20-F 1 v059556_20f.htm
UNITED STATES SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
 

 
FORM 20-F
 
o
REGISTRATION STATEMENT PURSUANT TO SECTION 12(b) OR (g) OF THE SECURITIES EXCHANGE ACT OF 1934
OR
 
x
REPORT PURSUANT TO SECTION 13 or 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 for the fiscal year ended June 30, 2006
OR
 
o
TRANSITION REPORT PURSUANT TO SECTION 13 or 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 for the transition period from to
OR
 
o
SHELL COMPANY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
COMMISSION FILE NUMBER 000-51122
 

 
pSivida Limited
(Exact name of Registrant as specified in its charter)
 
N/A
(Translation of Registrant’s name into English)
 
Western Australia, Commonwealth of Australia
(Jurisdiction of incorporation or organization)
 
Level 12 BGC Centre
28 The Esplanade
Perth WA 6000
Australia
(Address of principal executive offices)
 

 
Securities registered or to be registered pursuant to Section 12(b) of the Act:
 
None
 
Securities registered or to be registered pursuant to Section 12(g) of the Act:
 
None
 
Securities for which there is a reporting obligation pursuant to Section 15(d) of the Act:
 
Ordinary Shares
American Depositary Shares each representing
10 Ordinary Shares and evidenced by American Depositary Receipts
 
The number of outstanding shares of each of the issuers’ classes of capital or common stock as of December 7, 2006 was: 399,711,107 ordinary shares
 

 
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.
Yes o No x
 
If this report is an annual or transition report, indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934. Yes x No o
 
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No o
 
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer.
 
Large accelerated filer o  Accelerated filer x  Non-accelerated filer o
 
Indicate by check mark which financial statement item the registrant has elected to follow.
 
Item 17 o Item 18 x
 
If this is an annual report, 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
 
Please send copies of notices and communications from the
Securities and Exchange Commission to:
 
Lawrence Goodman, Esq.
Curtis, Mallet-Prevost, Colt & Mosle LLP
101 Park Avenue
New York, NY 10178
 

 
TABLE OF CONTENTS
 

 
Page #
2
2
2
2
20
39
39
56
73
75
78
80
91
92
   
93
93
93
93
94
94
94
95
95
   
96
96
96
96
 
-i-

 
INTRODUCTION 
 
References in this annual report to “pSivida”, “the company”, “we”, “us”, “our”, or similar terms refer to pSivida Limited and its consolidated subsidiaries, except as otherwise indicated. On December 30, 2005, we completed the acquisition of Control Delivery Systems, Inc., which was renamed pSivida Inc. We make reference to Control Delivery Systems as “CDS” or as “pSivida Inc.” depending on whether such reference relates to that company before or after the acquisition. As of July 1, 2006, the NASDAQ National Market changed its name to the NASDAQ Global Market. References to the NASDAQ Global Market relating to periods before such date refer to the NASDAQ National Market.
 
We prepare consolidated financial statements in Australian dollars in accordance with Australian equivalents to International Financial Reporting Standards, or A-IFRS. Our financial statements are sometimes referred to herein as the “financial statements”. Throughout this annual report, references to “A$” are to Australian dollars and references to “US$” and “U.S. dollars” are to United States dollars, except for in the financial statements, where references to “$” are to Australian dollars and references to “US$” are to United States dollars. On June 30, 2005, the Federal Reserve Bank of New York Noon Buying Rate was US$0.7618 = A$1.00, and on June 30, 2006, that exchange rate was US$0.7423 = A$1.00.
 
Our fiscal year ends on June 30, and references in this annual report to any specific fiscal year are to the twelve month period ended June 30 of that year.
 
BioSiliconTM, BrachySilTM, SIMPLTM, DurasertTM (formerly known as AEON), CODRUGTM and MedidurTM are our trademarks. Vitrasert® and RetisertTM are Bausch & Lomb Incorporated’s trademarks. This annual report also contains trademarks, trade names and service marks of other companies, which are the property of their respective owners.
 
FORWARD-LOOKING STATEMENTS
 
This annual report and the documents that we incorporate by reference include forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended. Forward-looking statements that express our beliefs, plans, objectives or assumptions, or refer to future events or performance may involve estimates, assumptions, risks and uncertainties. Therefore, our actual results and performance may differ materially from those expressed in the forward-looking statements. Forward-looking statements often, although not always, include words or phrases such as the following: “will likely result”, “are expected to”, “will continue”, “is anticipated”, “estimate”, “intends”, “plans”, “projection” and “outlook.”
 
You should not unduly rely on forward-looking statements contained or incorporated by reference in this annual report. Various factors discussed in this annual report, including, but not limited to, the risks described in “Risk Factors” may cause actual results or outcomes to differ materially from those expressed in forward-looking statements. You should read and interpret any forward-looking statements together with these risks.
 
Any forward-looking statement applies only as of the date on which that statement is made. We will not update any forward-looking statement to reflect events or circumstances that occur after the date on which such statement is made.
 

 
 
 
Not applicable.
 
 
Not applicable.
 
 
A.
SELECTED CONSOLIDATED FINANCIAL DATA
 
The following table presents our selected historical consolidated financial data as of the dates and for each of the periods indicated. The information set forth below is not necessarily indicative of future results and should be read in conjunction with Item 5, “Operating and Financial Review and Prospects”, and our audited consolidated financial statements and the notes thereto appearing elsewhere in this annual report.
 
We adopted A-IFRS for the first time in our financial statements for the year ended June 30, 2006, which include comparative financial statements for the year ended June 30, 2005. The Australian Accounting Standards Board’s “First-time Adoption of Australian Equivalents to International Financial Reporting Standards”, or AASB 1, requires that an entity develop accounting policies based on the standards and related interpretations effective at the reporting date of its first annual A-IFRS financial statements (June 30, 2006). AASB 1 also requires that those policies be applied as of the date of transition to A-IFRS (July 1, 2004) and throughout all periods presented in the first A-IFRS financial statements. An explanation of how the transition from superseded policies to A-IFRS has affected our financial position, financial performance and cash flows is discussed in Note 28 to the audited consolidated financial statements.
 
The Securities and Exchange Commission, or SEC, has adopted a one-time accommodation that permits eligible foreign private issuers, such as our company, to present two years rather than three years of statements of operations, changes in equity and cash flow statements prepared in accordance with International Financial Reporting Standards, or IFRS, for their first year of reporting under IFRS. Our first annual consolidated financial statements prepared under A-IFRS (which is compliant with IFRS) are for the fiscal year ended June 30, 2006, and this report has been prepared in reliance on such SEC accommodation.
 
A-IFRS differ in certain significant respects from accounting principles generally accepted in the United States of America, or U.S. GAAP. Please refer to Note 29 to the audited consolidated financial statements contained in Item 18 of this report for a description of the differences between A-IFRS and U.S. GAAP as they relate to us, and a reconciliation of net loss and total equity to U.S. GAAP for the periods and as of the dates indicated.
 
The selected consolidated financial data as of and for the years ended June 30, 2006 and 2005 has been derived from our audited consolidated financial statements and the notes thereto appearing elsewhere in this annual report. The U.S. GAAP selected consolidated financial data as of and for the years ended June 30, 2004 and 2003 has been derived from the reconciliation to U.S. GAAP included in our audited consolidated financial statements which are not included herein.
 
-2-

 
   
Years ended June 30,
 
   
2006
 
2005
 
   
(In Australian Dollars)
 
STATEMENT OF OPERATIONS DATA:
         
           
A-IFRS
         
Revenue
   
1,393,000
   
161,666
 
Loss before income tax
   
(37,685,934
)
 
(20,813,923
)
Net loss
   
(28,166,129
)
 
(16,793,836
)
Loss per share - basic and diluted
   
(0.09
)
 
(0.08
)

   
As of June 30,
 
   
2006
 
2005
 
   
(In Australian Dollars)
 
BALANCE SHEET DATA:
         
           
A-IFRS
         
Total assets
   
235,486,077
   
91,866,102
 
Net assets
   
175,032,585
   
79,695,747
 
Long-term debt
   
3,940,092
   
-
 
Contributed equity
   
230,377,035
   
107,883,835
 
 
   
Years ended June 30,
 
   
2006
 
2005
 
2004
 
2003
 
2002
 
   
(In Australian Dollars)
 
STATEMENT OF OPERATIONS DATA:
                     
                       
U.S. GAAP
                     
Revenue
   
1,393,000
   
161,666
   
56,200
   
-
   
N/A
 
Loss from operations
   
(68,750,810
)
 
(21,227,989
)
 
(10,509,574
)
 
(6,177,088
)
 
N/A
 
Net loss
   
(63,481,126
)
 
(16,561,512
)
 
(5,019,974
)
 
(2,268,603
)
 
N/A
 
Loss per share - basic and diluted
   
(0.21
)
 
(0.08
)
 
(0.04
)
 
(0.02
)
 
N/A
 
 
   
As of June 30,
 
   
2006
 
2005
 
2004
 
2003
 
2002
 
   
(In Australian Dollars)
 
BALANCE SHEET DATA:
                     
                       
U.S. GAAP
                     
Total assets
   
219,903,245
   
100,063,276
   
41,295,099
   
8,220,492
   
N/A
 
Net assets
   
172,598,133
   
87,650,337
   
37,794,706
   
7,140,316
   
N/A
 
Long-term debt
   
3,940,092
   
-
   
-
   
-
   
N/A
 
Contributed equity
   
269,361,617
   
117,798,149
   
51,030,718
   
15,428,635
   
N/A
 
 
-3-

 
Exchange Rates
 
The following tables set forth, for the periods and dates indicated, certain information concerning the rates of exchange of A$1.00 into U.S. dollars based on the noon market buying rate in New York City for cable transfers in Australian dollars as certified for customs purposes by the Federal Reserve Bank of New York, which we refer to as the noon buying rate.
 
Month
 
High
 
Low
 
November 2006
   
0.7896
   
0.7629
 
October 2006
   
0.7743
   
0.7434
 
September 2006
   
0.7704
   
0.7461
 
August 2006
   
0.7699
   
0.7568
 
July 2006
   
0.7664
   
0.7407
 
June 2006
   
0.7527
   
0.7284
 
 
The noon buying rate on December 1, 2006 was US$0.7914 = A$1.00.
 
Year Ended June 30,
 
At Period
End
 
Average
Rate
 
High
 
Low
 
2006
   
0.7423
   
0.7475
   
0.7781
   
0.7056
 
2005
   
0.7618
   
0.7568
   
0.7974
   
0.6880
 
2004
   
0.6952
   
0.7155
   
0.7979
   
0.6390
 
2003
   
0.6713
   
0.5884
   
0.6729
   
0.5280
 
2002
   
0.5628
   
0.5682
   
0.5748
   
0.4841
 
 
B.
CAPITALIZATION AND INDEBTEDNESS 
 
Not applicable.
 
C.
REASONS FOR THE OFFER AND USE OF PROCEEDS 
 
Not applicable.
 
D.
RISK FACTORS 
 
The following risk factors, in addition to the other information and financial data contained in this annual report, should be considered carefully in evaluating our company and its business.
 
Risks related to our company and our business
 
Our ability to obtain additional capital is uncertain, and if we do not obtain it, we will not have the funding necessary to conduct our operations and develop our products.
 
We expect to require substantial additional capital resources in order to conduct our operations and develop our products. We had cash and cash equivalents of A$7.9 million (US$5.9 million) as of September 30, 2006, and we have used A$8.3 million (US$6.3 million) and A$7.4 million (US$5.5 million) for operating activities in the three months ended September 30, 2006 and June 30, 2006, respectively.  Therefore, we will need to raise additional funds in the near term to continue to conduct our operations as we have been conducting them to date. The timing and degree of our future capital requirements will depend on many factors, including:
 
 
·
the amount of royalty and other revenue that we earn;
 
 
·
whether and to what extent our investors exercise redemption rights provided for in our outstanding convertible debt securities;
 
 
·
continued scientific progress in our research and development programs;
 
 
·
the magnitude and scope of our research and development programs;
 
-4-

 
 
·
our ability to maintain and establish strategic arrangements for research, development, clinical testing, manufacturing and marketing;
 
 
·
our progress with preclinical and clinical trials;
 
 
·
the time and costs involved in obtaining regulatory approvals; and
 
 
·
the costs involved in preparing, filing, prosecuting, maintaining, defending and enforcing patent claims.
 
We will attempt to acquire additional funding through strategic collaborations, public or private equity financings, capital lease transactions or other financing sources that may be available. Additional financing may not be available on acceptable terms, or at all. In addition, the terms of our outstanding convertible notes, including among others, the market price-based conversion rate adjustments, may reduce the likelihood that we will be able to find additional capital at a reasonable valuation if at all.
 
Additional equity financings could result in significant dilution to stockholders. Further, in the event that additional funds are obtained through arrangements with collaborative partners, these arrangements may require us to relinquish rights to some of our technologies, product candidates or products that we would otherwise seek to develop and commercialize ourselves.
 
If sufficient capital is not available in the near term and in the longer term, we may not be able to fund our operations and may be required to suspend, curtail or terminate our operations or delay, reduce the scope of or eliminate one or more of our research and development programs.
 
We have a history of losses; we expect to continue to incur losses; and we may never become profitable.
 
pSivida was formed in 2000. As primarily a research and development company, we have incurred operating losses in every year of existence. Under A-IFRS (effective from July 1, 2004), we incurred a net loss of A$28.2 million (US$21.1 million) for the year ended June 30, 2006, and a net loss of A$16.8 million (US$12.7 million) for the year ended June 30, 2005. As of June 30, 2006, we had an accumulated deficit under A-IFRS of A$56.9 million (US$40.9 million). We have not achieved profitability and expect to continue to incur net losses through at least 2010, and we may incur losses beyond that time, particularly if we are not successful in having BrachySil or Medidur approved and widely marketed by that time. Even if BrachySil or Medidur is approved and marketed at some point in 2010 or beyond, sales of BrachySil, Medidur or any of our other marketed products, combined with royalty income and any other sources of revenue, may not be sufficient to result in profitability at that time or at any other time. The extent of our future losses and how long it may take for us to achieve profitability are uncertain.
 
We recently acquired CDS, which has incurred net losses in each of its last five fiscal years (ended December 31). As a result of the acquisition, we have been receiving royalties from sales of Vitrasert, CDS’ first commercial product. However, sales of Vitrasert have declined in each of the past four years and we do not expect that Vitrasert royalties will comprise a significant portion of our future revenue. Following regulatory approval for Retisert in April 2005, CDS entered into an advance royalty agreement with Bausch & Lomb in June 2005 pursuant to which CDS received US$3.0 million (A$3.9 million) in lieu of US$6.25 million (A$8.5 million) of Retisert royalties that otherwise would be payable under the license agreement. Subsequent to June 30, 2006, of the next US$6.6 million (A$9.0 million) of future royalties otherwise payable from the sales of Retisert, US$5.7 million (A$7.8 million) will be retained by Bausch & Lomb. We are unable to predict the future sales of Retisert by Bausch & Lomb and, as a result, we cannot predict when, if ever, Bausch & Lomb will have retained that amount of royalties and we will begin receiving full royalty payments from them.
 
If our funds are insufficient to pay the principal of and interest on our convertible notes, then our noteholders may declare an event of default, foreclose on the collateral and require immediate payment of the entire principal of the notes plus penalties.
 
On November 16, 2005, we issued a subordinated convertible promissory note in the principal amount of US$15 million (A$19.7 million) to an institutional investor. On September 14, 2006, in connection with an amendment of the note, we repaid US$2.5 million (A$3.3 million) of the principal. The convertible note must be repaid in full in cash on the third anniversary of its issuance, unless the principal is earlier paid or converted. In addition, the holder may require payment in cash of up to US$6.25 million (A$8.3 million) of the principal on each of July 31, 2007 and January 31, 2008. The holder of the note has also been provided with a security interest in our existing royalty streams from Bausch & Lomb, which represent a substantial portion of our current revenue. In connection with the terms of a further letter agreement with the investor dated October 17, 2006, we are obligated to make compensating payments of US$800,000 (A$1.1 million) on December 28, 2006 and US$150,000 (A$205,000) each on January 31, 2007, February 28, 2007 and March 30, 2007. If we are unable to pay interest or principal that becomes due or otherwise are unable to make payments under the note or related agreements, the holder may foreclose on and collect those royalties or sell that collateral. The proceeds of any sale would be applied to satisfy amounts owed to the holder.
 
-5-

 
On September 26, 2006, we issued new subordinated convertible promissory notes in the principal amount of US$6.5 million (A$8.5 million) to other investors. These convertible notes must be repaid in full in cash on the third anniversary of their issuance, unless the principal is earlier paid or converted. In addition, under specified conditions, the holders may require payment in cash of up to US$3.25 million (A$4.25 million) of the principal on each of August 14, 2008 (unless the initial note is still outstanding) and February 14, 2009 (or such later date that is 91 days after the maturity date of the initial note).
 
All of our outstanding subordinated convertible promissory notes bear interest at the rate of 8% per annum. We may make quarterly interest payments on the notes by issuing ADSs if certain conditions are met, including the continued effectiveness of registration statements covering the ADSs, continued listing of our shares or ADSs, and timely delivery of conversion ADSs during the period preceding the payment date, among others. If any of the conditions are not met, we will be required to pay the interest due in cash. Given the cash needs of our business and our current level of revenue, we cannot predict whether or not we will be able to meet any of these cash payment obligations or what impact these obligations might have on our business and operations.
 
If we do not obtain certain waivers or fail to maintain an effective resale registration statement for our ADSs, then we may owe further penalties related to the inability of certain shareholders to sell ADSs. We may not have sufficient funds to pay such penalties.
 
In connection with our acquisition of CDS, we entered into an agreement to register with the SEC the resale of ADSs issued to CDS stockholders. We were required to complete that registration no later than June 28, 2006. Our agreement to register these ADSs required that we pay cash penalties equal to one percent of the number of such ADSs multiplied by the deemed value of such ADSs at the time of closing, or US$5.087 per ADS, for every 30-day period until the registration statement became effective and for certain periods during which the registration statement could not be used to sell ADSs. The registration statement was declared effective on September 29, 2006 and we filed additional information making it usable to effect sales on October 31, 2006. To date, we have not paid any of these penalties. Although we are seeking a waiver of these payment requirements from the holders of ADSs issued in connection with the acquisition of CDS, such persons may not grant us such a waiver on reasonable terms or at all. We may not have sufficient funds to pay these penalties. If we are forced to do so, we may be required to suspend, curtail or terminate our operations or delay, reduce the scope of or eliminate one or more of our research and development programs, any of which could have a material adverse effect on our business.
 
In connection with the amendments to our initial convertible note financing and our subsequent new convertible note financing, we have entered into agreements to register with the SEC the resale of additional ADSs issued to the investors. Our obligation to register ADSs in each of these transactions is subject to a deadline, which may be extended in certain situations, and our failure to meet this deadline results in monetary penalties against us. With respect to the amendments to our initial convertible note financing, we are required to complete the registration of shares issuable pursuant to exercise of the additional warrant granted no later than December 31, 2006. If our registration statement registering those shares is not effective by that date, we must pay penalties of 7.5% of the outstanding principal amount of the initial note and, from that date until the date on which the effectiveness failure is cured, 1.0% of the outstanding principal amount of the note per 30-day period. Further, failure to comply with this deadline within 60 days may result in an event of default under the convertible note. With respect to our new convertible note financing, we are required to complete the registration no later than January 1, 2007. Failure to comply with this deadline may result in our having to pay cash penalties equal to one percent of the convertible note purchase price, or US$65,000 (A$85,000) per 30 days, until the registration statement becomes effective. Further, failure to comply with this deadline by in excess of 60 days may result in an event of default under the new convertible notes. Each of these registration deadlines is subject to extension under certain circumstances.
 
-6-

 
Our failure or inability to maintain the effectiveness of any of our registrations or to adequately update information in the related prospectuses may subject us to additional penalties. In addition, we expect to have other registration obligations with similar penalty provisions related to registration deadlines in connection with future financing activities.
 
Most of our products and planned products are based upon new and unproven technologies, and if we are unable to develop products from those technologies, we may not have sufficient revenue to continue our operations.
 
We are currently developing products based upon Durasert, BioSilicon and CODRUG drug delivery systems for multiple applications across many sectors of healthcare, including controlled drug delivery and diagnostics. The successful development and market acceptance of our current products and potential product technologies is subject to many risks. These risks include the potential for ineffectiveness, lack of safety, unreliability, failure to receive necessary regulatory clearances or approvals and the emergence of superior or equivalent products, as well as the effect of changes in future general economic conditions. To date, we have developed two marketed products, Vitrasert and Retisert, which are based on our Durasert technology and have been approved by the U.S. Food and Drug Administration, or FDA, for treatment of two sight-threatening eye diseases. However, these technologies may prove useful in other products which would also be subject to many risks. Our failure to develop our current and future products could have a material adverse effect on our business, financial condition and results of operations. Further, BioSilicon is a new and unproven technology for which we have received no FDA approvals.
 
We rely heavily upon patents and trade secrets to protect our proprietary technologies. If we fail to protect our intellectual property or infringe on others’ technologies, our ability to market our products may suffer.
 
Protection of intellectual property rights is crucial to our business, since that is how we keep others from copying the innovations which are central to our existing and future products. Our success is dependent on whether we can obtain patents, defend our existing patents and operate without infringing on the proprietary rights of third parties. As of September 28, 2006, we had 95 patents and over 322 pending patent applications, including patents and pending applications covering our Durasert, BioSilicon and CODRUG technologies. We expect to aggressively patent and protect our proprietary technologies. However, we cannot be sure that any additional patents will be issued to us as a result of our pending or future patent applications or that any of our patents will withstand challenges by others. In addition, we may not have sufficient funds to patent and protect our proprietary technologies to the extent that we would desire or at all. If we were determined to be infringing any third party patent, we could be required to pay damages, alter our products or processes, obtain licenses, pay royalties or cease certain operations. We may not be able to obtain any required licenses on commercially favorable terms, if at all. Our failure to obtain a license for any technology that we may require to commercialize our products could have a material adverse effect on our business, financial condition and results of operations. In addition, many of the laws of foreign countries in which we intend to operate may treat the protection of proprietary rights differently from, and may not protect our proprietary rights to the same extent as, laws in Australia, the United States and Patent Co-operation Treaty countries.
 
Prior art may reduce the scope or protection of, or invalidate, patents. Previously conducted research or published discoveries may prevent patents from being granted, invalidate issued patents or narrow the scope of any protection obtained. Reduction in scope of protection or invalidation of our licensed or owned patents, or our inability to obtain patents, may enable other companies to develop products that compete with our products and product candidates on the basis of the same or similar technology. As a result, our patents and those of our licensors may not provide any or sufficient protection against competitors.
 
While we have not been and we are not currently involved in any litigation over intellectual property, such litigation may be necessary to enforce any patents issued or licensed to us or to determine the scope and validity of third party proprietary rights. We may also be sued by one or more third parties alleging that we infringe its intellectual property rights. Any intellectual property litigation would be likely to result in substantial costs to us and diversion of our efforts. If our competitors claim technology also claimed by us and if they prepare and file patent applications in the U.S., we may have to participate in interference proceedings declared by the U.S. Patent and Trademark office to determine priority of invention, which could result in substantial cost to us and diversion of our efforts. Any such litigation or interference proceedings, regardless of the outcome, could be expensive and time consuming. Litigation could subject us to significant liabilities to third parties, requiring disputed rights to be licensed from third parties or require us to cease using certain technologies and, consequently, could have a material adverse effect on our business, financial condition and results of operations.
 
-7-

 
We also rely on trade secrets, know-how and technology that are not protected by patents to maintain our competitive position. We try to protect this information by entering into confidentiality agreements with parties that have access to it, such as our corporate partners, collaborators, employees, and consultants. Any of these parties could breach these agreements and disclose our confidential information, or our competitors might learn of the information in some other way. If any material trade secret, know-how or other technology not protected by a patent were to be disclosed to or independently developed by a competitor, our competitive position could be materially harmed.
 
