S-1/A 1 ds1a.htm AMENDMENT NO.2 TO FORM S-1 Amendment No.2 to Form S-1
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As filed with the Securities and Exchange Commission on May 16, 2008

Registration No. 333-148875

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 

Amendment No. 2

to

FORM S-1

REGISTRATION STATEMENT

UNDER

THE SECURITIES ACT OF 1933

 

PHENOMIX CORPORATION

(Exact Name of Registrant as Specified in Its Charter)

 

Delaware   2834   33-0975733
(State of Incorporation)  

(Primary Standard Industrial

Classification Code Number)

 

(I.R.S. Employer

Identification Number)

5930 Cornerstone Court West

Suite 230

San Diego, California 92121

(858) 731-5200

(Address, Including Zip Code, and Telephone Number, Including Area Code, of Registrant’s Principal Executive Offices)

 

Laura K. Shawver, Ph.D.

Chief Executive Officer

Phenomix Corporation

5930 Cornerstone Court West

Suite 230

San Diego, California 92121

(858) 731-5200

(Name, Address, Including Zip Code, and Telephone Number, Including Area Code, of Agent For Service)

 

Copies to:

Stephen C. Ferruolo

Ryan A. Murr

Maggie L. Wong

Goodwin Procter LLP

4365 Executive Drive, Suite 300

San Diego, California 92121

(858) 202-2700

 

Bruce K. Dallas

Davis Polk & Wardwell

1600 El Camino Real

Menlo Park, CA 94025

(650) 752-2000

 

Approximate date of commencement of proposed sale to the public: As soon as practicable after this registration statement becomes effective.

If any of the securities being registered on this form are to be offered on a delayed or continuous basis pursuant to Rule 415 under the Securities Act of 1933, check the following box.  ¨

If this form is filed to register additional securities for an offering pursuant to Rule 462(b) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering.  ¨

If this form is a post-effective amendment filed pursuant to Rule 462(c) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering.  ¨

If this form is a post-effective amendment filed pursuant to Rule 462(d) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering.  ¨

 

 

The registrant hereby amends this registration statement on such date or dates as may be necessary to delay its effective date until the registrant shall file a further amendment which specifically states that this registration statement shall thereafter become effective in accordance with Section 8(a) of the Securities Act or until the registration statement shall become effective on such date as the Commission, acting pursuant to said Section 8(a), shall determine.

 

 


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The information in this prospectus is not complete and may be changed. We may not sell these securities until the registration statement filed with the Securities and Exchange Commission is effective. This prospectus is not an offer to sell securities and we are not soliciting offers to buy these securities in any state where the offer or sale is not permitted.

 

PROSPECTUS (Subject to Completion)

Issued May 16, 2008

 

             Shares

LOGO

COMMON STOCK

 

 

 

Phenomix Corporation is offering              shares of its common stock. This is our initial public offering and no public market exists for our shares. We anticipate that the initial public offering price will be between $             and $             per share.

 

 

 

We have applied to have our common stock listed on the NASDAQ Global Market under the symbol “PHMX.”

 

 

 

Investing in our common stock involves risks. See “ Risk Factors” beginning on page 8.

 

 

 

PRICE $             A SHARE

 

 

 

    

Price to

  Public  

    

Underwriting

Discounts and

  Commissions  

    

Proceeds to
Phenomix Corporation

Per Share

   $               $             $         

Total

   $                          $                      $                    

 

We have granted the underwriters the right to purchase up to an additional              shares of common stock to cover over-allotments.

 

The Securities and Exchange Commission and state securities regulators have not approved or disapproved of these securities, or determined if this prospectus is truthful or complete. Any representation to the contrary is a criminal offense.

 

The underwriters expect to deliver the shares to purchasers on                     , 2008.

 

 

 

MORGAN STANLEY   CREDIT SUISSE
OPPENHEIMER & CO.   PACIFIC GROWTH EQUITIES

 

                    , 2008


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You should rely only on the information contained in this prospectus and any free-writing prospectus that we authorize to be distributed to you. We have not, and the underwriters have not, authorized anyone to provide you with information different from or in addition to that contained in this prospectus or any related free-writing prospectus. If anyone provides you with different or inconsistent information, you should not rely on it. We are offering to sell, and are seeking offers to buy, shares of common stock, only in jurisdictions where offers and sales are permitted. The information contained in this prospectus is accurate only as of the date of this prospectus, regardless of the time of delivery of this prospectus or of any sale of the common stock. Our business, financial conditions, results of operations and prospects may have changed since that date.

 

Until                     , 2008 (25 days after the commencement of this offering), all dealers that buy, sell or trade shares of our common stock, whether or not participating in this offering, may be required to deliver a prospectus. This delivery requirement is in addition to the dealers’ obligation to deliver a prospectus when acting as underwriters and with respect to their unsold allotments of subscriptions.

 

We have not taken any action to permit a public offering of the shares of common stock outside the United States or to permit the possession or distribution of this prospectus outside the United States. Persons outside the United States who come into possession of this prospectus must inform themselves about, and observe any restrictions relating to, the offering of the shares of common stock and the distribution of this prospectus outside the United States.

 

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PROSPECTUS SUMMARY

 

This summary highlights selected information contained elsewhere in this prospectus. This summary does not contain all of the information you should consider before investing in our common stock. You should read this entire prospectus carefully, especially the risks of investing in our common stock discussed under “Risk Factors” beginning on page 8, and the financial statements and notes to those financial statements, before making an investment decision. Unless the context indicates otherwise, the references in this prospectus to “Phenomix,” “we,” “us” and “our” refer to Phenomix Corporation.

 

PHENOMIX CORPORATION

 

Corporate Overview

 

We are a biopharmaceutical company focused on the discovery and development of novel small-molecule product candidates directed toward clinically validated targets in significant therapeutic markets. Our goal is to design product candidates that have improved efficacy, safety or convenience relative to existing therapies and other product candidates in clinical development. Our lead product candidate, PHX1149, is a dipeptidyl peptidase-4, or DPP-4, inhibitor that we are developing as an oral, once-daily treatment for Type 2 diabetes. DPP-4 inhibitors prevent the DPP-4 enzyme from breaking down proteins such as glucagon-like peptide-1, or GLP-1, a naturally-occurring hormone that slows the emptying of the stomach, stimulates insulin production and reduces blood glucose. In our randomized, 422 patient Phase 2b clinical trial completed in the first quarter of 2008, PHX1149 demonstrated statistically significant reductions in hemoglobin A1c, or HbA1c, a measure of blood glucose control, when administered in combination with existing drugs for the treatment of Type 2 diabetes. In addition, the safety and tolerability of PHX1149 were not substantially different from placebo in this Phase 2b clinical trial or in our earlier Phase 2a and Phase 1 clinical trials. The U.S. Food and Drug Administration, or the FDA, currently approves diabetes medications based primarily on safety and on effectiveness in lowering HbA1c levels. We expect to commence Phase 3 clinical trials of PHX1149 in the second half of 2008. At an end-of-Phase 2 meeting held in April 2008, the FDA agreed that we could proceed with our planned Phase 3 clinical trials and confirmed the scope of the trials necessary to support a marketing application for PHX1149. The number of subjects required to be treated and the duration of the Phase 3 clinical trials that we will be required to conduct are consistent with draft guidelines for diabetes clinical trials published by the FDA in February 2008. The FDA did not request an outcome study at the end-of-Phase 2 meeting. We plan to conduct a safety and efficacy study of PHX1149 in patients with impaired kidney function, as required by the FDA. Our second product candidate, PHX1766, is a protease inhibitor currently in preclinical development for the treatment of hepatitis C virus, or HCV, infection. We expect to commence Phase 1 clinical trials of PHX1766 in the second half of 2008.

 

We discovered our product candidates using our “fast-follower” strategy for drug discovery, which is directed toward clinically validated therapeutic targets for which the pharmacological effect of a product candidate can be demonstrated in early-stage clinical trials. We have an active discovery program focused on enzyme targets, including proteases, kinases and polymerases, which play a role in human diseases. We believe that by pursuing this strategy, we can reduce the risk associated with novel targets and the time required to advance a product candidate into clinical trials. Using this approach, we advanced PHX1149 into human clinical trials 27 months after initiating our DPP-4 inhibitor discovery program.

