2007

 

$

 

%

 

 

 

(In thousands, except %)

 

Cost of collaboration service revenue

 

$

164

 

$

22

 

$

142

 

645%

 

$

232

 

$

186

 

$

46

 

25%

 

 

Cost of revenue was associated with our collaboration agreement with P&G. The increase in cost of revenue for both the three and six months ended June 30, 2008, as compared to the same periods in 2007, was directly associated with the increase in collaboration service revenue in the same periods. These were costs that were incurred directly by us and were passed through to P&G.

 

Research and Development Expense

 

 

 

Three Months Ended

 

 

 

 

 

Six Months Ended

 

 

 

 

 

 

 

June 30,

 

Change

 

June 30,

 

Change

 

 

 

2008

 

2007

 

$

 

%

 

2008

 

2007

 

$

 

%

 

 

 

(In thousands, except %)

 

Research and development expense

 

$

10,045

 

$

6,499

 

$

3,546

 

55%

 

$

17,645

 

$

11,016

 

$

6,629

 

60%

 

 

For the three months ended June 30, 2008, as compared to the same period in 2007, our research and development expense increased by $3.5 million, or 55%. The increase was primarily due to:

 

                  a $2.2 million increase in clinical trial expenditures related to the initiation of a double-blinded, placebo-controlled Phase 2/3 clinical trial involving approximately 600 patients that will study the efficacy of ATI-5923; and

 

                  a $1.3 million increase in external pharmaceutical manufacturing and manufacturing start-up costs in support of the Phase 2/3 clinical studies on our ATI-5923 program.

 

For the six months ended June 30, 2008, as compared to the same period in 2007, our research and development expense increased by $6.6 million, or 60%. The increase was primarily due to:

 

                  a $3.0 million increase in clinical and pre-clinical expenditures related to the 600 patient efficacy study of ATI-5923;

 

                  a $1.1 million increase in clinical trial expenditures related to a pilot efficacy study on ATI-5923, partially offset by a $900,000 reduction in expenditures due to the completion of a proof-of-concept study on ATI-5923 in 2007;

 

                  a $1.7 million increase in external pharmaceutical manufacturing and manufacturing start-up costs in support of the Phase 2/3 clinical studies on our ATI-5923 program;

 

                  a $1.2 million increase in external expenditures related to a Phase 2 clinical study for our ATI-2042 program; and

 

                  a $400,000 increase in spending on our other research programs.

 

Selling, General and Administrative Expense

 

 

 

Three Months Ended

 

 

 

 

 

Six Months Ended

 

 

 

 

 

 

 

June 30,

 

Change

 

June 30,

 

Change

 

 

 

2008

 

2007

 

$

 

%

 

2008

 

2007

 

$

 

%

 

 

 

(In thousands, except %)

 

Selling, general and administrative expense

 

$

2,664

 

$

1,727

 

$

937

 

54%

 

$

5,596

 

$

3,624

 

$

1,972

 

54%

 

 

The higher selling, general and administrative expense for the three and six months ended June 30, 2008 as compared to the same periods in 2007 was primarily due to increases in personnel and personnel related costs, including stock-based compensation expense, higher compensation costs for non-employee directors, and increases in our legal, professional services and insurance costs, much of which was attributable to our transition as a public company. Non-cash stock-based compensation expense included in selling, general and administrative expense was $326,000 for the three months ended June 

 

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30, 2008, representing an increase of $218,000 as compared to the same three month period in 2007, and $646,000 for the six months ended June 30, 2008, representing an increase of $372,000 as compared to the same six month period in 2007.

 

Interest and Other Income, Net

 

 

 

Three Months Ended

 

 

 

 

 

Six Months Ended

 

 

 

 

 

 

 

June 30,

 

Change

 

June 30,

 

Change

 

 

 

2008

 

2007

 

$

 

%

 

2008

 

2007

 

$

 

%

 

 

 

(In thousands, except %)

 

Interest and other income, net

 

$

308

 

$

543

 

$

(235

)

(43)%

 

$

857

 

$

1,179

 

$

(322

)

(27)%

 

 

Interest and other income, net of other expenses, consists of interest income from our investments in marketable securities and benefits related to the reassessment of the fair value of our preferred stock warrant liability prior to the conversion of our preferred stock warrants into common stock warrants. Lower interest income for the three and six months ended June 30, 2008 as compared to the same period in 2007 was primarily attributable to lower prevailing short-term interest rates as well as lower average investments in marketable securities.

 

Interest Expense

 

 

 

Three Months Ended

 

 

 

 

 

Six Months Ended

 

 

 

 

 

 

 

June 30,

 

Change

 

June 30,

 

Change

 

 

 

2008

 

2007

 

$

 

%

 

2008

 

2007

 

$

 

%

 

 

 

(In thousands, except %)

 

Interest expense

 

$

469

 

$

311

 

$

158

 

51%

 

$

963

 

$

643

 

$

320

 

50%

 

 

The increase in interest expense for three and six months ended June 30, 2008 as compared to the same period in 2007 was primarily due to additional interest expense related to the amortization of warrants and debt servicing costs related to the utilization of the additional $9.0 million loan facility in the first quarter of 2008 extended to us by Lighthouse Capital Partners.

 

Liquidity and Capital Resources

 

 

 

Six Months Ended

 

 

 

June 30,

 

 

 

2008

 

2007

 

 

 

(In thousands)

 

Cash (used in) provided by:

 

 

 

 

 

Operating activities

 

$

(22,250

)

$

(13,323

)

Investing activities

 

(6,223

)

10,685

 

Financing activities

 

7,533

 

(1,371

)

Total cash (used) provided

 

$

(20,940

)

$

(4,009

)

 

In November 2007, we completed our initial public offering of common stock and received aggregate net proceeds of approximately $43.8 million. Prior to our initial public offering, we financed our operations primarily through the private placement of equity securities, receiving aggregate net proceeds from such sales totaling $110.7 million. In August 2006, we received a $25.0 million nonrefundable upfront license fee in connection with our collaboration agreement with P&G. As of June 30, 2008, we had $47.4 million in cash, cash equivalents and marketable securities and a $159,000 receivable from P&G. Since inception, we have incurred significant net operating losses and, as of June 30, 2008, we had an accumulated deficit of $144.1 million. We have not achieved profitability and anticipate that we will continue to incur significant net losses for the next several years. We believe that our current capital resources will be sufficient to fund our planned operations for at least twelve months following June 30, 2008.

 

Net cash used in operating activities for the six months ended June 30, 2008 was $22.3 million as compared to $13.3 million for the same period in 2007. Net cash used in each of these periods was due to the funding of our operating costs and expenses in connection with the conduct of our research, development and administrative activities.

 

Net cash used in investing activities was $6.2 million for the six months ended June 30, 2008. Net cash provided by investing activities was $10.7 million for the six months ended June 30, 2007. Investing activities consist primarily of purchases and sales of marketable securities and property and equipment purchases. Purchases of property and equipment were $556,000 and $236,000 for the six months ended June 30, 2008 and 2007, respectively. As a majority of the cash proceeds from our initial public offering remained invested in our cash and cash equivalent portfolio during most of the six-

 

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month period ended June 30, 2008, cash used in investing activities during this period reflects a net transfer of cash into our investment portfolio.

 

Net cash provided by financing activities was $7.5 million during the six months ended June 30, 2008 and was primarily due to the utilization of the additional $9.0 million loan facility extended to us by Lighthouse Capital Partners, partially offset by $1.5 million in principal payments on our long-term debt. Net cash used in financing activities was $1.4 million during the six months ended June 30, 2007 and was due to principal payments on our long-term debt.

 

On March 28, 2005, we entered into a loan agreement with Lighthouse Capital Partners that was amended on October 19, 2007. The original agreement provided for up to $10.0 million in debt financing. The agreement was amended in October 2007 to provide for up to $9.0 million of additional financing. The original loan agreement provided for a 42 month repayment term which began on April 1, 2006. The original outstanding promissory note provides for monthly cash payments of principal and interest at a stated interest rate of 9.75% per annum through September 2009 and a balloon interest payment of $1.2 million in September 2009. The agreement also allows for prepayment of principal with respect to the original promissory note whereupon the $1.2 million terminal interest payment is accelerated and due at the time of prepayment of the outstanding loan balance. The amended loan agreement provides that additional amounts borrowed under a new promissory note will be subject to an interest-only period expiring in September 2008 followed by 36 equal monthly payments of principal and interest at a fixed rate of the prime rate plus 2.0%, to be fixed as of September 2008. In addition, we will be obligated to make a final interest payment of 7.5% of the amount borrowed at loan maturity. The loan agreement contains no financial covenants. Default terms under the loan agreement are standard terms including borrower default upon nonpayment of amounts due, noncompliance with loan covenants, misrepresentations under the agreement, bankruptcy and other standard provisions. Under the terms of the loan agreement, as amended, Lighthouse Capital Partners has a first priority security interest in all of our tangible and intangible assets except for the following: (i) assets specifically identified and used as security for equipment loans, (ii) any first priority interest Comerica Bank may have in our operating bank accounts at Comerica Bank, (iii) any certificates of deposit that are used as security for letters of credit issued to third parties, (iv) any interest or claims our landlord may have in certain leasehold improvements and (v) our intellectual property assets. The loan agreement precludes us from incurring additional material debt amounts with the exception of up to an aggregate of $3.0 million in equipment financing and up to $500,000 in other indebtedness. As of June 30, 2008, we had fully utilized the total debt commitment available under the loan agreement, as amended, and had a total unpaid principal balance outstanding of $12.9 million.

 

        Our debt financing with GE provides for a 42 month repayment term from each date of funding, a stated interest rate that is based on an average of the Federal Reserve’s three-year and five-year Treasury Constant Maturities rate plus a spread of 766 basis points and standard default provisions. We currently have three promissory notes outstanding under the loan agreement with GE with stated interest rates ranging from 11.73% to 12.89%. Under the loan agreement with GE, events of default include non-payment of amounts owed, a non-permitted sale or transfer of collateral, misrepresentations under the agreement, bankruptcy and other standard provisions. Funds borrowed under the loan agreement with GE are secured by specific equipment assets and GE has a first priority security interest in those assets. The loan agreement with GE contains no financial covenants and no warrants to purchase shares of our capital stock were issued to GE in connection with the debt financing. The loan agreement provides for monthly payments of principal and interest through July 2010. As of June 30, 2008, the total unpaid principal balance outstanding under our existing GE equipment loans was $646,000.