If we do not receive the necessary regulatory approvals, we will be unable to commercialize our products.
 
Our current and future activities are and will be subject to regulation by governmental authorities in the U.S., Europe, Singapore and other countries. Before we can manufacture, market and sell any of our products, we must first obtain approval from the FDA and/or foreign regulatory authorities. In order to obtain these approvals, pre-clinical studies and clinical trials must demonstrate that each of our products is safe for human use and effective for its targeted disease. Our proposed products are in various stages of pre-clinical and clinical testing. If clinical trials for any of these products are not successful, those products cannot be manufactured and sold and will not generate revenue from sales. Clinical trials for our product candidates may fail or be delayed by many factors, including the following:
 
 
·
our lack of sufficient funding to pursue trials rapidly or at all;
 
 
·
our inability to attract clinical investigators for trials; 
 
 
·
our inability to recruit patients in sufficient numbers or at the expected rate;
 
 
·
adverse side effects; 
 
 
·
failure of the trials to demonstrate a product’s safety or efficacy;
 
 
·
our failure to meet FDA or other regulatory agency requirements for clinical trial design or for demonstrating efficacy for a particular product;
 
 
·
our inability to follow patients adequately after treatment; 
 
 
·
changes in the design or manufacture of a product;
 
 
·
our inability to manufacture sufficient quantities of materials for use in clinical trials; and
 
 
·
governmental or regulatory delays.
 
Results from pre-clinical testing and early clinical trials often do not accurately predict results of later clinical trials. Data obtained from pre-clinical and clinical activities are susceptible to varying interpretations which may delay, limit or prevent regulatory approval. Data from pre-clinical studies, early clinical trials and interim periods in multi-year trials are preliminary and may change, and final data from pivotal trials for such products may differ significantly. Adverse side effects may develop that delay, limit or prevent the regulatory approval of products, or cause their regulatory approvals to be limited or even rescinded. Additional trials necessary for approval may not be undertaken or may ultimately fail to establish the safety and efficacy of proposed products. The FDA or other regulatory agency may not approve proposed products for manufacture and sale.
 
In addition to testing, regulatory agencies impose various requirements on manufacturers and sellers of products under their jurisdiction, such as labeling, manufacturing practices, record keeping and reporting. Regulatory agencies may also require post-marketing testing and surveillance programs to monitor a product’s effects. Furthermore, changes in existing regulations or the adoption of new regulations could prevent us from obtaining, or affect the timing of, future regulatory approvals.
 
-8-

 
At present, Vitrasert and Retisert are our only products that have been approved for sale in the U.S. for specific purposes. BrachySil and other product candidates utilizing BioSilicon have not been approved and their approval in the future remains uncertain. Any product approvals we achieve could also be withdrawn for failure to comply with regulatory standards or due to unforeseen problems after the product’s marketing approval.
 
Fast track status for Medidur may not actually lead to faster development, regulatory review or approval, and if approval is delayed, the future growth of our revenue that this product is expected to generate will also be delayed.
 
The FDA has granted fast track designation to Medidur for the treatment of diabetic macular edema, or DME. Although this designation makes this product eligible for expedited approval procedures, it does not ensure faster development, review or approval compared to the conventional FDA procedures. Further, the FDA may withdraw the fast track designation if it determines that the designation is no longer supported by emerging data from clinical trials or if it determines that the criteria for the designation is no longer satisfied.
 
We have a limited ability to develop and market our products ourselves. If we are unable to find marketing or commercialization partners, or our marketing or commercialization partners do not successfully develop or market our products, we may be unable to effectively develop and market our products on our own.
 
We presently have no marketing or sales staff. Achieving market acceptance for the use of our products will require extensive and substantial efforts by experienced personnel as well as expenditure of significant funds. We may not be able to establish sufficient capabilities necessary to achieve market penetration.
 
We intend to license and/or sell our products to companies who will be responsible in large part for sales, marketing and distribution. The amount and timing of resources which may be devoted to the performance of their contractual responsibilities by these licensees are not expected to be within our control. Further, these partners may not perform their obligations.
 
Our business strategy includes entering into collaborative arrangements for the development and commercialization of our product candidates. The curtailment or termination of any of these arrangements could adversely affect our business, our ability to develop and commercialize our products and proposed products and our ability to fund operations.
 
The success of these and future collaborative arrangements will depend heavily on the experience, resources, efforts and activities of our collaborators. Our collaborators have, and are expected to have, significant discretion in making these decisions. Risks that we face in connection with our collaboration strategy include the following:
 
 
·
our collaborative arrangements are, and are expected to be, subject to termination under various circumstances including, in some cases, on short notice and without cause;
 
 
·
we are required, and expect to be required, under our collaborative arrangements not to conduct specified types of research and development in the field that is the subject of the collaboration, limiting the areas of research and development that we can pursue;
 
 
·
our collaborators may develop and commercialize, either alone or with others, products that are similar to or competitive with our products;
 
 
·
our collaborators, consistent with other pharmaceutical and biotechnology companies that have historically acted similarly, may for a variety of reasons change the focus of their development and commercialization efforts or decrease or fail to increase spending related to our products, limiting the ability of our products to reach their potential; and
 
 
·
our collaborators may lack the funding or experience to develop and commercialize our products successfully or may otherwise fail to do so.
 
-9-

 
To the extent that we choose not to, or we are unable to, enter into future license agreements with marketing and sales partners, we may experience increased capital requirements to develop the ability to market and sell future products. We may not be able to market or sell our technology or future products independently in the absence of such agreements.
 
Our current licensees may terminate their agreements with us at any time, and if they do, we may not be able to effectively develop and sell our products.
 
Our licensees have rights of termination under our agreements with them. Exercise of termination rights by those parties may leave us temporarily or permanently without any marketing or sales resources, which may have an adverse effect on our business, financial condition and results of operations. Additionally, our interests may not continue to coincide with those of our partners, and our partners may develop independently or with third parties, products or technologies that could compete with our products. Further, disagreements over rights or technologies or other proprietary interests may occur.
 
We have exclusively licensed our technology with respect to Vitrasert, Retisert and certain other ophthalmic uses to Bausch & Lomb, and with respect to Medidur for DME and certain other ophthalmic uses to Alimera Sciences. Bausch & Lomb is responsible for funding and managing the development and commercialization of all licensed products and can terminate its agreement with us at any time upon 90 days’ written notice. We are jointly funding with Alimera Sciences the development of products licensed under our agreement with them, and Alimera Sciences may terminate its agreement with us if we fail to make a development payment or may terminate the agreement with respect to a particular product if we abandon the product. Further, in the event that we fail to make development payments exceeding US$2.0 million (A$2.7 million) for a product, Alimera Sciences may complete the development using other funds and substantially reduce our economic interest in any sales of the developed product from a share of profits to a sales-based royalty. As of November 30, 2006, we have chosen not to make development payments to Alimera Sciences in an aggregate amount of approximately US$1.9 million (A$2.6 million). Alimera Sciences was incorporated in June 2003 and has limited resources. Either Bausch & Lomb or Alimera Sciences may decide not to continue with or commercialize any or all of the licensed products, change strategic focus, pursue alternative technologies, develop competing products or terminate their agreements with us. While Bausch & Lomb has significant experience in the ophthalmic field and substantial resources, there is no assurance as to whether, and to what extent, that experience and those resources will be devoted to our technologies. Because we do not currently have sufficient funding or internal capabilities to develop and commercialize these products and proposed products, decisions, actions, breach or termination of these agreements by Bausch & Lomb or Alimera Sciences could delay or stop the development or commercialization of Retisert, Medidur for DME or other of our products licensed to such entities. We have licensed BrachySil to Beijing Med-Pharm for China, and similar risks exist under the terms of that license agreement.
 
If our competitors develop more effective products that receive regulatory approval before our products reach the market, our products could be rendered obsolete.
 
We are, or plan to be, engaged in the rapidly evolving and competitive fields of drug delivery and diagnostics. Our competitors include many major pharmaceutical companies and other biotechnology, drug delivery, diagnostics and medical products companies.
 
Many of our potential competitors have substantially greater financial, technological, research and development, marketing and personnel resources than us. Our competitors may succeed in developing alternate technologies and products that:
 
 
·
are more effective and easier to use;
 
 
·
are more economical than those which we have developed; or
 
 
·
would render our technologies and products obsolete and non-competitive in these fields.
 
These competitors may also have greater experience in developing products, conducting clinical trials, obtaining regulatory approvals or clearances and manufacturing and marketing such products or technologies.
 
-10-

 
We believe that pharmaceutical, drug delivery and biotechnology companies, research organizations, governmental entities, universities, hospitals, other nonprofit organizations and individual scientists are seeking to develop the drugs, therapies, products, approaches or methods to treat our targeted diseases or their underlying causes. For many of our targeted diseases, competitors have alternate therapies that are already commercialized or are in various stages of development ranging from discovery to advanced clinical trials. Any of these drugs, therapies, products, approaches or methods may receive government approval or gain market acceptance more rapidly than our products and proposed products, may offer therapeutic or cost advantages or may cure our targeted diseases or their underlying causes completely, which could reduce demand for our products and proposed products and could render them noncompetitive or obsolete. For example, sales of Vitrasert for the treatment of cytomegalovirus, or CMV, retinitis, a disease which affects people with late-stage AIDS, have declined significantly, because of new treatments that delay the onset of late-stage AIDS.
 
Our competitive position is based upon our ability to:
 
 
·
create and maintain scientifically-advanced technology and proprietary products and processes;
 
 
·
attract and retain qualified personnel;
 
 
·
develop safe and efficacious products, alone or in collaboration with others;
 
 
·
obtain patent or other protection for our products and processes;
 
 
·
obtain required government approvals on a timely basis;
 
 
·
manufacture products on a cost-effective basis; and
 
 
·
successfully market products.
 
If we are not successful in meeting these goals, our business could be adversely affected.
 
If we expand our efforts beyond our core area of expertise and experience, then we may have to enter into collaboration agreements that limit the extent to which we can profit from our own technologies.
 
We plan to expand our focus outside of our initial areas of experience and expertise in order to broaden our product pipeline and this will require additional internal expertise or external collaborations in areas in which we currently do not have internal resources and expertise. Such expertise and collaborations may be difficult to obtain. We are currently focused on targeted controlled drug delivery specifically for ophthalmic drug delivery, localized oncology and other controlled delivery mechanisms. We have started to expand our focus into diagnostics and the food industry and may plan to expand into other areas at a later time. In connection with the foregoing, we may have to enter into collaboration arrangements with others that may require us to relinquish rights to certain of our technologies or products that we would otherwise pursue independently. We may be unable to acquire the necessary expertise or enter into collaboration agreements on acceptable terms.
 
-11-

 
Problems associated with international business operations could affect our ability to manufacture and sell our products. If we encounter such problems, our costs could increase and our development of products could be delayed.
 
We currently maintain offices in Australia, the UK, Singapore and the U.S. BrachySil is produced for us in Germany and the UK, and BioSilicon is produced in-house and by third party contractors in the UK. We are conducting product trials in Singapore and in Europe, we have research and development facilities in the UK and the U.S. and we intend to license and/or sell products in most major world healthcare markets. A number of risks are inherent in our international strategy. In order for us to license and manufacture our products, we must obtain country and jurisdiction-specific regulatory approvals or clearances to comply with regulations regarding safety and quality. We may not be able to obtain or maintain regulatory approvals or clearances in such countries, and we may be required to incur significant costs in obtaining or maintaining foreign regulatory approvals or clearances. In addition, our operations and revenues are subject to a number of risks associated with foreign commerce, including the following:
 
 
·
managing foreign distributors;
 
 
·
staffing and managing foreign operations;
 
 
·
political and economic instability;
 
 
·
foreign currency exchange fluctuations;
 
 
·
foreign tax laws, tariffs and freight rates and charges;
 
 
·
timing and availability of export licenses;
 
 
·
inadequate protection of intellectual property rights in some countries; and
 
 
·
obtaining required governmental approvals.
 
If we encounter problems with product manufacturing, we could experience delays in product development and commercialization, which would adversely affect our future profitability.
 
Our ability to conduct timely preclinical and clinical research and development programs, obtain regulatory approvals, commercialize our product candidates and fulfill our contract manufacturing obligations to others will depend, in part, upon our ability to manufacture our products, either directly or through third parties, in accordance with FDA and other regulatory requirements. We currently have BioSilicon production capability at our facilities in the UK, which may be augmented where required by QinetiQ’s UK production facilities for use in internal and collaborative research. BrachySil is currently manufactured under contract, in accordance with applicable current good manufacturing practices, or cGMP, by Hosokawa Micron Group, Atomising Systems Ltd, HighForce Ltd and AEA Technology QSA GmbH. We currently manufacture clinical supplies pursuant to our agreement with Alimera Sciences.
 
We could experience delays in development or commercialization of our proposed products if we are unable to manufacture BioSilicon, BrachySil or other product candidates by ourselves, or we acquire BioSilicon, BrachySil or other product candidates from third parties, such as QinetiQ. We may not be able to manufacture our proposed products successfully or in a cost-effective manner at our own or third party facilities. If we are unable to develop our own manufacturing facilities or to obtain or retain third-party manufacturing on acceptable terms, we may not be able to conduct certain future pre-clinical and clinical testing or to supply commercial quantities of our products.
 
-12-

 
We have licensed to Bausch & Lomb the exclusive rights to manufacture Vitrasert, Retisert and other products covered by its license agreement with us. We have licensed to Alimera Sciences the rights to manufacture Medidur for DME, if approved for marketing, and other products covered by its license agreement. Our current reliance on third party manufacturers for some of our products entails risks, including:
 
 
·
the possibility that third parties may not comply with the FDA’s cGMP regulations, other regulatory requirements, and those of similar foreign regulatory bodies, and may not employ adequate quality assurance practices;
 
 
·
supply disruption, deterioration in product quality or breach of a manufacturing or license agreement by the third party because of factors beyond our control;
 
 
·
the possible termination or non-renewal of a manufacturing or licensing agreement with a third party at a time that is costly or inconvenient to us; and
 
 
·
our inability to identify or qualify an alternative manufacturer in a timely manner, even if contractually permitted to do so.
 
If third-party reimbursement and health care providers do not cover the cost of our products, market acceptance could be limited.
 
In both domestic and foreign markets, our ability to commercialize our products will depend, in part, upon the availability of reimbursement from third-party payors, such as government health administration authorities, private health insurers and other organizations. Third-party payors are increasingly challenging the price and cost-effectiveness of medical products. If our products are not considered cost-effective, third-party payors may limit reimbursement. Government and other third-party payors are increasingly attempting to contain healthcare costs by limiting both coverage and the level of reimbursement for new therapeutic products and by refusing, in some cases, to provide any coverage for uses of approved products for disease indications for which they have not been granted regulatory approval. If government and third-party payors do not provide adequate coverage and reimbursement levels for uses of our products, the market acceptance of our products would be limited.
 
There have been a number of U.S. federal and state proposals during the last few years to subject the pricing of pharmaceuticals to government control and to make other changes to the health care system of the U.S. It is uncertain what legislative proposals will be adopted or what actions federal, state or private payors for health care goods and services may take in response to any health care reform proposals or legislation. Similar health care reforms may also be implemented outside of the U.S. We cannot predict the effect health care reforms may have on our business.
 
If we fail to retain some or all of our key personnel, then our business could suffer.
 
We are dependent upon the principal members of our management, administrative and scientific staff. In addition, we believe that our future success in developing our products and achieving a competitive position will depend to a large extent on whether we can attract and retain additional qualified management and scientific personnel. There is strong competition for such personnel within the industry in which we operate and we may not be able to continue to attract such personnel either to Malvern in the United Kingdom or to Massachusetts, where much of our research and development is conducted. Further, the economic climate in Perth could make employee retention difficult there. As we do not have large numbers of employees and our products are unique and highly specialized, the loss of the services of one or more of the senior management or scientific staff, or the inability to attract and retain additional personnel and develop expertise as needed, could have a material adverse effect on our results of operations and financial condition.
 
If we are subject to product liability suits and do not have sufficient insurance to cover damages, our ability to fund research and development would be negatively impacted.
 
The testing, manufacturing, and future marketing and sale of the products utilizing our technologies involves risks that product liability claims may be asserted against us or our licensees. Our current clinical trial insurance may not be adequate or continue to be available, and we may be unable to obtain adequate product liability insurance on reasonable commercial terms, if at all. In the event clinical trial insurance is not adequate, our ability to continue with planned research and development in the relevant area could be negatively impacted.
 
-13-

 
We have experienced rapid changes in our business, and if we fail to effectively manage these changes, we may experience increased expenses.
 
As evidenced by our purchase of the remaining shares of pSiMedica in 2004 and our acquisition of CDS on December 30, 2005, our business is rapidly changing. See “Risks related to our recent acquisition of CDS and other recent transactions”.
 
We may be required to increase the number of our employees, and we may suffer if we do not manage and train our new employees effectively. Further, our efforts span various geographies. Continued operations in multiple locations may place significant strains on our managerial, financial and other resources. The rate of any future expansion, in combination with our complex technologies and products, may demand a level of managerial effectiveness in anticipating, planning, coordinating and meeting our operational needs which we may not be able to successfully provide.
 
In addition, if we make additional acquisitions or divestitures, we could encounter difficulties that harm our business. We may acquire companies, products or technologies that we believe to be complementary to our business. If we do so, we may have difficulty integrating the acquired personnel, operations, products or technologies. In addition, acquisitions may distract our management and employees and increase our expenses, which could harm our business. We may also sell businesses or assets as part of our strategy or if we receive offers from third parties. If we do so, we may sell an asset or business for less than its full value or may lose valuable opportunities attendant to such asset or business.
 
If we fail to comply with environmental laws and regulations, our ability to manufacture and commercialize products may be adversely affected.
 
Medical and biopharmaceutical research and development involves the controlled use of hazardous materials, such as radioactive compounds and chemical solvents. We are subject to federal, state and local laws and regulations in the U.S. and abroad governing the use, manufacture, storage, handling and disposal of such materials and waste products. We could be subject to both criminal liability and civil damages in the event of an improper or unauthorized release of, or exposure of individuals to, hazardous materials. In addition, claimants may sue us for injury or contamination that results from our use or the use by third parties of these materials, and our liability may exceed our total assets. Compliance with environmental laws and regulations is expensive, and current or future environmental regulations may impair our research, development or production efforts or harm our operating results.
 
Risks related to our being headquartered and incorporated outside of the United States
 
You may have difficulty in effecting service of legal process and enforcement of judgments against us or our management.
 
We are a public company limited by shares, registered and operating under the Australian Corporations Act 2001. Several of our directors and officers reside outside the U.S. Substantially all or a substantial portion of the assets of those persons are located outside the U.S. As a result, it may not be possible to effect service on such persons in the U.S. or to enforce, in foreign courts, judgments against such persons obtained in U.S. courts and predicated on the federal securities laws of the U.S. Furthermore, a large percentage of our directly owned assets are located outside the U.S., and, as such, any judgment obtained in the U.S. against us may not be collectible within the U.S. There is doubt as to the enforceability in the Commonwealth of Australia, in original actions or in actions for enforcement of judgments of U.S. courts, of civil liabilities predicated solely upon federal or state securities laws of the U.S., especially in the case of enforcement of judgments of U.S. courts where the defendant has not been properly served in Australia.
 
-14-

 
As a foreign private issuer we do not have to provide you with the same information as an issuer of securities based in the U.S.
 
Because we are a foreign private issuer within the meaning of the rules under the Exchange Act, we are exempt from certain provisions that are applicable to U.S. public companies, including:
 
 
·
the rules under the Exchange Act requiring the filing with the SEC of quarterly reports on Form 10-Q or current reports on Form 8-K;
 
 
·
the sections of the Exchange Act regulating the solicitation of proxies, consents or authorizations in respect of a registered security; and
 
 
·
the sections of the Exchange Act requiring insiders to file public reports of their stock ownership and trading activities and liability for insiders who profit from trades made in a short period of time.
 
Thus, you are not afforded the same protections or information which would be made available to you were you investing in a U.S. public corporation.
 
In accordance with the requirements of the Australian Stock Exchange, we disclose annual and semi-annual results. Until July 1, 2005, our results were presented in accordance with accounting principles generally accepted in Australia, or A-GAAP, and they are now presented in accordance with A-IFRS. Our annual results reported in the U.S. with the SEC include a reconciliation to U.S. GAAP. Our annual results are audited, and our semi-annual results undergo a limited review by our independent auditors. Subject to certain exceptions, we are also required to immediately disclose to the Australian Stock Exchange any information concerning us that a reasonable person would expect to have a material effect on the price or value of our shares. This would include matters such as:
 
 
·
any major new developments relating to our business which are not public knowledge and may lead to a substantial movement in our share price;
 
 
·
any changes in our board of directors;
 
 
·
any purchase or redemption by us of our own equity securities;
 
 
·
interests of directors in our shares or debentures; and
 
 
·
changes in our capital structure.
 
We are required to provide our semi-annual results, and other material information that we disclose in Australia or in the U.S. under the cover of Form 6-K. Nevertheless, this information is not the same and may not be as much information as would be made available to you were you investing in a U.S. public corporation.
 
Risks related to our stock and our ADSs
 
If we are a passive foreign investment company, holders of our shares and ADSs may suffer adverse tax consequences.
 
U.S. holders of our ADSs may experience unfavorable tax consequences if we are treated as a passive foreign investment company, or PFIC, under the U.S. Internal Revenue Code of 1986, as amended, for any year during which the U.S. holder owned our ADSs. In general, we are a PFIC for any taxable year if either (1) 75% or more of our gross income in the taxable year is passive income, or (2) 50% or more of the average value of our assets in the taxable year produces, or is held for the production of, passive income. We were likely a PFIC for the fiscal year ended June 30, 2005. For example, if a U.S. holder disposes of an ADS at a gain, and during any year of its holding period we were a PFIC, then such gain would be taxable as ordinary income and not as capital gain and would be subject to additional taxation based on the length of time the U.S. holder held such stock. Most of the tax consequences of our being a PFIC may be mitigated if the U.S. holder makes certain elections as described in Item 10.E of this Annual Report on Form 20-F under “U.S. Federal Income Tax Considerations”.
 
-15-

 
Holders of our ADSs may have limited rights relative to holders of our ordinary shares in certain circumstances.
 
The rights of holders of ADSs with respect to voting of ordinary shares and receiving certain distributions may be limited in certain respects by the deposit agreement entered into by us and Citibank, N.A. For example, although ADS holders are entitled under the deposit agreement, subject to any applicable provisions of Australian law and of our constitution, to instruct the depositary as to the exercise of their voting rights pertaining to the ordinary shares represented by the American Depositary Shares, and the depositary has agreed that it will vote the ordinary shares so represented in accordance with such instructions, ADS holders may not receive notices sent by the depositary in time to ensure that the depositary will vote the ordinary shares. This means that holders of ADSs may not be able to exercise their right to vote. In addition, under the deposit agreement, the depositary has the right to restrict distributions to holders of the ADSs in the event that it is unlawful or impractical to make such distributions. We have no obligation to take any action to permit distributions to holders of our American Depositary Receipts, or ADRs. As a result, holders of ADRs may not receive distributions made by us.
 
Our stock price is volatile. If our trading volume fluctuates significantly, based on events both within and outside our control, you may have difficulty selling your ADSs when you desire to.
 