 

We have not received FDA approval to market any of our product candidates, and we have not generated any revenues from the sale of any products to date. We intend to maximize the value of our product candidates through independent development, licensing and other partnership opportunities with collaborators. These may include co-development or co-marketing agreements or licensing agreements with pharmaceutical and biotechnology companies that possess established development and commercialization capabilities. To date, we have not entered into any of these types of arrangements. If the FDA approves any of our product candidates for marketing, we may also pursue direct commercialization by building our own sales and marketing force.

 

 

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PHX1149 for the Treatment of Type 2 Diabetes

 

We are developing PHX1149 for the treatment of Type 2 diabetes, a chronic disease associated with abnormally high levels of glucose in the blood. Type 2 diabetes affects more than 160 million people worldwide, including approximately 18 million people in the United States. According to the American Diabetes Association, direct and indirect expenditures related to diabetes comprise 11% of all U.S. healthcare expenditures. In 2006, worldwide sales of diabetes medications totaled approximately $21 billion, with approximately $12 billion spent on oral anti-diabetic medications, or OADs. Despite existing therapies and increasing awareness of the need for careful glucose control, according to the National Health and Nutrition Examination Surveys, nearly two-thirds of patients diagnosed with Type 2 diabetes do not achieve and maintain proper control of blood glucose, as measured by HbA1c. Furthermore, many existing therapies result in common side effects, including an increased risk of hypoglycemia, or abnormally low blood glucose levels, weight gain and gastrointestinal problems, as well as less common adverse events such as heart attacks and congestive heart failure. As a result, we believe there is a need for improved therapies for Type 2 diabetes.

 

DPP-4 inhibitors represent a new class of OADs that improve the control of blood glucose and have a favorable tolerability profile. Sitagliptin, marketed by Merck & Co., Inc. as Januvia and Janumet, is the first DPP-4 inhibitor approved by the FDA and the European Agency for the Evaluation of Medicinal Products, or EMEA, for the treatment of Type 2 diabetes. From its commercial launch in October 2006 through March 2008, sitagliptin has generated over $1.1 billion in worldwide sales. Although sitagliptin represents a significant advancement in the treatment of Type 2 diabetes, its product label reports various common side effects, including upper respiratory tract infections, nasal congestion and headache, as well as rare adverse events such as serious allergic and hypersensitivity reactions. Sitagliptin and other DPP-4 inhibitors in development have exhibited similar efficacy profiles as measured by reductions in HbA1c. As a result, we believe DPP-4 inhibitors will be differentiated in the market primarily based on their tolerability and convenience.

 

Our Phase 2 and preclinical data suggest that PHX1149 has the potential to compete favorably with sitagliptin and other DPP-4 inhibitors in development due to the following characteristics:

 

 

 

Efficacy. In our Phase 2b clinical trial, PHX1149 demonstrated statistically significant reductions in HbA1c, as well as statistically significant effects on secondary efficacy endpoints, including change in fasting blood glucose levels, change in post-meal blood glucose levels and achievement of a target HbA1c level of less than 7%. This is consistent with the results from our Phase 2a clinical trial, where patients treated with PHX1149 experienced increased levels of GLP-1 and statistically significant reductions in post-meal glucose levels, similar to other DPP-4 inhibitors.

 

   

Tolerability. Published preclinical studies have demonstrated that compounds that inhibit other DPP family members, in particular those that inhibit both DPP-8 and DPP-9, have significantly greater toxicity than inhibitors that are selective for DPP-4. In our preclinical studies, PHX1149 demonstrated low cross-reactivity with other cellular targets closely related to DPP-4. We believe this characteristic reduces the potential for off-target effects from PHX1149 relative to less selective DPP-4 inhibitors. PHX1149 was well tolerated in our Phase 2 clinical trials. Overall adverse events in patients treated with PHX1149 did not differ significantly from placebo.

 

   

Convenience. In our Phase 2a clinical trial, we observed that mean percent inhibition of the DPP-4 enzyme at 24 hours after administration in patients treated with PHX1149 was 53%, 73% and 78% in the 100 mg, 200 mg and 400 mg dose groups, respectively, and maximal DPP-4 inhibition exceeded 80% for all dose levels. We observed similar DPP-4 inhibition in our Phase 2b clinical trial, which included 200 mg and 400 mg dose groups. Based on these results, we believe PHX1149 will be suitable for oral, once-daily administration with no time-of-day restrictions. From our study of food interaction in our Phase 1 clinical trials, we also expect that PHX1149 can be administered without regard to the timing of meals.

 

 

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We also believe PHX1149 may have an improved safety profile relative to other DPP-4 inhibitors due to the following combination of characteristics:

 

   

Stable concentration profile over time. The stable drug levels of PHX1149 in the blood over time may enable PHX1149 to avoid potential safety concerns relative to other DPP-4 inhibitors in development that have a more pronounced peak of concentration shortly after administration.

 

   

Limited distribution within the body. Our studies demonstrate that PHX1149 has a low volume of distribution and negligible penetration into cells. Thus, PHX1149 may have a more limited distribution within the body than other DPP-4 inhibitors. Because the DPP-4 in tissues degrades certain proteins that promote inflammation, DPP-4 inhibitors that penetrate into tissues may increase the risk of unintended inflammatory effects by inhibiting the DPP-4 expressed in these tissues. As a result, we believe that PHX1149 may be less likely to cause adverse events, such as sinus inflammation, nasal congestion and headache, which have been reported in patients treated with other DPP-4 inhibitors that penetrate into tissues.

 

   

Favorable metabolism and excretion profile. Because PHX1149 is not metabolized in the liver, it is not susceptible to potential issues related to chemical by-products, or metabolites, which typically occur when drugs are broken down by the liver. Furthermore, PHX1149 does not interfere with the liver enzymes that metabolize other drugs, which reduces the potential for drug-drug interactions.

 

We are party to agreements relating to specified DPP-4-inhibiting compounds for use in the treatment of diabetes. The agreements cover, among other things, the development and commercialization of PHX1149 alone or in combination with other drugs for the treatment of diabetes. Pursuant to these agreements, we paid license and milestone fees totaling approximately $5.8 million in 2006 and $.8 million in 2007. We expect to make additional milestone payments of up to $7.5 million in 2008 under these agreements and additional payments upon the achievement of specified pre-commercialization milestones with respect to PHX1149. We are also obligated to make royalty payments on net sales of products covered under the agreements until the expiration of the last-to-expire covered patent right, unless the agreements are earlier terminated.

 

PHX1766 for the Treatment of HCV Infection

 

Our second product candidate, PHX1766, is an orally available NS3/4A protease inhibitor, which we are developing for the treatment of HCV infection. Proteases are enzymes that break down specific proteins and are involved in various physiological processes; compounds that inhibit proteases, or prevent them from breaking down specific proteins, can play important roles in therapeutic areas. The NS3/4A protease is an enzyme necessary for the replication of HCV. HCV is the most common chronic blood-borne viral infection in the United States and a leading cause of liver failure, liver transplants and liver cancer. The Centers for Disease Control and Prevention, or the CDC, estimate that approximately 3.2 million people in the United States are chronically infected with HCV. The current standard of care for the treatment of HCV infection is a combination therapy of injected pegylated interferon and orally-administered ribavirin. However, this combination therapy has been associated with serious side effects, including neuropsychiatric and autoimmune disorders, anemia that may lead to heart attacks and an increased risk of birth defects or death of the fetus. The side effect profile of the standard of care, together with its long duration of therapy and the requirement that interferon be administered by injection, may reduce patients’ motivation to initiate or continue HCV therapy under this standard of care. Furthermore, among patients infected with HCV genotype 1, the most prevalent form of HCV in the United States, only 42% to 46% treated under the standard of care achieve a sustained viral response, or SVR, which is defined as the absence of a detectable amount of HCV in the blood six months after completion of therapy.

 

Unlike interferons, which work by stimulating the immune system’s response to viral infection, HCV protease inhibitors directly target the virus by inhibiting NS3/4A protease. When tested in Phase 2 clinical trials,

 

 

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HCV protease inhibitors have reduced the levels of virus in the blood and, when added to the standard of care, provided greater SVR rates and a shorter duration of therapy compared to the standard of care alone. Based on our preclinical data, we believe PHX1766 may offer advantages over other HCV protease inhibitors in development, including an improved dosing regimen, higher potency and greater selectivity. We expect to commence clinical trials of PHX1766 in the second half of 2008.