 

Our future funding requirements will depend upon many factors, including:

 

                  the scope, rate of progress, results and cost of our preclinical testing, clinical trials and other research and development activities;

 

                  the terms and timing of any collaborative, licensing and other arrangements 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 sales, marketing and distribution capabilities;

 

                  the cost of establishing clinical and commercial supplies of our product candidates and any products that we may develop;

 

                  the timing, receipt and amount of sales or royalties generated, if any, from our product candidates; and

 

                  the cost of preparing, filing, prosecuting, defending and enforcing any patent claims and other intellectual property rights.

 

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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 research and development programs. We may seek to raise any necessary additional funds through public or private equity, debt financings, collaborative arrangements with corporate partners or other sources. If we raise additional funds through the issuance of debt securities, these securities could have rights that are senior to the holders of our common stock and could contain covenants that restrict our operations. If we raise additional funds by issuing equity securities, dilution to our existing stockholders may result. In addition, if we raise additional funds through the sale of equity securities, new investors could have rights superior to our existing stockholders. To the extent that we raise additional capital through licensing arrangements or arrangements with collaborative partners, 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 commercialize ourselves for a higher profit margin. The terms of future financings may restrict our ability to raise additional capital, which could delay or prevent the further development of our product candidates or commercialization of our products. Our failure to raise capital when needed may harm our business and operating results.

 

Contractual Obligations

 

In February 2008, we fully utilized the additional $9.0 million loan facility pursuant to the terms of the loan agreement with Lighthouse Capital Partners dated October 19, 2007, as amended. The loan agreement, as amended, provides for a seven-month interest-only period and a 36 month repayment term which will begin on October 1, 2008. There were no additional material changes in our contractual obligations from those disclosed in our annual report on Form 10-K filed with the SEC on March 17, 2008, other than scheduled payments made through June 30, 2008.

 

Recent Accounting Pronouncements

 

See Note 1 of the Notes to our Condensed Consolidated Financial Statements included elsewhere in this report for recent accounting pronouncements that could have an effect on us.

 

Off-Balance Sheet Arrangements

 

Since inception, except for standard operating leases, we have not engaged in any off-balance sheet arrangements, including the use of structured finance, special purpose entities or variable interest entities.

 

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

 

There were no material changes to our market risk from those disclosed in our annual report on Form 10-K filed with the SEC on March 17, 2008.  As of June 30, 2008, $875,000 of auction rate securities remained in our marketable securities portfolio. As of June 30, 2008, those securities had limited market liquidity. While we believe that the limited liquidity for these instruments is due to temporary market conditions, in light of current market conditions, we have revalued our estimate of fair value for the auction rate securities held in our portfolio. Based on this revaluation, we recorded $77,000 in unrealized losses as a component of other comprehensive loss as of June 30, 2008, representing an 8.8% reduction to the carrying value of our auction rate holdings.

 

ITEM 4T. CONTROLS AND PROCEDURES

 

Changes in Internal Control over Financial Reporting

 

No change was made in our internal control over financial reporting during the quarter ended June 30, 2008 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

 

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PART II — OTHER INFORMATION

 

ITEM 1. LEGAL PROCEEDINGS

 

From time to time we are involved in legal proceedings arising in the ordinary course of our business. We believe there is no litigation pending that could have, individually or in the aggregate, a material adverse effect on our results of operations or financial condition.

 

ITEM 1A. RISK FACTORS

 

We have identified the following risks and uncertainties that may have a material adverse effect on our business, financial condition or results of operations. The risks described below are not the only ones we face. Additional risks not presently known to us or that we currently believe are immaterial may also significantly impair our business operations. Our business could be harmed by any of these risks. The trading price of our common stock could decline due to any of these risks, and our investors may lose all or part of their investment. We have marked with an asterisk (*) those risks described below that reflect substantive changes from the risks described in our Annual Report on Form 10-K  filed with the Securities and Exchange Commission on March 17, 2008. In assessing these risks, you should also refer to the other information contained in this quarterly report on Form 10-Q, including our financial statements and related notes.

 

Risks Related to Our Business and Industry

 

We have incurred significant operating losses since inception and expect to continue to incur substantial and increasing losses for the foreseeable future. We may never achieve or sustain profitability.*

 

We have a limited operating history and have incurred significant losses since our inception. As of June 30, 2008, we had an accumulated deficit of approximately $144.1 million. We expect our research and development expenses to continue to increase as we continue to expand our development programs, and, subject to regulatory approval for any of our product candidates, we expect to incur significant expenses associated with the potential establishment of a North American specialty sales force and increased manufacturing expenses. Although it is not expected to occur in the next several years, the cost of establishing a 100-person North American specialty sales force will be substantial. As a result, we expect to continue to incur substantial and increasing losses for the foreseeable future. These losses have had and will continue to have an adverse effect on our stockholders’ equity and working capital.

 

Because of the numerous risks and uncertainties associated with drug development, we are unable to predict the timing or amount of increased expenses or when or if we will be able to achieve or sustain 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 financings, debt financings and a single corporate partnership with P&G that was terminated in July 2008. We have devoted substantially all of our efforts to research and development, including clinical trials. If we are unable to develop and commercialize any of our product candidates, if development is delayed or if sales revenue from any product candidate that receives marketing approval is insufficient or if we fail to enter into partnering arrangements for our product candidates on terms favorable to us, we may never become profitable. Even if we do become profitable, we may not be able to sustain or increase our profitability on a quarterly or annual basis.

 

Our success depends substantially on our most advanced product candidates, which are still under development. If we are unable to bring any or all of these product candidates to market, or experience significant delays in doing so, our ability to generate product revenue and our likelihood of success will be harmed.*

 

Our three most advanced product candidates are in Phase 2 clinical trials and a fourth compound entered into Phase 1 clinical trial in April 2008. Our ability to generate product revenue in the future will depend heavily on the successful development and commercialization of these product candidates. Our other product candidates are in the discovery stage. Any of our product candidates could be unsuccessful for a variety of reasons, including that they:

 

                  do not demonstrate acceptable safety and efficacy in preclinical studies or clinical trials or otherwise do not meet applicable regulatory standards for approval;

 

                  do not offer therapeutic, safety or other improvements over existing or future drugs used to treat the same conditions;

 

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                  are not capable of being produced in commercial quantities at acceptable costs; or

 

                  are not accepted in the medical community and by third-party payors.

 

We do not expect any of our current product candidates to be commercially available before 2012, 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. The results of our clinical trials to date do not provide assurance that acceptable efficacy or safety will be shown upon completion of Phase 3 clinical trials.

 

We expect to depend on collaborative arrangements to complete the development and commercialization of each of our product candidates. Potential collaborative arrangements will likely place the development of our product candidates outside of our control and will likely require us to relinquish important rights or may otherwise be on terms unfavorable to us.*

 

We plan to enter into collaborative arrangements with third parties to develop and commercialize each of our lead product candidates. Dependence on collaborative arrangements for development and commercialization of our product candidates will subject us to a number of risks, including:

 

                  we may not complete a collaborative arrangement in time to avoid delays in clinical development, if at all, and if no collaborative arrangement is achieved, product development may be halted altogether;

 

                  we may not be able to control the amount and timing of resources that our collaborators may devote to the development or commercialization of product candidates or to their marketing and distribution;

 

                  collaborators may delay clinical trials, provide insufficient funding for a clinical trial program, stop a clinical trial or abandon a product candidate, repeat or conduct new clinical trials or require a new formulation of a product candidate for clinical testing;

 

                  we may have limited control over our clinical trial design;

 

                  disputes may arise between us and our collaborators 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 resources;

 

                  our collaborators may experience financial difficulties;

 

                  collaborators may not properly maintain or defend our intellectual property rights or may use our proprietary information in such a way as to invite litigation that could jeopardize or invalidate our proprietary information or expose us to potential litigation;

 

                  business combinations or significant changes in a collaborator’s business strategy may adversely affect a collaborator’s willingness or ability to fulfill its obligations under any arrangement;

 

                  a collaborator could independently move forward with a competing product candidate developed either independently or in collaboration with others, including our competitors; and

 

                  any collaborative arrangement may be terminated or allowed to expire, which would delay the development and may increase the cost of developing our product candidates.

 

Collaborative arrangements do not currently exist for any of our product candidates. If we do not establish collaborations for each of our ATI-5923, ATI-2042, ATI-9242 and ATI-7505  product candidates or future product candidates, we may have to alter our development and commercialization plans.*

 

Our strategy includes selectively collaborating with leading pharmaceutical and biotechnology companies to assist us in furthering the development and potential commercialization of some of our product candidates, including  ATI-5923, ATI-2042, ATI-9242 and ATI-7505. We intend to seek partners because the commercialization of each of our first four product candidates involves a large, primary care market that must be served by large sales and marketing organizations and because we do not currently have the capabilities to perform Phase 3 clinical trials. We face significant competition in seeking

 

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appropriate collaborators, and these collaborations are complex and time-consuming to negotiate and document. We may not be able to negotiate collaborations on acceptable terms, if at all. We are unable to predict when, if ever, we will enter into any collaborations because of the numerous risks and uncertainties associated with establishing collaborations. If we are unable to negotiate an acceptable collaboration, we may have to curtail the development of a particular product candidate, reduce or delay its development program or one or more of our other development programs, delay its potential commercialization or reduce the scope of our sales or marketing activities or increase our expenditures and undertake development or commercialization activities at our own expense. 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, if at all. If we do not have sufficient funds, we will not be able to bring our product candidates to market and generate product revenues.

 

The commercial success of our potential collaborations will depend in part on the development and marketing efforts of our potential partners, over which we will have limited control. If our collaborations are unsuccessful, our ability to develop and commercialize and to generate future revenue from the sale of our products will be significantly reduced.*

 

Our dependence on future collaboration arrangements will subject our company to a number of risks. Our ability to develop and commercialize each of our product candidates will depend on our and our potential collaboration partner(s)’ ability to establish the safety and efficacy of each respective product candidate, obtain and maintain regulatory approvals and achieve market acceptance of the product candidate(s) once commercialized. Our potential collaboration partner(s) may elect to delay or terminate development of our product candidates, independently develop products that compete with ours, or fail to commit sufficient resources to the marketing and distribution of our product candidates. The termination of a collaboration agreement may cause us to incur additional and unanticipated costs that may be material to our operations.