Since December 2000, the price of our ordinary shares has ranged from A$0.09 to A$1.44 per share, and since January 27, 2005, the price of our ADSs has ranged from US$1.83 to US$12.14. The price of our ordinary shares and ADSs may be affected by developments directly affecting our business and by developments out of our control or unrelated to pSivida. The biotechnology sector in particular, and the stock market generally, are vulnerable to abrupt changes in investor sentiment. Prices of securities and trading volume of companies in the biotechnology industry, including ours, can swing dramatically in ways unrelated to or that bear a disproportionate relationship to, operating performance. Our ordinary share and ADS prices and their trading volumes may fluctuate based on a number of factors including, but not limited to:
 
 
·
clinical trial results and other product and technological developments and innovations;
 
 
·
FDA and other governmental regulatory actions, receipt and timing of approvals of our proposed products, and any denials and withdrawals of approvals;
 
 
·
competitive factors including new product ideas and technologies, clinical trial results and approvals of competitive products in our markets;
 
 
·
advancements with respect to treatment of the diseases targeted by our proposed products;
 
 
·
developments relating to collaborative partners, including execution and termination of agreements, achievement of milestones and receipt of payments;
 
 
·
availability and cost of capital and our financial and operating results;
 
 
·
changes in reimbursement policies or other practices relating to our proposed products or the pharmaceutical industry generally;
 
 
·
meeting, exceeding or failing to meet analysts’ or investors’ expectations, and changes in evaluations and recommendations by securities analysts;
 
 
·
economic, industry and market conditions, changes or trends; and
 
 
·
other factors unrelated to us and the biotechnology industry.
 
In addition, low trading volume may increase the price volatility of our ADSs. Trading volume in our ordinary shares on other markets has not been historically high, and trading volume of our ADSs on the NASDAQ Global Market has also been low. Further, because each of our ADSs represents ten of our ordinary shares, trading volume in our ADSs may be lower than that for our ordinary shares. A thin trading market could cause the price of our ADSs to fluctuate significantly more than the stock market as a whole. For example, trades involving a relatively small number of our ADSs may have a greater impact on the trading price for our ADSs than would be the case if their trading volume were higher. Accordingly, holders of our ADSs may not be able to liquidate a position in our ADSs in the desired time or at the desired price.
 
-16-

 
The fact that we do not expect to pay cash dividends may lead to decreased prices for our stock.
 
We have never paid a cash dividend on our ordinary shares and we do not anticipate paying any cash dividend. We intend to retain future cash earnings, if any, for reinvestment in the development and expansion of our business. In addition, the cash balance requirements in our convertible note agreements limit our ability to pay dividends.
 
If the holders of our outstanding convertible notes, warrants and stock options convert their notes or exercise their warrants and options, your ownership may be diluted and our stock price may decline.
 
The issuance of our ordinary shares or ADSs upon conversion of the convertible notes and upon exercise of the share purchase warrants and stock options would result in dilution to the interests of other holders of our ADSs and ordinary shares.
 
As of November 30, 2006, we had outstanding convertible securities, including stock options and warrants, representing the right to acquire 21,516,205 ADSs (215,162,057 ordinary shares), or approximately 53.8% of our total outstanding shares as of November 30, 2006, including:
 
 
·
US$18.5 million (A$23.8 million) in principal amount of subordinated convertible notes that are convertible, at the option of the note holders, or under certain circumstances at our election, into 9,234,638 ADSs (92,346,385 ordinary shares);
 
 
·
warrants to purchase 9,891,804 ADSs (98,918,040 ordinary shares); and
 
 
·
stock options to purchase the equivalent of 2,389,763 ADSs (23,897,632 ordinary shares).
 
Through November 30, 2006, holders of our convertible notes have exercised their option to convert US$530,723 (A$726,918) in principal amount of and US$4,277 (A$5,858) in interest on the convertible notes for 267,500 ADSs (2,675,000 ordinary shares).
 
Under certain circumstances, the number of shares into which the convertible notes can be converted will be increased. These circumstances include:
 
 
·
in the event we issue securities at a price lower than the price at which the notes may then be converted;
 
 
·
in the event that 108% of the volume-weighted average trading price of our ADSs for the ten trading days prior to April 30, 2007 is lower than the current conversion price; and
 
 
·
in the event that we issue a share dividend or otherwise recapitalize our shares.
 
The warrant exercise prices may also be adjusted under certain circumstances, including, among others, in the event we issue securities in a rights offering at a lower price than the exercise price, or in the event that we issue a share dividend or otherwise recapitalize our shares.
 
Any such downward adjustment of the note conversion price or warrant exercise prices could result in a higher number of ADSs or ordinary shares being issued, resulting in further dilution to existing shareholders.
 
Future issuances and sales of our stock could dilute your ownership and cause our stock price to decline.
 
We intend to continue to finance our operations through the issuance of equity and convertible securities, if feasible, including by way of the public equity markets, private financings and debt. If we raise additional capital through the issuance of equity or securities convertible into equity, existing holders of our securities may experience dilution. Those securities may have rights, preferences or privileges senior to those of the holders of our ADSs and ordinary shares. Additional financing may not be available to us on favorable terms, and financing available at less favorable terms may lead to more substantial dilution of existing shareholders.
 
-17-

 
Certain of our shareholders own a significant percentage of our ordinary shares and therefore may be able to influence our business in ways that are less beneficial to you.
 
Our current executive officers, directors (including the officers and directors of our subsidiaries) and their affiliates beneficially own or control approximately 8.15% of our outstanding ordinary shares (based on the number of our ordinary shares outstanding on November 30, 2006 and assuming the issuance of shares upon the exercise of options vested or vesting within 60 days of November 30, 2006). As a result, if our executive officers and directors and their affiliates were all to vote in the same way, they would have the ability to exert significant influence over our board of directors and how we operate our business. The concentration of ownership may also have the effect of delaying or preventing a change in control of our company.
 
If we fail to comply with internal controls evaluations and attestation requirements our stock price could be adversely affected.
 
We are subject to United States securities laws, including the Sarbanes-Oxley Act of 2002 and the rules and regulations adopted by the SEC pursuant to such Act. Based on our evaluation of the effectiveness of the design and operation of our disclosure controls and procedures, as defined in Rule 13a-15(e) and Rule 15d-15(e) of the Securities Exchange Act of 1934, we have concluded that, as of June 30, 2006, our disclosure controls and procedures were ineffective in that we had insufficient accounting personnel who have sufficient knowledge and experience in U.S. GAAP and the U.S. SEC accounting requirements.
 
As a foreign private issuer, under Section 404 of the Sarbanes-Oxley Act and the related regulations, we are required to perform an evaluation of our internal controls over financial reporting, including (1) management’s annual report on its assessment of the effectiveness of internal controls over financial reporting for the year ending June 30, 2007 and (2) our independent registered public accounting firm’s annual audit of management’s assessment beginning in the year ending June 30, 2008. If our foreign private issuer status were to change prior to June 30, 2007, the attestation requirement of our independent registered public accounting firm would be accelerated to cover the year ending June 30, 2007. We are just beginning the systems documentation and evaluation process. Combined with our initial testing of key internal controls during fiscal 2007 and the subsequent evaluation and testing by our independent registered public accounting firm commencing in fiscal 2008, we expect compliance with these requirements to be time-consuming and expensive. If we fail to complete the evaluation of our internal controls over financial reporting in time, if we identify material weaknesses in these internal controls or if our independent registered public accounting firm does not timely attest to our evaluation, we could be subject to regulatory scrutiny and decreased public confidence in our internal controls, which may adversely affect the market price of our stock.
 
Risks related to our recent acquisition of CDS and recent financing transactions
 
The following risk factors relate to our December 30, 2005 acquisition of CDS, as well as three recently completed financing transactions: (1) our US$4.3 million (A$5.7 million) private placement structured as a private investment in public equity, referred to herein as the PIPE; (2) our US$15 million (A$20.5 million) convertible note financing, referred to herein as our initial convertible note financing and (3) our US$6.5 million (A$8.5 million) convertible note financing referred to herein as the new convertible note financing.
 
A default under our outstanding convertible notes could seriously harm our operations.
 
On September 14, 2006, we repaid US$2.5 million (A$3.3 million) of our initial subordinated convertible promissory note issued in November 2005 and agreed to convert the unsecured, un-guaranteed debt represented by the note into secured, guaranteed debt. On September 26, 2006, we issued US$6.5 million (A$8.5 million) of new subordinated convertible promissory notes to other investors. Each of the notes and their respective related agreements contain numerous events of default which include:
 
·
failure to register securities or maintain the registration of securities for resale after applicable cure periods;
 
·
suspension of our ADSs or ordinary shares from trading for five consecutive trading days;
 
·
failure to issue shares pursuant to a conversion within the applicable cure period;
 
-18-

 
·
failure to pay interest, principal payments or other fees when due;
 
·
if any indebtedness exceeding, US$250,000 (A$333,000) is declared due and payable prior to its specified maturity;
 
·
a bankruptcy or insolvency proceeding instituted by or against us or a material subsidiary which is not dismissed within 30 days;
 
·
breach by us of any material covenant or term or condition of the notes or any agreements made in connection therewith; and
 
·
breach by us of any material representation or warranty made in the notes or in any agreements made in connection therewith.
 
If we default on the notes, a holder could demand that we redeem the full outstanding amount. In that event, any cash required to be paid would most likely come out of our working capital, which may not be sufficient to repay the amounts due. In addition, since we rely on our working capital for our day to day operations, such a default on the notes could materially adversely affect our business, operating results or financial condition to such extent that we are forced to restructure, file for bankruptcy, sell assets or cease operations. Further, our obligations under the initial notes are secured by the royalties on our currently marketed products and a guaranty by our U.S. subsidiary, pSivida Inc. Failure to fulfill our obligations under those notes and related agreements could lead to loss of these assets and subject pSivida Inc. to direct liability in the U.S., which would be detrimental to our financial condition and operations.
 
We may fail to integrate our operations successfully with the operations of CDS. As a result, pSivida and CDS may not achieve the anticipated benefits of the merger, which could adversely affect the price of ADSs.
 
We entered into the merger agreement and consummated the merger with the expectation that the merger would result in benefits to the combined companies, including the opportunity to combine the two companies’ technologies, products and product candidates and the opportunity for us to establish a substantial presence in the U.S. that would facilitate access to U.S. markets. However, these expected benefits may not be fully realized. Failure of the combined company to meet the challenges involved with successfully integrating the personnel, products, technology and research and development operations of the two companies following the merger or to realize any of the other anticipated benefits of the merger, could have a material adverse effect on our business. Any such adverse effect could impair our financial condition and results of operations, or impair those of our subsidiaries, including pSivida Inc. These integration efforts may be difficult and time consuming, especially considering the highly technical and complex nature of each company’s products. The challenges involved in this integration include the following:
 
 
·
coordinating research and development operations in a rapid and efficient manner;
 
 
·
combining platform technologies of disparate sources;
 
 
·
demonstrating to collaboration partners that the merger will not result in adverse changes in technology focus or development standards;
 
 
·
retaining key alliances with collaboration partners;
 
 
·
absorbing costs and delays in implementing overlapping systems and procedures, including financial accounting systems and accounting principles;
 
 
·
persuading employees that our business culture and that of CDS are compatible, maintaining employee morale and retaining key employees; and
 
 
·
overcoming potential distraction of management attention and resources from the business of the combined company.
 
-19-

 
We may not successfully integrate our operations and technology with those of CDS in a timely manner, or at all. We may not realize the anticipated benefits of the merger to the extent, or in the timeframe anticipated which could significantly harm our business.
 
Our operating results could be adversely affected as a result of purchase accounting treatment, and the corresponding impact of amortization or impairment of other intangibles relating to the merger, if the results of the combined company do not offset these additional expenses.
 
Under A-IFRS (effective from July 1, 2005), we accounted for the merger with CDS using the purchase method of accounting. Under purchase accounting, we recorded the market value of our ADSs, cash, and other consideration issued in connection with the merger and the amount of direct transaction costs as the cost of acquiring the business of CDS. We allocated that cost to the individual assets acquired and liabilities assumed, including identifiable intangible assets, based on their respective estimated fair values. The amount we allocated to goodwill was A$30.4 million, the amount we allocated to patents was A$88.5 million and the amount we allocated to in-process research and development, or IPR&D, was A$34.3 million, giving rise to a deferred tax liability of approximately A$32.5 million net of deferred tax assets. Goodwill is not subject to amortization, but is subject to at least an annual impairment analysis, which may result in an impairment charge if the carrying value of the cash-generating unit to which goodwill has been allocated exceeds its fair value. The amount allocated to patents is being amortized over a 12-year period following completion of the merger, or approximately A$7.4 million per fiscal year. Acquired IPR&D is subject to annual impairment analysis, which may result in a write-down of its carrying value. At such times, if any, that the project included in acquired IPR&D is successfully developed and available for commercial use, it will become subject to amortization over its then estimated useful life. As a result, purchase accounting treatment of the merger will increase our net loss or decrease our net income in the foreseeable future, which could have a material and adverse effect on the future market value of our ADSs.
 
If CDS’ former stockholders sell substantial amounts of ADSs, the market price of ADSs may decline.
 
The resale by former CDS stockholders of our ADSs after the merger could cause the market price of our ADSs to decline. In connection with the merger, we have issued 16,104,779 ADSs. While those ADSs were not initially freely tradable, we have registered their resale for stockholders entering into the registration rights agreement. Those ADSs became freely tradable under U.S. securities laws as of October 31, 2006.
 
We may have liability under the U.S. securities laws related to the recent changes to our outstanding convertible note.
 
On September 14, 2006, we revised certain terms of the initial subordinated convertible promissory note that we issued on November 16, 2005. In connection with the amendments, we repaid US$2.5 million (A$3.3 million) of the outstanding principal of the existing note and granted the holder an additional warrant to purchase 5.7 million ADSs and a security interest in our current royalties. Because we had earlier filed a registration statement related to the ordinary shares represented by ADSs underlying the initial note and the warrant issued with it, the revisions to the note and the issuance of the additional warrant, and our subsequent filing of an amendment to our registration statement to include the shares issuable pursuant thereto, may have resulted in a violation of the federal securities laws.
 
If the investor were to bring an action in court successfully making such an argument, we could be required to rescind the modified note and warrants for a period of one year following the date of the violation. In addition, if it is determined that we offered securities without properly registering them under federal or state law, or securing an exemption from registration, regulators could impose monetary fines or other sanctions as provided under these laws.
 
 
A.
HISTORY AND DEVELOPMENT OF PSIVIDA
 
pSivida Limited is an Australian company existing pursuant to the Australian Corporations Act 2001 with shares listed on the Australian Stock Exchange, the NASDAQ Global Market, the Frankfurt Stock Exchange and London’s OFEX International Market Service. Our corporate headquarters are located at Level 12 BGC Centre, 28 The Esplanade, Perth WA 6000, Australia, and our phone number is (+61 8) 9226 5099. We also operate subsidiaries in the United Kingdom, Singapore, Australia and the United States.
 
-20-

 
The legal entity that became pSivida was incorporated as the Sumich Group Ltd in April 1987. The Sumich Group operated a business that was placed into administration or receivership in 1998. pSivida was subsequently formed on December 1, 2000 upon entering into a court-approved arrangement with Sumich Group’s creditors which fully extinguished all prior liabilities as of that time. We then appointed new directors and officers and re-listed on the Australian Stock Exchange under our new name. pSivida was then recapitalized through a placement to investors of 9.3 million ordinary shares at A$0.30 per share, raising A$2.79 million.
 
Our principal capital expenditures and acquisition transactions in the past three fiscal years through the present are described below. We have made no substantial divestitures during these periods.
 
 
·
In October 2003, we subscribed for additional convertible preference share capital in pSiMedica Ltd., increasing our direct ownership interest in pSiMedica by 3.4% to 46.25% with indirect effective control over 53.05%. The consideration paid by us in relation to this additional investment amounted to £2 million (A$4.8 million). This investment was required to fund continued research and development by pSiMedica.
 
 
·
In May 2004, the minority shareholders in pSiOncology, Singapore General Hospital Technology Ventures Pte Ltd and Biotech Research Ventures Pte Ltd, exchanged their pSiOncology shares for newly issued shares in pSiMedica. Since that time, pSiMedica has been the holder of 100% of the issued share capital of pSiOncology.
 
 
·
In August 2004, we acquired the remaining shares in pSiMedica Ltd. that we did not already own. The consideration paid was A$4,323,622 together with a total of 49,804,381 ordinary shares of pSivida issued at a value of A$1.09 per share. In addition, 638,537 pSivida options with an estimated fair value of A$292,828 were issued to employees of pSiMedica in exchange for their rights being waived in relation to options previously issued by pSiMedica. This amounted to total consideration equal to A$59.2 million. As a result of this transaction QinetiQ Group plc, one of Europe’s largest science and technology companies and the principal shareholder (besides pSivida) of pSiMedica, became our largest shareholder holding 17.5% of our issued capital at that time.
 
 
·
In August 2004, we incorporated AION Diagnostics Limited in Australia to develop and commercialize diagnostic applications of BioSilicon. We intend to license diagnostic and sensor applications of the BioSilicon platform technology developed by AION Diagnostics. We capitalized AION Diagnostics with A$1.2 million. In addition, zero exercise price options have been created over 20% of the issued capital to be awarded to directors, staff and consultants of AION Diagnostics, subject to the achievement of milestones.
 
 
·
In October 2005, we capitalized A$2.4 million as a completed cleanroom facility for the supply of our cancer therapy product, BrachySil, at QSA’s Auriga Medical facility in Braunschweig, Germany. The facility is designed to complete the final stage in the manufacture of BrachySil and to allow us to supply future clinical and commercial needs.
 
 
·
In October 2005, we entered into a merger agreement with CDS, a Boston-based company engaged in the design and development of drug delivery products. The merger agreement provided that a newly-formed subsidiary of pSivida would merge into CDS, with CDS surviving the merger as a wholly-owned subsidiary of pSivida with the name of pSivida Inc. The merger was completed on December 30, 2005. In exchange for their CDS shares, the former stockholders of CDS received 15,983,661 of our ADSs. Based on a price of A$0.71 per share, the price prevailing upon the closing of the merger, the transaction represented a purchase price of approximately A$116.9 million (US$86.7 million). As of the December 30, 2005 acquisition date, the ADSs received by the former CDS stockholders represented approximately 41.3% of the capital stock of the combined company. The former CDS stockholders were subject to lock-up periods of no less than six months.
 
-21-

 
B.
BUSINESS OVERVIEW
 
Our Business
 
pSivida is a global, bio-nanotech company focusing on the development of products utilizing our proprietary technologies for targeted and controlled drug delivery. We are developing three key technologies as follows:
 
 
·
Durasert
 
·
BioSilicon
 
·
CODRUG
 
The generation of value from these drug delivery technologies is being achieved through two core product development routes:
 
 
·
Development of our own products utilizing our proprietary technologies to produce new and improved versions of previously approved (generic) drug molecules and therapeutic agents, i.e., reformulated generics. These products will be licensed out to development and marketing partners at an appropriate stage to maximize their value to us.
 
 
·
Establishment of drug delivery partnerships with pharmaceutical and biotechnology companies to develop novel and improved formulations of their proprietary drug molecules and therapeutics. The objective of these partnerships is to generate value by licensing our drug delivery technologies for third parties’ specific drug molecules and applications.
 
The following are the key features, attributes and status of our three key technologies and associated product developments. Subsequent sections provide a more detailed analysis of our related activities.
 
 
·
Durasert
 
This technology uses a drug core with one or more surrounding polymer layers. The drug permeates through the polymers into the body at a controlled and pre-determined rate for periods of up to three years in our approved products. We believe that this technology may allow delivery periods of up to 10 years.
 
Two products based on this technology have been developed and approved by the FDA: Vitrasert, for AIDS-associated cytomegalovirus infections of the eye, and Retisert, for uveitis. These two products are licensed to and marketed by Bausch & Lomb. A third product utilizing the technology, Medidur, is partnered with Alimera Sciences and is in Phase III clinical trials for the treatment of DME. The technology is also being evaluated by a number of pharmaceutical companies for the delivery of their proprietary therapeutics for both ophthalmic and non-ophthalmic disease indications.
 
 
·
BioSilicon
 
This technology uses nanostructured elemental silicon. This novel-porous biomaterial has been shown to be both biodegradable and biocompatible. For the delivery of therapeutics it has been shown to enhance dissolution and bioavailability of poorly soluble molecules and to provide controlled release. BrachySil, our lead BioSilicon application, is a targeted oncology product, which is presently in Phase II clinical trials for the treatment of both primary liver cancer and pancreatic cancer. The product is licensed to the Beijing Med-Pharm Corporation for China, Hong Kong and Macau. BioSilicon is also being evaluated for the delivery of proprietary molecules in partnership with pharmaceutical and biotechnology companies, for oral and sub-cutaneous dosage forms. It also has potential applications in diagnostics, nutraceuticals and food packaging.
 
 
·
CODRUG
 
Our third drug delivery technology, CODRUG, allows for the simultaneous release of two or more drugs at a controlled rate from the same product. It involves chemically linking two or more drugs together in such a manner that once administered in the body they separate into the original active drug. A library of CODRUG compounds has been synthesized and Phase I clinical trials have been undertaken in post-surgical pain and two dermatological indications.
 
-22-

 
Our Commercial Strategy
 
Our commercialization strategy is to concentrate on internal product development, the licensing of the Durasert, BioSilicon and CODRUG technology platforms, and the generation and potential sale of non-core intellectual property.
 
Market Overview
 
Drug Delivery Generally
 
The therapeutic value of a drug depends on its distribution throughout the body, reaction with the targeted site, reaction with other tissues and organs in the body, and clearance from the body. In an ideal treatment, the appropriate amount of drug is delivered to the intended site in the body and maintained there for an adequate period of time without adversely affecting other tissues and organs. Accordingly, the manner in which a drug is delivered can be as important to the ultimate therapeutic value of the treatment as the intrinsic properties of the drug itself.
 
Drugs are typically administered systemically by oral dosing or by injection and are subsequently dispersed throughout the body via the circulatory system. In many cases, systemic administration does not deliver drugs to the intended site at an adequate concentration for a sufficient period of time or fails to achieve the maximum potential therapeutic benefit.
 
Because systemically delivered drugs disperse throughout the body, they often must be administered at high dosage levels in order to achieve sufficient concentrations at the intended site. Some areas of the body, such as the eyes, joints, brain, and nervous system, have natural barriers that impede the movement of drugs to those areas, requiring the administration of even higher systemic doses. These high dosage levels can cause harmful side effects when the drug interacts with other tissues and organs.
 
Timely and repeated administration of drugs by the patient is often necessary to maintain therapeutic drug levels over an extended period of time. Patients, however, often fail to take drugs as prescribed and, as a result, do not receive the potential therapeutic benefit. The risk of patient noncompliance increases if multiple drugs are required, if the dosing regimen is complicated, or if the patient is elderly or cognitively impaired.
 
Due to the drawbacks of traditional systemic drug delivery, the development of novel methods to deliver drugs to patients in a more precise, controlled fashion over sustained periods of time has become a multi-billion dollar industry. Recently developed drug delivery methods include oral and injectable controlled-release products and skin patches. These methods seek to improve the consistency of the dosage over time and extend the duration of delivery. However, most of these methods still cannot provide constant, controlled dosage or deliver drugs for a sufficiently long duration. This reduces their effectiveness for diseases that are chronic or require precise dosing. In addition, most of these methods still deliver drugs systemically and, as a result, can still cause adverse systemic side effects.
 
Ophthalmic Drug Delivery
 
Treatment for diseases in the back of the eye is a significant issue in ophthalmology. Due to the efficiency of the blood/eye barrier, it is difficult for systemically administered drugs to reach the eye in sufficient quantities to have a beneficial effect. There is a need for delivering drugs inside the eye in a manner that is safe, effective, and practical for long-term use. While there are currently many approaches to delivering medications to the eye, most do not achieve sufficient concentrations within the eye for the appropriate period of time.
 
Injecting solutions of drugs directly into the back of the eye can achieve effective but often transient drug levels in the eye, requiring repeated injections. Examples include Macugen® (pegaptanib sodium) and Lucentis® (ranibizumab, formerly RhuFab V2), both of which must be injected into the eye approximately every month. Apart from inconvenience and cost, repeated intravitreal injections carry many risks including cataract formation, perforated schlera, vitreous hemorrhage and serious intraocular infection. We believe that there is presently a great deal of commercial interest in developing improved ocular drug delivery systems.
 