 

Risks Related to Our Business

 

Our business is subject to a number of risks of which you should be aware before making an investment decision. These risks are discussed more fully in “Risk Factors.” For example:

 

   

We are dependent on the success of PHX1149. All of our other product candidates are in the research stage of development. If we are unable to successfully develop, receive regulatory approval for and commercialize PHX1149, we may never be profitable and may have to cease operations.

 

   

The market opportunity for PHX1149 may be adversely affected if competing DPP-4 inhibitors or other alternative drug therapies are more efficacious, safer or less costly than PHX1149.

 

   

Even if approved for sale by the appropriate regulatory authorities, physicians may decide not to prescribe PHX1149 or any of our future product candidates.

 

   

We have incurred net losses of $124.1 million from our inception to March 31, 2008, and we anticipate that we will continue to incur losses for the foreseeable future.

 

Corporate Information

 

We were founded on July 30, 2001 as a Delaware corporation. Our principal executive offices are located at 5930 Cornerstone Court West, Suite 230, San Diego, California 92121, and our telephone number is (858) 731-5200. Our website is www.phenomix.com. The information on our website is not part of this prospectus.

 

Phenomix Corporation and our logo are our trademarks. This prospectus includes additional trademarks of Phenomix Corporation and others.

 

 

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THE OFFERING

 

Common stock offered by us

             shares

 

Common stock to be outstanding after this offering

             shares

 

Use of proceeds

We intend to use the proceeds from this offering for the first of our planned Phase 3 clinical trials, the ongoing extension phase of our Phase 2b clinical trial and our other ongoing clinical trials of PHX1149 for the treatment of Type 2 diabetes, the repayment of amounts borrowed under our loan and security agreement with Pinnacle Ventures, L.L.C. and our ongoing preclinical studies and planned Phase 1 clinical trials of PHX1766 for the treatment of HCV infection. We also intend to use the proceeds from this offering for our other drug discovery and development programs, working capital and general corporate purposes. For a more complete description of our intended use of the proceeds from this offering, see “Use of Proceeds.”

 

Proposed NASDAQ Global Market symbol

PHMX

 

The number of shares of our common stock to be outstanding following this offering is based on 32,767,461 shares of our common stock outstanding as of March 31, 2008 but excludes:

 

   

4,017,916 shares of common stock subject to options outstanding as of March 31, 2008 and having a weighted average exercise price of $.67 per share and 341,302 additional shares of common stock reserved as of March 31, 2008 for future issuance under our stock-based compensation plans;

 

   

957,440 shares of common stock subject to warrants outstanding as of March 31, 2008 and having a weighted average exercise price of $4.30 per share, including warrants currently exercisable for 913,585 shares of our preferred stock; and

 

   

up to 57,693 additional shares of Series C preferred stock that may become issuable upon the exercise of a warrant issued by us in December 2007 at an exercise price of $4.16 per share.

 

Unless otherwise indicated, all information in this prospectus assumes:

 

   

the automatic conversion of all of our outstanding shares of our preferred stock into shares of common stock immediately prior to the completion of this offering;

 

   

the conversion of outstanding warrants to purchase shares of our preferred stock into warrants to purchase shares of our common stock immediately prior to the completion of this offering;

 

   

the filing of our amended and restated certificate of incorporation and the adoption of our amended and restated bylaws immediately prior to the completion of this offering; and

 

   

no exercise of the underwriters’ over-allotment option.

 

None of the information contained in this prospectus has been adjusted to reflect a reverse stock split that we intend to effect prior to the pricing of this offering.

 

 

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SUMMARY CONSOLIDATED FINANCIAL DATA

 

The following tables present our summary consolidated financial data for our fiscal years 2005 through 2007 and for the three months ended March 31, 2007 and 2008 and our summary consolidated balance sheet data as of March 31, 2008. The consolidated financial data for the fiscal years ended December 31, 2005, 2006 and 2007 and for the three months ended March 31, 2007 and 2008 and as of March 31, 2008 have been derived from our consolidated financial statements, which appear elsewhere in this prospectus. The financial data as of and for the period from July 30, 2001 (inception) through March 31, 2008 are derived from our consolidated financial statements, which, in the opinion of management, contain all adjustments necessary for a fair presentation of such consolidated financial data. You should read this information in conjunction with our consolidated financial statements, the related notes to these financial statements and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” included elsewhere in this prospectus.

 

    Years Ended December 31,     Three Months Ended
March 31,
    Period from
July 30, 2001
(inception)
through
March 31,
2008
 
    2005     2006     2007     2007     2008    
    (in thousands, except share and per share data)  
                      (unaudited)     (unaudited)  

Operating expenses:

           

Research and development

  $ 11,075     $ 22,800     $ 31,329     $ 5,316     $ 14,777     $ 90,184  

General and administrative

    3,871       6,129       6,126       1,754       2,100       25,348  
                                               

Total operating expenses

    14,946       28,929       37,455       7,070       16,877       115,532  
                                               

Operating loss

    (14,946 )     (28,929 )     (37,455 )     (7,070 )     (16,877 )     (115,532 )

Interest income

    457       655       1,221       150       329       3,122  

Interest expense

    (456 )     (372 )     (709 )     (124 )     (230 )     (2,092 )

Other income (expense), net

    (26 )     (47 )     (31 )     (13 )     (10 )     (141 )
                                               

Loss from continuing operations

    (14,971 )     (28,693 )     (36,974 )     (7,057 )     (16,788 )     (114,643 )

Income (loss) from discontinued operations, net of tax

    304       915       95       (43 )     —         (6,374 )
                                               

Net loss

    (14,667 )     (27,778 )     (36,879 )     (7,100 )     (16,788 )     (121,017 )

Deemed dividend related to beneficial conversion feature on preferred stock

    —         —         —         —         (3,088 )     (3,088 )
                                               

Net loss applicable to common stockholders

  $ (14,667 )   $ (27,778 )   $ (36,879 )   $ (7,100 )   $ (19,876 )   $ (124,105 )
                                               

Loss per share from continuing operations, basic and diluted

  $ (81.89 )   $ (109.48 )   $ (137.71 )   $ (37.88 )   $ (30.47 )  

Income (loss) per share from discontinued operations, basic and diluted

    1.66       3.49       .35       (.23 )     —      
                                         

Net loss per share, basic and diluted

    (80.23 )     (105.99 )     (137.36 )     (38.11 )     (30.47 )  

Loss per share from beneficial conversion feature

    —         —         —         —         (5.61 )  
                                         

Net loss per share applicable to common stockholders

  $ (80.23 )   $ (105.99 )   $ (137.36 )   $ (38.11 )   $ (36.08 )  
                                         

Weighted average shares, basic and diluted

    182,804       262,098       268,492       186,334       550,903    

Pro forma loss per share from continuing operations, basic and diluted(1)

      $ (1.66 )     $ (.54 )  

Pro forma income per share from discontinued operations, basic and diluted(1)

        .01         —      
                       

Pro forma net loss per share, basic and diluted(1)

      $ (1.65 )     $ (.54 )  
                       

Pro forma weighted average shares outstanding, basic and diluted

        22,357,873      

 

31,490,626

 

 
                       

 

  (1)   The pro forma net loss per share, basic and diluted, gives effect to the weighted average conversion of all outstanding shares of our preferred stock into 27,595,177 and 32,006,100 shares of our common stock as of December 31, 2007 and March 31, 2008, respectively.

 

 

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The following table presents our summary consolidated balance sheet data as of March 31, 2008:

 

   

on an actual basis; and

 

   

on a pro forma basis to reflect (i) the automatic conversion of all outstanding shares of our preferred stock into an aggregate of 32,006,100 shares of our common stock immediately prior to the completion of this offering and (ii) the receipt by us of net proceeds of $            million from the sale of the             shares of common stock offered by us in this offering at an assumed public offering price of $            per share, the midpoint of the range set forth on the cover of this prospectus, less estimated underwriting discounts and commissions and estimated offering expenses payable by us.