 

Business combinations, significant changes in business strategy, litigation and/or financial difficulties may also adversely affect the willingness or ability of our potential collaboration partners to fulfill their obligations to us. If a partner fails to perform in the manner we expect, our potential to develop and commercialize the respective product candidate(s) through other collaborations and to generate future revenue from the sale of the product candidate(s) may be significantly reduced. If a conflict of interest arises between us and our collaboration partner(s), they may act in their own self-interest and not in the interest of our company or our stockholders. If a collaboration partner breaches or terminates their collaboration agreement with us or otherwise fails to perform their obligations thereunder in a timely manner, the clinical development or commercialization of the respective product candidate(s) could be delayed or terminated. For example, our collaboration with P&G on the development and commercialization of ATI-7505 was terminated by P&G and we may experience a similar result with collaboration partners in the future on any of our product candidates.

 

If we are not able to obtain required regulatory approvals, we will not be able to commercialize our product candidates, our ability to generate revenue will be materially impaired and our business will not be successful.*

 

Our product candidates and the activities associated with their development and commercialization are subject to comprehensive regulation by the Food and Drug Administration, or FDA, and other federal and state regulatory agencies in the United States and by comparable authorities in other countries. The inability to obtain FDA approval or approval from comparable authorities in other countries would prevent us and our collaborative partners from commercializing our product candidates in the United States or other countries. Future collaborative agreements will likely cause us to give up control of interactions with the FDA and other regulatory bodies. We or our partners may never receive regulatory approval for the commercial sale of any of our product candidates. We have only limited experience in preparing and filing the applications necessary to gain regulatory approvals and have not received regulatory approval to market any of our product candidates in any jurisdiction. The process of applying for regulatory approval is expensive, often takes many years and can vary substantially based upon the type, complexity and novelty of the product candidates involved.

 

Because our product candidates are modeled after drugs which are known to have safety problems, the FDA and other regulatory agencies may require additional safety testing which may delay our clinical progress, increase our expected costs or make further development unfeasible. For instance, because of known problems with the drug after which it was modeled, we were required to conduct significant monitoring for cardiac toxicity in our clinical studies of ATI-7505.

 

Changes in regulatory approval policies during the development period, changes in, or the enactment of, additional regulations or statutes or changes in the regulatory review team for each submitted product application may cause delays in the approval or rejection of an application. Even if the FDA or a foreign regulatory agency approves a product candidate, the approval may impose significant restrictions on the indicated uses, conditions for use, labeling, advertising, promotion, marketing and/or production of such product and may impose requirements for post-approval studies, including additional research and development and clinical trials. The FDA and other agencies also may impose various civil or criminal

 

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sanctions for failure to comply with regulatory requirements, including substantial monetary penalties and withdrawal of product approval.

 

The FDA has substantial discretion in the approval process and may refuse to accept any application or decide that our data are insufficient for approval and require additional preclinical, clinical or other studies. For example, varying interpretations of the data obtained from preclinical and clinical testing could delay, limit or prevent regulatory approval of a product candidate. Moreover, the FDA may not agree that certain target indications are approvable. For instance, the FDA has never approved a drug for postprandial distress syndrome, or PDS, and we cannot be certain that the FDA will recognize PDS as an indication for which ATI-7505 or other drugs can be approved. As another example, while we believe we have clear direction from the FDA as to the development path for ATI-5923 based on our initial discussions, the FDA may change their judgment on the appropriate development pathway for ATI-5923 at any time.

 

We will need to obtain regulatory approval from authorities in foreign countries to market our product candidates in those countries. We have not yet initiated the regulatory process in any foreign jurisdictions. Approval by one regulatory authority does not ensure approval by regulatory authorities in other jurisdictions. If we fail to obtain approvals from foreign jurisdictions, the geographic market for our product candidates would be limited.

 

Safety issues relating to our product candidates or the original drugs upon which our product candidates have been modeled, or relating to approved products of third parties that are similar to our product candidates, could give rise to delays in the regulatory approval process.*

 

Discovery of previously unknown problems with an approved product may result in restrictions on its permissible uses, including withdrawal of the medicine from the market. Each of the opportunities upon which we have chosen to focus is based upon our belief that our RetroMetabolic Drug Design technology can be used to create a new product based upon an existing product which is efficacious in treating a specific condition, but which has a known safety problem. Each of our four lead product candidates is modeled on drugs which have significant safety problems. ATI-5923 is modeled on warfarin which is known to have safety risks because of its potential for bleeding and for drug-drug interactions with numerous other drugs as listed on the package insert for the product. ATI-2042 is modeled on amiodarone which is used, but not approved, for atrial fibrillation in spite of known safety problems due to its accumulation in the body and interaction with other drugs. Both amiodarone and ATI-2042 contain iodine which can accumulate in the thyroid and must be monitored for safety purposes. . In addition, ATI-2042 is partially metabolized by CYP450 and, at high dose levels has caused drug-drug interactions with warfarin which increased INR and could increase the risk of hemorrhage complications. ATI-9242 is modeled to retain certain of the positive features of the class of atypical antipsychotic drugs while lessening certain of the safety issues that vary but exist within the class. The receptor profile which yields the positive and avoids the negative features of this class of drugs is a matter of great debate. While we have designed ATI-9242 to have an appropriate balance across a very complex set of receptors, we may have targeted an inappropriate profile or the profile attained may result in an unanticipated lack of efficacy or safety problems. ATI-7505 is modeled on cisapride which was withdrawn from the market due to fatal cardiac problems. Although we have designed our drugs to largely address each of the original drugs’ key safety problems, we will need to continue to demonstrate this through continued clinical testing. It is possible that the FDA may impose additional requirements on the development or approval of our products because of its concern about the original drug’s safety problems. These potential additional barriers could delay, increase the cost of, or prevent the commercialization of our product candidates.

 

Our product candidates are engineered to be broken down by the body’s natural metabolic processes in a manner we believe to be safer than that of the original drug. There can be no assurance that the products we develop will actually be metabolized as we expect. While we have designed the breakdown products to be safe, it is possible that there will be unexpected toxicity associated with these breakdown products that could cause our products to be poorly tolerated by, or toxic to, humans. Additionally, while we believe we have addressed the key safety problem of each of the original drugs, it is possible that our change to the chemical structure may result in new unforeseen safety issues. Any unexpected toxicity or suboptimal tolerance of our products would delay or prevent commercialization of these product candidates.

 

Additionally, problems with approved products marketed by third parties that utilize the same therapeutic target as our product candidates could adversely affect the development of our product candidates. For example, the recent product withdrawals of Vioxx by Merck & Co., Inc. and Bextra by Pfizer because of safety issues caused other drugs that have the same therapeutic target, such as Celebrex from Pfizer, to receive additional scrutiny from regulatory authorities. Another prokinetic, tegaserod marketed by Novartis Pharmaceuticals Corporation as Zelnorm, was temporarily withdrawn from the market and then reintroduced in a very limited manner due to certain cardiac effects which we believe were related to its off-target effects. It is possible that we or a future collaboration partner may be required by regulatory agencies to perform tests, in addition to those we have planned, in order to demonstrate that ATI-7505 does not have the safety problems associated

 

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with Zelnorm. Any failure or delay in commencing or completing clinical trials or obtaining regulatory approvals for our product candidates would delay commercialization of our product candidates and severely harm our business and financial condition.

 

We will need substantial additional funding and may be unable to raise capital when needed, which would force us to delay, reduce or eliminate our product development programs or commercialization efforts.*

 

Our operations have consumed substantial amounts of cash since inception. We expect to continue to spend substantial amounts of cash to fund our operations, including research and development expenses and costs associated with the conduct of clinical trials for our product candidates. Net cash used in operating activities was $22.3 million and $13.3 million in the six months ended June 30, 2008 and 2007, respectively. We expect that our net cash used in operations may increase significantly in each of the next several years in order to support our operations and complete the development and commercialization of our product candidates. We will need to raise additional capital to fund our operations and complete the development of our product candidates. It is our intention to enter into collaboration arrangements to commercialize our products. However, within those arrangements, we may retain the commercial right to co-promote our products to selected physicians through a specialty sales force. If any of our product candidates receive regulatory approval for commercial sale, we may need to raise additional capital to fund our portion of the commercialization efforts. Our future funding requirements will depend on many factors, including:

 

                  the scope, rate of progress, results and cost of our preclinical testing, clinical trials and other research and development activities;

 

                  the terms and timing of any collaborative, licensing and other arrangements 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 sales, marketing and distribution capabilities for our specialty sales force;

 

                  the cost of establishing clinical and commercial supplies of our product candidates and any products that we may develop;

 

                  the timing, receipt and amount of sales or royalties, if any, from our potential products;

 

                  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.

 

Until we can generate a sufficient amount of product revenue, if we ever do, we expect to finance future cash needs through public or private equity offerings, debt financings or corporate collaboration and licensing arrangements, as well as through interest income earned on cash balances.

 

If we raise additional funds by issuing equity securities, our stockholders will experience dilution. Any debt financing or additional equity that we raise may contain terms that are not favorable to our stockholders or us. If we raise additional funds through collaboration and licensing arrangements with third parties, we may be required to relinquish some rights to our technologies or our product candidates or grant licenses on terms that are not favorable to us.

 

We do not expect our existing capital resources to be sufficient to enable us to fund the completion of the development of any of our product candidates. We expect that our existing capital resources will enable us to maintain currently planned operations through the second quarter of 2009. However, our operating plan may change, and we may need additional funds sooner than planned to meet operational needs and capital requirements for product development and commercialization.

 

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Additional funds may not be available when we need them on terms that are acceptable to us, or at all. If adequate funds are not available on a timely basis, we may:

 

                  terminate or delay clinical trials for one or more of our product candidates;

 

                  delay our establishment of sales and marketing capabilities or other activities that may be necessary to commercialize our product candidates; or

 

                  curtail significant drug development programs that are designed to identify new product candidates.

 

Global credit and financial market conditions could negatively impact the value of our current portfolio of cash equivalents or short-term investments and our ability to meet our financing objectives.

 

Our cash and cash equivalents are maintained in highly liquid investments with remaining maturities of 90 days or less at the time of purchase. Our investments in marketable securities consist primarily of readily marketable debt securities with remaining maturities of more than 90 days at the time of purchase. While as of the date of this filing, we are not aware of any material losses, or other significant deterioration in the fair value of our cash equivalents or investments in marketable securities since June 30, 2008, no assurance can be given that further deterioration in conditions of the global credit and financial markets would not negatively impact our current portfolio of cash equivalents or investments in marketable securities or our ability to meet our financing objectives and incur required debt to fund our operations.