-23-

 
Technologies and Products
 
The Durasert Technology System
 
Our proprietary Durasert system delivers specific quantities of drugs directly to a target site in the body at controlled rates for predetermined periods of time ranging from days to years. Durasert is designed to address drawbacks of systemic drug delivery for our target diseases adverse side effects characteristic of high dosing levels and reduced treatment benefits due to variations in drug levels at the target site.
 
Durasert is designed to offer three principal advantages:
 
 
·
Localized Delivery. The Durasert system permits implantation, injection or other application directly at the target site. This administration allows the natural barriers of the body to isolate and maintain appropriate concentrations of the drug at the target site in an effort to achieve the maximum therapeutic effect of a drug while minimizing unwanted systemic effects.
 
 
·
Controlled Release Rate. The Durasert system releases drugs at a constant or controlled rate. We believe that this feature allows our products and product candidates to maintain optimal drug concentrations at a target site and eliminate variability in dosing over time.
 
 
·
Extended Delivery. The Durasert system delivers drugs for predetermined periods of time ranging from days to years. We believe that uninterrupted, sustained delivery offers the opportunity to develop products that reduce the need for repeat applications, eliminate the risk of patient noncompliance and provide more effective treatment.
 
The Durasert system uses a drug core with one or more surrounding polymer layers. The drug permeates through the polymers into the body at a controlled rate for a predetermined period of time ranging from days to years. By changing the design of the Durasert system, we can control both the rate and duration of release to meet different therapeutic needs. We believe that the Durasert system can be used to deliver a wide variety of different drugs. We currently have two commercial products utilizing the Durasert system approved by the FDA for treatment of two sight-threatening eye diseases. These two products, Vitrasert and Retisert, are the only local sustained-release products approved by the FDA for the back of the eye. Marketed by Bausch & Lomb and sold since 1996, Vitrasert is one of the most effective treatments for CMV retinitis, a disease that afflicts late-stage AIDS patients. Retisert was approved by the FDA in April 2005 and is marketed by Bausch & Lomb. Retisert treats chronic noninfectious uveitis affecting the posterior segment of the eye, or posterior uveitis, a leading cause of vision loss. Retisert is the only FDA approved drug for this condition. Medidur, an injectable version of Durasert, is designed to treat diabetic macular edema, or DME, and is currently in Phase III clinical trials conducted by Alimera Sciences Inc. We also have two Durasert system candidates in pre-clinical studies for other back of the eye diseases.
 
We are currently using Durasert technology for most of our ophthalmic products and product candidates. Vitrasert, Retisert and Medidur represent the evolution of the Durasert technology. Vitrasert is a device surgically implanted through a 5-6 mm incision that releases drug from its core for approximately 8 months. Retisert is a device implanted through a 3-4 mm incision that releases drug from its core for 30 months. Medidur is a device injected through a needle to the back of the eye in an in-office procedure designed to release drug from its core for up to 36 months. We also have a bioerodible Durasert system that is in pre-clinical testing.
 
-24-

 
Products and Product Candidates
 
Our ophthalmic portfolio is as follows:
Disease
 
Product
 
Stage of Development
CMV retinitis
 
Vitrasert
 
FDA approved and commercialized
Posterior uveitis
 
Retisert
 
FDA approved and commercialized
Diabetic macular edema
 
Medidur
 
Phase III clinical trials
Elevated intraocular pressure (steroid induced)
 
Mifepristone
 
Phase II clinical trials
Dry age-related macular degeneration
 
 
Preclinical
Retinitis Pigmentosa
 
 
Preclinical
 
Vitrasert and Retisert, are the only two sustained-release products approved by the FDA for back of the eye diseases. The Vitrasert implant is approved for the treatment of CMV retinitis and the Retisert implant is approved for the treatment of posterior uveitis, both sight-threatening diseases. Our leading injectable Durasert product Medidur is in Phase III clinical trials for DME. We are also investigating the use of this injectable technology in other eye conditions including wet and dry age-related macular degeneration and retinitis pigmentosa, or RP.
 
Sight-Threatening Eye Diseases
 
CMV Retinitis. Our Vitrasert implant treats CMV retinitis, a blinding eye disease that frequently occurs in individuals with advanced AIDS. Vitrasert provides sustained treatment of the disease through the intravitreal delivery of the anti-viral drug ganciclovir for six to eight months. Vitrasert has been marketed and sold since 1996, first by Chiron Corporation and subsequently by Bausch & Lomb. Although CMV retinitis was common in the early 1990s, improvements in the treatment of AIDS/HIV have since significantly decreased the incidence of the disease in more developed countries. Vitrasert is currently being sold by Bausch & Lomb and has been used in over 12,000 eyes since its approval in 1996. Studies show that Vitrasert is one of the most effective approved treatments for CMV retinitis.
 
Posterior Uveitis. Our Retisert implant for treatment of posterior uveitis was approved by the FDA in April 2005. It is the first drug approved by the FDA to treat this disease. Posterior uveitis is an autoimmune condition characterized by inflammation of the inside of the eye that can cause sudden or gradual vision loss. Retisert was approved as an orphan drug and has seven-year exclusive marketing rights that the FDA provides for orphan drugs first approved for a particular indication. Retisert is marketed and sold by Bausch & Lomb.
 
Like Vitrasert, Retisert is implanted into the back of the eye in a simple, outpatient procedure. It delivers sustained levels of the anti-inflammatory corticosteroid, fluocinolone acetonide or FA, for 30 months. Although no other drugs are approved for posterior uveitis, off-label treatments include steroidal eye drops, ocular injections of steroids, orally administered steroids, immunosuppressants, and chemotherapy. These treatments, if successful, generally only slow the progression of the disease and can have serious side effects such as severe osteoporosis, muscle wastage, psychosis, cancer and stunted growth. Bausch & Lomb estimates that posterior uveitis affects 175,000 people in the United States and 800,000 people worldwide. It is estimated that approximately 30,000 people in the U.S. are blind from uveitis. Clinical trials showed Retisert to be effective in treating uveitis with many patients actually gaining vision. The most common adverse events — which are anticipated given the nature of the disease and the type of drug used — include (1) cataract progression, which is managed by standard cataract surgery, (2) increased intraocular pressure, which is managed with the use of intraocular pressure, or IOP, lowering eye drops or filtering surgery, and (3) procedural complications and eye pain.
 
Diabetic Macular Edema. Our injectable Medidur product is currently in Phase III trials for treatment of diabetic macular edema, or DME, a disease causing swelling in the macula, the most sensitive part of the retina, and a major cause of vision loss in diabetics and a leading cause of vision loss for Americans under 65. We are not aware of any approved drug treatment for this disease. DME is currently treated by laser therapy (which burns the retina either in specific sites or in a grid) and vitrectomy (eye surgery that involves the removal of the vitreous gel from the cavity of the eye). Both have serious limitations, which include repeat treatments or invasive surgical procedures. In general, both treatments only temporarily reverse vision loss and slow the progression of the disease.
 
-25-

 
Medidur is an implant small enough to be injected through a needle to the back of the eye and is expected to release drug for up to three years. Alimera Sciences is currently conducting two Phase III clinical trials for Medidur to treat DME which will follow 900 patients in the U.S. and Europe for 36 months. We have agreed to license Alimera Sciences to market and sell Medidur for DME pending its approval.
 
Elevated Intraocular Pressure. Our Mifepristone eye drops product is presently in a 45 patient Phase II clinical trial conducted under an investigator-sponsored investigational new drug, or IND, in the U.S. The product is designed to prevent or reduce the development of elevated intraocular pressure resulting from steroid use. Intraocular steroids are gaining rapid acceptance in the ophthalmic community as a means to treat eye diseases such as DME, retinal vein occlusion, retinal artery occlusion, presumed ocular histoplamosis, Irvine Gass syndrome and uveitis. Elevated intraocular pressure is a common side effect. Together these diseases account for more than half of all blindness in the western world.
 
Dry Age-Related Macular Degeneration. We are in pre-clinical development of a Medidur product to treat dry age-related macular degeneration, or AMD. AMD is a leading cause of visual impairment in Americans over the age of 60 and affects over 10 million people in the United States. With dry AMD, the cells in the central retina die slowly resulting in gradual central vision loss. There are currently no approved treatments for dry AMD, though some studies show that treatment with high doses of antioxidants and zinc may help delay its development in individuals with less severe forms of dry AMD.
 
Retinitis Pigmentosa. We are in pre-clinical development of a Medidur product to treat retinitis pigmentosa, or RP. RP comprises a group of inherited eye diseases that affect the retina, causing the degeneration of photoreceptor cells and resulting in progressive vision loss. Approximately 100,000 adults in the U.S. have RP. RP is currently treated by antioxidants such as vitamin A palmitate, which have been shown to slightly slow the progression of the disease.
 
The BioSilicon Technology System
 
BioSilicon is composed of elemental silicon, which is processed to create a “honeycomb” structure of pores. These pores can be formed into a diverse array of shapes and sizes and can be filled with various drugs, including small chemical entities, peptides and proteins. We believe that BioSilicon’s features include:
 
 
·
Biocompatibility. BioSilicon is biocompatible, meaning that it is not injurious and does not cause immunological rejection within the body. We have assessed the biocompatibility of BioSilicon in a series of pre-clinical studies, as well as in our ongoing clinical work. BioSilicon degrades in the body into silicic acid, the non-toxic, dietary form of silicon which is found in some common foods.
 
 
·
Biodegradability. We believe that BioSilicon can be made biodegradable in vivo and in vitro (in animals and humans and in solution). The rate of biodegradation depends on the degree of nanostructure that is imparted on the material. As a result, we believe that BioSilicon can be made to dissolve in suitable environments in days, weeks or months, depending upon the particle size and nature of the BioSilicon implanted. This has been demonstrated in various models, including in vitro buffer and simulated body fluid systems and in pre-clinical in vivo models.
 
The focus of our internal BioSilicon product development is therapeutic delivery, with an initial emphasis on targeted oncology products. Other potential BioSilicon drug delivery products include reformulation of generic drugs or formulation of new chemical entities to enhance bioavailability and/or provide controlled release. We have established detailed commercialization plans for BrachySil, our lead BioSilicon product, bearing in mind market sizes, benefits offered to patients and alternative competitive therapies. The first step in our commercialization strategy for BrachySil was a validation of human safety and efficacy through human clinical trials in primary liver cancer (hepatocellular carcinoma, or HCC). Results of our first trial were reported in mid-2005. Our Phase IIb dose optimization stage clinical trials are now underway. We expect that these trials will be followed directly by pivotal efficacy and safety trials. We also intend to continue dialogue with the FDA, the EU regulatory authorities and government regulators in various other jurisdictions in order to facilitate regulatory approval of the product. In addition to the primary liver cancer program, we have recently begun a Phase IIa safety trial in pancreatic cancer. We may develop BrachySil for a number of other solid tumor indications in the future, such as liver metastases, breast, brain and lung cancer.
 
-26-

 
We are also strongly focused on the application of BioSilicon technology for the formulation of poorly water soluble drugs as well as the development of controlled, slow release drug delivery products. We intend to achieve this primarily through licensing the use of BioSilicon to pharmaceutical and biotechnology companies for delivery of their patented drugs.
 
The following properties make BioSilicon a potentially effective drug delivery platform:
 
 
·
high level drug loading (up to 95%) and up to 50% weight/weight;
 
 
·
ability to improve the dissolution and bioavailability of poorly water soluble drugs and the ability to control drug release;
 
 
·
ability to accommodate different drug sizes;
 
 
·
ability to serve as a conductor of electrical charge which can be altered to regulate drug delivery rate (in potential future advanced drug delivery systems); and
 
 
·
potential incorporation of diagnostics and delivery intelligence (in potential future advanced drug delivery systems).
 
BioSilicon functions as a “honeycomb” structure to retain drugs within the ‘cells’ inside of the nanometer scale structure. BioSilicon’s biodegradability can be finely tuned without changing the chemical nature of the material itself. Thus, unlike polymer-based systems, BioSilicon’s composition is identical for all potential products whether they are implants for drug delivery or biodegradable orthopedic devices. The only characteristic that is varied is the level of engineering and shape of the silicon matrix.
 
Product Candidate: BrachySil
 
Brachytherapy is a relatively new form of treatment for cancer involving the localized delivery of radioactive agents directly into a tumor. With improved tumor location and mapping, this approach to cancer therapy has grown substantially in recent years allowing the clinician to specifically expose tumor tissue to radioisotopes in a targeted manner.
 
The market is currently dominated by the use of radioactive ‘seeds’ for the treatment of hormone non-responsive prostate cancer. Current mainline brachytherapy implants are relatively large, causing trauma and hemorrhaging in tumors. Such seeds also carry comparatively long-range radio emitters that cause normal tissue damage and other quality of life problems to the patient.
 
Other products in this area such as Yttrium 90 (Y90) ceramic spheres are not generally administered directly into tumors but into the vasculature feeding tumor-bearing organs such as the liver. The latter approach causes a significant degree of damage to healthy tissues. These current therapeutic regimens may have limited value for inoperable primary liver cancer. This disease is currently one of the world’s major causes of cancer-based mortality.
 
We are utilizing our BioSilicon technology to develop BrachySil, a novel targeted ablative oncology product for the treatment of inoperable primary liver cancer.
 
BrachySil consists of an injectable BioSilicon structure that carries 32-phosphorus, or 32-P, a beta-emitting radioactive isotope which has been shown to shrink tumors. However, as this radiation is harmful to healthy tissue, the 32-P and its radiation must be confined to the area of the tumor and not allowed to travel within the body. Existing 32-P-based products do not fully immobilize 32-P, allowing the isotope to dissolve, disperse throughout the body and harm healthy tissue in other parts of the body. We have engineered BrachySil to minimize 32-P leakage from the BioSilicon particle. Therefore, the 32-P is in effect “locked” into BrachySil by producing an amalgam of phosphorus and silicon. BrachySil is administered, without surgery, via a localized injection into the abdomen using a fine gauge needle under a local anesthetic. This allows the clinician to administer a single dose of BrachySil directly into the tumor site. BrachySil offers interventional radiologists a short-range longer life isotope that can be delivered through a fine bore needle making it a more user-friendly and precise product for both patient and physician.
 
-27-

 
In summary, for this form of treatment, we believe BrachySil has many significant advantages:
 
 
·
Short range. 32-P isotope has a short active range resulting in less damage to healthy tissue;
 
 
·
Range of tumors. Fine gauge needle delivery allows potential application to a range of solid tumors;
 
 
·
Direct delivery. Injection via fine gauge needle minimizes side effects and tissue trauma;
 
 
·
Distribution. 32-P half-life of 14 days allows more convenient distribution to hospitals and application in the patient;
 
 
·
Immobilization. 32-P particles are localized in the tumor, significantly reducing risk of leakage or systemic side effects.
 
Indications
 
Our BioSilicon technology is currently at the following stages of development for the listed diseases:
 
Disease
 
Product
 
Stage of Development
Primary liver cancer
 
BrachySil
 
Phase IIb
Pancreatic cancer
 
BrachySil
 
Phase IIa
 
Primary liver cancer. A Phase IIa clinical trial to assess BrachySil in inoperable primary liver cancer at the Singapore General Hospital was completed in July 2005. In this trial, BrachySil was found to be both safe and well tolerated. It was also found to significantly reduce the size of some tumors treated even with a low dose of the product.
 
A Phase IIb clinical trial in inoperable primary liver cancer patients has recently commenced. This is a multi-center dose profiling study designed to determine the optimal dose of BrachySil in treating this disease. Patients will be evaluated up to 12 months after treatment, and the endpoints are based on evaluations of patient safety and target tumor responses, as well as overall survival. This dose profiling phase of the development program will include a clinical evaluation of our proprietary SIMPL implantation system. SIMPL is a fine-gauge needle, multi-injection device, through which BrachySil is injected as a liquid suspension directly into tumors under local anesthetic. The device has been designed to distribute the implanted dose from a single entry point and to enable physicians to treat larger tumors.
 
Assuming that the Phase IIb trial is successful and an optimal dose is established, we intend to undertake larger multi-center clinical trials involving approximately 50 patients in both Asia and Europe to produce data sufficient to register BrachySil for use as an approved treatment for primary liver cancer.
 
Pancreatic cancer. In parallel to our work in primary liver cancer, we have been developing BrachySil for the treatment of pancreatic cancer and a Phase IIa clinical trial has recently begun. We believe BrachySil has the potential to be used to treat other solid tumors and we intend to investigate other tumor indications, such as liver metastases in due course.
 
-28-

 
During 2006, we began a dialogue with the FDA in order to clarify and facilitate the clinical development activities for BrachySil in the U.S. We are pursuing a similar strategy with respect to EU regulatory authorities to qualify for device registration in Europe under the auspices of a CE mark application. Generally speaking, obtaining regulatory approval to market a medical device is less expensive and time consuming than the process required for a new drug.
 
Other BioSilicon Applications
 
Diagnostics. Through our wholly-owned subsidiary AION Diagnostics, we seek to develop diagnostic applications using the key properties of BioSilicon. AION Diagnostics will attempt to develop products through strategic collaborations with universities, research institutions and industry partners. Preliminary research is currently being conducted.
 
Orthopedics. We believe that BioSilicon also has potential to be used as a biodegradable scaffold for orthopedic tissue engineering. A porous silicon structure could be deliberately sculpted to provide bone-building cells with a scaffold that the cells can penetrate and to which cells can anchor. As the bone tissue deposits itself onto the scaffold, the silicon would slowly dissolve away, eventually leaving just the new bone. Silicon’s ability to carry an electrical current charge bias may also give BioSilicon an advantage in the treatment of bone conditions, promote bone growth and may have other orthopedic applications. Data gathered to date in preclinical studies indicate that cells will grow and divide in BioSilicon substrates and that BioSilicon can be osteoinductive, promoting bone growth and deposition.
 
Tissue Regeneration/Wound Healing. We believe that BioSilicon also has potential uses in tissue regeneration as a biodegradable scaffold or framework. For example, a BioSilicon scaffold containing growth factors could be used to assist with tissue regeneration. We also believe that BioSilicon could be used in the area of wound management products, including the development of potentially novel biodegradable sutures. Our research initiatives involving the use of BioSilicon in the area of tissue regeneration are at a preliminary stage.
 
Food Technology. We are developing applications of our silicon technology in the food industry. We plan to license the use of BioSilicon as an ingestible ingredient in food applications and to develop patentable intellectual property using silicon in the food packaging area. Our research in the area of food technology is at a preliminary stage.
 
The CODRUG Technology System
 
Our proprietary CODRUG system allows for the simultaneous release of two or more drugs from the same product at the same controlled rate over a predetermined period of time. Using this technology, we chemically link together two or more identical or different drugs. Codrugs can be administered by virtually any delivery method. Regardless of delivery method, codrugs dissolve into the body at a predetermined rate and then separate into the original active drug(s) when the chemical bond breaks apart. We believe that many drugs can be chemically linked with our CODRUG technology and have synthesized a library of approximately several hundred codrug compounds.
 
We have performed Phase I clinical trials involving codrugs for the treatment of post-surgical pain and two skin diseases, psoriasis and actinic keratosis.
 
Strategic Collaborations
 
We have entered into a number of collaboration/license agreements to develop and commercialize our product candidates and technologies. In all of these agreements, we retain our right to use and develop the underlying technologies.
 
Chiron Vision Corporation
 
Our first collaboration was with Chiron Vision Corporation, a subsidiary of Chiron Corporation. Under a 1992 licensing and development agreement with CDS, Chiron Vision financed the development of Vitrasert, and we granted Chiron Vision a worldwide, exclusive license to make and sell products based on the Durasert technology used in Vitrasert for the treatment of conditions of the eye. Chiron Vision commenced commercial sales of Vitrasert following FDA approval in 1996. Bausch & Lomb acquired Chiron Vision in 1997, assumed our agreement and currently markets and sells Vitrasert. Bausch & Lomb pays royalties on net sales of Vitrasert.
 
-29-

 
Bausch & Lomb Incorporated
 
In 1999, CDS entered into a licensing and development agreement with Bausch & Lomb for additional products for the treatment of eye diseases. CDS granted Bausch & Lomb a worldwide, exclusive license for the life of the relevant patents to use its technologies for the treatment, prevention or diagnosis of any disease, disorder or condition of the eye in humans or in animals.
 
In December 2003, the two companies entered into an amended and restated license agreement that significantly revised the 1992 and 1999 agreements. Under this new agreement, CDS granted Bausch & Lomb a worldwide, exclusive license to certain of its technologies to make and sell Vitrasert and its first generation products, as defined in the agreement, including the Retisert device, for the treatment, prevention and diagnosis of any disease, disorder or condition of the human eye. Bausch & Lomb agreed to pay CDS royalties based on net sales for any products that meet the definition of first generation products.
 
In June 2005, pursuant to an amendment to this amended and restated license agreement, CDS received US$3.0 million (A$3.9 million) from Bausch & Lomb as an advance payment in lieu of US$6.25 million (A$8.5 million) of Retisert royalties that otherwise would be payable under the license agreement. Bausch & Lomb is entitled to retain 50% of the first US$3.0 million (A$4.1 million) of royalties otherwise payable, or US$1.5 million (A$2.1 million), and 100% of the next US$4.75 million (A$6.5 million) of royalties otherwise payable. Thereafter, we are entitled to receive 100% of the royalties payable under the license agreement. The following table summarizes the applicable royalty amounts for the period from inception (July 1, 2005) through September 30, 2006 and the future effect of this agreement prospectively from that date:
 
   
Royalties Otherwise Payable Under the License Agreement
 
Net Royalty Amount Payable Under the Amended License Agreement
 
   
(In thousands of U.S. dollars)
 
For the six months ended December 31, 2005 (1)
 
555
 
278
 
For the six months ended June 30, 2006
 
589
 
294
 (2)
For the three months ended September 30, 2006
 
495
 
248
 
           
From inception through September 30, 2006
 
1,639
 
820
 
           
For the period from October 1, 2006 until such time as cumulative royalties otherwise payable under the license agreement total US$3.0 million
 
1,361
 
680
 
           
Subtotal
 
3,000
 
1,500
 
           
Thereafter for the next US$4.75 million of royalties otherwise payable under the license agreement
 
4,750
 
-
 
           
Total
 
7,750
 
1,500
 
 
(1) Represents the period prior to our acquisition of CDS which closed on December 30, 2005.
 
(2) Represents the Retisert royalties (A$396,000) included as revenue in our audited consolidated financial statements for the fiscal year ended June 30, 2006.
 
CDS also granted Bausch & Lomb a non-exclusive license to these technologies to make and sell certain other products for the delivery of specified active ingredients, using specified delivery systems, methods of delivery and anchoring methods, to be used in specified locations for specified indications. If Bausch & Lomb has not commenced an Investigational New Drug application, or IND, a process by which the FDA approves investigational drugs for administration to humans, for any of those products by December 9, 2005, we may terminate the non-exclusive license for those products (unless this failure is cured within 90 days of receipt of notice). We are not aware as to whether Bausch & Lomb has commenced an IND for any of those products and we have not given any termination notices. If Bausch & Lomb does market any of those products, it will pay us royalties based on net sales of those products.
 
-30-

 
Bausch & Lomb is responsible for funding and managing the development and commercialization of all products under the agreement. Bausch & Lomb also agreed to pay us specified amounts if it achieves certain milestones related to certain licensed products.
 
We agreed not to develop, commercialize or license to a third party the rights to develop or commercialize any product to treat posterior uveitis so long as (1) Bausch & Lomb is actively pursuing the commercialization of a product to treat uveitis for which Bausch & Lomb would be required to pay us a specified level of royalty, and (2) Bausch & Lomb is not selling any other uveitis product for which it would not be required to pay us a specified level of royalty. We also may not develop, commercialize or license any product that meets the definition of first generation product as long as Bausch & Lomb has an exclusive license to such products using our technologies.
 