 

     As of March 31, 2008
     Actual    Pro Forma(1)
     (unaudited)
     (in thousands)

Balance Sheet Data:

     

Cash and cash equivalents

   $ 34,377    $             

Working capital

     24,863   

Total assets

     37,480   

Long-term debt, net of current portion

     2,837   

Total stockholders’ equity

     23,247   

 

  (1)   A $1.00 increase (decrease) in the assumed initial public offering price of $            per share, the midpoint of the range set forth on the cover page of this prospectus, would increase (decrease) each of cash and cash equivalents, and stockholders’ deficit by $            , assuming the number of shares offered by us, as set forth on the cover page of this prospectus, remains the same and after deducting the estimated underwriting discounts and commissions and estimated offering expenses payable by us.

 

 

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RISK FACTORS

 

Any investment in our stock involves a high degree of risk. You should consider carefully the risks and uncertainties described below and all information contained in this prospectus before you decide whether to purchase our common stock. Our business, financial condition or results of operation could be materially harmed by any of these risks. The trading price of our common stock could decline due to any of these risks or uncertainties, and you may lose part or all of your investment.

 

Risks Related to Our Business and Industry

 

We are dependent on the success of PHX1149, and we cannot give any assurance that PHX1149 or any of our product candidates will receive regulatory approval or be successfully commercialized.

 

We are a clinical-stage biopharmaceutical company and the future of our business depends primarily on our ability to develop and commercialize PHX1149 and our other product candidates successfully. To date, we have not marketed, distributed or sold any products, and we do not currently have any commercial products that generate revenues or any other sources of revenues. We may never be able to develop any marketable products. We are highly dependent on the success of our lead product candidate, PHX1149, for the treatment of Type 2 diabetes. In the first quarter of 2008, we completed a Phase 2b clinical trial of PHX1149, which demonstrated statistically significant reductions in HbA1c when administered in combination with existing drugs for the treatment of Type 2 diabetes. Our other programs and product candidates, including PHX1766 for the treatment of HCV infection, are in preclinical development or the discovery stage. In order to commercialize PHX1149 or any other product candidate, we will be required to conduct clinical trials, which may not succeed, and to obtain regulatory approvals, which we may fail to do. We do not know, and are unable to predict, what type of, and how many, clinical trials the U.S. Food and Drug Administration, or the FDA, will require us to conduct before granting approval for us to market our product candidates. Our development programs may not lead to a commercial product, either because we fail to demonstrate that our product candidates are safe and effective in clinical trials and we therefore fail to obtain necessary approvals from the FDA and similar foreign regulatory agencies or because we have inadequate financial or other resources to advance our product candidates through the clinical trial process to successful commercialization. Any failure to obtain approval for, or to successfully commercialize, PHX1149 would impair our ability to generate revenues, and it would require a significant amount of time and resources to bring any other product candidates to market.

 

Our lead product candidate, PHX1149, is still under clinical development for the treatment of Type 2 diabetes, and we may not be able to advance PHX1149 through clinical trials into successful commercialization.

 

Before we can obtain regulatory approvals for the commercial sale of PHX1149 or any other product candidate, we must demonstrate that the product candidate is safe and effective for use for its respective target indications with substantial evidence gathered in well-controlled clinical trials. Despite our efforts and the expenditure of significant resources, we may not be able to advance PHX1149 through clinical trials to successful commercialization for a variety of reasons, including:

 

   

PHX1149 may prove to be carcinogenic in our ongoing carcinogenicity studies, or we may otherwise be unable to demonstrate the safety and efficacy of PHX1149 in our planned Phase 3 clinical trials;

 

   

we may not meet other applicable regulatory standards;

 

   

PHX1149 may not offer safety advantages, therapeutic benefits or other improvements over existing DPP-4 inhibitors and other products and product candidates under development for the treatment of Type 2 diabetes;

 

   

we may not able to produce PHX1149 in commercial quantities at acceptable costs; or

 

   

we may not otherwise be able to successfully commercialize PHX1149.

 

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The observation of adverse events in either humans or animals may impair our ability to obtain approval for and commercialize PHX1149. For example, we observed skin toxicity in some of our preclinical studies of PHX1149 at high doses in monkeys. We have not observed similar skin toxicity in humans in our clinical trials of PHX1149 to date, and studies of other DPP-4 inhibitors have suggested that there may be no correlation between this side effect in animal toxicology studies and human clinical trials. However, the connection, if any, between DPP-4 inhibitors, including PHX1149, and skin toxicity is not fully understood. We or other developers of DPP-4 inhibitors may observe this side effect or other adverse events in ongoing or future clinical trials, which would adversely impact our ability to obtain FDA approval.

 

In addition, the results from our planned Phase 3 clinical trials may be negative or inconclusive. Pharmaceutical and biotechnology companies have suffered significant setbacks in late-stage clinical trials even after achieving promising results in preclinical studies and earlier clinical trials. Any of these setbacks could impair our ability to generate revenues and harm our business and results of operations.

 

PHX1766 is still in preclinical development and remains subject to clinical testing and regulatory approval, and all of our other product candidates except for PHX1149 are in discovery stage research. If we are unable to successfully advance PHX1766 into clinical trials and complete the development and testing of this or any other potential product candidate, our business prospects will be harmed.

 

Except for PHX1149, all of our product candidates are in preclinical development or discovery stage research. Our HCV program, including PHX1766, and other early-stage research and development programs are based upon relatively new science and involve new chemical entities. Subsequent discoveries by us and third parties may lead us to reconsider our scientific hypotheses, including how novel mechanisms regulate various biological functions. Like any scientific undertaking, we may draw the wrong inference from, or fail to appreciate the significance of, scientific data, which could result in compounds emerging from our development programs having a lower than anticipated efficacy profile or an unacceptable safety profile.

 

Our strategy for product development focuses on identifying new chemical entities directed toward clinically validated biological points of intervention, or targets, and for which a pharmacological effect can be demonstrated in early-stage clinical trials. Research programs to identify disease targets and new product candidates require substantial technical, financial and human resources, and may fail to yield successful product candidates. We may experience numerous setbacks during, or as a result of, preclinical testing or other developmental research that could delay or prevent our ability to identify and to advance earlier stage product candidates into or through clinical trials, including:

 

   

our ongoing preclinical toxicology studies of PHX1766 and other preclinical research may produce negative or inconclusive results, which may require us to conduct additional preclinical testing or abandon the development of the product candidate;

 

   

we may be unable to produce sufficient quantities of materials at acceptable purities to conduct necessary preclinical studies and clinical trials;

 

   

our preclinical studies or any future clinical trials may not demonstrate that PHX1766 can be administered less frequently than other NS3/4A protease inhibitors, that PHX1766 is a sufficiently potent inhibitor of the NS3/4A protease or that PHX1766 is sufficiently selective against cellular targets;

 

   

newer therapies or competitive products may supersede the development opportunity; or

 

   

we may determine that PHX1766 or our other early-stage product candidates do not have sufficient potential to warrant the allocation of resources toward them.

 

Even if we are able to advance PHX1766 or any other product candidate beyond preclinical development into clinical trials, we will be subject to all of the risks associated with clinical development of a product candidate. Results from any completed preclinical studies may not be predictive of the results we may obtain in

 

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clinical trials or the likelihood of approval of a drug candidate for commercial sale. Currently, no protease inhibitor has been approved by the FDA for the treatment of HCV infection. We cannot be certain that any protease inhibitors, including PHX1766, will ever be approved by the FDA or any foreign regulatory agency for the treatment of HCV infection. If we are unable to develop suitable product candidates through our internal research programs or otherwise, we may not be able to generate or increase revenues in future periods, which could result in significant harm to our financial position.

 

Delays in the commencement or successful completion of clinical trials could result in increased costs to us and delay or limit our ability to generate revenues.

 

Each of our product candidates must undergo extensive preclinical studies and clinical trials as a condition to regulatory approval. Preclinical studies and clinical trials are expensive and take many years to complete. We estimate that clinical trials and related regulatory review in initial indications for our lead product candidate, PHX1149, will continue for at least four years. PHX1766 is in preclinical development, and we do not expect to commence clinical trials for this product candidate until the second half of 2008. In each case, our preclinical studies or clinical trials could take significantly more time to complete than anticipated. Delays in the commencement or successful completion of clinical trials could affect our product development costs significantly. We do not know whether our planned clinical trials will begin or be completed on schedule, if at all.