 

Any failure or delay in commencing or completing clinical trials for our product candidates could severely harm our business.

 

To date, we have not completed the clinical trial program of any product candidate. The commencement and completion of clinical trials for our product candidates may be delayed or terminated as a result of many factors, including:

 

                  our inability or the inability of our collaborators or licensees to manufacture or obtain from third parties materials sufficient for use in preclinical studies and clinical trials;

 

                  delays in patient enrollment, which we have experienced in the past specifically in the enrollment of atrial fibrillation patients with implanted recordable pacemakers as part of our Phase 2 clinical trials for ATI-2042, and variability in the number and types of patients available for clinical trials;

 

                  difficulty in maintaining contact with patients after treatment, resulting in incomplete data;

 

                  poor effectiveness of product candidates during clinical trials;

 

                  unforeseen safety issues or side effects; and

 

                  governmental or regulatory delays and changes in regulatory requirements, policies and guidelines.

 

Any delay in commencing or completing clinical trials for our product candidates would delay commercialization of our product candidates and severely harm our business and financial condition. It is also possible that none of our product candidates will complete clinical trials in any of the markets in which our collaborators or we intend to sell those product candidates. Accordingly, our collaborators or we would not receive the regulatory approvals needed to market our product candidates, which would severely harm our business and financial condition.

 

We rely on third parties to conduct our clinical trials. If these third parties do not perform as contractually required or expected, we may not be able to obtain regulatory approval for or commercialize our product candidates.*

 

We do not have the ability to independently conduct clinical trials for our product candidates, and thus for each of our product candidates we must rely on third parties such as contract research organizations, medical institutions, clinical investigators and contract laboratories, to conduct our clinical trials. We have, in the ordinary course of business, entered into agreements with these third parties. To date, we have utilized numerous vendors to provide clinical trial management, data collection and analysis, laboratory and safety analysis services to us in the conduct of our clinical trials. In addition, to date we have conducted our clinical trials at numerous sites in North America and Europe.  Nonetheless, we are responsible for confirming that each of our clinical trials is conducted in accordance with its general investigational plan and protocol. Moreover, the FDA requires us to comply with regulations and standards, commonly referred to as good clinical practices, for conducting and recording and reporting the results of clinical trials to assure that data and reported results are credible and accurate and that the trial participants are adequately protected. Our reliance on third parties that we do not control does not relieve us of these responsibilities and requirements. If these third parties do not successfully carry out their contractual

 

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duties or regulatory obligations or meet expected deadlines, if the third parties need to be replaced or if the quality or accuracy of the data they obtain is compromised owing to the failure to adhere to our clinical protocols or regulatory requirements or for other reasons, our clinical trials may be extended, delayed, suspended or terminated, and we may not be able to obtain regulatory approval for, or successfully commercialize, our product candidates.

 

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 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 rely on composition of matter patents for the compounds we develop. We cannot guarantee that any patents will issue from any of our pending or future patent applications. Alternatively, 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 future 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;

 

                  any patents issued to us or our collaborators may not provide a basis for commercially viable products or may be challenged by third parties;

 

                  the patents of others may have an adverse effect on our ability to do business; or

 

                  regulators or courts may retroactively diminish the value of our intellectual property.

 

Even if valid and enforceable patents cover our product candidates and technologies, the patents will provide protection only for a limited amount of time. As our patents are based on a parent drug where much research has been conducted, we may encounter many competitive patents from covered analogs of the parent drug. Our know-how and trade secrets may only provide a competitive advantage for a short amount of time.

 

Our ability and our potential collaborators’ ability to obtain patents is highly 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. Recent patent-related decisions in the United States Federal Courts may make protection of patents in our industry even more difficult. Similarly, the U.S. Patent and Trademark Office, or USPTO, recently attempted to promulgate changes to patent rules that could have materially affected the ability of companies in our industry to obtain patents. An April 1, 2008 decision by the U.S. District Court for the Eastern District of Virginia set aside the new rules, but the USPTO has indicated that they intend to appeal the decision. The USPTO has further proposed rule changes that could be enacted at any time. While such rule changes may also be challenged, there is no guarantee of a decision that is favorable to patent holders’ rights.  In addition to the changes originating in the courts and the USPTO, Congress has been debating the enactment of substantial changes to U.S. patent law, which may make obtaining new patents more difficult, diminish the value of our intellectual property or narrow the scope of our patent protection. The patent reform bill has passed in the House (H.R. 1908) but has not yet passed in the Senate (S. 1145). At present, it is uncertain whether S.1145 will be introduced or passed in the current session of Congress.  It is also uncertain whether the bills will be reintroduced in future years if not passed this year. The above-described changes, as well as future changes, to either patent rules, 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. Furthermore, the policies governing biotechnology patents outside the United States are even more uncertain.

 

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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 such patents are invalid and/or unenforceable. 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 FDA regulations and policies provide incentives to manufacturers to challenge patent validity or create modified, noninfringing versions of a drug 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.

 

As of June 30, 2008, we held 43 issued or allowed U.S. patents and had 16 patent applications pending before the U.S. Patent and Trademark Office, or USPTO. For some of our inventions, corresponding foreign patent protection is pending. Of the 43 U.S. patents that we hold, 39 patents are compound- and composition-related, having expiration dates from 2013 to 2025.  The composition of matter patent for ATI-5923, our compound for anticoagulation, issued in August 2007 and has an expiration date in 2025. Our composition of matter patent for ATI-2042, our compound for the treatment of atrial fibrillation, issued in April 2002 and has an expiration date in 2020. The composition of matter patent for ATI-7505 for the treatment of gastrointestinal disorders issued in February 2007 and has an expiration date in 2025. Although third parties may challenge our rights to, or the scope or validity of, our patents, to date we have not received any communications from third parties challenging our patents or patent applications covering our clinical candidates.

 

While ATI-5923, ATI-2042 and ATI-7505 are all covered in the United States by issued composition of matter patents, additional patent applications would be required to extend patent protection beyond 2025, 2020 and 2025, respectively (assuming the validity and enforceability of the current composition of matter patents). We cannot guarantee that any patents will be issued from our pending or future patent applications, and any patents that issue from such pending or future patent applications would be subject to the same risks described herein for currently issued patents.

 

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. In most cases, these individuals or entities are, at the least, precluded from publicly disclosing our confidential information and are only allowed to disclose other data or information generated during the course of the research after we have been afforded an opportunity to consider whether patent and/or other proprietary protection should be sought. 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.

 

Failure to adequately protect our trade secrets and other intellectual property could substantially harm our business and results of operations.

 

We also rely on trade secrets to protect our technology, especially where we do not believe that patent protection is appropriate or obtainable. This is particularly true for our RetroMetabolic Drug Design technology. However, trade secrets are difficult to protect. Our employees, consultants, contractors, outside scientific collaborators and other advisors are required to sign confidential disclosure agreements but they 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 obtain or maintain trade secret protection could adversely affect our competitive business position.

 

Third-party claims of intellectual property infringement would require us to spend significant time and money and could prevent us from developing or commercializing our products.

 

Our commercial success depends in part on not infringing the patents and proprietary rights of other parties and not breaching any licenses that we have entered into with regard to our technologies and products. Because others may have filed, and in the future are likely to file, patent applications covering products or other technologies of interest to us that are similar or identical to ours, patent applications or issued patents of others may have priority over our patent applications or issued patents. There are numerous issued and applied for patents related to the original molecules and analogs of such from which our products are engineered. If the patents are determined to be valid and construed to cover our products, the development and commercialization of any or all could be affected. We do not believe that our activities infringe the patents of others or that the patents of others inhibit our freedom to operate. However, it is possible that others may choose to challenge this position and that a judge or jury will disagree with our conclusions, and we could incur substantial costs in litigation if we are required to defend against patent suits brought by third parties. Similarly, if we initiate suits to defend our

 

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patents, such litigation could be costly and there is no assurance we would be successful in such processes. Any legal action against our collaborators or us claiming damages and seeking to enjoin commercial activities relating to the affected products and processes could, in addition to subjecting us to potential liability for damages, require our collaborators or us to obtain a license to continue to manufacture or market the affected products and processes. Licenses required under any of these patents may not be available on commercially acceptable terms, if at all. Failure to obtain such licenses could materially and adversely affect our ability to develop, commercialize and sell our product candidates. We believe that there may continue to be significant litigation in the biotechnology and pharmaceutical industry regarding patent and other intellectual property rights. If we become involved in litigation, it could consume a substantial portion of our management and financial resources and we may not prevail in any such litigation.

 

Furthermore, our commercial success will depend, in part, on our ability to continue to conduct research to identify additional product candidates in current indications of interest or opportunities in other indications. Some of these activities may involve the use of genes, gene products, screening technologies and other research tools that are covered by third-party patents. Court decisions have indicated that the exemption from patent infringement afforded by Title 35, Section 271(e)(1) of the United States Code does not encompass all research and development activities associated with product development. In some instances, we may be required to obtain licenses to such third-party patents to conduct our research and development activities, including activities that may have already occurred. It is not known whether any license required under any of these patents would be made available on commercially acceptable terms, if at all. Failure to obtain such licenses could materially and adversely affect our ability to maintain a pipeline of potential product candidates and to bring new products to market. If we are required to defend against patent suits brought by third parties relating to third-party patents that may be relevant to our research activities, or if we initiate such suits, we could incur substantial costs in litigation. Moreover, an adverse result from any legal action in which we are involved could subject us to damages and/or prevent us from conducting some of our research and development activities.

 

If third parties do not manufacture our product candidates in sufficient quantities or at an acceptable cost, clinical development and commercialization of our product candidates would be delayed. *

 

We presently do not have sufficient quantities of our product candidates to complete clinical trials of any of our lead product candidates. We do not currently own or operate manufacturing facilities, and we rely and expect to continue to rely on a small number of third-party manufacturers and active pharmaceutical ingredient formulators for the production of clinical and commercial quantities of our product candidates. We do not have long-term agreements with any of these third parties, and our agreements with these parties are generally terminable at will by either party at any time. If for any reason, these third parties are unable or unwilling to perform under our agreements or enter into new agreements, we may not be able to locate alternative manufacturers or formulators or enter into favorable agreements with them. Any inability to acquire sufficient quantities of our product candidates in a timely manner from these third parties could delay clinical trials and prevent us from developing and commercializing our product candidates in a cost-effective manner or on a timely basis.