Bausch & Lomb may terminate our agreement in its entirety or with respect to Vitrasert or any non-exclusively licensed product at any time on 90 days’ written notice. In the event Bausch & Lomb terminates the agreement in its entirety, Bausch & Lomb’s license to our technologies will terminate. In the event Bausch & Lomb terminates the agreement with respect to Vitrasert or a non-exclusively licensed product, Bausch & Lomb will lose the right to rely upon our intellectual property to make and sell the relevant product.
 
Alimera Sciences Inc.
 
In February 2005, CDS granted Alimera Sciences a world-wide exclusive right to use certain of its technologies to make and sell, for the treatment and prevention of eye diseases (except uveitis) in humans, products that have a drug core within a polymer layer and are approved or designed to be approved to deliver only specified compounds by a direct delivery method to the posterior portion of the eye. In addition, CDS granted Alimera Sciences a world-wide exclusive right to use certain technologies to treat DME by delivering a compound or formulation by a direct delivery method other than through specified incisions, and which are not exclusively licensed to Bausch & Lomb.
 
A joint development team of both parties is responsible for monitoring the execution of activities under the development plan for licensed products. Both parties pay co-development costs that are incurred and included in the development budget. The agreement provided for Alimera Sciences to pay a licensing fee and milestone payment both of which were paid to CDS. Alimera Sciences has sole responsibility for making commercially reasonable efforts to commercialize products licensed under the agreement and for paying all costs and expenses incurred in connection with such commercialization. After a product becomes profitable in a country, we share the net profits for that product in that country with Alimera Sciences, after recovery by Alimera Sciences’ of its pre-profitability net losses for that product. If either party fails to pay the other party its share of development costs, the unpaid amount plus a delay charge is recouped from net profits. Further, in the event that we fail to make development payments exceeding US$2.0 million (A$2.7 million) for a product, Alimera Sciences may complete the development using other funds and substantially reduce our economic interest in any sales of the developed product from a share of profits to a sales-based royalty. As of November 30, 2006, we have chosen not to make development payments to Alimera Sciences in an aggregate amount of approximately US$1.9 million (A$2.6 million).
 
Improvements and other inventions developed during the license term in whole or in part by Alimera Sciences that are covered by or derived from the practice of our licensed technologies are jointly owned by us and Alimera Sciences, except for improvements specifically related to active ingredients provided by Alimera Sciences, which are owned by Alimera Sciences. Each party is free to use and sublicense such improvements, except that Alimera Sciences shall not have the right to use such improvements in connection with ophthalmic drug delivery devices (or related methods or processes) that include a drug core.
 
Either party may terminate the agreement for the other party’s failure to make a development payment. Either party may terminate the agreement with respect to a particular product if the other party gives written notice of its intent to abandon the product. The agreement provides for specific, exclusive remedies in the event of termination resulting from the occurrence of one of the above events.
 
On November 10, 2006, we signed a non-binding memorandum of understanding with Nordic Biotech Advisors, or Nordic, under which, upon closing, Nordic will invest US$4.0 million (A$5.2 million) in newly issued shares of our preferred stock and invest US$22.0 million (A$28.5 million), over time, to fund our expected share of the costs, and to receive our profit share payments, under the collaborative development and product license agreement with Alimera Sciences for the development of our Medidur for DME product.
 
Under the memorandum of understanding, our preferred stock issued in the transaction will be convertible into our ADSs at a conversion price of US$2.00 per ADS, will contain anti-dilution adjustment provisions, and will be subject to mandatory conversion under specified circumstances. We will also issue to Nordic warrants to purchase 1.0 million ADSs exercisable for five years with an exercise price of US$2.00 per ADS.
 
-31-

 
Also, under the memorandum of understanding, Nordic will invest US$3.5 million (A$4.5 million) in the Medidur project at closing (of which US$1.0 million (A$1.3 million) will be useable by us for general corporate purposes) and the remaining US$18.5 million (A$24.0 million) in regular installments. These investments will fund the expected amount of our share of development costs under the Alimera Sciences license agreement. If our share of the development cost exceeds the budgeted amount of US$22.0 million (A$28.5 million), any such excess will be our financial responsibility.
 
Nordic and pSivida will share all revenue received as a result of the Medidur project as follows:
 
(1) until receipt by Nordic of amounts equal to four times its investment, 75% to Nordic and 25% to us; and thereafter
 
(2) until receipt by Nordic of amounts equal to eight times its investment, 50% to Nordic and 50% to us; and thereafter
 
(3) 20% to Nordic and 80% to us.
 
Subject to our shareholders’ approval, Nordic would have the right to convert its US$22.0 million (A$28.5 million) investment into our ADSs at US$2.00 per ADS. In the event that Nordic were to convert some portion of its investment into ADSs, a proportionate amount of Nordic’s revenue share would revert to us.
 
We have also agreed to file a resale registration statement to register the sale by Nordic of ADSs into which its preferred stock, warrants and investment could be converted.
 
Subject to mutual agreement and applicable law, we would also appoint a representative of Nordic to our board of directors.
 
Beijing Med-Pharm Corporation
 
In October 2005 we signed a license with Beijing Med-Pharm Corporation for the clinical development, marketing and distribution of BrachySil in China. Under the terms of the license, we will manufacture BrachySil and Beijing Med-Pharm will be responsible for clinical development, securing regulatory approval, marketing and distribution in China and Hong Kong. We will retain manufacturing rights for BrachySil under the license. It is a condition of the license that a manufacturing and supply agreement for us to supply BrachySil to Beijing Med-Pharm be concluded. The deadline for completion of the manufacturing and supply agreement has been extended from January 2006 to April 2007. If a manufacturing and supply agreement is not concluded by April 2007, the upfront payment is required to be refunded to Beijing Med-Pharm Corporation, and the license agreement terminates. The license with Beijing Med-Pharm included an upfront payment to us of US$375,000 (A$514,000) upon entering into the license, a payment of US$375,000 (A$514,000) due upon entering into the manufacturing and supply agreement, and additional payments of up to US$1.75 million (A$2.4 million) will be made to us if certain milestones are achieved. In addition, we will receive royalties ranging from 10% up to 30%, depending upon the level of sales.
 
-32-

 
Other Collaborations
 
We entered into a series of agreements with several undisclosed pharmaceutical, biotechnology and device companies to evaluate our technologies for the delivery of these companies’ drugs. These agreements cover our three core drug delivery technologies, Durasert, BioSilicon and CODRUG. If the work being conducted under any of these evaluation agreements is successful, we believe there is the potential for one or more of these companies to license the relevant technology from us for a specific drug molecule and/or application.
 
QinetiQ
 
In connection with the organization of pSivida and pSiMedica, in December 2000, pSiMedica entered into a technology license agreement with the United Kingdom Defense Evaluation and Research Agency, or DERA, an instrumentality of the UK government. The technology license gave pSiMedica the right to use intellectual property associated with BioSilicon to develop, manufacture and sell products for uses on or in the human and animal body. The intellectual property included patents, patent applications, various research reports, trademarks, know-how and other materials. The license was granted on a worldwide, royalty free basis in exchange for shares in pSiMedica. DERA retained the right to use the intellectual property in connection with defense-related, noncommercial purposes. The license provided that DERA would later assign the intellectual property outright upon the fulfillment of certain conditions, including pSiMedica successfully raising additional funds.
 
In March 2002, subsequent to our making an additional investment in pSiMedica funded by our November 2001 placement of ordinary shares, pSiMedica entered into an assignment agreement with QinetiQ. Pursuant to the assignment agreement, QinetiQ, the successor to DERA’s rights to the intellectual property, assigned the outright ownership of the intellectual property to pSiMedica with QinetiQ retaining only the right to sublicense the intellectual property for noncommercial, defense-related uses and, subject to reasonable terms, in connection with purposes outside of pSiMedica’s original field of use. Pursuant to the assignment agreement, pSiMedica became the owner of all the relevant patents, patent applications, research reports, trademarks, know-how and other materials associated with BioSilicon.
 
University of South Australia / ARC Grant
 
Together with the University of South Australia, we were awarded an ARC Industry Linkage Grant to conduct research to characterize and evaluate FioSilicon for the delivery of biological molecules.
 
Other Potential Collaborations
 
We intend to license diagnostic and sensor applications of the BioSilicon platform technology developed by our subsidiary, AION Diagnostics. We also believe that the potential range of applications for BioSilicon will permit early stage licensing for non-core applications such as biomaterial in orthopedics, tissue engineering and regenerative medicine.
 
Manufacturing Partners
 
We currently produce BioSilicon at our facilities at Malvern in the UK, and also have an option to acquire additional BioSilicon from QinetiQ in the UK for use in internal and collaborative research. Our lead product, BrachySil, is currently manufactured by Hosokawa Micron Group, Atomising Systems Ltd, High Force Ltd and AEA Technology QSA GmbH to cGMP standards. The manufacture of BrachySil requires four steps. These steps include:
 
 
·
the smelting and subsequent atomization of silicon and “cold” (non-radioactive) phosphorus to produce phosphorus-containing silicon particles;
 
 
·
size classification of 30 micron phosphorus-containing silicon particles
 
-33-

 
 
·
acid etching to produce biocompatible phosphorus-containing BioSilicon particles; and
 
 
·
neutron bombardment of the phosphorus-containing silicon particles to product radioactive 32-P BioSilicon particles.
 
In order to achieve the four steps above, we have contracted with four separate companies, each an expert in one of the above manufacturing processes.
 
Intellectual property
 
We believe that we enjoy a strong intellectual property position, with core biomaterial and drug delivery patents granted in the United States and European markets. The following table provides general details relating to our patents (including both patents that have been issued and applications that have been accepted for issuance) and patent applications, and is based on information available as of September 28, 2006.
 
Technology
 
United States Patents
 
United States Applications
 
Foreign Patents
 
Foreign Applications
 
Patent Families
Durasert1
 
10
 
17
 
28
 
130
 
18
BioSilicon
 
  7
 
26
 
38
 
  75
 
32
CODRUG
 
   1
 
17
 
  6
 
  50
 
18
Other
 
   1
 
  6
 
  4
 
    1
 
  8
Total
 
19
 
66
 
76
 
256
 
76
 

1 Formerly referred to as our AEON Technology.
 
Durasert Technology. Our patent portfolio comprises patents and patent applications relating to the use of drug-containing core and one or more polymer layers, membranes or coatings, that deliver drugs locally or systemically at a controlled rate for a predetermined period of time ranging from days to years.
 
BioSilicon Technology. Our patent portfolio comprises patents and patent applications relating to the use of BioSilicon on or in the body. We hold granted patents in various healthcare applications, including our core focus of specialized drug delivery, targeted internal cancer therapy, diagnostics and the use of silicon in pharmaceuticals and food. Our lead oncology product BrachySil is protected by this series of patents and patent applications.
 
CODRUG Technology. Our patent portfolio comprises patents and patent applications relating to the use and delivery of codrugs for various pharmaceutical- and healthcare-related applications.
 
Other Technology. We have patents and patent applications relating to various other technologies, including treatment of optic disorders and methods for controlling elevated intraocular pressure.
 
Sales and Marketing
 
We have no experience in the sales, marketing and distribution of healthcare products. If in the future we fail to reach or elect not to enter into an arrangement with a collaborative partner with respect to the sales and marketing of any of our future products, we would need to develop a sales and marketing organization with supporting distribution capability in order to market such products directly. Significant additional expenditures would be required for us to develop such a sales and marketing organization.
 
Bausch & Lomb currently markets and sells both Vitrasert and Retisert and has rights to market and sell any other products licensed to them. Alimera Sciences has the rights to market and sell Medidur for DME if approved and any other products developed under our license agreement. Beijing Med-Pharm has the rights to market and sell BrachySil (if approved) for solid tumor indications in China and Hong Kong. In the future, we may independently commercialize and sell some of our other products. In appropriate cases, we may also enter into joint marketing or license arrangements for other products.
 
-34-

 
Reimbursement
 
The successful commercialization of our products will depend in significant part on the extent to which reimbursement of the cost of the products and the related implantation or injection procedures will be available from government health administration authorities, private health insurers, and other organizations. Medicaid and Medicare, most major health maintenance organizations, and most health insurance carriers reimburse US$4,240 (A$5,800) for the cost of the Vitrasert implant, with additional reimbursement for associated surgical fees. The Centers for Medicare and Medicaid Services have designated Retisert as eligible for Medicare reimbursement at the rate of US$19,345 (A$26,500), with associated surgical fees to be reimbursed separately.
 
Competition
 
We are engaged in healthcare product development, an industry that is characterized by extensive research efforts and rapid technological progress. Many established biotechnology companies, universities and other research institutions with financial, scientific and other resources significantly greater than ours are marketing or may develop products that directly compete with any products we may develop. These entities may succeed in developing products that are safer, more effective or less costly than products we may develop. Even if we can develop products which should prove to be more effective than those developed by other companies, other companies may be more successful than us because of greater financial resources, greater experience in conducting preclinical studies and clinical trials and in obtaining regulatory approval, stronger sales and marketing efforts, earlier receipt of approval for competing products and other factors. If we commence significant commercial sales of any products, we or our collaborators will compete in areas in which we have no experience, such as marketing. There can be no assurance that our products, if commercialized, will be accepted and prescribed by healthcare professionals.
 
Our principal competitors in this market are the numerous drug delivery and pharmaceutical companies that are attempting to improve the safety and efficiency of pharmaceuticals by developing and introducing novel delivery methods.
 
Vitrasert primarily competes with treatments involving the systemic delivery of ganciclovir, a Roche Holdings AG product, and other drugs. Retisert is the only FDA approved treatment for posterior uveitis, although steroids and other existing drugs approved for other uses are commonly administered systemically or by local injection to treat this condition in off-label use.
 
We believe that pharmaceutical, drug delivery, and biotechnology companies, research organizations, governmental entities, universities, hospitals, other nonprofit organizations, and individual scientists are seeking to develop therapies for our targeted diseases. We expect that our products and product candidates, if approved, will compete with existing therapies for these targeted diseases, as well as new drugs, therapies, drug delivery systems, or technological approaches that may be developed and approved to treat these diseases or their underlying causes as well as off-label use of products approved to treat other diseases. For many of these targeted diseases, competitors have alternate therapies that are already commercialized or are in various stages of development ranging from discovery to advanced clinical trials. Most of the entities with whom we will or may compete are much larger, have much greater financial resources and have much more experience in drug development and sale than us.
 
Many companies are pursuing products to treat back of the eye diseases. These include the following:
 
 
·
Eli Lilly and Company is in advanced clinical trials for its protein kinase C beta inhibitor for the treatment of diabetic retinopathy.
 
 
·
Genentech, Inc. has developed an FDA approved cancer drug, Avastin, which may be used as an off-label treatment for DME.
 
 
·
Novartis Ophthalmics AG markets cyclosporine, which is used for the systemic treatment of uveitis.
 
-35-

 
 
·
Allergan, Inc. is in Phase III clinical trials of its product, Posurdex® for the treatment of persistent macular edema. If approved by the FDA, this product may be used off-label for the treatment of DME. In addition, Allergan and EntreMed, Inc. are collaborating on a program to develop a treatment for AMD that is at the pre-clinical development stage.
 
 
·
Eyetech Pharmaceuticals, Inc., which was acquired by OSI Pharmaceuticals, Inc. in November 2005, has an intraocular injectable product, Macugen, approved to treat wet AMD and had commenced a pivotal clinical trial for the use of Macugen in the treatment of DME. In addition, Eyetech entered into a collaboration with Pfizer, Inc. to co-promote Macugen.
 
 
·
SurModics Inc. has initiated a Phase I clinical trial of a helical coil coated with drug releasing polymer which is implanted in the back of the eye to treat DME.
 
 
·
Neurotech SA has completed Phase I clinical trials of its NT-501, a cell-based implant that releases ciliary neurotrophic factor for the treatment of RP.
 
BrachySil competes with a number of therapies used in the treatment of inoperable primary liver cancer. Examples of these treatment options include local ablative therapies such as radiofrequency ablation, and regional therapies such as transarterial chemoembolisation and transarterial radiotherapy. Each of these treatment options has its own features and limitations.
 
Revenue
 
The following table details revenues recognized by us by type and by geographical location for the years ended June 30, 2006 and 2005 (in Australian dollars):
 
   
Years Ended June 30,
 
   
2006
 
2005
 
   
United States
 
United Kingdom
 
Total
 
United States
 
United Kingdom
 
Total
 
                           
Revenue:                                      
Royalties
   
460,926
   
-
   
460,926
   
-
   
-
   
-
 
Collaborative research and development
   
863,143
   
-
   
863,146
   
-
   
-
   
-
 
Other
   
-
   
68,931
   
68,931
   
-
   
161,666
   
161,666
 
     
1,324,069
   
68,931
   
1,393,000
   
-
   
161,666
   
161,666
 
 
Government Regulation
 
The FDA and comparable regulatory agencies in state and local jurisdictions and in foreign countries impose substantial requirements upon the clinical development, manufacture and marketing of pharmaceutical products. These agencies and other federal, state and local entities regulate research and development activities and the testing, manufacture, quality control, safety, effectiveness, labeling, storage, record keeping, approval, advertising and promotion of our drug delivery products. The process required by the FDA under the new drug provisions of the Federal Food, Drug, and Cosmetic Act before our products may be marketed in the United States generally involves the following:
 
 
·
pre-clinical laboratory and animal tests;
 
 
·
submission to the FDA of an investigational new drug application, or IND, which must become effective before clinical trials may begin in the United States;
 
 
·
adequate and well-controlled human clinical trials to establish the safety and efficacy of the proposed pharmaceutical for its intended use;
 
-36-

 
 
·
submission to the FDA of a new drug application; and
 
 
·
FDA review and approval of the new drug application.
 
The testing and approval process requires substantial time, effort, and financial resources, and we cannot be certain that any approval will be granted on a timely basis, if at all.
 
Pre-clinical tests include laboratory evaluation of the product, its chemistry, formulation and stability, as well as animal studies to assess the potential safety and efficacy of the product. The results of the pre-clinical tests, together with manufacturing information, analytical data and protocols for proposed human clinical trials, are submitted to the FDA as part of an IND, which must become effective before we may begin human clinical trials. The IND automatically becomes effective 30 days after receipt by the FDA, unless the FDA, within the 30-day time period, raises concerns or questions about the conduct of the proposed clinical trials as outlined in the IND and imposes a clinical hold. In such a case, the IND sponsor and the FDA must resolve any outstanding concerns before clinical trials can begin. There is no certainty that pre-clinical trials will result in the submission of an IND or that submission of an IND will result in FDA authorization to commence clinical trials.
 
Clinical trials involve the administration of the investigational product to human subjects under the supervision of a qualified principal investigator. Clinical trials are conducted in accordance with protocols that detail the objectives of the study, the parameters to be used to monitor safety and any efficacy criteria to be evaluated. Each protocol must be submitted to the FDA as part of the IND. Further, each clinical study must be conducted under the auspices of an independent institutional review board at the institution where the study will be conducted. The institutional review board will consider, among other things, ethical factors, the safety of human subjects and the possible liability of the institution. Some clinical trials, called “investigator-sponsored” clinical trials, are conducted by third-party investigators. The results of these trials may be used as supporting data by a company in its application for FDA approval, provided that the company has contractual rights to use the results.
 
Human clinical trials are typically conducted in three sequential phases which may overlap:
 
 
·
Phase I: The drug is initially introduced into healthy human subjects or patients and tested for safety, dosage tolerance, absorption, metabolism, distribution and excretion.
 
 
·
Phase II: Studies are conducted in a limited patient population to identify possible adverse effects and safety risks, to determine the efficacy of the product for specific targeted diseases and to determine dosage tolerance and optimal dosage.
 
 
·
Phase III: Phase III trials are undertaken to further evaluate clinical efficacy and to further test for safety in an expanded patient population, often at geographically dispersed clinical study sites.
 
In the case of products for life-threatening diseases such as cancer, or severe conditions such as blinding eye disease, the initial human testing is often conducted in patients with the disease rather than in healthy volunteers. Since these patients already have the targeted disease or condition, these studies may provide initial evidence of efficacy traditionally obtained in Phase II trials and so these trials are frequently referred to as Phase I/II trials. If a product uses a combination of drugs, the FDA requires that clinical trials demonstrate that the combination is safe and effective and that each drug contributes to efficacy. We cannot be certain that we will successfully complete Phase I, Phase II or Phase III testing of our product candidates within any specific time period, if at all. Furthermore, we, the FDA, the institutional review board or the sponsor, if any, may suspend clinical trials at any time on various grounds, including a finding that the subjects or patients are being exposed to an unacceptable health risk.
 
The results of product development, pre-clinical studies and clinical studies are submitted to the FDA as part of a new drug application, or NDA, for approval of the marketing and commercial shipment of the product. The FDA may deny an NDA if the applicable regulatory criteria are not satisfied or may require additional clinical data. Even if the additional data are submitted, the FDA may ultimately decide that the new drug application does not satisfy the criteria for approval. As a condition of approval, the FDA may require post-marketing “Phase IV” clinical trials to confirm that the drug is safe and effective for its intended uses. Once issued, the FDA may withdraw product approval if compliance with regulatory standards for production and distribution is not maintained or if safety problems occur after the product reaches the market. The FDA requires surveillance programs to monitor approved products which have been commercialized. The agency also has the power to require changes in labeling or to prevent further marketing of a product based on the results of these post-marketing programs.
 
-37-

 
If a drug is intended for the treatment of a serious or life-threatening condition and has the potential to address unmet medical needs for this condition, the drug sponsor may apply for FDA “fast track” designation. The fast track designation applies only for the specific indications for which the product satisfies these two requirements. Under fast track provisions, the FDA is committed to working with the sponsor for the purpose of expediting the clinical development and evaluation of the drug’s safety and efficacy for the fast track indication.
 
Marketing applications filed by sponsors of products in fast track development often will qualify for expedited review under policies or procedures offered by the FDA, but fast track designation does not assure this qualification.
 
If a drug treats a disease or condition that affects fewer than 200,000 people in the United States, the drug sponsor may apply to the FDA for “orphan drug” designation under the Orphan Drug Act. More than one drug may be given an orphan drug designation by the FDA for a given disease or condition. However, the first drug with an orphan drug designation to receive marketing approval for the treatment of that disease or condition is granted a period of marketing exclusivity. Sponsors are granted seven years of exclusive rights to market the first approved orphan drug for treatment of that disease or condition, independent of any additional patent protection that may apply to the product. This marketing exclusivity does not prevent a competitor from obtaining approval to market a different drug that treats the same disease or condition or the same drug to treat a different disease or condition. Sponsors also are granted tax incentives for clinical research undertaken to support an application for an orphan drug, and grants to defray some of these clinical costs may also be available. In addition, the FDA will typically coordinate with the sponsor on research study design for an orphan drug and may exercise its discretion to grant marketing approval on the basis of more limited product safety and efficacy data than would ordinarily be required. If the FDA withdraws a product’s orphan drug designation, however, these various benefits no longer apply.
 
Satisfaction of FDA requirements or similar requirements of state, local and foreign regulatory agencies typically takes several years, and the actual time required may vary substantially based upon factors including the type, complexity and novelty of the pharmaceutical product. Such government regulation may delay or prevent marketing of potential products for a considerable period of time and impose costly procedures upon our activities. Success in pre-clinical or early stage clinical trials does not assure success in later stage clinical trials. Data from pre-clinical and clinical activities is not always conclusive and may be susceptible to varying interpretations which could delay or prevent regulatory approval. Even if a product receives regulatory approval, the approval may be subject to significant limitations based on data from pre-clinical and clinical activities. Further, discovery of previously unknown problems in connection with a product’s use may result in restrictions on the product or even complete withdrawal of the product from the market.
 