 

The commencement and completion of clinical trials can be delayed for a number of reasons. We may experience delays in our clinical programs related to:

 

   

obtaining regulatory approval to commence a clinical trial or complying with conditions imposed by a regulatory authority regarding the size, scope and design of a clinical trial;

 

   

unexpected clinical or nonclinical results that necessitate a change in the clinical testing plan;

 

   

difficulties recruiting clinical sites at which to conduct clinical trials, which may occur for a variety of reasons, including the size of the patient population that meets the eligibility criteria to participate in the trials, the nature of our trial protocols, the availability of approved alternative treatments for the relevant indications and competition from other clinical trial programs for similar indications;

 

   

obtaining institutional review board or ethics committee approvals to conduct a clinical trial at prospective sites;

 

   

reaching agreement on acceptable terms with prospective clinical research organizations, or CROs, and trial sites, the terms of which can be subject to extensive negotiation and may vary significantly among different CROs and trial sites;

 

   

delays in the manufacture of sufficient quantities of our product candidates with acceptable stability and purity profiles for use in clinical trials;

 

   

severe or unexpected drug-related side effects experienced by participants in a clinical trial, which could result in the FDA’s placing the program on clinical hold;

 

   

retaining participants who have enrolled in a clinical trial but may be prone to withdraw due to the design of the trial, lack of efficacy or personal issues or who fail to return for follow-up visits for a variety of reasons; and

 

   

lack of adequate funding or other internal resources and expertise to continue the clinical trial.

 

Additionally, changes in regulatory requirements and guidance may occur, and we may need to amend clinical trial protocols or add new clinical trials to comply with these changes. Amendments may require us to resubmit our clinical trial protocols to institutional review boards or ethics committees for reexamination, which may impact the cost, timing or successful completion of the clinical trials. If we experience delays in the completion of, or if we terminate, our planned Phase 3 clinical trials for PHX1149 or any of our other future

 

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clinical trials, the commercial prospects for our product candidates may be harmed and our ability to generate product revenues will be delayed. In addition, many of the factors that cause, or lead to, a delay in the commencement or completion of clinical trials may also ultimately lead to the denial of regulatory approval of a product candidate.

 

New and future policies adopted by the FDA or other regulatory authorities and new and future clinical findings could increase the time and cost required for us to conduct and complete clinical trials of PHX1149.

 

A long-term study of Type 2 diabetes patients being conducted by the National Institutes of Health was recently halted after results suggested that lowering blood sugar to normal or nearly normal levels may actually increase the risk of death in patients treated with various anti-diabetes medications, compared to patients who control their blood sugar levels less rigidly. These and other new findings in clinical research may cause the FDA and other regulatory authorities to change their standards for approving drugs for the treatment of diabetes.

 

In February 2008, the FDA published draft guidance for the development of drugs and biologics for the treatment and prevention of diabetes. The guidance recommends, among other things, that Phase 3 trials be sized to allow meaningful evaluation of safety and efficacy across different patient population subgroups based on sex, age, ethnic background, duration and severity of the disease, interactions with other drugs likely to be used as combination therapies and other factors that may be relevant. The guidance also indicates that trials lasting longer than one year are strongly encouraged and may be needed if safety concerns have been raised in preclinical studies or Phase 2 or Phase 3 clinical trials. In addition, the guidance suggests that large outcome trials that test for clinical endpoints, such as improvement in a serious morbidity or mortality related to diabetes, in addition to the currently accepted surrogate endpoint of HbA1c reduction may be required where a product candidate has shown evidence of adverse effects such as macrovascular damage, or damage to large blood vessels, particularly in the heart, in preclinical studies or clinical trials. Even where no deleterious effect on cardiovascular outcome has been observed during pre-marketing evaluation, further post-approval assessment for effects on macrovascular disease may be needed. While the FDA did not request an outcome study of PHX1149 at our end-of-Phase 2 meeting held in April 2008, the FDA may request that we conduct such a study as a condition to marketing approval. The FDA is soliciting comments on the draft guidance and has not published final guidance. Although we currently do not know what impact, if any, the final guidance will have on the design and conduct of our planned Phase 3 clinical trials of PHX1149, revised policies established by the FDA may require us to increase the size and scope of our trials or modify the design of our trials in ways that could significantly increase the time and cost required for us to conduct and complete these trials.

 

We rely on third parties to conduct preclinical research and clinical trials for our product candidates, and if they do not properly and successfully perform their obligations to us, we may not be able to obtain regulatory approvals for our product candidates.

 

We design the preclinical programs and clinical trials for our product candidates, but we rely on CROs to assist us in conducting many aspects of preclinical research and in managing, monitoring and otherwise carrying out our clinical trials. We compete with other companies, including larger, more established companies, for the resources of these third parties. MDS Pharma Services and iGATE Clinical Research International, Inc., both of which are global CROs, conducted our Phase 2b clinical trial of PHX1149 in India, North America and South America under services agreements, and we will need to engage third-party CROs to conduct our planned Phase 3 clinical trials for PHX1149.

 

Although we rely on third parties to conduct our preclinical research and clinical trials, we are responsible for confirming that each of our clinical trials is conducted in accordance with the approved protocol and investigational guidelines. Moreover, the FDA and foreign regulatory agencies require us to comply with regulations and standards, commonly referred to as good clinical practices, for conducting, recording and reporting the results of clinical trials to assure that the data and results are credible and accurate and that the trial participants are adequately protected. Our reliance on third parties does not relieve us of these responsibilities and requirements.

 

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If our CROs do not successfully carry out their duties under their agreements with us, if the quality or accuracy of the data they obtain is compromised due to failure to adhere to regulatory requirements or our clinical protocols, or if they otherwise fail to comply with clinical trial protocols or meet expected deadlines, our clinical trials may not meet regulatory requirements. If our clinical trials do not meet regulatory requirements or if these third parties need to be replaced, our clinical trials may be extended, delayed, suspended or terminated. If any of these events occurs, the clinical development costs for our candidates would be expected to rise and we may not be able to obtain regulatory approval of our product candidates.

 

Our dependence upon third parties for the manufacture and supply of PHX1149 and our future product candidates and products may cause delays in, or prevent us from, successfully developing and commercializing products.

 

We do not currently have the infrastructure or capability internally to manufacture the product candidates that we need to conduct our clinical trials. We employ the services of Hovione, LLC to produce the active pharmaceutical ingredient in PHX1149 under a master services agreement, and we have entered into agreements with other contract suppliers and manufacturers to produce our supplies of the finished form of PHX1149, but we have no long-term contracts for the supply of this product candidate or any of our future product candidates. PHX1149 is a new chemical entity that has never been produced at commercial scale, and, as such, there are underlying risks associated with its manufacture, which could include cost overruns, impurities, difficulties in scaling up or reproducing manufacturing processes, and lack of timely availability of raw materials. Any of these risks may prevent or delay us from successfully developing PHX1149 or our future product candidates.

 

We and our third-party manufacturers are required to comply with applicable FDA manufacturing practice regulations. If one of our third-party manufacturers fails to maintain compliance with these regulations, the production of our product candidates could be interrupted, resulting in delays and additional costs. Additionally, our third-party manufacturers must pass a pre-approval inspection before we can obtain regulatory approval for any of our product candidates. If for any reason these third-party manufacturers are unable or unwilling to perform under their agreements with us, we may not be able to locate alternative manufacturers or enter into favorable agreements with them in an expeditious manner. We could also experience manufacturing delays if our third-party manufacturers give greater priority to the supply of other products over our product candidates. Any inability to acquire sufficient quantities of our product candidates or their components in a timely manner from third parties could delay clinical trials or result in product shortages and prevent us from developing and commercializing our product candidates in a cost-effective manner or on a timely basis.

 

We expect to depend on collaborative arrangements to complete the development and commercialization of our product candidates, which we may fail to do. These collaborative arrangements, if any, would likely place the development of our product candidates outside of our control and require us to relinquish important rights or may otherwise be on terms unfavorable to us.

 

We expect to enter into collaborative arrangements with pharmaceutical companies or third parties to develop and commercialize our product candidates. The development of PHX1149 through Phase 3 clinical trials will require significant additional resources that may not be available to us unless we are able to enter into a collaborative arrangement pursuant to which our partner or partners fund all or part of the clinical trial costs. In addition, we believe that PHX1149, if approved, would be promoted extensively to primary care physicians because diabetes is typically treated by these physicians rather than by specialists, which would require a large sales and marketing force. We expect that we will need to enter into one or more collaborative arrangements to successfully develop and commercialize PHX1149.