 

The starting materials for the production of ATI-5923 are provided by Synquest Labs, Inc. and Chem Uetikon, GmbH. To date, the active pharmaceutical ingredient for ATI-5923 has been produced by ChemShop BV of the Netherlands and Corum Inc. of Taiwan on an ongoing purchase order basis. We have also transferred the ATI-5923 manufacturing processes to an additional vendor, Ampac Fine Chemicals, or Ampac, and are currently qualifying this vendor. Should ChemShop BV or Corum Inc. cease to serve as the supplier of ATI-5923 and our current vendor qualification efforts fail, a delay in the development of ATI-5923 could occur, impairing our ability to commercialize ATI-5923 on our existing timeline. ATI-5923’s active pharmaceutical ingredient is processed into 1 milligram, 2 milligram, 5 milligram or 10 milligram tablets by QS Pharma.

 

The starting materials for the production of ATI-2042 are provided by the following vendors: SCI Pharmtech, Inc., Lexen Inc., Panchim, Julich GmbH and Weylchem Inc. To date, Ricerca, Biosciences, LLC, ScinoPharm Ltd. and SCI Pharmtech have produced all of ATI-2042’s active pharmaceutical ingredient. Historically, we have relied on Ricerca and ScinoPharm as single-source suppliers for ATI-2042’s active pharmaceutical ingredients. In the event that Ricerca, Biosciences, LLC, ScinoPharm Ltd. or SCI Pharmtech could not produce ATI-2042, we would not be able to manufacture ATI-2042’s active pharmaceutical ingredient. This could delay the development of, and impair our ability to, commercialize ATI-2042. To produce ATI-2042 drug product, drug substance is processed into 50 milligram or 200 milligram capsule forms by Patheon Inc.

 

The starting materials for the production of ATI-9242 are provided by the following vendors: Corum Inc., Alfa Aesar, Apollo Scientific Ltd., and SKECHEM. To date, the active pharmaceutical ingredient for ATI-9242 has been produced exclusively by Corum Inc. in Taiwan. In the event that Corum Inc. could not produce ATI-9242, we would not be able to manufacture ATI-9242’s active pharmaceutical ingredient. This could delay the development of, and impair our ability to,

 

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commercialize ATI-9242. To produce ATI-9242 drug product, drug substance is processed into 20 milligram capsule form by Xcelience LLC.

 

The starting materials for the production of ATI-7505 are provided by the following vendors: SCI Pharmtech, Inc., Corum, Inc., and Lexen Inc. To produce ATI-7505 drug products, drug substance is processed into 20 milligram or 40 milligram tablet form by Pharmaceutics International, Inc. In the event that any of these vendors are unable or unwilling to produce sufficient quantities of material for the manufacture of ATI-7505, the development and/or commercialization of ATI-7505 could be delayed or impaired.

 

All of our current arrangements with third-party manufacturers and suppliers for the production of our product candidates are on a purchase order basis.  We currently do not have long-term supply contracts with any of the third-party manufacturers and suppliers for our product candidates, and they are not required to supply us with products for any specified periods, in any specified quantities or at any set price, except as may be specified in a particular purchase order. We have no reason to believe that any of the current manufacturers and suppliers for our product candidates is the sole source for the materials they supply us. However, if we were to lose one of these vendors and were unable to obtain an alternative source on a timely basis or on terms acceptable to us, our clinical and production schedules could be delayed. In addition, to the extent that any of these vendors uses technology or manufacturing processes that are proprietary, we may be unable to obtain comparable materials from alternative sources.

 

If we are required to obtain alternate third-party manufacturers, it could delay or prevent the clinical development and commercialization of our product candidates.

 

We may not be able to maintain or renew our existing or any other third-party manufacturing arrangements on acceptable terms, if at all. If we are unable to continue relationships with our current suppliers, or to do so at acceptable costs, or if these suppliers fail to meet our requirements for these product candidates for any reason, we would be required to obtain alternative suppliers. Any inability to obtain qualified alternative suppliers, including an inability to obtain or delay in obtaining approval of an alternative supplier from the FDA, would delay or prevent the clinical development and commercialization of these product candidates.

 

Changes in manufacturing site, process or scale can trigger additional regulatory requirements that could delay our ability to perform certain clinical trials or obtain product approval.

 

The manufacturing and formulation of each of our lead product candidates that have been tested in humans to date has been performed by entities other than those that will likely manufacture the products for future clinical trials or commercial use. There is a possibility that analysis of future clinical trials will show that the results from our earlier clinical trials have not been replicated. The failure to replicate these earlier clinical trials would delay our clinical development timelines. New impurity profiles that occur as a result of changing manufacturers may lead to delays in clinical trial testing and approvals.

 

Use of third-party manufacturers may increase the risk that we will not have adequate supplies of our product candidates.

 

Our current and anticipated future reliance on third-party manufacturers will expose us and our future collaborative partners to risks that could delay or prevent the initiation or completion of our clinical trials, the submission of applications for regulatory approvals, the approval of our product by the FDA or the commercialization of our products may result in higher costs or lost product revenues. In particular, our contract manufacturers could:

 

                  encounter difficulties in achieving volume production, quality control and quality assurance or suffer shortages of qualified personnel, which could result in their inability to manufacture sufficient quantities of drugs to meet our clinical schedules or to commercialize our product candidates;

 

                  terminate or choose not to renew manufacturing agreements, based on their own business priorities, at a time that is costly or inconvenient for us;

 

                  fail to establish and follow FDA-mandated current good manufacturing practices, or cGMPs, which are required for FDA approval of our product candidates, or fail to document their adherence to cGMPs, either of which could lead to significant delays in the availability of material for clinical studies and delay or prevent marketing approval for our product candidates; and

 

                  breach or fail to perform as agreed under manufacturing agreements.

 

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If we are not able to obtain adequate supplies of our product candidates, it will be more difficult for us to develop our product candidates and compete effectively. Our product candidates and any products that we may develop may compete with other product candidates and products for access to manufacturing facilities.

 

In addition, Lexen, SCI Pharmtech, Scinopharm, Corum Inc. and ChemShop BV are located outside of the United States. This may give rise to difficulties in importing our product candidates or their components into the United States as a result of, among other things, FDA import inspections, incomplete or inaccurate import documentation, or defective packaging.

 

If our preclinical studies do not produce successful results or our clinical trials do not demonstrate safety and efficacy in humans, we will not be able to commercialize our product candidates.

 

To obtain the requisite regulatory approvals to market and sell any of our product candidates, we must demonstrate, through extensive preclinical studies and clinical trials, that the product candidate is safe and effective in humans. To date, we have not completed the clinical trials of any product candidate. Preclinical and clinical testing is expensive, can take many years and has an uncertain outcome. A failure of one or more of our clinical trials could occur at any stage of testing. In addition, success in preclinical testing and early clinical trials does not ensure that later clinical trials will be successful, and interim results of a clinical trial do not necessarily predict final results. We may experience numerous unforeseen events during, or as a result of, preclinical testing and the clinical trial process, which could delay or prevent our ability to commercialize our product candidates, including:

 

                  regulators or institutional review boards may not authorize us to commence a clinical trial at a prospective trial site;

 

                  our preclinical studies or clinical trials may produce negative or inconclusive results, which may require us to conduct additional preclinical or clinical testing or to abandon development projects;

 

                  we may suspend or terminate our clinical trials if the participating patients are being exposed to unacceptable health risks;

 

                  regulators or institutional review boards may suspend or terminate clinical research for various reasons, including noncompliance with regulatory requirements;

 

                  the effects of our product candidates may not be the desired effects or may include undesirable side effects; and

 

                  our preclinical studies or clinical trials may show that our product candidates are not superior to the original drugs on which our product candidates are modeled.

 

For instance, our preclinical studies and clinical trials may indicate that our product candidates cause unexpected drug-drug interactions and result in adverse events. As another example, more extensive and robust clinical trials of ATI-5923 will be necessary in order to demonstrate clinical superiority to warfarin. Even if we adequately demonstrate that ATI-5923 is safe and effective and obtain FDA approval, we may not be permitted to market it as superior to warfarin. In addition, ATI-2042’s preclinical studies contain results that are currently being monitored in the clinic. Inhibition of testicular function was observed in one animal species as part of these studies. No such effect has been observed to date in the clinic and monitoring continues. In published studies, a similar effect is thought to be correlated with the accumulation of amiodarone in tissues. A possible renal effect was also observed at high doses in our rat and dog toxicology studies for ATI-2042. While we will continue to monitor patients for these effects, there is no assurance these effects will not occur in patients as part of our ongoing and planned clinical trials for ATI-2042, and have a resulting adverse effect on our ability to obtain requisite regulatory approval to market and sell ATI-2042. In a canine toxicology study of ATI-7505 performed by our former collaboration partner, P&G, six deaths occurred at doses that were 10 and 20 times greater than doses currently being used in clinical trials. Our clinical trials to date have indicated only mild to moderate side effects in humans. However, further observation is warranted.

 

Even when our product candidates do not cause any adverse effects, clinical studies of efficacy may show that our product candidates do not have significant effects on target symptoms or may be inconclusive. For example, ATI-7505 was tested in two Phase 2 clinical trials in which the primary endpoints were not met in comparison to placebo. Although these studies did support ATI-7505’s efficacy against certain symptoms as secondary endpoints, if future studies show that ATI-7505 is not sufficiently efficacious to justify its use as a therapy, our business and prospects may be materially adversely affected.

 

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Unforeseen events could cause us to experience significant delays in, or the termination of, clinical trials. Any such events would increase our costs and could delay or prevent our ability to commercialize our product candidates, which would adversely impact our financial results.

 

We may not be successful in our efforts to identify or discover additional candidates using our RetroMetabolic Drug Design Technology. *

 

An important element of our strategy is to continue to identify existing molecules which have demonstrated efficacy, but have safety problems that are amenable to our RetroMetabolic Drug Design technology. Other than ATI-5923, ATI-2042, ATI-9242 and ATI-7505, all of our programs are in the preclinical or discovery stage. Research programs to identify new product candidates require substantial technical, financial and human resources. These programs may initially show promise in identifying potential product candidates, yet fail to yield product candidates for clinical development for a number of reasons, including:

 

                  the research methodology used may not be successful in identifying potential product candidates; or

 

                  potential product candidates may, on further study, be found not to retain the efficacy profile of the original molecule or be shown to retain harmful side effects or other characteristics suggesting that they are unlikely to be effective products. For instance, at high doses our ATI-2042 product candidate interacts with warfarin and causes prolonged INR which could increase the risk of hemorrhage complications.