Any products we manufacture or distribute under FDA clearances or approvals are subject to pervasive and continuing regulation by the FDA, including record-keeping requirements and reporting of adverse experiences with the products. Drug manufacturers and their subcontractors are required to register with the FDA and state agencies. They are also subject to periodic unannounced inspections by the FDA and state agencies for compliance with good manufacturing practices, which impose procedural and documentation requirements upon us and our third-party manufacturers.
 
We are also subject to numerous other federal, state and local laws relating to such matters as safe working conditions, manufacturing practices, environmental protection, fire hazard control, and disposal of hazardous or potentially hazardous substances. We may incur significant costs to comply with such laws and regulations now or in the future. In addition, we cannot predict what adverse governmental regulations may arise from future United States or foreign governmental action.
 
We are also subject to foreign regulatory requirements governing human clinical trials and marketing approval for pharmaceutical products which we sell outside the U.S. The requirements governing the conduct of clinical trials, product licensing, pricing and reimbursement vary widely by country. Whether or not we obtain FDA approval, we must obtain approval of a product by the comparable regulatory authorities of foreign countries before manufacturing or marketing the product in those countries. The approval process varies from country to country, and the time required for these approvals may differ substantially from that required for FDA approval. There is no assurance that clinical trials conducted in one country will be accepted by other countries or that approval in one country will result in approval in any other country. For clinical trials conducted outside the United States, the clinical stages generally are comparable to the phases of clinical development established by the FDA.
 
-38-

 
C.
ORGANIZATIONAL STRUCTURE
 
As of November 30, 2006, we had the organizational structure diagrammed below.

chart
 
(1) The 99% ownership applies only to capital stock that is currently issued and outstanding and does not include outstanding options to acquire shares of AION Diagnostics Inc., for no consideration, currently held by directors and employees of AION Diagnostics Inc., of which options over 9.7% of capital, calculated on a fully diluted basis, have vested.
 
D.
PROPERTY, PLANT AND EQUIPMENT
 
We own computer equipment, office furniture and lab equipment, the majority of which are used in our Malvern laboratory facilities. We lease the following:
 
 
·
2,400 square feet of laboratory space and 4,833 square feet of office space in Malvern, United Kingdom;
 
 
·
3,283 square feet of office space in Perth, Western Australia; and
 
 
·
3,940 square feet of laboratory space, 1,582 square feet of clean room space and 7,890 square feet of office space in Boston, Massachusetts.
 
Our manufacturing partner QSA, has recently completed the construction and validation of a state-of-the-art cleanroom facility, dedicated to the supply of our lead cancer therapy BrachySil, at QSA’s Auriga Medical facility in Braunschweig, Germany. This cGMP facility will fulfill the final process in the manufacture of BrachySil for future clinical and commercial use, and represents the crucial final stage in establishing the manufacturing and supply infrastructure to support BrachySil as it advances through clinical trials towards the market.
 
 
None.
 
 
The following discussion and analysis includes certain forward-looking statements with respect to our business, financial condition, and results of operations. The words “estimate”, “project”, “intend”, “expect” and similar expressions are intended to identify forward-looking statements within the Private Securities Litigation Act Reform of 1995. These forward-looking statements are subject to risks and uncertainties that could cause actual results to differ materially from those contemplated by such forward-looking statements. 
 
-39-

 
Background
 
pSivida Limited is incorporated in Western Australia. We are a global bio-nanotech company committed to the biomedical sector and the development of drug delivery products. Our core focus is the development and commercialization of products based on our Durasert, BioSilicon and CODRUG technologies.
 
 
·
The Durasert technology, obtained as part of the acquisition of CDS, uses a drug core with one or more surrounding polymer layers. The drug permeates through the polymers into the body at a controlled and pre-determined rate for extended periods of time. Two of our products, Vitrasert and Retisert, are FDA-approved and licensed to Bausch & Lomb, and a third product candidate, Medidur, is in Phase III trials with our collaboration partner Alimera Sciences.
 
 
·
BioSilicon, which uses nanostructured elemental silicon, has been shown to be biodegradable and biocompatible. BrachySil, a targeted oncology product which comprises a combination of BioSilicon and the isotope 32Phosphorus, a proven anti-cancer therapeutic, is in Phase II clinical trials for the treatment of primary liver cancer and pancreatic cancer. BioSilicon offers multiple other potential applications across the healthcare sector, including controlled slow release drug delivery, tissue engineering and orthopedics.
 
 
·
CODRUG allows for the simultaneous release of two or more drugs at a controlled rate from the same product. A library of codrug compounds has been synthesized and Phase I clinical trials have been undertaken for post-surgical and two dermatological indications.
 
On May 18, 2001, we re-listed on the Australian Stock Exchange (ASX Code: PSD). Our shares are also listed in Germany on the Frankfurt Stock Exchange on the XETRA system (German Symbol: PSI. Securities Code (WKN) 358705), in the United Kingdom on the OFEX International Market Service (IMS) under the ticker symbol PSD and on the NASDAQ Global Market under the ticker symbol PSDV.
 
A.
OPERATING RESULTS 
 
 
We are committed to the development of drug delivery products in the healthcare sector, initially in ophthalmology and oncology.
 
We have developed the only two FDA-approved, sustained release, back of the eye treatments for chronic eye disease - Vitrasert and Retisert. Both products are manufactured and sold by global ophthalmology company, Bausch & Lomb. A next generation product, Medidur, which is in Phase III clinical trials, is licensed to Alimera Sciences for the treatment of Diabetic Macular Edema (DME), the leading cause of vision loss for Americans under the age of 65.
 
We also own the rights to develop and commercialize a modified form (porosified or nano-structured) of silicon known as BioSilicon, which has potential applications in drug delivery, wound healing, orthopedics, and tissue engineering.
 
Our lead BioSilicon product is BrachySil, a brachytherapy product in pivotal Phase IIb clinical trials, which is being developed for the treatment of inoperable primary liver cancer and pancreatic cancer. A Phase IIa clinical trial involving BrachySil demonstrated significant tumor regression as well as being both safe and well tolerated in humans. We have a licensing agreement with Beijing Med-Pharm Corporation for the clinical development, marketing and distribution of BrachySil in China.
 
We have a number of evaluation agreements for our drug delivery technologies with three of the five largest pharmaceutical companies in the world and have a further evaluation agreement with an undisclosed global medical device company to evaluate cardiovascular delivery of drugs using our drug delivery technologies.
 
-40-

 
We have focused our efforts since inception primarily on research and development activities, corporate partnering, and raising capital. We currently have research and development programs focused in the areas of ophthalmology and oncology, however we are unable to predict when, if ever, we will be able to commence sales of any new products. We have not achieved profitability and expect to incur additional losses over the next several years. We expect our net losses to continue primarily due to our research and development activities and other general corporate activities. Our ability to continue development of our programs depends heavily on obtaining adequate funding. Our potential sources of funding for the next several years are expected to include proceeds from the sale of equity, license and other fees, funded research and development payments and milestone payments under existing and future collaborative arrangements. Such collaborative arrangements typically involve upfront payments and milestone payments. The availability of equity funding depends on a number of factors including the condition of the equity markets for a developmental stage business.
 
Since inception we have generated net losses of A$56.9 million, and have relied primarily on the proceeds from sales of our equity and debt securities and license fees and collaboration payments to fund our operations.
 
Our shares are currently listed on the Australian Stock Exchange, in Germany on the Frankfurt Stock Exchange on the XETRA System, in the United Kingdom on the OFEX International Market System and in the United States on the NASDAQ Global Market. We are required to prepare financial statements in accordance with A-IFRS and to reconcile our financial statements to U.S. GAAP which has resulted in significant administrative costs. In the future, we plan to change our organizational structure which will enable us to report only in U.S. GAAP.
 
We have research and development and administrative facilities in Malvern (United Kingdom), Perth (Western Australia) and Boston (United States). The geographic scope of our operations has also resulted in higher administrative costs. The Australian operation is being scaled back as more of our corporate functions are being transferred to the United States. Primarily as a result of our acquisition of CDS on December 30, 2005, our functional currency was changed from Australian dollars to U.S. dollars as of January 1, 2006.
 
Financial Operations Overview
 
Revenue
 
Our revenue is derived primarily from collaborative research and development funding and earned royalties from sales of Retisert and Vitrasert by our corporate partner, Bausch & Lomb. Vitrasert has been sold since 1996, but improvements in the treatment of AIDS/HIV have significantly decreased the incidence of the disease and therefore revenues are expected to continue to decline as the product nears the end of its life cycle. Retisert was approved for commercialization in April 2005, and is still in the early phase of its product life cycle. Although we currently expect that Bausch & Lomb’s sales of Retisert will continue to increase, a substantial portion of Retisert royalties otherwise payable to us, at least in the near term, will be retained by Bausch & Lomb pursuant to an advance royalty agreement entered into by CDS in June 2005. Other income consists primarily of interest income earned on cash and investments.
 
Development Programs and Product Candidates
 
Product candidates in clinical trials have significantly higher associated development costs than those in the preclinical stages since the former involve testing on humans while the latter will typically involve shorter-term animal studies. Moreover, as a product candidate moves into later-stage clinical trials, such as from Phase I to Phase  II or Phase II to Phase III, the costs are significantly higher due to the increased size and length of the later stage trials. Our future financial requirements include resources to manage the broader scope of future later-stage trials, additional pre-clinical support costs, increased costs for specialty clinical management organizations, higher general and administrative costs and higher quantities of clinical trial materials. We are sharing development cost responsibilities of Medidur (an injectible implant for the treatment of DME) with Alimera Sciences. Currently, we are conducting two Phase III clinical trials which will monitor 900 patients in the United States and Europe for 36 months.
 
We currently have sole development cost responsibility for BrachySil (an injectible BioSilicon-based particulate that carries a radioactive isotope which has been shown to shrink tumors). We recently concluded a Phase IIa clinical trial to assess BrachySil in inoperable primary liver cancer. BrachySil was found to be safe, well tolerated and to significantly reduce the size of some tumors.
 
-41-

 
A Phase IIb trial for the treatment of inoperable primary liver cancer has begun. Patients will be evaluated for up to 12 months after treatment to target tumor responses as well as overall survival. We also have sole development cost responsibility for BrachySil for the treatment of pancreatic cancer. A Phase IIa clinical trial has recently begun for that indication.
 
Our other developmental products (Mifepristone) and products for other targeted diseases (dry age-related macular degeneration and retinitis pigmentosa) are in various stages of earlier development. We have recently focused our development efforts and expenses in our later stage programs and reduced our expenses related to earlier stage programs.
 
The development of our product candidates is uncertain. At this time, we cannot reasonably estimate or know the nature, timing and estimated costs of the efforts that will be necessary to complete the remainder of the development of, or the period, if any, in which material net cash inflows will commence from of our product candidates. This is due to numerous risks and uncertainties associated with developing drugs, including the uncertainty of:
 
 
·
our ability to progress any product candidates into pre-clinical and clinical trials;
 
 
·
the scope, rate and progress of our pre-clinical trials and other research and development activities;
 
 
·
the views and standards applied by the applicable regulatory agencies;
 
 
·
the scope, rate of progress and cost of any clinical trials we commence;
 
 
·
the results of our clinical trials;
 
 
·
the expense of filing, prosecuting, defending and enforcing patent claims and other intellectual property rights;
 
 
·
the terms and timing of any collaborative, licensing and other arrangements that we may establish;
 
 
·
the expense and timing of regulatory approvals;
 
 
·
the cost of establishing sources of clinical trials materials of any product that we may develop; and
 
 
·
the effect of competing technological and marketing developments.
 
We generally seek collaborative partners to share the development costs and risks in our later-stage development programs. The commercial success of any of our products that are approved for sale will depend upon both the clinical results including efficacy and safety as well as the selling price of our product and the competition from other products that treat the same indication. In addition, we do not currently have an internal sales and marketing group, which would cause us to rely on a third party to bring our product to market.
 
Financial Resources
 
We have completed the following financings since July 1, 2005:
 
 
·
In September 2005, we raised US$4.3 million (A$5.7 million) of gross proceeds in a private placement structured as a PIPE. In the PIPE, we sold 665,000 ADSs to investors at US$6.50 per ADS and issued three-year warrants exercisable for 133,000 ADSs at US$12.50 per ADS.
 
 
·
On November 16, 2005, we issued a subordinated convertible promissory note in the principal amount of US$15.0 million (A$19.7 million) to an institutional investor in a private placement. The note bears interest at a rate equal to 8% per year, which we can pay in ADSs instead of cash if certain conditions are met. The note has a term of three years and was initially convertible into ADSs at a conversion price of US$7.10 per ADS, subject to adjustment based upon certain events or circumstances, including, without limitation, the market price of ADSs for the ten trading days ending August 5, 2006, if such price was lower than US$6.57. We also issued a warrant with a term of six years which entitled the institutional investor to purchase up to 633,803 ADSs at US$7.20 per ADS, also subject to adjustment upon specified events. Since the completion of our rights issue on June 14, 2006, the exercise price under the warrant was adjusted to US$7.17 per ADS. We have also entered into a registration rights agreement pursuant to which we agreed to file a registration statement covering the resale of the ADSs underlying the note (as well as any ADSs received by the institutional investor as interest under the note) and the warrant, as soon as practicable and to have the registration statement declared effective within 180 days of issuance of the note and warrant. The gross proceeds received by us in the private placement were US$15.0 million (A$19.7 million). Proceeds may increase to approximately US$19.5 million (approximately A$25.9 million) if the warrant is exercised in full in cash. 
 
-42-

 
 
·
On June 14, 2006, we announced that our non-renounceable rights issue had closed. Proceeds of A$6,309,487, before costs, were raised through the issuance of 10,515,811 new ordinary shares at a price of A$0.60 per share. This represented a subscription of 22% of the total shares available for subscription under the rights issue.
 
 
·
On September 14, 2006, we amended the terms of the subordinated convertible promissory note that was issued on November 16, 2005 to an institutional investor. The note continues to have a three year term and to bear 8% interest payable quarterly. We may make future interest payments in the form of our NASDAQ-listed ADSs, or, at our sole option, we may make such payments in cash. Per the amended terms, the note is now convertible into ADSs at a conversion price of US$2.00 per ADS, subject to adjustment based upon certain events or circumstances, including, without limitation, if 108% of the market price of ADSs for the ten trading days ending April 30, 2007 is lower than the current conversion price. In connection with the amendments, we repaid US$2.5 million (A$3.3 million) of the outstanding principal note and agreed to pay US$1.0 million (A$1.3 million) in related penalties, which were paid on September 14, 2006. The investor retains its existing warrants to purchase 633,803 additional ADSs, exercisable for six years at a current exercise price of US$7.17 per ADS. In connection with the amendments, we agreed with the institutional investor to extend the deadline for the registration statement required by the registration rights agreement to be declared effective by the SEC through October 15, 2006, with increased penalties if that deadline were missed. Our registration statement was declared effective on September 29, 2006. We were also released from the restrictions on future fundraising transactions contained in the note documentation. We also granted the investor an additional warrant to purchase 5.7 million ADSs exercisable for five years with an exercise price of US$1.80 per ADS and a security interest in our current royalties, subject to release of that security upon any disposition by us of the royalty stream.
 
 
·
On September 26, 2006, we issued three new subordinated convertible promissory notes in the principal amount of US$6.5 million (A$8.5 million) to institutional investors. The notes are convertible into our ADSs at a conversion price of US$2.00 per ADS (A$0.27 per ordinary share), subject to adjustment based on certain events or circumstances, including the market price of our ADSs on April 30, 2007. The notes bear interest at a rate equal to 8% per annum and mature three years from issuance. Interest is payable quarterly in arrears in cash or ADSs at an 8% discount to the 10 day volume weighted average closing price. We also issued warrants to the investors with a term of five years which will entitle the investors to purchase 2,925,001 ADSs at US$2.00 per ADS. We have also entered into a registration rights agreement pursuant to which we have agreed to file a registration statement covering the resale of the ADSs underlying the notes and the warrants as soon as practicable and to have the registration statement declared effective on or before January 1, 2007. We may redeem the notes at any time by payment of 108% of the face value and may force conversion if the ADS price remains above two times the conversion price for a period of 25 days. The proceeds of the issuance are expected to be used for general corporate purposes.
 
 
·
On October 17, 2006, we signed an agreement with our investor further revising the terms of the November 16, 2005 subordinated convertible promissory note. Pursuant to that agreement, we were released until March 30, 2007 from the requirement to maintain a net cash balance in excess of 30% of the principal amount of the note outstanding. Up to and including March 30, 2007, the net cash balance required to be held by us has been reduced to US$1.5 million (A$2.1 million). The investor further waived any default that would otherwise have resulted from the unavailability of our resale prospectus until we filed our 2006 audited U.S. GAAP-reconciled financial statements. We filed those financial statements on October 31, 2006, thus satisfying the condition in the agreement. In exchange for the foregoing, we will be required to make a one-time payment to the investor of US$800,000 (A$1.1 million) on December 28, 2006 and three payments of US$150,000 (A$205,000) on January 31, 2007, February 28, 2007 and March 30, 2007.
 
-43-

Key Business Developments
 
We have had the following key business developments since July 1, 2005:
 
 
·
On October 3, 2005, we entered into a merger agreement with CDS, a Boston-based company engaged in the design and development of drug delivery products. The merger agreement provided that a newly-formed subsidiary of pSivida would merge into CDS, with CDS surviving the merger as a wholly-owned subsidiary of pSivida with the name of pSivida Inc. After approval by the required majorities of both companies’ shareholders and the fulfillment of other closing conditions, the merger was completed on December 30, 2005. Pursuant to the merger, we issued a total of 161,047,790 ordinary shares (represented by 16,104,779 ADSs) consisting of:
 
 
·
150,844,680 ordinary shares (represented by 15,084,468 ADSs) in exchange for the outstanding CDS common and preferred shares on the date of the acquisition in accordance with the merger agreement;
 
 
·
1,211,180 nonvested ordinary shares (represented by 121,118 nonvested ADSs) in connection with CDS employee retention agreements (not accounted for as part of the purchase price); and
 
 
·
8,991,930 nonvested ordinary shares (represented by 899,193 nonvested ADSs) in exchange for the nonvested shares of CDS common stock outstanding on the date of the acquisition in accordance with retention agreements between CDS and its officers and employees. 
 
As of the December 30, 2005 acquisition date, the ADSs received by the former CDS stockholders represented approximately 41.3% of the capital stock of the combined company. Certain former shareholders of CDS received cash rather than ADSs for their CDS shares. In addition, we assumed and converted each outstanding option to purchase CDS stock into an option to acquire such number of ADSs as the holder would have been entitled to receive in the merger (if such holder had exercised such option in full immediately before completion of the merger). In connection with the merger, we entered into a registration rights agreement pursuant to which we agreed to file a registration statement covering the resale of the ADSs issued in the merger.
 
 
·
On October 27, 2005, we signed a license with Beijing Med-Pharm Corporation for the clinical development, marketing and distribution of BrachySil in China. Under the terms of the license, we will manufacture BrachySil and Beijing Med-Pharm will be responsible for clinical development, securing regulatory approval, marketing and distribution in China and Hong Kong. We will retain manufacturing rights for BrachySil under the license.
 
 
·
On February 10, 2006, we announced that Bausch & Lomb and Novartis Ophthalmics, a business unit of Novartis Pharmaceutical Corp., had reached an agreement to co-promote Retisert in the United States.
 
 
·
On February 21, 2006, we reported that preliminary data from Bausch & Lomb’s clinical trial of Retisert for the treatment of chronic non-infectious posterior segment uveitis showed a lower recurrence rate in eyes receiving Retisert than in non-implanted eyes. This study involved 278 patients from 27 hospitals in the United States and one in Singapore. The study showed that, at three years, control of uveitis in eyes implanted with Retisert was better than in non-implanted eyes, but was less effective than at two years and that some eyes may need to be re-implanted between 24 and 36 months. In the study, patients received either a 0.59 mg or a 2.1 mg Retisert device. Data presented was the aggregate of the two doses. At three years, the recurrence rate of uveitis was 33% in the eye receiving Retisert compared to 57% of fellow eyes. A greater number of eyes receiving Retisert experienced an improvement in vision of at least 15 letters (three lines on an eye chart) compared to fellow eyes (22% versus 6%). 45% of eyes receiving Retisert required an operation to relieve elevated intraocular pressure and 92% developed a cataract.
 
-44-

 
 
·
On March 17, 2006, we announced that our ADSs had been included in the Nanotechnology.com ‘Small Technology’ Index. Nanotechnology.com is owned by The Nanotech Company, LLC an independent advisory firm specializing in advising nanotechnology companies.
 
 
·
On March 20, 2006, we announced that an independent audit of our Boston, Massachusetts facility performed by a European Qualified Person had resulted in the issuance of a certificate indicating that our product Medidur is manufactured to the standard of Good Manufacturing Practice (GMP) set out in European Union directive 2003/94/EC and the EC Guide to Good Manufacturing Practice.
 
 
·
On March 21, 2006, we announced that following a planned interim review, an independent data safety monitoring board, commonly known as a DSMB, had recommended the continuation of the Phase III clinical trial being conducted by us and Alimera Sciences involving our product Medidur.
 
 
·
On April 3, 2006, we reported that randomized safety and efficacy trials conducted by Bausch & Lomb had demonstrated that after two years, 30% of eyes receiving repeat laser treatment, the current standard of care, had a worsening of their diabetic retinopathy compared with only 10% of eyes receiving a Retisert implant. We also reported that Retisert reduced retinal thickening involving the center most part of the macula responsible for sharp, central vision, or fovea, and led to a statistically significant three line improvement in vision compared to the current standard of care. The study involved 277 patients from hospitals in the U.S.
 
 
·
On April 6, 2006, we reported that randomized safety and efficacy trials involving patients with DME conducted by Bausch & Lomb had demonstrated that after two years, the recurrence rate for uveitis was significantly lower in eyes receiving Retisert than in eyes receiving systemic corticosteroid or other immunosuppressive agents, the current standard of care. The study involved 146 patients across ten countries in Europe and the Middle East.
 
 
·
On April 6, 2006, we entered into an evaluation agreement with an undisclosed large medical device company to evaluate cardiovascular delivery of drugs using our drug delivery technologies.
 
 
·
On May 25, 2006, we announced that the Phase IIb clinical trial for inoperable primary liver cancer for BrachySil had been extended to centers in Vietnam and Malaysia and that we were negotiating an extension to centers in the Philippines and Taiwan. In addition, we announced that the Phase IIa clinical trial for the treatment of pancreatic cancer for BrachySil was expected to commence in June 2006 in hospitals in London and Singapore.
 
 
·
On May 30, 2006, we announced that the Medicines and Healthcare Products Regulatory Agency in the UK granted approval for the first human study of BrachySil for the treatment of inoperable pancreatic cancer. This six month Phase IIa clinical trial study is expected to involve 15 patients at the Guy’s and St Thomas’ Hospital in London and Singapore General Hospital, which are leading centers for cancer treatment.
 
 
·
On June 7, 2006, we announced that regulatory agencies in the UK, Canada and India had approved the start of Phase III clinical trials for our product device Medidur for use in the treatment of DME.
 
 
·
On June 8, 2006, we announced that our subsidiary AION Diagnostics had discovered that BioSilicon can be detected on the following key imaging platforms: x-ray, ultrasound, CT and MRI. This property of BioSilicon is expected to allow it to be used in tissue marker, contrast agent products and molecular imaging products currently under development by AION Diagnostics.
 
 
·
On July 6, 2006, we announced that BioSilicon has shown the capability to act as an adjuvant when delivered with an antigen. An adjuvant is any substance that is capable of enhancing a host response towards an active agent, and is often used in conjunction with antigens to enhance the immune response of humans and animals. An antigen is any substance capable of eliciting an immune response. A patent application has been filed in the UK for the use of BioSilicon as an adjuvant.
 