 

Dependence on collaborative arrangements for the development or commercialization of our product candidates would subject us to a number of risks, including:

 

   

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

 

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

 

   

to the extent we enter into a collaborative arrangement prior to completion of development work and we rely on our collaborators to conduct such work, we would not control the amount and timing of resources applied to the collaborative arrangement;

 

   

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

 

   

we may have limited control over the clinical trial design or other aspects of the development or commercialization of the product candidates that we partner;

 

   

disputes may arise between us and our collaborators that result in the delay or termination of the research, development or commercialization of our product candidates or that result in costly litigation or arbitration that diverts management’s attention and resources;

 

   

collaborators may not properly maintain or defend our patents and other intellectual property rights or may use these rights in such a way as to expose us to potential litigation that could jeopardize or invalidate our patents;

 

   

a collaborator could develop a competing product candidate, either independently or in collaboration with others, including our competitors;

 

   

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

 

   

our collaborators may not market our potential products in a manner that is competitive to others also marketing products for the treatment of Type 2 diabetes or other indications for which we may develop product candidates.

 

The occurrence of any of the risks described above would impair our ability to generate revenues from our product candidates and harm our results of operations.

 

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

 

Our success depends in part on our continued ability to attract, retain and motivate highly qualified management, clinical and scientific personnel and on our ability to develop and maintain important relationships with leading academic institutions, clinicians and scientists. We are highly dependent upon our senior management and scientific staff, particularly Laura Shawver, Ph.D., our Chief Executive Officer, Julie Cherrington, Ph.D., our President, Chris Burnley, our Executive Vice President and Chief Operating Officer, John E. Crawford, our Chief Financial Officer, Hans-Peter Guler, M.D., our Vice President, Clinical Development, and David Campbell, Ph.D., our Vice President, Drug Discovery and Preclinical Sciences. Although we have employment agreements with each of these individuals, each such agreement is terminable at will at any time with or without notice, and, therefore, we may not be able to retain their services as expected. The loss of services of any of these individuals or one or more other members of our senior management could delay or prevent the successful completion of our planned clinical trials or the commercialization of our product candidates.

 

Competition for qualified personnel in the biotechnology and pharmaceuticals field is intense, particularly in the San Diego, California area, where our offices are located. We will need to hire additional personnel as we expand our clinical development and commercial activities. We may not be able to attract and retain quality personnel on acceptable terms. Currently, we maintain “key person” life insurance on Dr. Shawver in an amount of $1.0 million. We do not carry “key person” life insurance covering any other members of our senior

 

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management. Each of our officers and key employees may terminate his or her employment at any time without notice and without cause or good reason.

 

If we are unable either to create sales, marketing and distribution capabilities or to enter into agreements with third parties to perform these functions, we will be unable to commercialize our product candidates successfully.

 

We currently have no sales or distribution capabilities and only limited marketing capabilities. To commercialize our product candidates, we must either develop internal sales, marketing and distribution capabilities, which will be expensive and time consuming, or make arrangements with third parties to perform these services. If we decide to market any of our products directly, we must commit significant financial and managerial resources to develop a marketing and sales force with relevant scientific or technical expertise and supporting distribution capabilities. Factors that may inhibit our efforts to commercialize our products directly include:

 

   

our inability to recruit and retain sales and marketing personnel;

 

   

the inability of sales personnel to obtain access to physicians or persuade physicians to prescribe our products;

 

   

the lack of complementary products to be offered by sales personnel, which may put us at a competitive disadvantage relative to companies with more extensive product lines; and

 

   

unforeseen costs and expenses associated with creating and sustaining an independent sales and marketing organization.

 

If we are not able to collaborate with a third party and are not successful in recruiting sales and marketing personnel or building a sales and marketing infrastructure, we will not be able to commercialize our product candidates, which would adversely affect our business and financial condition. If we do collaborate with and rely on pharmaceutical or biotechnology companies with established sales, marketing and distribution systems to market our products, we will need to establish and maintain partnership arrangements, and we may not be able to enter into these arrangements on acceptable terms, or at all. To the extent that we enter into co-promotion or similar arrangements, any revenues we receive will depend upon the efforts of third parties, which will only partially be in our control and may not be successful. In any partnering arrangement, our product revenues would likely be lower than if we marketed and sold our products directly.

 

Our commercial success depends upon the achievement of significant market acceptance of PHX1149 and future product candidates among physicians, patients, and healthcare payors.

 

None of our product candidates has been commercialized for any indication. Even if approved for sale by the appropriate regulatory authorities, physicians may not prescribe PHX1149 or any of our future product candidates, in which case we would not generate revenues or become profitable. PHX1149, if approved, will likely be one of several available DPP-4 inhibitors for the treatment of Type 2 diabetes, including sitagliptin, which Merck & Co. Inc. markets worldwide as Januvia and Janumet, vildagliptin, which Novartis AG has begun to market in Europe as Galvus and Eucreas, and alogliptin, for which Takeda Pharmaceutical Company Limited recently filed for marketing approval in the United States. Type 2 diabetes, as well as HCV infection, for which we are developing PHX1766, is currently treated by other therapies, some of which have been in existence for many years. Where other products currently are, or succeed in becoming, the standard of care before we achieve approval, it may be difficult to encourage healthcare providers to switch from these products.

 

Market acceptance of PHX1149 and any of our future product candidates by physicians, patients and healthcare payors will also depend on a number of additional factors, including:

 

   

the ability of PHX1149 to achieve significant market penetration, given the earlier entry of other DPP-4 inhibitors into the U.S. and European markets;

 

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acceptance by physicians and patients of the product candidate as a safe and effective treatment;

 

   

actual and perceived advantages over alternative treatments;

 

   

the cost of treatment in relation to alternative treatments;

 

   

relative convenience and ease of administration;

 

   

the prevalence and severity of side effects;

 

   

any labeling restrictions imposed by the FDA and other regulatory authorities;

 

   

the suitability of our product candidates for use in combination with other therapies for the same indications; and

 

   

the availability of adequate reimbursement by third parties.

 

If PHX1149 or any of our other product candidates are approved but do not achieve an adequate level of acceptance by physicians, patients and healthcare payors, we may not generate sufficient revenues, and we may not become profitable.

 

Competition in the pharmaceutical industry is intense. If our competitors are able to develop and market products that are more effective, safer or less costly than any future products that we may develop, our commercial opportunity will be reduced or eliminated.

 

We face competition from established and emerging pharmaceutical and biotechnology companies, as well as from academic institutions, government agencies and private and public research institutions. Our commercial opportunity will be reduced or eliminated if our competitors develop and commercialize products that are more effective, have fewer side effects, are easier to administer or are less expensive than PHX1149 and any of our other product candidates. In addition, because our strategy is to develop product candidates directed toward clinically validated targets for which the pharmacological effect of a product candidate can be demonstrated in early-stage clinical trials, PHX1149 will not be, and we do not expect any of our other product candidates to be, the first to market for their respective indications or in their respective product classes. This strategy may not succeed as we seek to compete against established products. Further, significant delays in the development of PHX1149 or our other product candidates could allow multiple competitors to commercialize their products and establish them in the market before we do. Competitors may also reduce the price of their products in order to gain market share, forcing us to lower the price of our product candidates in order to compete effectively, potentially resulting in lower revenues.

 

We anticipate that, if approved, PHX1149 would compete primarily with sitagliptin, which is currently the only DPP-4 inhibitor approved by both the FDA and the EMEA for the treatment of Type 2 diabetes. We also expect that PHX1149 would compete in Europe with vildagliptin, which is currently approved for marketing in Europe both as a fixed-dose combination product with metformin and as a stand-alone therapy. We may also face competition from other DPP-4 inhibitors, including alogliptin, for which Takeda Pharmaceutical Company Limited filed for marketing approval in the United States in January 2008, BI 1356, which is under development in Phase 3 clinical trials by Boehringer Ingelheim GmbH, and saxagliptin, which is under development by Bristol-Myers Squibb Company and AstraZeneca PLC. Various other products to treat Type 2 diabetes also are available or are in development, including metformin, sulfonylureas, TZDs, GLP-1 analogs and insulins. In addition, Vertex Pharmaceuticals Incorporated, in collaboration with Tibotec Pharmaceuticals, Ltd., a subsidiary of Johnson & Johnson, and Schering-Plough Corp. are each developing NS3/4A protease inhibitors for the treatment of HCV infection, and, if they receive FDA approval for their product candidates before we are able to complete the development of PHX1766, our ability to commercialize this product candidate would be impaired.