 

If we are unable to develop suitable product candidates through internal research programs or otherwise, we may not be able to increase our revenues in future periods, which could result in significant harm to our financial position and adversely impact our stock price.

 

Our product candidates will remain subject to ongoing regulatory review even if they receive marketing approval. If we fail to comply with continuing regulations, we could lose these approvals and the sale of our products could be suspended.

 

Even if we receive regulatory approval to market a particular product candidate, the approval could be conditioned on our conducting additional costly post-approval studies or could limit the indicated uses included in our 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, the manufacturer of the product and its facilities will continue to be subject to FDA review and periodic inspections to ensure adherence to applicable GMPA regulations. After receiving marketing approval, the manufacturing, labeling, packaging, adverse event reporting, storage, advertising, promotion and record keeping related to the product will remain subject to extensive regulatory requirements.

 

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 our products, manufacturers or manufacturing processes are discovered, we could be subject to administrative or judicially imposed sanctions, including:

 

                  restrictions on the products, manufacturers or manufacturing processes;

 

                  warning 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

 

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                  refusal to approve pending applications for marketing approval of new drugs or supplements to approved applications.

 

Because we have a number of product candidates and are considering a variety of target indications, we may expend our limited resources to pursue a particular candidate or indication and fail to capitalize on candidates or indications that may be more profitable or for which there is a greater likelihood of success.

 

Because we have limited financial and managerial resources, we must focus on research programs and product candidates for the specific opportunities that we believe are the most amenable to our RetroMetabolic Drug Design and are the most commercially promising. As a result, we may forego or delay pursuit of opportunities with other product candidates or other indications that later prove to have greater commercial potential. Our resource allocation decisions may cause us to fail to capitalize on viable commercial products or profitable market opportunities. In addition, we may spend valuable time and managerial and financial resources on research programs and product candidates for specific indications that ultimately do not yield any commercially viable products. If we do not accurately evaluate the technical feasibility and the commercial potential or target market for a particular product candidate, we may relinquish valuable rights to that product candidate through collaboration, licensing or other royalty arrangements in situations where it would have been more advantageous for us to retain sole rights to development and commercialization.

 

The commercial success of any products that we may develop will depend upon the degree of market acceptance among physicians, patients, healthcare payors and the medical community.

 

Any products that we may develop may not gain market acceptance among physicians, patients, healthcare payors and the medical community. If these products do not achieve an adequate level of acceptance, we may not generate material product revenues and we may not 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;

 

                  demonstration that we have adequately addressed the specific safety problem of the original molecule;

 

                  the prevalence and severity of any side effects;

 

                  potential or perceived advantages over alternative treatments;

 

                  perceptions about the relationship or similarity between our product candidates and the original drug upon which each RetroMetabolic Drug Design candidate was based;

 

                  advantage over other drugs may not be sufficiently great enough to obtain premium pricing;

 

                  the timing of market entry relative to competitive treatments;

 

                  the ability to offer our product candidates for sale at competitive prices;

 

                  relative convenience and ease of administration;

 

                  the strength of marketing and distribution support;

 

                  sufficient third-party coverage or reimbursement; and

 

                  the product labeling or product insert required by the FDA or regulatory authorities in other countries.

 

If we are unable to establish sales and marketing capabilities or enter into agreements with third parties to market and sell our product candidates, we may be unable to generate product revenue.*

 

We do not have a sales and marketing organization and have no experience in the sales, marketing and distribution of pharmaceutical products. It is our intention to use collaborative arrangements to gain access to large sales and marketing organizations in order to commercialize our product candidates. Additionally, in the event we enter into any collaboration arrangements for any of our product candidates, we may retain the right to co-promote the sales of any ultimate product(s) by

 

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establishing a small specialty sales force to market such product(s) to specific physician groups. There are risks involved with establishing our own sales and marketing capabilities and 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 are likely to be lower than if we market and sell any products that we develop ourselves.

 

We may decide to establish our own specialty sales force and engage pharmaceutical or other healthcare companies with an existing sales and marketing organization and distribution system to sell, market and distribute our products. We may not be able to establish these sales and distribution relationships on acceptable terms, or at all. Factors that may inhibit our efforts to commercialize our products without collaborators or licensees include:

 

                  our inability to convince future corporate partners to allow us to retain commercialization rights for specific physician groups;

 

                  our inability to obtain financing to establish the specialty sales force;

 

                  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 our 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 toward 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 we will establish our own sales and marketing capabilities. If we are not able to partner with a third party and are not successful 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.

 

Our ability to generate revenue from any products that we may develop will depend on reimbursement and drug pricing policies and regulations. *

 

Many patients may be unable to pay for any products that we may develop. In the United States, many patients will rely on Medicare, Medicaid, private health insurers and other third-party payors to pay for their medical needs. Our ability to achieve acceptable levels of reimbursement for drug treatments by governmental authorities, private health insurers and other organizations will have an effect on our ability to successfully commercialize, and attract collaborative partners to invest in the development of, our product candidates. We cannot be sure that reimbursement in the United States, Europe or elsewhere will be available for any products that we may develop, and any reimbursement that may become available may be decreased or eliminated in the future. Third-party payors increasingly are challenging prices charged for medical products and services, and many third-party payors may refuse to provide reimbursement for particular drugs when an equivalent generic drug is available. Although we believe that the safety profile of any products that we may develop will be sufficiently different from the original drugs from which they are modeled to be considered unique and not subject to substitution by a generic of the original drug in the case of ATI-2042 and ATI-5923, it is possible that a third-party payor may consider our product candidate and the generic original drug as equivalents and only offer to reimburse patients for the generic drug. There are five atypical antipsychotics which currently dominate an estimated $16 billion market for such drugs. Most will be generic competitors against ATI-9242 if it ever reaches the marketplace. While we have designed ATI-9242 to have the improved efficacy and safety features over the existing atypical antipsychotics, these desired features may not be proven in clinical testing or payors may be unwilling to pay a higher price for improved features when generic alternatives are available. Even if we show improved safety with our product candidates, pricing of the existing original drug may limit the amount we will be able to charge for each of our product candidates. In the case of ATI-7505, the original molecule, cisapride, was withdrawn from the market and no generic version exists, but there are many competitive products which may limit the amount we can charge for this product candidate. If reimbursement is not available or is available only at limited levels, we may not be able to successfully commercialize our product candidates, and may not be able to obtain a satisfactory financial return on products that we may develop.

 

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The trend toward managed healthcare in the United States and the changes in health insurance programs, as well as legislative proposals to reform healthcare or reduce government insurance programs, may result in lower prices for pharmaceutical products, including any products that may be offered by us. In addition, any future regulatory changes regarding the healthcare industry or third-party coverage and reimbursement may affect demand for any products that we may develop and could harm our sales and profitability.

 

If our competitors are able to develop and market products that are more effective, safer or less costly than any products that we may develop, our commercial opportunity will be reduced or eliminated. *

 

We face competition from established 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 products that we may develop. 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.

 

Competition for ATI-5923 for use as an oral anticoagulant will continue to come from generic coumadin owing to its pricing and the years of experience physicians and patients have with the drug. Other oral anticoagulants are in development throughout the pharmaceutical and biotechnology industry. Most of these development programs fall into either the factor Xa or direct thrombin inhibitor categories. We are aware that Johnson & Johnson in collaboration with Bayer AG, Bristol-Myers Squibb Company in collaboration with Pfizer, Inc., Eli Lilly and Company and Portola Pharmaceuticals, Inc. each have factor Xa programs in Phase 2 or Phase 3 testing. We are aware of a direct thrombin inhibitor program at Boehringer-Ingelheim GmbH. The first direct thrombin inhibitor presented to the FDA for approval, ximelagatran, previously marketed as Exanta by AstraZeneca plc, has not been recommended for approval due to idiosyncratic liver toxicity problems. Although we believe ATI-5923’s mechanism of action (VKOR inhibition as with warfarin) and broadly available inexpensive monitoring methodology (INR) provide an advantage, these factor Xa and direct thrombin inhibitor programs will likely provide major competition in this market. In addition, there may be other compounds of which we are not aware that are at an earlier stage of development and may compete with our product candidates. If any of those compounds are successfully developed and approved, they could compete directly with our product candidates.

 

We believe generic amiodarone will continue to provide competition to ATI-2042 for the treatment of atrial fibrillation, even though it is not labeled for use in atrial fibrillation. Amiodarone will continue to be used off-label in spite of its safety problems because of its generic pricing. Other treatments for atrial fibrillation, such as sotalol, marketed by Bayer HealthCare Pharmaceuticals, Inc., flecainide marketed by 3M Company and propafenone, marketed by Reliant Pharmaceuticals, Inc., do not have equivalent efficacy to amiodarone, but will continue to compete in the atrial fibrillation marketplace. Cardiome Pharma Corp. is in Phase 2 testing with an oral product, vernakalant, for the treatment of atrial fibrillation which they hope will have efficacy equal to or better than flecainide or sotalol, but with reduced pro-arrhythmic effects. There are other companies developing devices or procedures to treat atrial fibrillation through ablation, including CryoCor, Inc. and CryoCath Technologies, Inc.

 

Competition for ATI-9242 will likely come from the five largest selling atypical antipsychotics: Risperdal by Janssen Pharmaceutica, Seroquel by AstraZeneca Pharmaceuticals LP, Zyprexa by Eli Lilly and Company, Abilify by Bristol-Myers Squibb/Otsuka America Pharmaceutical, Inc., and Geodon by Pfizer Inc., which sold a collective $15.7 billion in 2007. It is likely that virtually all of these would be sold as generic versions by the time ATI-9242 could come to market. Other antipsychotics are in development which may also be competitive to ATI-9242.