 
·
On July 27, 2006, we entered into a consulting agreement with Navigator Asset Management Limited, or NAML. Pursuant to the consulting agreement, NAML agreed to perform various financial advisory services for us. In exchange for those services, we agreed to pay NAML a consulting fee of US$750,000, and to issue to NAML warrants exercisable to purchase up to 500,000 ADSs. NAML later assigned its warrants to Australian IT Investments Ltd. and Absolute Octane Fund.
 
-45-

 
 
·
On July 31, 2006, we announced that Gavin Rezos had resigned for personal and family reasons as Managing Director and CEO of pSivida and its subsidiaries. Mr. Rezos has agreed to make himself available in Australia as we may request his assistance to achieve certain goals pending the appointment of a permanent replacement.
 
 
·
On September 19, 2006, we announced the initiation of a Phase II clinical trial for Mifepristone as an eye drop treatment for steroid-associated elevated intraocular pressure. The investigator -sponsored trial will involve up to 45 patients in the United States.
 
 
·
On October 10, 2006, we announced that the first patient has been implanted with BrachySil for the treatment of inoperable pancreatic cancer at Guys and St. Thomas’ NHS Foundation Trust Hospital in London, a major centre for cancer therapy in the United Kingdom.
 
 
·
On November 20, 2006, we announced that we had entered into a collaboration with another company to evaluate our BioSilicon technology for the development of transdermal drug delivery systems. The collaboration is expected to last for twelve months, during which time, the parties plan to evaluate a range of biodegradable porous silicon structures, including microneedles, for the controlled release of drugs through the skin.
 
Recently Issued Accounting Pronouncements Applicable to pSivida
 
Australian Pronouncements
 
We adopted A-IFRS for the first time in our financial statements for the year ended June 30, 2006, which included comparative financial statements for the year ended June 30, 2005. Compliance with A-IFRS ensures compliance with IFRS. AASB 1 requires that an entity develop accounting policies based on the standards and related interpretations effective at the reporting date of its first annual A-IFRS financial statements (June 30, 2006). AASB 1 also requires that those policies be applied as of the date of transition to A-IFRS (July 1, 2004) and throughout all periods presented in the first A-IFRS financial statements. An explanation of how the transition from superseded policies to A-IFRS has affected our financial position, financial performance and cash flows is discussed in Note 28 to the audited consolidated financial statements.
 
In applying A-IFRS, we relied on an exemption to such accounting standards with respect to the valuation of share-based payments granted to employees, directors, and consultants. Under AASB 2 “Share-based Payment”, the fair value of share-based payments granted is determined at grant date and expensed over the expected vesting period of the options. Upon transition to A-IFRS, we elected not to retrospectively recognize share based payments that were granted before November 7, 2002 and share based payments granted after November 7, 2002 that vested before January 1, 2005. As a result of this election, we did not apply Black-Scholes to the affected equity. Had we elected to retrospectively recognize the value of this equity, share based payments reserve and accumulated deficit would have increased. This would not have had any effect on the overall total equity of our Company.
 
 
Please refer to Note 30(e) to the audited consolidated financial statements for recently issued but not yet adopted accounting pronouncements in the United States that are applicable to us.
 
Summary of Critical Accounting Policies
 
We prepare our consolidated financial statements in accordance with A-IFRS. In preparing these financial statements, we make certain estimates, judgments, and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the periods presented. These estimates, judgments and assumptions, which management believes are reasonable under the circumstances and are based upon the information available at that time, cannot be made with certainty. These estimates may change as new events occur or as additional information is obtained, and because the use of such estimates is inherent in the financial reporting process, actual results could differ from those estimates. While there are a number of accounting policies, methods and estimates affecting our financial statements as described in Note 1 to the audited consolidated financial statements, management has identified certain of these accounting policies to be critical to aid in a full understanding and evaluation of our financial condition and results of operations. A critical accounting policy is one that is both material to the presentation of our financial statements and requires us to make subjective or complex judgments that could have a material effect on our financial condition and results of operations. We believe the following critical accounting policies, and our procedures relating to these policies, include our more significant judgments and estimates used in the preparation of our consolidated financial statements. Some of our accounting policies would be different if we prepared our consolidated financial statements in accordance with U.S. GAAP. Please refer to Note 29 to the audited consolidated financial statements for a summary of adjustments and related explanations used to reconcile our financial position at June 30, 2006 and 2005, and results of operations for the years then ended, from A-IFRS to U.S. GAAP.
 
-46-

 
Accounting for Business Combinations
 
On December 30, 2005, we acquired CDS in exchange for:
 
 
·
A$114,319 in cash;
 
 
·
150,844,680 ordinary shares (represented by 15,084,468 ADSs) issued in exchange for the outstanding shares of CDS common and preferred shares;
 
 
·
1,211,180 nonvested ordinary shares (represented by 121,118 nonvested ADSs) issued in connection with CDS employee retention agreements;
 
 
·
8,991,930 nonvested ordinary shares (represented by 899,193 nonvested ADSs) issued in exchange for the nonvested CDS common shares outstanding in connection with director and employee retention agreements; and
 
 
·
1,724,460 vested share options (represented by vested options to purchase 172,446 ADSs) in exchange for the outstanding vested options to purchase common stock of CDS.
 
The transaction was accounted for using the purchase method of accounting and accordingly, the assets and liabilities of the acquired entity are recorded at their estimated fair values at the date of acquisition. Cost is measured as the fair value of the assets given, shares issued or liabilities incurred or assumed at the date of exchange plus costs directly attributable to the acquisition. The excess of the cost of acquisition over the fair value of the identifiable net assets acquired is recorded as goodwill.
 
In applying the purchase method to our acquisition of CDS, it was necessary for us to make various estimates and assumptions concerning the valuation of the consideration given by us and the fair values of the assets and liabilities of CDS. These included the following considerations:
 
 
·
We determined that the closing price on the ASX provided the best estimate of fair value for our shares at a single point in time (A$0.71 at December 30, 2005, the date of exchange) since that market was the primary market at that time for our shares and the ASX had significantly greater trading volume in our shares than the NASDAQ Global Market or any other market on which our shares were then traded.
 
 
·
We determined that the issue of 1,211,180 nonvested ordinary shares in connection with employee retention was not in exchange for existing awards held by CDS employees and, accordingly, the entire fair value of these nonvested shares were considered unearned compensation to be expensed over the future service (vesting) period and not part of the purchase consideration.
 
-47-

 
 
·
We made a judgment that the value of 8,991,930 nonvested ordinary share issued in exchange for nonvested CDS common shares outstanding should not be discounted from the fair value per share determined for the vested ordinary shares on the basis that (1) the holders had the same rights as normal holders of ordinary shares and (2) the Company’s estimate was that all the underlying shares would vest.
 
 
·
We applied assumptions related to determining the fair value of share-based payments (see discussion below) to the issuance of 1,724,460 vested share options in exchange for the outstanding vested CDS options.
 
 
·
We estimated the value of identifiable intangibles of CDS (Vitrasert, Retisert and Medidur) utilizing the discounted value of projected cash flows. Management reviewed the estimate future cash flows and the discount rates used to calculate a present value. The patents supporting Vitrasert were given no value based upon the judgment that the incidence of the disease to which the application of this technology relates has significantly reduced due to advancements in the treatment of AIDS. Projected cash flows for Medidur were adjusted downwards after applying an estimated probability of successful commercialization in light of that product’s then current stage of development. As a result, the value ascribed to patents is primarily associated with Retisert, and the value attributed to in-process research and development is primarily related to Medidur.
 
 
·
We reviewed the sales and leaseback transaction that CDS had entered into in relation to its premises, which resulted in a gain that was accounted for by CDS as deferred revenue subject to amortization over the subsequent lease period. Based upon our analysis of the lease transaction, we concluded that the lease was an operating lease and that the transaction was established at fair value, and therefore the fair value of the deferred liability at the date of the acquisition was determined to be zero.
 
Intangible assets and goodwill
 
Intangible assets acquired in a business combination
 
All potential intangible assets acquired in a business combination are identified and recognized separately from goodwill, where they satisfy the definition of an intangible asset and their fair value can be measured reliably.
 
We have determined that the portion of the purchase price allocation assigned to Medidur meets the definition of in-process research and development, or IPR&D, as the product is currently in Phase III clinical trials and has not been approved by the FDA. Although the product candidate may have significant future importance, we consider that Medidur for DME does not have alternative future use other than the technological indications for which it is in development. Under AASB 3 and AASB 138, IPR&D is recognized as an asset separate from goodwill and, since the asset is not commercially available for use, the IPR&D will not be subject to amortization, but rather tested at least annually for impairment under A-IFRS.
 
The portion of the purchase price allocation assigned to Retisert, which was a commercially available product approved for sale by the FDA at the date of the CDS acquisition, is subject to amortization over the estimated useful life of the intangible asset. We evaluated several pertinent factors to determine an appropriate useful life. These included:
 
 
·
the Retisert for Uveitis patents will be further commercialized as we advance other development programs using these patents for similar drug delivery devices for other eye diseases;
 
 
·
the acquired intellectual property is not related to another asset or asset group that could limit its life;
 
 
·
the acquired patents have a legal expiration of 12 to 15 years from the date of acquisition and we are unaware of any regulatory or contractual provisions that would limits its life;
 
-48-

 
 
·
the potential for product obsolescence as a result of competition and the financial limitations on our product development capabilities; and
 
 
·
the minimal expected costs of ongoing patent maintenance.
 
On the basis of these and other considerations, our judgment was that the acquired patents have an estimated useful life of 12 years from the date of acquisition. As a result, the rate of amortization expense is currently expected to be approximately A$7.4 million per year (A$3.6 million for the six months ended June 30, 2006). We will evaluate the patents for impairment whenever events or changes in circumstances indicate that the carrying amount may not be recoverable.
 
Goodwill
 
Goodwill arising on consolidation consists of the excess of the cost of the acquisition over our interest in the fair value of the identifiable assets and liabilities of a subsidiary at the date of acquisition. The excess of the A$116.9 million purchase price over the A$86.5 million of fair value of the assets and liabilities of CDS acquired at December 30, 2005, or A$30.4 million, was recorded as purchased goodwill and is subject to testing for impairment on at least an annual basis. In applying impairment testing, our judgment was that the consolidated entity is the deemed reporting unit. In making this determination we considered that (1) we operate in one business segment, the biotechnology sector; and (2) our executive management assesses operating performance and reviews financial statements predominantly at the consolidated level. As our ordinary shares are publicly traded on an active market, we performed this impairment test by comparing the imputed fair value of our outstanding ordinary shares at June 30, 2006 to the carrying value of our consolidated assets and liabilities at that date.
 
Share Based Payments
 
Equity-settled share-based payments granted after November 7, 2002 that were unvested as of January 1, 2005 are measured at fair value at the date of grant (or the measurement date in the case of share-based payments granted to non-employees). Fair value is measured by use of the Black-Scholes option pricing model in most instances. Where conditions of the options make use of the Black-Scholes method inappropriate, such as where employee options have long lives, and are exercisable during the period between vesting date and the end of the option’s life and the exercise date cannot be reliably estimated, the entity will use another more appropriate option valuation method, such as the Binomial method. The expected life used in the Binomial model is adjusted, based on management’s best estimate, for the effects of exercise restrictions and behavioral considerations.
 
The fair value of the equity-settled share-based payments is expensed over the vesting period, based on our estimate of shares that will eventually vest.
 
Convertible Promissory Note
 
On November 16, 2005, we issued an 8% subordinated convertible promissory note in the principal amount of US$15.0 million (A$19.7 million) due in three years to an institutional investor. The terms of the financing included:
 
 
·
investor conversion rights;
 
 
·
conditional investor redemption rights; and
 
 
·
issuance of detachable warrants.
 
After defining the host contract in this hybrid instrument as the fixed interest rate debt, we evaluated the various features embedded in the debt host to determine which, if any, should be recognized and accounted for separately from the fixed rate note. Our analysis concluded that the note holder conversion and redemption options should be valued and recognized separately from the host debt instrument. The fair value of each embedded derivative was estimated using a binomial tree model, taking into account assumptions as to share price volatility, dividend yield and market interest rates for a comparable non-convertible debt instrument. After initial recognition, subsequent changes in the estimated fair value of the embedded derivative are charged or credited to the income statement in the period. For the period from the November 16, 2005 issuance date to June 30, 2006, the embedded derivative value decreased by US$2.5 million (A$3.4 million), primarily related to the lower ADS price, which amount was included as income in our accompanying consolidated statement of operations.
 
-49-

 
The fair value of the detachable warrant was estimated based upon the relative fair values of the two instruments (note and warrants) in accordance with the binomial tree model and was classified, net of allocable transaction costs, as option premium reserve within the equity section of our consolidated balance sheet.
 
The difference between the face value of the note (US$15.0 million) and the initial accounting value for the debt host contract (US$8.9 million), or US$6.1 million (A$8.4 million), which primarily represented the initial fair value of the compound embedded derivative and the detachable warrant, is amortized as finance costs using the effective interest method over the 3-year expected term of the note. For the year ended June 30, 2006, amortization of finance costs totaled US$2.2 million (A$3.0 million).
 
Revenue Recognition
 
Revenue is recognized to the extent that it is probable that the economic benefits will flow to the entity and the revenue can be reliably measured. The following specific recognition criteria must also be met before revenue is recognized:
 
Royalties
 
Royalty revenue is generally recognized on an accrual basis in accordance with the substance of the relevant agreement. Non-refundable royalties received in advance for which we have no obligation to perform future services are recognized when received.
 
Collaborative research and development
 
Collaborative research and development revenue comprises amounts received for research and development activities under the consolidated group’s collaboration agreements. For contracts with specifically defined milestones, revenues from milestone payments related to agreements under which the consolidated group has no continuing performance obligations are recognized upon achievement of the related milestone which represents the culmination of the earnings process. Revenues from milestone payments related to research collaboration agreements under which the consolidated group has continuing performance obligations are recognized as revenue upon achievement of the milestone only if all of the following conditions are met: the milestone payments are non-refundable; substantive effort is involved in achieving the milestone; and the amount of the milestone is reasonable in relation to the effort expended or the risk associated with achievement of the milestone. If any of these conditions are not met, the milestone payments are deferred and recognized as revenue when the collaborating party confirms that the performance obligations have been met.
 
Results of Operations for the Year Ended June 30, 2006 Compared to the Year Ended June 30, 2005
 
You should read the following discussion and analysis in conjunction with our consolidated financial statements and the notes thereto included elsewhere herein. Our consolidated financial statements have been prepared in accordance with A−IFRS and reconciled to U.S. GAAP. The SEC has adopted an accommodation permitting eligible foreign private issuers, such as our company, to file two years rather than three years of statements of operations, changes in shareholders’ equity and cash flow statements prepared in accordance with IFRS for their first year of reporting under IFRS. The fiscal year 2006 is our first year of operating under A−IFRS (which is compliant with IFRS) and this Form 20-F has been prepared in reliance on such SEC accommodation. As a result, the operating and financial review that follows covers the fiscal year 2006 and the comparable fiscal year 2005.
 
-50-

 
Net Loss
 
For reasons described further below, our net loss increased to A$28.2 million for the year ended June 30, 2006 from A$16.8 million for the year ended June 30, 2005, an increase of approximately A$11.4 million, or 67.7%. The increase in net loss for 2006 compared to 2005 was primarily attributable to:
 
 
·
the results of operations of pSivida Inc. (formerly CDS) from the date of acquisition on December 30, 2005, including amortization of acquired intangibles;
 
 
·
increased costs associated with ongoing development of our BioSilicon technology, including commencement of our BrachySil Phase IIb clinical trial for inoperable primary liver cancer; and
 
 
·
increased share-based payments expense resulting from fiscal 2006 being the first full year of the implementation of AASB 2 and SFAS 123R.
 
Revenue
 
Revenue increased to A$1.4 million for the year ended June 30, 2006 from A$162,000 for the year ended June 30, 2005, an increase of approximately A$1.2 million or 761.7%. This increase was attributable to A$1.3 million of royalty and collaborative research and development revenue earned by pSivida Inc, during the six months ended June 30, 2006.
 
Other Income
 
Other income, which consisted primarily of interest income, decreased to A$581,000 for the year ended June 30, 2006 from A$660,000 for the year ended June 30, 2005, a decrease of A$80,000 or 13.7%. This decrease was attributable to reduced levels of cash held by us throughout the year, partially offset by higher interest rates.
 
Selling, General and Administrative
 
Selling, general and administrative costs increased to A$21.4 million for the year ended June 30, 2006 from A$11.7 million for the year ended June 30, 2005, an increase of A$9.7 million, or 83.0%. This increase was primarily due to:
 
 
·
approximately A$3.2 million of amortization of intangible assets acquired in the acquisition of CDS;
 
 
·
operating costs of approximately A$2.4 million for pSivida Inc, which consisted primarily of personnel and associated costs, office expense, insurance and depreciation;
 
 
·
approximately A$1.6 million of additional consulting, legal, audit fees associated with U.S. regulatory and statutory reporting requirements that were largely the result of the listing of our ADSs on the NASDAQ Global Market from January 2005, the acquisition of CDS in December 2005 and the registration statement filing requirements associated with our initial convertible note transaction in November 2005 and other issuances of our equity securities; and
 
 
·
approximately A$1.5 million of additional share-based payments expense in connection with (1) the adoption of AASB 2 as of July 1, 2005 and and its retrospective application for options that were unvested as of January 1, 2005; and (2) amortization of unearned compensation related to the issuance of non-vested ADSs in connection with the December 30, 2005 acquisition of CDS. 
 
Research and Development
 
Research and development expense increased to A$17.9 million for the year ended June 30, 2006 from A$8.3 million for the year ended June 30, 2005, an increase of A$9.6 million, or 115.4%. Approximately A$4.9 million of the increase was attributable to the operations of pSivida Inc., primarily related to the Medidur for DME Phase III clinical trial in conjunction with Alimera Sciences and patent and legal costs. The remaining increase of A$4.7 million was primarily attributable to the ongoing development of our BioSilicon technology, including commencement of our Phase IIb clinical trial for lead product candidate BrachySil for the treatment of primary liver cancer, a related increase in headcount, principally at our Malvern, UK and Singapore offices to support the commencement of the trial and depreciation expense related to the completion, in September 2005, of the construction of a cleanroom facility dedicated to the final process in the manufacture of BrachySil for future clinical and commercial use.
 
-51-

 
Interest and Finance Costs
 
Interest and finance costs increased to A$4.5 million for the year ended June 30, 2006 from A$32,000 for the year ended June 30, 2005, an increase of approximately A$4.5 million. These interest and finance costs incurred for the year ended June 30, 2006 were primarily related to A$1.1 million of interest expense and A$3.0 million of amortization of the discount and issuance costs components of the convertible note issued in November 2005. In addition, we incurred A$498,000 of penalties attributable to delayed fulfillment of the registration rights requirements of the convertible note and underlying warrants.
 
Change in Fair Value of Derivative
 
Our initial convertible note was determined to be a hybrid instrument which included a host contract (the fixed interest rate debt) and several embedded derivative features that required bifurcation and separate accounting as derivative instruments. The fair value of the conversion option derivative is revalued over time on a “marked to market” basis. For the year ended June 30, 2006, we recorded a A$3.4 million credit in our consolidated statement of operations as a result of a reduction in the fair value of the embedded derivatives.
 
Foreign Exchange Gain/(Loss)
 
Foreign exchange gain/(loss) was a gain of A$725,000 for the year ended June 30, 2006 compared to a loss of A$1.6 million for the year ended June 30, 2005, a net increase of A$2.3 million. This increase was primarily due to the recognition of significant unrealized foreign exchange gains caused by the strengthening in the Pound Sterling and the U.S. dollar against the Australian dollar foreign exchange rates on foreign currency transactions during the year and on significant cash deposits held in foreign currencies.
 
Income Tax Benefit
 
Income tax benefit increased to A$9.5 million for the year ended June 30, 2006 from A$3.6 million for the year ended June 30, 2005, an increase of A$5.9 million, or 162.9%. The majority of this increase, A$5.1 million was due to the recognition of additional deferred tax assets attributable to tax losses generated during the year ended June 30, 2006 that are available for carry forward.
 
Inflation and Seasonality
 
Our management believes inflation has not had a material impact on our operations or financial condition and that our operations are not currently subject to seasonal influences.
 
Conditions in Australia
 
pSivida is incorporated under the laws of, and our principal offices are located in the Commonwealth of Australia. Therefore, we are directly affected by political and economic conditions in Australia.
 
B.
LIQUIDITY AND CAPITAL RESOURCES
 
We have incurred operating losses since inception, and at June 30, 2006, we had an accumulated deficit of A$56.9 million. Since our inception, we have relied primarily on the proceeds from sales of our equity and debt securities, consulting revenue, license fees and collaboration payments to fund our operations.
 
Cash and cash equivalents totaled A$15.4 million at June 30, 2006, compared to A$12.9 million at June 30, 2005. Under the terms of our initial convertible note agreement, we had a requirement to maintain net cash balances in excess of 30% of the outstanding principal balance (representing approximately A$6.2 million at June 30, 2006). In connection with a further amendment of the convertible note agreement dated October 17, 2006, the required minimum cash balance has been reduced to US$1.5 million (A$2.1 million) through March 30, 2007, after which the original 30% requirement will apply.
 
-52-

 
Net cash used in operating activities totaled A$21.7 million for the year ended June 30, 2006, compared to A$12,3 million for the year ended June 30, 2005. Research and development expenditure was the most significant expenditure item resulting in cash out flows during the years ended June 30, 2006 and 2005 and amounted to A$13 million and A$8.3 million, respectively. The increase of A$4.7 million was primarily related to research and development activities of CDS, which was acquired on December 30, 2005, and the commencement of the BrachySil primary liver cancer Phase IIb dose profiling study. Payments to suppliers and employees during the years ended June 30, 2006 and 2005 were A$10.9 million and A$4.8 million, respectively. The increase in payments from the year ended June 30, 2005 to the year ended June 30, 2006 consisted of increased expenses relating to additional administrative activities and the timing of cash payments related to these activities.
 
Net cash used in investing activities totaled A$5.6 million for the year ended June 30, 2006, compared to A$8.1 million for the year ended June 30, 2005. Cash flows from investing activities during the year ended June 30, 2005 included A$4.6 million cash paid on the acquisition of the remaining minority interest in pSiMedica and the for the year ended June 30, 2006 included A$4.0 million cash paid on the acquisition of CDS (net of cash acquired). The reduction in net cash used in investing activities was also attributable to a A$1.9 million reduction in purchases of plant and equipment in fiscal 2006 compared to fiscal 2005, primarily due to the construction of our clean room facility in Germany during 2005.
 
Net cash flows from financing activities totaled A$29.2 million for the year ended June 30, 2006 compared to A$3.6 million for the year ended June 30, 2005. Cash flows from financing activities during the year ended June 30, 2006 reflected the following:
 
 
·
in September 2005, we issued 665,000 ADSs (representing 6,650,000 of our ordinary shares) at a price of US$6.50 (A$8.48) each, raising US$4.3 million (A$5.7 million) before costs of A$468,873 in a private placement structured as a PIPE;
 
 
·
in November 2005, we issued a subordinated convertible promissory note in the principal amount of US$15 million (A$19.7 million) before costs of A$607,196 to an institutional investor. That note was amended and partially repaid via a payment of US$3.5 million (A$4.7 million) in September 2006 and is currently in the principal amount of US$12.5 million (A$17.1 million) and convertible into 6.25 million ADSs at a conversion price of US$2.00 per ADS, subject to adjustment based on certain events or circumstances, including a reset provision based on the market price as of April 30, 2007; and
 
 
·
in June 2006, we issued 10,515,811 new ordinary shares at a price of A$0.60 each, raising A$6.3 million, before costs, through a Rights Issue
 
Cash flows from financing activities during the years ended June 30, 2006 and June 30, 2005 also included A$27,521 and A$3.7 million, respectively, received related to the exercise of stock options.
 