 

We cannot predict whether any of our product candidates, if successfully developed, will have sufficient advantages to cause healthcare professionals to adopt our products over competing products or whether our

 

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products, if approved, would offer an economically feasible alternative to competing products. Many of our competitors have substantially greater financial resources and expertise in research and development, manufacturing, preclinical testing, conducting clinical trials, obtaining regulatory approvals and marketing approved products than we do. Established pharmaceutical and large biotechnology companies may invest heavily to advance the discovery and development of novel compounds or drug delivery technologies that could make our product candidates obsolete. Smaller or early-stage companies may also prove to be significant competitors, particularly through strategic partnerships with larger and more established companies. These third parties may compete with us in recruiting and retaining qualified scientific and management personnel, establishing clinical trial sites and patient registration for clinical trials, as well as in acquiring technologies and technology licenses complementary to our programs or advantageous to our business. Our ability to generate revenues will be harmed if our competitors succeed in obtaining patent or other intellectual property protection, receiving FDA approval or commercializing products before we do.

 

Even if we receive regulatory approval for a product candidate, we will be subject to ongoing FDA obligations and continued regulatory review, which may result in significant additional expenses and limit our ability to commercialize our future products.

 

Any regulatory approvals that we receive for PHX1149 or our other product candidates may also be subject to limitations on the indicated uses for which the product may be marketed, or contain requirements for potentially costly post-marketing follow-up studies. For example, the FDA might impose labeling restrictions, similar to those for sitagliptin, on the use of PHX1149 in patients with impaired kidney function if we are unable to demonstrate in clinical trials that PHX1149 is sufficiently safe in those patients. If the FDA approves any of our product candidates, the labeling, packaging, adverse event reporting, storage, advertising, promotion and recordkeeping for the product will be subject to extensive and ongoing regulatory requirements. In addition, manufacturers of drug products and their facilities are subject to continual review and periodic inspections by the FDA and other regulatory authorities for compliance with current Good Manufacturing Practice and other regulations. If we or a regulatory agency discovers previously unknown problems with a product or the product class, such as adverse events of unanticipated severity or frequency, or problems with the facility where the product is manufactured, a regulatory agency may impose restrictions on that product, the manufacturer or us, including requiring withdrawal of the product from the market or suspension of manufacturing. If we, our product candidates or the manufacturing facilities for our product candidates fail to comply with applicable regulatory requirements, a regulatory agency may:

 

   

issue warning letters;

 

   

impose civil or criminal penalties or monetary fines;

 

   

suspend or withdraw regulatory approval;

 

   

suspend any ongoing clinical trials;

 

   

refuse to approve pending applications or supplements to applications filed by us;

 

   

impose restrictions on operations, including costly new manufacturing requirements;

 

   

seize or detain products or require us to initiate a product recall; or

 

   

withdraw the product from the market.

 

In addition, the FDA’s policies may change, and additional government regulations may be enacted, which could prevent or delay regulatory approval of our product candidates. We cannot predict the likelihood, nature or extent of government regulation that may arise from future legislation or administrative action, either in the United States or abroad. If we are not able to maintain regulatory compliance, we might not be permitted to market our future products and we may not achieve or sustain profitability.

 

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

 

Many patients may be unable to pay for any products that we may develop. In the United States, many patients rely on Medicare, Medicaid, private health insurers and other third-party payors to pay for their medical needs. Our ability to achieve acceptable levels of reimbursement for drug treatments by governmental authorities, private health insurers and other organizations will impact our ability to successfully commercialize, and attract collaborative partners to invest in the development of, our product candidates. We cannot be sure that reimbursement in the United States, Europe or elsewhere will be available for any products that we may develop, and any reimbursement that may become available may be decreased or eliminated in the future. Third-party payors increasingly are challenging prices charged for medical products and services, and many third-party payors may refuse to provide reimbursement for particular drugs when an equivalent generic drug is available. If a third-party payor considers any of our product candidates to be equivalent to an existing generic drug, the third-party payor may only offer to reimburse patients for the generic drug. Even if we show improved safety or efficacy with our product candidates, pricing of existing generic drugs may limit the amount we will be able to charge for our product candidates. If reimbursement is not available or is available only at limited levels, we may not be able to successfully commercialize our product candidates, and may not be able to obtain a satisfactory financial return on products that we may develop.

 

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

 

Failure to obtain regulatory approval in foreign jurisdictions will prevent us from marketing our products abroad.

 

We intend to market our future products in international markets. In order to market our future products in the European Union and many other foreign jurisdictions, we must obtain separate regulatory approvals. We have had limited interactions with foreign regulatory authorities, and the approval procedures vary among countries and can involve additional testing. Also, the time required to obtain approval may differ from that required for FDA approval. Approval by the FDA does not ensure approval by regulatory authorities in other countries, and approval by one foreign regulatory authority does not ensure approval by regulatory authorities in other foreign countries or by the FDA. The foreign regulatory approval process may include all of the risks associated with obtaining FDA approval. We may not obtain foreign regulatory approvals on a timely basis, if at all, which could impair our ability to generate revenues from product sales outside the United States.

 

Foreign governments often impose strict price controls, which may adversely affect our future profitability.

 

We intend to seek approval to market our future products both in the United States and in foreign jurisdictions. If we obtain approval in one or more foreign jurisdictions, we will be subject to rules and regulations in those jurisdictions relating to those products. In some foreign countries, particularly countries in the European Union, prescription drug pricing is subject to governmental control. In these countries, pricing negotiations with governmental authorities can take considerable time after the receipt of marketing approval for a drug candidate. To obtain reimbursement or pricing approval in some countries, we may be required to conduct a clinical trial that compares the cost-effectiveness of our future product to other available therapies. If reimbursement of our future products is unavailable or limited in scope or amount in foreign jurisdictions, or if pricing is set at unsatisfactory levels in these jurisdictions, we may be unable to achieve or sustain profitability.

 

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Recent federal legislation and actions by state and local governments may permit re-importation of drugs from foreign countries into the United States, including foreign countries where the drugs are sold at lower prices than in the United States, which could harm our operating results and our overall financial condition.

 

We may face competition for any of our product candidates, once approved, from lower priced products from foreign countries that have placed price controls on pharmaceutical products. The Medicare Prescription Drug, Improvement, and Modernization Act of 2003, or MMA, contains provisions that may change U.S. importation laws and expand pharmacists’ and wholesalers’ ability to import lower priced versions of our product candidates and competing products from Canada, where there are government price controls. These changes to U.S. importation laws will not take effect unless and until the Secretary of Health and Human Services certifies that the changes will pose no additional risk to the public’s health and safety and will result in a significant reduction in the cost of products to consumers. The Secretary of Health and Human Services has not yet announced any plans to make this required certification. As directed by Congress, a task force on drug importation conducted a comprehensive study regarding the circumstances under which drug importation could be conducted safely and the consequences of importation on the health, medical costs and development of new medicines for U.S. consumers. The task force issued its report in December 2004, finding that there are significant safety and economic issues that must be addressed before importation of prescription drugs is permitted. However, a number of federal legislative proposals have been made to implement the changes to the U.S. importation laws without any certification and to broaden permissible imports in other ways. Even if these changes do not take effect, imports from Canada and elsewhere may continue to increase due to market and political forces, and the limited enforcement resources of the FDA, the U.S. Customs Service and other government agencies. For example, a law that was passed in October 2006 expressly prohibits the U.S. Customs Service from using funds to prevent individuals from importing from Canada less than a 90-day supply of a prescription drug for personal use, when the drug otherwise complies with the Federal Food, Drug, and Cosmetic Act. Further, several states and local governments have implemented importation schemes for their citizens, and, in the absence of federal action to curtail such activities, we expect other states and local governments to launch importation efforts. The importation of foreign products that compete with any of our approved product candidates could negatively impact our profitability.

 

We may incur significant costs in complying with environmental laws and regulations, and failure to comply with these laws and regulations could expose us to significant liabilities.