 

ATI-7505 has potential use in five indications: chronic constipation, functional dyspepsia, GERD, gastroparesis and IBS with constipation. Some of these indications may not be recognized by the FDA as sufficiently defined to enable regulatory approval of a drug for treatment. ATI-7505 is a prokinetic which has been shown to increase motility in the upper and lower gastrointestinal tract, including the ability to improve gastric emptying and colonic motility. Products which affect the gastrointestinal system’s motility could be useful in the treatment of each of these disorders. Other prokinetics are on the market or in development which will also be competitive to ATI-7505, including tegaserod, marketed by Novartis Pharmaceuticals Corporation as Zelnorm, which was temporarily withdrawn from the market and recently re-introduced with restrictive use labeling, TD-5108 being developed by Theravance, and erythromycin. Many additional prokinetics are in development targeting these indications. We believe the most significant competition to ATI-7505 for the treatment of GERD is proton pump inhibitors and H2 blockers, which are currently on the market in both prescription formulations and strengths as well as in over-the-counter forms. Many major pharmaceutical companies currently market proton pump inhibitors and H2 blockers generating worldwide sales of over $17.0 billion in 2006. ATI-7505 is targeted at the approximately 20-25% of GERD patients who do not receive adequate relief from proton pump inhibitors, which reduce the creation of acid in the

 

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stomach. ATI-7505 will face competition from the prokinetics as well as many inexpensive over-the-counter indications for the treatment of these gastrointestinal disorders.

 

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 quickly discover and develop novel compounds that could make our product candidates obsolete. Smaller or early-stage companies may also prove to be significant competitors, particularly through collaborative arrangements 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 medicines before we do. We are also aware of other companies that may currently be engaged in the discovery of medicines that will compete with the product candidates that we are developing. In addition, in the markets that we are targeting, we expect to compete against current market-leading medicines. 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.

 

If we fail to attract and keep senior management and key scientific personnel, we may be unable to successfully develop or commercialize our product candidates.

 

Our success depends on our continued ability to attract, retain and motivate highly qualified management, clinical and scientific personnel and on our ability to develop and maintain important relationships with leading clinicians. If we are not able to retain Dr. Goddard, our Chairman and Chief Executive Officer, Dr. Milner, our President, Research and Development, Dr. Canafax, our Vice President and Chief Development Officer, and Dr. Druzgala, our Senior Vice President and Chief Scientific Officer, we may not be able to successfully develop or commercialize our product candidates. Competition for experienced scientists may limit our ability to hire and retain highly qualified personnel on acceptable terms. In addition, none of our employees have employment commitments for any fixed period of time and could leave our employment at will. We carry “key person” insurance in the amount of $1 million for each of Drs. Milner and Druzgala, but do not carry “key person” insurance covering any other members of senior management or key scientific personnel. If we fail to identify, attract and retain qualified personnel, we may be unable to continue our development and commercialization activities.

 

We will need to hire additional employees in order to commercialize our product candidates. Any inability to manage future growth could harm our ability to commercialize our product candidates, increase our costs and adversely impact our ability to compete effectively.*

 

In order to commercialize our product candidates, we will need to expand the number of our managerial, operational, financial and other employees.  Because the projected time frame for hiring these additional employees depends on the development status of our product candidates and because of the numerous risks and uncertainties associated with drug development, we are unable to project when we will hire these additional employees. While to date we have not experienced difficulties in recruiting, hiring and retaining qualified individuals, the competition for qualified personnel in the pharmaceutical and biotechnology field is intense.

 

Future growth will impose significant added responsibilities on members of management, including the need to identify, recruit, maintain and integrate additional employees. Our future financial performance and our ability to commercialize our product candidates and compete effectively will depend, in part, on our ability to manage any future growth effectively.

 

If product liability lawsuits are brought against us, we will incur substantial liabilities and may be required to limit commercialization of any products that we may develop. *

 

We face an inherent risk of product liability exposure related to the testing of our product candidates in human clinical trials and will face an even greater risk if we commercially sell any products that we may develop. If we cannot successfully defend ourselves against claims that our product candidates or products that we may develop caused injuries, we will incur substantial liabilities. 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;

 

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                  withdrawal of clinical trial participants;

 

                  costs to defend the related litigation;

 

                  substantial monetary awards to clinical trial participants or patients;

 

                  loss of revenue; and

 

                  the inability to commercialize any products that we may develop.

 

We have product liability insurance that covers our clinical trials up to an aggregate $10.0 million annual limit. We intend to expand our insurance coverage to include the sale of commercial products if marketing approval is obtained for any products that we may develop. Insurance coverage is increasingly expensive, and we may not be able to maintain insurance coverage at a reasonable cost and we may not be able to obtain insurance coverage that will be adequate to satisfy any liability that may arise.

 

If we use biological and hazardous materials in a manner that causes contamination, injury or violates laws, we may be liable for damages.

 

Our research and development activities involve the use of potentially harmful biological materials as well as hazardous materials, chemicals and various radioactive compounds. We cannot completely eliminate the risk of accidental contamination or injury from the use, storage, handling or disposal of these materials. In the event of contamination or injury, we could be held liable for damages that result, and any liability could exceed our resources. We, the third parties that conduct clinical trials on our behalf and the third parties that manufacture our product candidates are subject to federal, state and local laws and regulations governing the use, storage, handling and disposal of these materials and waste products. The cost of compliance with these laws and regulations could be significant. The failure to comply with these laws and regulations could result in significant fines and work stoppages and may harm our business.

 

Our principal facility is located in California’s Silicon Valley, in an area with a long history of industrial activity and use of hazardous substances, including chlorinated solvents. Certain environmental laws, including the U.S. Comprehensive, Environmental Response, Compensation and Liability Act of 1980, impose strict, joint and several liabilities on current operators of real property for the cost of removal or remediation of hazardous substances. These laws often impose liability even if the owner or operator did not know of, or was not responsible for, the release of such hazardous substances. As a result, while we have not been notified of any claim against us, we are not aware of any such release, nor have we been held liable for costs to address contamination at the property beneath our facility in the past, we cannot rule out the possibility that this may occur in the future. We do not carry specific insurance against such a claim.

 

We will need to implement additional finance and accounting systems, procedures and controls in the future as we grow our business and organization and to satisfy new reporting requirements.*

 

As a public reporting company, we need to comply with the Sarbanes-Oxley Act of 2002 and the related rules and regulations of the Securities and Exchange Commission, including expanded disclosures and accelerated reporting requirements and more complex accounting rules. Compliance with Section 404 of the Sarbanes-Oxley Act of 2002 and other requirements will increase our costs and require additional management resources. We are continuing to upgrade our finance and accounting systems, procedures and controls and may need to continue to implement additional finance and accounting systems, procedures and controls as we grow our business and organization and to satisfy new reporting requirements. Compliance with Section 404 will first apply to our annual report on Form 10-K for our year ending December 31, 2008. If we are unable to complete the required assessment as to the adequacy of our internal control over financial reporting as of December 31, 2008, or if our independent registered public accounting firm is unable to provide us with an unqualified report as to the effectiveness of our internal controls over financial reporting as of December 31, 2009, investors could lose confidence in the reliability of our internal controls over financial reporting, which could adversely affect our stock price and our ability to raise capital.

 

Our principal facility is located near known earthquake fault zones, and the occurrence of an earthquake, extremist attack or other catastrophic disaster could cause damage to our facilities and equipment, which could require us to cease or curtail operations.

 

Our principal facility is located in California’s Silicon Valley near known earthquake fault zones and, therefore, is vulnerable to damage from earthquakes. In October 1989, a major earthquake struck this area and caused significant property

 

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damage and a number of fatalities. We are also vulnerable to damage from other types of disasters, including power loss, attacks from extremist organizations, fire, floods and similar events. If any disaster were to occur, our ability to operate our business could be seriously impaired. In addition, the unique nature of our research activities and of much of our equipment could make it difficult for us to recover from this type of disaster. We currently may not have adequate insurance to cover our losses resulting from disasters or other similar significant business interruptions, and we do not currently plan to purchase additional insurance to cover such losses because of the cost of obtaining such coverage. Any significant losses that are not recoverable under our insurance policies could seriously impair our business and financial condition. Our current insurance does not specifically cover property loss or business interruption due to earthquake damage.

 

Risks Relating to Ownership of Our Common Stock

 

Our stock price may be extremely volatile, and your investment in our common stock could suffer a decline in value.*

 

You should consider an investment in our common stock risky and invest only if you can withstand a significant loss and wide fluctuations in the market value of your investment. Investors who purchase our common stock may not be able to sell their shares at or above the purchase price. Security market prices for securities of biopharmaceutical companies have been highly volatile. In addition, the volatility of biopharmaceutical company stocks often does not correlate to the operating performance of the companies represented by such stocks. Some of the factors that may cause the market price of our common stock to fluctuate include:

 

                  adverse results or delays in our clinical trials;

 

                  the timing of achievement of our clinical, regulatory, partnering and other milestones, such as the commencement of clinical development, the completion of a clinical trial, the receipt of regulatory approval or the establishment of a commercial partnership for one or more of our product candidates;

 

                  announcement of FDA approval or nonapproval of our product candidates or delays in the FDA review process;

 

                  actions taken by regulatory agencies with respect to our product candidates, our clinical trials or our sales and marketing activities;

 

                  the commercial success of any product approved by the FDA or its foreign counterparts;

 

                  regulatory developments in the United States and foreign countries;

 

                  changes in the structure of healthcare payment systems;

 

                  any intellectual property infringement lawsuit involving us;

 

                  announcements of technological innovations or new products by us or our competitors;

 

                  market conditions for the biotechnology or pharmaceutical industries in general;

 

                  changes in financial estimates or recommendations by securities analysts;

 

                  sales of large blocks of our common stock;

 

                  sales of our common stock by our executive officers, directors and significant stockholders;

 

                  restatements of our financial results and/or material weaknesses in our internal controls; and

 

                  the loss of any of our key scientific or management personnel.

 

The stock markets in general, and the markets for biotechnology stocks in particular, have experienced extreme volatility and price and volume fluctuations that have often been unrelated or disproportionate to the operating performance of particular companies. These broad market and industry factors may seriously harm the market price of our common stock, regardless of our operating performance. In the past, class action litigation has often been instituted against companies whose securities have experienced periods of volatility in market price. Any such litigation brought against us could result in substantial costs, which would hurt our financial condition and results of operations, divert management’s attention and resources, and possibly delay our clinical trials or commercialization efforts.

 

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Fluctuations in our operating results could cause our stock price to decline.