Our existing cash resources will not be sufficient to support the commercial introduction of any of our current product candidates. In order to fund our operations, we will need to raise additional funds through public or private equity offerings, debt financings or additional corporate collaboration and licensing arrangements. Our future funding requirements will depend upon many factors, including, but not limited to:
 
 
·
costs and timing of obtaining regulatory approvals;
 
 
·
costs and timing of obtaining, enforcing and defending our patents and intellectual property;
 
 
·
progress and success of pre-clinical and clinical trials of BioSilicon and Durasert;
 
 
·
timing and degree of Retisert product sales resulting in royalty revenue;
 
-53-

 
 
·
progress and number of our research programs in development; and
 
 
·
success, if any, of the ongoing evaluations of our technology by third parties.
 
We do not know whether such additional financing will be available when needed or on terms favorable to us or our stockholders. Further, any additional equity financing may be dilutive to stockholders, and debt financing, if available, may involve restrictive covenants. If adequate funds are not available, we may be required to delay, reduce the scope of or eliminate one or more of our research or development programs or to obtain funds through collaborations with others that are on unfavorable terms or that may require us to relinquish certain rights to our technologies or products, including potentially our Medidur product that we would otherwise seek to develop in collaboration with Alimera or our lead BioSilicon product that we would otherwise seek to develop on our own.
 
C.
RESEARCH AND DEVELOPMENT, PATENTS AND LICENSES, ETC.
 
Our primary activity is the development of products based on our Durasert, BioSilicon and CODRUG technologies. Our research and development expenses were A$17.9 million and A$8.3 million during the years ended June 30, 2006 and 2005, respectively. These research and development expenses consisted primarily of costs for research and development personnel, expenses for clinical trials and testing, laboratory facilities and depreciation on property, plant and equipment used solely for research and development activities. Such costs are charged to the operations as incurred. The increase in our research and development expenses in the latest fiscal year was attributable to:
 
 
·
the operations of pSivida Inc., primarily related to the Medidur for DME Phase III clinical trial in conjunction with Alimera Sciences and patent and legal costs; and
 
 
·
the ongoing development of our BioSilicon technology, including:
 
 
·
commencement of our Phase IIb clinical trial for lead product candidate BrachySil for the treatment of primary liver cancer;
 
 
·
a related increase in headcount, principally at our Malvern, UK and Singapore offices to support the commencement of the trial; and
 
 
·
depreciation expense related to the completion, in September 2005, of the construction of a cleanroom facility dedicated to the final process in the manufacture of BrachySil for future clinical and commercial use.
 
For a more detailed discussion of our research and development activities and policies, please see Item 4B, “Business Overview”.
 
D.
TREND INFORMATION
 
We are a development stage enterprise, and it is not possible for us to predict with any degree of accuracy the outcome of our ongoing research and commercialization efforts.
 
As in prior periods, our expenditures on research and development, as a proportion of total costs, are expected to be significant and to increase from the A$17.9 million incurred during the year ended June 30, 2006, unless cutbacks are required to conserve cash.
 
Our recent acquisition of CDS will have a significant impact on the nature of our business and operations as a whole, and therefore, we expect that our current reported financial information may not be indicative of our future results or financial condition. The results of the operations of CDS have been included since the December 30, 2005 acquisition date.
 
-54-

 
E.
OFF-BALANCE SHEET ARRANGEMENTS
 
We currently do not have any off-balance sheet arrangements that have or are reasonably likely to have a current or future effect on our financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources that is material to investors.
 
F.
TABULAR DISCLOSURE OF CONTRACTUAL OBLIGATIONS
 
The following table summarizes our minimum contractual obligations as of June 30, 2006 for payments under our indebtedness (including capital leases), purchase obligations, operating leases and other obligations and the effects such obligations are expected to have on our liquidity and cash flows in future periods:
 
   
Payments Due by Period
 
Contractual Obligations
 
Total
 
Less than
1 year
 
1-3 years
 
3-5 years
 
More than 5 years
 
   
(In Thousands of Australian Dollars)
 
Long-Term Debt Obligations:
                     
Principal (a)
   
20,545
   
13,697
   
6,848
   
-
   
-
 
Interest (a) (b)
   
1,444
   
1,237
   
207
   
-
   
-
 
Operating Lease Obligations
   
2,363
   
893
   
1,366
   
104
   
-
 
                                 
Total
   
24,352
   
15,827
   
8,421
   
104
   
-
 
 
(a)
Represents principal balance of initial subordinated convertible note at June 30, 2006, with scheduled payments of principal and interest based upon potential note holder redemption options in effect at that date (see Note 10 to the audited consolidated financial statements).
 
(b)
Under certain conditions, scheduled interest payments may be made in the form of ADSs.
 
Since June 30, 2006, there have been no material changes with respect to our contractual obligations other than described below.
 
 Initial Subordinated Convertible Note. Pursuant to the terms of the initial US$15.0 million (A$20.5 million) convertible subordinated note dated November 16, 2005, unless earlier converted to ordinary shares, the investor had a contingent right to require us to prepay one-third of the note at the 12, 18 and 24 month anniversary of its issuance. The initial note was amended and restated as of September 14, 2006 and further amended by letter agreement dated October 17, 2006. Under the terms of the amendments, US$2.5 million (A$3.3 million) of the principal amount was repaid on September 14, 2006 and the investor has the unilateral right, unless the note is earlier converted to ADSs, to require us to repay US$6.25 million (A$8.3 million) of the remaining principal on each of July 31, 2007 and January 31, 2008. In addition, we paid US$1.0 million (A$1.3 million) on September 14, 2006, and we are obligated to pay US$800,000 (A$1.1 million) on December 28, 2006 and three equal payments of US$150,000 (A$205,000) each from January thru March 2007 as consideration for the above amendments and registration rights delay penalties.
 
New Subordinated Convertible Notes. On September 26, 2006, we issued US$6.5 million (A$8.5 million) of three year subordinated convertible notes bearing interest at 8% per annum. Unless earlier converted to ADSs, the investors have the right under certain circumstances, including the prior repayment in full of the initial subordinated convertible note, to require us to repay up to 50% of the initial principal amount on each of August 14, 2008 and February 14, 2009.
 
Alimera Sciences. In February 2005, CDS entered into a collaborative development and product license agreement with Alimera Sciences relating to the development of our Medidur for DME product. Under the agreement, we jointly fund the development costs with Alimera, with our share currently estimated to be approximately US$22.0 million (A$28.5 million) through 2010. Should development efforts be successful, Alimera Sciences will manufacture and sell the product for us, subject to a revenue sharing arrangement. In the event that we fail to make development payments exceeding US$2.0 million (A$2.7 million) for the product, Alimera Sciences may complete the development using other funds and substantially reduce our economic interest in any sales of the developed product from a share of profits to a sales-based royalty. As of November 30, 2006, we have chosen not to make accrued development payments to Alimera Sciences in an aggregate amount of approximately US$1.9 million (A$2.6 million).
 
-55-

 
On November 10, 2006, we signed a non-binding memorandum of understanding with Nordic under which, if consummated, Nordic would:
 
 
·
invest US$4.0 million (A$5.2 million) in newly issued shares of our preferred stock; and
 
 
·
invest US$22.0 million (A$28.5 million), over time, to fund our expected share of the costs, and to receive our profit share payments, under the collaborative development and product license agreement with Alimera Sciences for the development of our Medidur for DME product.
 
Nordic would invest US$3.5 million (A$4.5 million) at closing and the remaining US$18.5 million (A$24.0 million) in regular installments. These investments will fund the expected amount of our share of development costs under the Alimera Sciences license agreement. If our share of the development cost exceeds the budgeted amount of US$22.0 million (A$28.5 million), any such excess will be our financial responsibility.
 
Nordic and pSivida will share all revenue received as a result of the Medidur project as follows:
 
(1) until receipt by Nordic of amounts equal to four times its investment, 75% to Nordic and 25% to us; and thereafter
 
(2) until receipt by Nordic of amounts equal to eight times its investment, 50% to Nordic and 50% to us; and thereafter
 
(3) 20% to Nordic and 80% to us.
 
 
A.
DIRECTORS AND SENIOR MANAGEMENT 
 
Board of Directors
 
The members of the board of directors of pSivida and their principal occupations are as follows:
 
Name
 
Date of
Appointment
 
Principal Occupation
Dr. Roger Brimblecombe (1)
 
March 5, 2002
 
Executive Chairman of the Board of Directors (principal executive officer), pSivida Limited
Mr. Stephen Lake
 
July 30, 2004
 
Investment Director, QinetiQ
Dr. David Mazzo
 
July 25, 2005
 
President and Chief Executive Officer, Chugai Pharma U.S.A
Mr. Michael Rogers
 
July 27, 2005
 
Vice President, Chief Financial Officer and Treasurer of Indevus Pharmaceuticals Incorporated
Dr. Paul Ashton
 
December 30, 2005
 
Executive Director of Strategy, pSivida Limited
 
(1) Dr. Roger Brimblecombe was appointed Executive Chairman of the Board of Directors on July 31, 2006.
 
Dr. Roger Brimblecombe
 
Dr. Brimblecombe, Ph.D., D.Sc., F.R.C.Path., C.Biol., F.I.Biol., is a former chairman of SmithKline and French Research Ltd. He is currently a Partner in MVM Life Science Partners LLP. He is also a non-executive director of Vertex Pharmaceuticals, Inc. (U.S.), Vertex Pharmaceuticals (Europe) Ltd and Tissue Science Laboratories Ltd. He has provided strategic consultancy services to research and development companies in Europe, the U.S. and Japan. He is a fellow of the Royal Society of Medicine, the Royal College of Pathologists and the Institute of Biology. He is consultant editor of Drug Discovery World magazine.
 
-56-

 
Stephen Lake
 
Mr. Lake, BA (Jt. Hons), MBA, ACA, is Investment Director, QinetiQ Limited. He has over 20 years of experience in the high technology sector as a senior executive in both large multi-national and early stage venture backed companies. He was a founding executive of Reuters venture capital arm Greenhouse. He has extensive international experience having worked in the U.S. for 10 years, as well as in France and the Nordic countries. Mr. Lake is a UK-qualified chartered accountant and has an MBA in technology and strategy from the Theseus Institut (France). He is a non-executive director of Quintel Technology Limited and QS4 Group Limited, a joint venture between Rotch and QinetiQ.
 
Dr. David Mazzo
 
Dr. Mazzo, BA (Hons), BSc (Hons), MSc, PhD, is President and Chief Executive Officer of Chugai Pharma U.S.A, and is based in New Jersey, U.S.A. Chugai Pharma U.S.A is part of the Roche group of companies and is a subsidiary of Chugai Pharmaceutical Company Limited (Japan), a global research-based pharmaceutical company. Dr. Mazzo holds a Bachelor of Arts with Honors (Interdisciplinary Humanities) and a Bachelor of Science with Honors in Chemistry from Villanova University, and a Master of Science in Chemistry and a PhD in Analytical Chemistry from the University of Massachusetts. He complemented his American education as a Research Fellow at the Ecole Polytechnique Federale de Lausanne, Switzerland. Dr. Mazzo is also a director of AMEX-listed Avanir Pharmaceuticals.
 
Michael Rogers
 
Mr. Rogers, BA, MBA, is Executive Vice President, Chief Financial Officer and Treasurer of Indevus Pharmaceuticals Incorporated, a biopharmaceutical company based in Lexington, Massachusetts, U.S.A. Mr. Rogers received an MBA from the Darden School of Business, University of Virginia and a BA, Political Science from Union College.
 
Dr. Paul Ashton
 
Dr. Ashton was the President and Chief Executive Officer of CDS prior to its acquisition by pSivida on December 30, 2005. He co-founded CDS in 1991 and served as a director of CDS, becoming President and Chief Executive Officer in 1996. As a scientist, Dr. Ashton is internationally renowned in the field of ocular drug delivery and is one of the inventors of Vitrasert and Retisert. He has authored over 200 papers and abstracts, holds more than 25 patents and has more than 150 pending patent applications. Dr. Ashton received a Bachelor of Science in Chemistry from Durham University, England and a PhD in pharmaceutical science for the University of Wales.
 
Recent Changes
 
Mr. Gavin Rezos resigned as Managing Director of pSivida Limited on July 31, 2006 after having served as Managing Director since December 1, 2000. Ms. Alison Ledger was an independent director from July 30, 2004 until her resignation on January 11, 2006. Ms. Heather Zampatti, a non-executive director, resigned from pSivida’s board on August 28, 2006. She was originally appointed on January 12, 2006.
 
-57-

 
Executive Officers
 
The current executive officers of pSivida and their titles are as follows:
 
Name
Title
Dr. Paul Ashton
Executive Director of Strategy
Dr. Roger Brimblecombe
Executive Chairman of the Board of Directors (principal executive officer)
Mr. Aaron Finlay
Company Secretary
Ms. Lori Freedman
Vice President for Corporate Affairs, General Counsel and Company Secretary
Mr. Michael Soja
Vice President of Finance, Chief Financial Officer and Treasurer
 
Aaron Finlay
 
Mr. Finlay joined pSivida as of May 17, 2004, as CFO and Company Secretary. Following our merger with CDS, he became Company Secretary of pSivida Limited. Prior to joining pSivida, Mr. Finlay was INVESCO Australia’s Chief Financial Officer where he had responsibility for the operations of finance, as well as the compliance, legal, and human resources functions. Prior to that position, he was head of group tax and treasury for INVESCO’s global operations in London. Prior to joining INVESCO, Mr. Finlay worked for PricewaterhouseCoopers (then Price Waterhouse) in London and Perth.
 
Lori Freedman
 
Ms. Freedman was appointed Vice President for Corporate Affairs, General Counsel and Company Secretary of pSivida Limited on May 23, 2006. She served as CDS’ Vice President of Corporate Affairs, General Counsel, and Secretary since 2001. From March 2001 through September 2001, Ms. Freedman served as Vice President, Business Development, and Counsel of Macromedia, Inc., a provider of software for creating Internet content and business applications. She served as Vice President, General Counsel, and Secretary of Allaire Corporation, a provider of Internet infrastructure for building business applications, from 1999 until Allaire was acquired by Macromedia in 2001. From May 1998 to December 1998, she worked for Polaroid Corporation as a Corporate Counsel. Prior to joining Polaroid, Ms. Freedman was with the law firm of McDermott, Will & Emery. Ms. Freedman received a B.S. in Economics and Psychology from Brandeis University and a J.D. from Boston University.
 
Michael Soja
 
Mr. Soja was appointed Vice President of Finance and CFO of pSivida Limited on May 23, 2006. Prior to his appointment, he served as CDS’ Vice President of Finance and Chief Financial Officer since 2001. From 1974 to 2001, he was employed by XTRA Corporation, a lessor of transportation equipment, serving as Vice President and Chief Financial Officer from 1980 to 2001. Mr. Soja received a B.A. in Mathematics from the College of the Holy Cross in 1970, an M.S. in Accounting from Northeastern University in 1971 and an M.B.A. from Babson College in 1978.
 
Recent Changes
 
Paul Ashton was appointed Executive Director of Strategy of pSivida Limited on December 30, 2005. Aaron Finlay’s position was changed from CFO and Company Secretary of pSivida Limited to Company Secretary of pSivida Limited on that same day. Michael Soja was appointed Vice President of Finance, CFO, and Treasurer of pSivida Limited on May 23, 2006 and Lori Freedman was appointed Vice President for Corporate Affairs, General Counsel and Company Secretary of pSivida Limited on the same day. Gavin Rezos resigned from his position as Managing Director of pSivida Limited on July 31, 2006.
 
B.
COMPENSATION 
 
 
-58-

 
Remuneration for the services of our directors are formalized in a service agreement. These agreements generally provide for a base salary, insurance benefits and reimbursement of expenses incurred on our behalf. Details of the nature and amount of each element of compensation paid to our directors and executive management for the year ended June 30, 2006 are shown in the following table.
 
   
Short-term benefits
 
Post-
employment
 
 Share-based payments
 
 
 
Proportion related to
 
   
Salary and fees
 
 Bonus (1)
 
 Other benefits
 
 Super-annuation
 
Options
* (2)
 
 Total
 
perfor-
mance
 
 
 
A$
 
A$
 
A$
 
A$
 
A$
 
A$
 
%
 
Directors
                             
Dr. R. Brimblecombe
   
223,218
   
-
   
-
   
-
   
101,898
   
325,116
   
31.3
 
Mr. G. Rezos
   
467,437
   
257,000
   
6,366
   
14,648
   
306,681
   
1,052,132
   
53.9
 
Dr. P. Ashton
   
184,159
   
-
   
4,776
   
5,542
   
48,195
   
242,672
   
19.9
 
Mr. S. Lake
   
25,000
   
-
   
-
   
-
   
-
   
25,000
   
-
 
Dr. D. Mazzo
   
32,102
   
-
   
-
   
-
   
32,852
   
64,954
   
-
 
Mr. M. Rogers
   
37,213
   
-
   
-
   
-
   
32,852
   
70,065
   
-
 
Ms. H. Zampatti
   
15,613
   
-
   
-
   
1,405
   
-
   
17,018
   
-
 
Dr. R. Aston
   
304,121
   
26,600
   
-
   
4,560
   
-
   
335,281
   
7.9
 
Ms. A. Ledger
   
15,806
   
-
   
-
   
1,423
   
-
   
17,229
   
-
 
Total
   
1,304,669
   
283,600
   
11,142
   
27,578
   
522,478
   
2,149,467
       
Other key management personnel
                             
Dr. M. Parry-Billings
   
303,059
   
-
   
7,703
   
36,367
   
144,238
   
491,367
   
29.4
 
Mr. A. Finlay
   
253,215
   
60,000
   
8,380
   
28,189
   
96,979
   
446,763
   
35.6
 
Dr. A. Kluczewska
   
250,000
   
-
   
4,774
   
-
   
49,603
   
304,377
   
16.6
 
Prof L Canham
   
197,476
   
-
   
6,389
   
22,498
   
28,083
   
254,446
   
11.0
 
Mr. S. Connor
   
182,444
   
-
   
8,608
   
21,893
   
32,033
   
244,978
   
13.1
 
Dr. J. Ogden
   
171,449
   
-
   
5,233
   
20,574
   
24,133
   
221,389
   
10.9
 
Ms. L. Freedman (3)
   
40,099
   
-
   
2,114
   
2,021
   
22,893
   
67,127
   
34.1
 
Mr. M. Soja (4)
   
40,099
   
-
   
2,114
   
2,021
   
22,893
   
67,127
   
34.1
 
Total
   
1,437,841
   
60,000
   
45,315
   
133,563
   
420,855
   
2,097,574
       
Total
   
2,742,510
   
343,600
   
56,457
   
161,141
   
943,333
   
4,247,041
       
 
*
These options had no intrinsic value at the date of issue.
 
(1)
Bonuses were paid in October 2005 to executive directors and staff as short term incentives following the achievement of key milestones following a recommendation from our Remuneration Committee. No other bonuses have been paid by the Company up to the date of issuing this report.
 
(2)
A total of 900,000 options were issued to directors and employees in November 2005. The options are exercisable at A$0.80, being a 10% premium to the share price at the time that the options were announced (subject to shareholder approval) in April 2005. The options are subject to varying vesting conditions and expire on March 31, 2010.
 
-59-

 
A total of 400,000 options were issued to directors and employees in November 2005. The options are exercisable at A$0.92, being a 10% premium to the 10 day weighted average share price prior to the date of the Notice of Meeting to approve the grant of the options. The options are subject to varying vesting conditions and expire on September 30, 2010.
 
A total of 1,850,000 options were issued to directors and employees in December 2005. The options are exercisable at A$0.92, being a 10% premium to the 10 day weighted average share price prior to the date of the Notice of Meeting to approve the grant of the options. The options are subject to varying vesting and performance conditions and expire on September 30, 2010. Of these options issued to directors and employees the following have performance conditions as detailed below:
 
Dr. P. Ashton
500,000
Subject to 250,000 vesting in 12 months and 250,000 vesting in 24 months from the date of grant. We have the right, with respect to the 250,000 vesting in 24 months, to require performance conditions to be met in relation to the vesting of these options as advised by management and applied by the Board and Remuneration Committee.
     
Ms. L. Freedman
237,500
Subject to 118,750 vesting in 12 months and 118,750 vesting in 24 months from the date of grant. We have the right, with respect to the 118,750 vesting in 24 months, to require performance conditions to be met in relation to the vesting of these options as advised by management and applied by the Board and Remuneration Committee.
     
Mr. M. Soja
237,500
Subject to 118,750 vesting in 12 months and 118,750 vesting in 24 months from the date of grant. We have the right, with respect to the 118,750 vesting in 24 months, to require performance conditions to be met in relation to the vesting of these options as advised by management and applied by the Board and Remuneration Committee.
 
(3)
Excludes salary and fees (A$145,942), benefits (A$10,209) and post-employment superannuation ($9,306) attributable to Ms Freedman for the period from December 30, 2005 to May 23, 2006 (date of appointment as executive officer).
 
(4)
Excludes salary and fees (A$145,942), benefits (A$10,240) and post-employment superannuation (A$7,389) attributable to Mr. Soja for the period from December 30, 2005 to May 23, 2006 (date of appointment as executive officer).
 
Pension, Retirement or Similar Benefits
 
Under Australian government regulations, we are legally required to contribute 9% of our Australian employees’ gross income to an approved superannuation fund. For the years ended June 30, 2006 and 2005, employer contributions totaled A$130,651 and A$44,005, respectively. Employees are entitled to contribute additional amounts to the fund at their own discretion. We make the required contribution to each employee’s nominated Superannuation Fund. Contributions by pSivida of up to 9% of employees’ wages and salaries are legally enforceable in Australia.
 
pSiMedica operates a defined contribution pension scheme. The pension cost charges for the years ended June 30, 2006 and 2005 under the defined contribution scheme were £96,504 (A$229,384) and £79,411 (A$195,863), respectively.
 
pSivida Inc. offers a savings plan to eligible employees that is intended to qualify under Section 401(k) of the Internal Revenue Code. Participating employees may contribute up to US$15,000 of their pre-tax compensation, subject to certain limitations. pSivida Inc. matches employee contributions up to a maximum of 5% of the employees qualified compensation, total contributions were US$44,503 (A$59,878) for the period from December 30, 2005 (date of acquisition) through June 30, 2006.
 
-60-

 
C.
BOARD PRACTICES 
 
The business of pSivida is managed by its directors. The directors exercise all of the powers that our constitution, the Corporations Act 2001, the Australian Stock Exchange or the Australian Stock Exchange Listing Rules do not reserve to the shareholders in general meeting. Compensation for the services of our independent directors is detailed in a service agreement which does not provide for benefits upon termination. Compensation for the services of our officers that also serve as directors is detailed in their respective employment documentation. Both Dr. Brimblecombe and Dr. Ashton would receive benefits in the event that his employment or role were to be terminated as follows:
 
 
·
In the event that Dr. Brimblecombe is terminated for other than cause, he would be entitled to severance benefits in the amount of six months base salary. In addition, all of his unvested options and restricted stock would automatically and immediately vest.
 
 
·
In the event that Dr. Ashton is terminated for other than cause, he would be entitled to severance benefits in the amount of one year’s base salary and a pro rated potion of the maximum bonus to which he was eligible in the year of termination. In addition, we would be obligated to provide medical, life and disability insurance benefits to him for 12 months after termination, and all of his unvested options and restricted stock would automatically and immediately vest.
 
The directors exercise their powers and discharge their duties as a board.
 
The board’s policies and practices exist within a framework of:
 
 
·
the Corporations Act 2001;
 
 
·
the general law, including the law relating to directors’ duties;
 
 
·
the Australian Stock Exchange Corporate Governance Council’s Principles of Good Corporate Governance and Best Practice Recommendations; and
 
 
·
the Australian Stock Exchange Listing Rules.
 
The overall role of the board, as set out in its charter, includes:
 
 
·