 

The following factors are likely to result in fluctuations of our operating results from quarter to quarter and year to year:

 

                  adverse results or delays in our clinical trials;

 

                  the timing and achievement of our clinical, regulatory, partnering and other milestones, such as the commencement of clinical development, the completion of a clinical trial, the receipt of regulatory approval or the establishment of a commercial partnership for one or more of our product candidates;

 

                  announcement of FDA approval or nonapproval of our product candidates or delays in the FDA review process;

 

                  actions taken by regulatory agencies with respect to our product candidates, our clinical trials or our sales and marketing activities;

 

                  the commercial success of any product approved by the FDA or its foreign counterparts;

 

                  regulatory developments in the United States and foreign countries;

 

                  changes in the structure of healthcare payment systems;

 

                  any intellectual property infringement lawsuit involving us; and

 

                  announcements of technological innovations or new products by us or our competitors.

 

Because of these potential fluctuations in our operating results, a period-to-period comparison of our results of operations may not be a good indication of our future performance. In any particular financial period the actual or anticipated fluctuations could be below the expectations of securities analysts or investors and our stock price could decline.

 

Because a small number of existing stockholders own a large percentage of our voting stock, they may be able to control our management and operations, acting in their best interests and not necessarily those of other stockholders. *

 

Based on our outstanding shares as of February 29, 2008, our executive officers, directors and holders of 5.0% or more of our outstanding common stock beneficially own approximately 55.0% of our common stock. As a result, these stockholders, acting together, will be able to control all matters requiring approval by our stockholders, including the election of directors and the approval of mergers or other business combination transactions. The interests of this group of stockholders may not always coincide with our interests or the interests of other stockholders.

 

Anti-takeover provisions in our charter documents and under Delaware law could make an acquisition of us, which may be beneficial to our stockholders, more difficult and may prevent attempts by our stockholders to replace or remove our current management.

 

Provisions in our certificate of incorporation and our bylaws may delay or prevent an acquisition of us, a change in our management or other changes that stockholders may consider favorable. These provisions include:

 

                  a classified board of directors;

 

                  a prohibition on actions by our stockholders by written consent;

 

                  the ability of our board of directors to issue preferred stock without stockholder approval, which could be used to adopt a stockholders’ rights plan that would make it difficult for a third party to acquire us;

 

                  notice requirements for nominations for election to the board of directors; and

 

                  limitations on the removal of directors.

 

Moreover, we are governed by the provisions of Section 203 of the Delaware General Corporation Law, which prohibits a person who owns in excess of 15% of our outstanding voting stock from merging or combining with us for a period of three years after the date of the transaction in which the person acquired in excess of 15% of our outstanding voting stock, unless the merger or combination is approved in a prescribed manner.

 

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Future sales of our common stock in the public market could cause our stock price to drop substantially.*

 

Sales of a substantial number of shares of our common stock in the public market, or the perception that these sales might occur, could depress the market price of our common stock and could impair our ability to raise capital through the sale of additional equity securities.

 

As of June 30, 2008, we had 17,680,991 shares of common stock outstanding. The five million shares of common stock sold in our initial public offering are freely tradable without restriction in the public market unless held by an affiliate of ours. The remaining 12,680,991 shares of common stock outstanding as of June 30, 2008 are now eligible for sale in the public market, subject in some cases to the volume limitations and manner of sale requirements under Rule 144. Any common stock that is either subject to outstanding options or warrants or reserved for future issuance under our 2001 Equity Incentive Plan, 2007 Equity Incentive Plan, 2007 Non-Employee Directors’ Stock Option Plan and 2007 Employee Stock Purchase Plan could also become eligible for sale in the public market to the extent permitted by the provisions of various vesting agreements, and Rules 144 and 701 under the Securities Act. If these additional shares are sold, or if it is perceived that they will be sold, in the public market, the trading price of our common stock could decline.

 

As of June 30, 2008, the holders of approximately 11,415,130 shares of common stock based on shares outstanding, including 189,647 shares underlying outstanding warrants, will be entitled to rights with respect to registration of such shares under the Securities Act of 1933, as amended. If such holders, by exercising their registration rights, cause a large number of securities to be registered and sold in the public market, these sales could have an adverse effect on the market price for our common stock. If we were to initiate a registration and include shares held by these holders pursuant to the exercise of their registration rights, these sales may impair our ability to raise capital. In addition, we filed a registration statement on Form S-8 under the Securities Act of 1933, as amended, to register up to 2,638,845 shares of our common stock for issuance under our stock option and employee stock purchase plans, and intend to file additional registration statements on Form S-8 to register the shares automatically added each year to the share reserves under these plans.

 

ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

 

None.

 

ITEM 3. DEFAULTS UPON SENIOR SECURITIES

 

None.

 

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

 

On May 28, 2008, our Annual Meeting of Stockholders was held at our corporate offices in Fremont, California. Of the 17,665,133 shares of our common stock entitled to vote at the meeting, 14,200,611 shares were represented at the meeting in person or by proxy, constituting a quorum. At this meeting, our stockholders voted on the following two proposals:

 

(i)         Proposal to elect three directors to hold office until the 2011 Annual Meeting of Stockholders:

 

Name

 

Shares Voted For

 

Votes Withheld

 

Robert Adelman, M.D.

 

14,182,349

 

18,262

 

Peter G. Milner, M.D.

 

14,170,403

 

30,208

 

Nicholas Simon

 

14,177,847

 

22,764

 

 

Our Class II directors, Lars Ekman, M.D., Ph.D., Keith R. Leonard and Paul Sekhri, will each continue to serve on our Board of Directors until our 2009 Annual Meeting of Stockholders and until their respective successor is elected and qualified or such director’s earlier death, resignation or removal.  Our Class III directors, Paul Goddard, Ph.D. and Herm Rosenman, will each continue to serve on our Board of Directors until our 2010 Annual Meeting of Stockholders and until their respective successor is elected and qualified or such director’s earlier death, resignation or removal.

 

(ii)  Proposal to ratify the selection by the Audit Committee of our Board of Directors of Ernst & Young LLP as our independent registered public accounting firm for the year ending December 31, 2008:

 

For

 

Votes Against

 

Abstain

 

14,193,973

 

2,046

 

4,592

 

 

ITEM 5. OTHER INFORMATION

 

Not applicable.

 

40



Table of Contents

 

ITEM 6. EXHIBITS

 

Exhibit
Number

 

Description of Document

 

 

 

3.2(1)

 

 

Amended and Restated Certificate of Incorporation.

 

 

 

 

3.3(2)

 

 

Bylaws.

 

 

 

 

4.2(2)

 

 

Specimen Common Stock Certificate.

 

 

 

 

4.3(2)

 

 

Form of Warrant to purchase shares of Series C preferred stock, issued September 3, 2003.

 

 

 

 

4.4(2)

 

 

Form of Warrant to purchase shares of Series C preferred stock, issued December 23, 2002.

 

 

 

 

4.5(2)

 

 

Form of Warrant to purchase shares of Series D preferred stock, issued March 28, 2005.

 

 

 

 

4.6(2)

 

 

Amended and Restated Investor Rights Agreement by and between Registrant and certain of its security holders.

 

 

 

 

4.7(2)

 

 

Form of Warrant to purchase shares of Series E preferred stock, issued October 19, 2007.

 

 

 

 

31.1

 

 

Certification of the Chief Executive Officer pursuant to Rule 13a-14(a) and Rule 15d-14(a) of the Securities Exchange Act, as amended.

 

 

 

 

31.2

 

 

Certification of the Chief Financial Officer pursuant to Rule 13a-14(a) and Rule 15d-14(a) of the Securities Exchange Act, as amended.

 

 

 

 

32.1

 

 

Certification of the Chief Executive Officer and Chief Financial Officer pursuant to 18U.S.C. 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

 


(1)             Previously filed as the like numbered exhibit to ARYx Therapeutics, Inc.’s Current Report on Form 8-K (No. 001-33782), as filed with the Securities and Exchange Commission on November 13, 2007 and incorporated by reference herein.

 

(2)             Previously filed as the like numbered exhibit to ARYx Therapeutics, Inc.’s Registration Statement on Form S-1 (File No. 333-145813), initially filed with the Securities and Exchange Commission on August 30, 2007, as amended, and incorporated by reference herein.

 

41



Table of Contents

 

SIGNATURE

 

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

 

Dated: August 13, 2008

 

 

ARYx Therapeutics, Inc.

 

 

 

 

 

By:

/s/ Paul Goddard

 

 

Paul Goddard, Ph.D.

 

 

Chairman of the Board and Chief Executive Officer

 

42



Table of Contents

 

EXHIBIT INDEX

 

Exhibit
Number

 

Description of Document

 

 

 

 

3.2(1)

 

 

Amended and Restated Certificate of Incorporation.

 

 

 

 

3.3(2)

 

 

Bylaws.

 

 

 

 

4.2(2)

 

 

Specimen Common Stock Certificate.

 

 

 

 

4.3(2)

 

 

Form of Warrant to purchase shares of Series C preferred stock, issued September 3, 2003.

 

 

 

 

4.4(2)

 

 

Form of Warrant to purchase shares of Series C preferred stock, issued December 23, 2002.

 

 

 

 

4.5(2)

 

 

Form of Warrant to purchase shares of Series D preferred stock, issued March 28, 2005.

 

 

 

 

4.6(2)

 

 

Amended and Restated Investor Rights Agreement by and between Registrant and certain of its security holders.

 

 

 

 

4.7(2)

 

 

Form of Warrant to purchase shares of Series E preferred stock, issued October 19, 2007.

 

 

 

 

31.1

 

 

Certification of the Chief Executive Officer pursuant to Rule 13a-14(a) and Rule 15d-14(a) of the Securities Exchange Act, as amended.

 

 

 

 

31.2

 

 

Certification of the Chief Financial Officer pursuant to Rule 13a-14(a) and Rule 15d-14(a) of the Securities Exchange Act, as amended.

 

 

 

 

32.1

 

 

Certification of the Chief Executive Officer and Chief Financial Officer pursuant to 18U.S.C. 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

 


(1)          Previously filed as the like numbered exhibit to ARYx Therapeutics, Inc.’s Current Report on Form 8-K (No. 001-33782), as filed with the Securities and Exchange Commission on November 13, 2007 and incorporated by reference herein.

 

(2)          Previously filed as the like numbered exhibit to ARYx Therapeutics, Inc.’s Registration Statement on Form S-1 (File No. 333-145813), initially filed with the Securities and Exchange Commission on August 30, 2007, as amended, and incorporated by reference herein.

 

43


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