 

We are subject to various environmental, health and safety laws and regulations governing, among other things, the generation, storage, handling, use and transportation of hazardous, radioactive and biological materials and wastes; the emission and discharge of hazardous materials into the ground, air or water; and the health and safety of our employees. We are required to obtain air emissions and other environmental permits from governmental authorities for our operations. While no environmental compliance investigations have been conducted on our facilities to date other than routine inspections, if we violate or fail to comply with these laws, regulations or permits, we could be fined or otherwise sanctioned by regulators. We use hazardous chemicals and radioactive and biological materials, and generate hazardous waste, in our business and are subject to a variety of federal, state and local laws and regulations governing the use, generation, manufacture, storage, handling and disposal of these materials. We maintain property insurance that includes annual coverage in the amounts of $250,000 per occurrence and in the aggregate for sudden and accidental radioactive contamination, $50,000 for the cleanup or removal of certain other contaminants, including biological materials and $250,000 for property damage to our facilities resulting from these other contaminants. In the event of contamination, injury or other damage arising out of hazardous or other regulated materials for which we are deemed liable, we could incur significant costs, including costs not covered by our insurance.

 

If product liability lawsuits are brought against us, we may incur substantial liabilities and may be required to limit commercialization of our product candidates.

 

We face an inherent risk of product liability as a result of the testing of our product candidates in clinical trials and will face an even greater risk if we commercialize any products. We may be held liable if any product

 

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that we develop causes injury or is found otherwise unsuitable during product testing, manufacturing, marketing or sale. If we cannot successfully defend ourselves against product liability claims, we may incur substantial liabilities or be required to limit commercialization of our product candidates. Even the successful defense against these claims would require significant financial and management resources. Regardless of the merit or eventual outcome, liability claims may result in:

 

   

injury to our reputation;

 

   

increased difficulty in recruiting, or the withdrawal of, clinical trial participants;

 

   

costs of related litigation;

 

   

substantial monetary awards to patients;

 

   

product recalls;

 

   

decreased demand for our products;

 

   

loss of revenues; and

 

   

our inability to continue marketing our products.

 

Our inability to obtain and retain sufficient product liability insurance at an acceptable cost to protect against potential product liability claims could prevent or inhibit the commercialization of pharmaceutical products that we develop. We currently carry product liability insurance covering our clinical trials in an annual aggregate amount of $10 million. However, our insurance carrier may not reimburse us, or our coverage may not be sufficient to reimburse us, for the expenses or losses that we may suffer in connection with any product liability claims. In addition, insurance coverage is becoming increasingly expensive, and in the future we may not be able to maintain insurance coverage at a reasonable cost or obtain insurance coverage that will be adequate to satisfy any liability that may arise.

 

Risks Related to Intellectual Property

 

It is difficult and costly to protect our proprietary rights, and we may not be able to ensure intellectual property protection of our product candidates.

 

Our commercial success will depend in part on obtaining and maintaining patent and trade secret protection for our product candidates, including their composition, their use and the methods used to manufacture them, as well as successfully defending our patents, if any, against third-party challenges. Our ability to protect our product candidates from unauthorized making, using, selling, offering to sell or importation by third parties is dependent upon the extent to which we have rights under valid and enforceable patents. Likewise, our ability to additionally protect information regarding these product candidates from misappropriation depends on the extent to which we have trade secret rights that cover this information. We currently hold one issued U.S. patent covering the composition of matter and method of use of PHX1149. We have filed multiple U.S. patent applications and foreign counterparts related to our DPP-4 inhibitor program, including PHX1149, as well as our NS3/4A protease inhibitor program, and may file additional U.S. and foreign patent applications related to our development programs. There can be no assurance that any patents will issue from these applications or that the claims under such patents, if issued, will have adequate scope to prevent others from practicing our inventions.

 

Even if we are able to obtain patents on our product candidates, any patent may be challenged, invalidated, held unenforceable or circumvented. A consistent policy regarding the breadth of claims allowed in biotechnology patents has not emerged to date in the United States. The biotechnology patent situation outside the United States is even more uncertain. In addition, changes to patent laws and their interpretation, such as the new “obviousness” standard in the United States and the new rules of practice proposed by the U.S. Patent and Trademark Office, may limit our ability to secure all the rights to which we would have otherwise been entitled in the absence of these changes. Accordingly, we cannot predict the breadth of claims that may be allowed or enforced in any future patents that may issue from our patent applications.

 

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The degree of future protection to be afforded by our proprietary rights is uncertain because legal means afford only limited protection and may not adequately protect our rights or permit us to gain or keep our competitive advantage. For example:

 

   

others may be developing compounds or related technologies with characteristics or applications similar to those of our product candidates but that are not covered by the claims of our patents, if any are issued;

 

   

we might not have been the first to make the inventions covered by our pending patent applications;

 

   

we might not have been the first to file patent applications for these inventions;

 

   

our pending patent applications may not result in issued patents;

 

   

any patents that may be issued on our patent applications may not provide us with any competitive advantages, or may be held invalid, unenforceable or so narrow in scope as to be easily circumvented as a result of legal challenges by third parties; or

 

   

we may not develop additional proprietary technologies that are patentable.

 

We also may rely on trade secrets to protect our technology, especially where we do not believe patent protection is appropriate or obtainable. However, trade secrets are difficult to protect. Although we use reasonable efforts to protect our trade secrets, our employees, consultants, contractors, outside scientific collaborators and other advisors may unintentionally or willfully disclose our information to our competitors, and our competitors may independently develop equivalent knowledge, methods and know-how. Enforcing a claim that a third party illegally obtained and is using any of our trade secrets is expensive and time consuming, and the outcome is unpredictable. In addition, courts outside the United States are sometimes less willing to protect trade secrets.

 

We sometimes engage individuals or entities to conduct research that may be relevant to our business. We may grant these individuals or entities rights to publish or otherwise publicly disclose data and other information generated during the course of their research, subject to certain contractual limitations. These contractual provisions may be insufficient or inadequate to protect our trade secrets and may impair our patent rights. If we do not apply for patent protection prior to such publication or if we cannot otherwise maintain the confidentiality of our technology and other confidential information, then our ability to receive patent protection or protect our proprietary information may be jeopardized.

 

If our license agreement relating to DPP-4 is terminated or if we are not able to enter into license agreements necessary for the development of our product candidates, our competitive position and business prospects will be harmed.

 

We are a party to a nonexclusive, royalty-bearing, worldwide sublicense, which gives us rights to third-party intellectual property relating to the use of DPP-4 inhibitors for the treatment of diabetes or lowering glucose levels. This license is necessary for the development and commercialization of PHX1149, and we may need to enter into additional licenses to third-party intellectual property in the future, although we currently have no plans to do so.

 

This license agreement is nonexclusive, which means our licensor may license the applicable patent rights to third parties, including our competitors. Our licensor also may terminate its license agreement with us in the event we breach the agreement and fail to cure the breach within a specified period of time. In addition, the original licensors of the intellectual property may terminate their license agreements with our licensor, which may leave some of our activities and/or product candidates unlicensed if we are unable to license the applicable technology directly from the original licensors. Other license agreements into which we may enter in the future may also contain similar provisions. Without sufficient exclusivity or protection for the intellectual property we license, other companies might be able to offer substantially identical products for sale, which could harm our competitive business position.

 

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We may incur substantial costs as a result of litigation or other proceedings relating to patent and other intellectual property rights.

 

Our ability to commercialize any approved products will depend, in part, on our ability to obtain patents, enforce those patents and operate without infringing the proprietary rights of third parties. There can be no assurance that any patents that issue from our patent applications or any patents that are licensed to us will provide sufficient protection to conduct our business as presently conducted or as proposed to be conducted, or that we will remain free from infringement claims by third parties.

 

There can also be no assurance that patents owned by us will not be challenged by others. We could incur substantial costs in proceedings, including interference proceedings before the U.S. Patent and Trademark Office and litigation before the U.S. federal courts addressing the scope, validity or enforceability of our patents, as well as comparable proceedings before similar agencies and courts in other countries in connection with any claims that may arise in the future. These proceedings could result in adverse decisions about the patentability of our inventions and products, as well as about the enforceability, validity or scope of protection afforded by our patents.

 

Patent applications in the U.S. and elsewhere are typically published only after 18 months from the priority date. The publication of discoveries in the scientific or patent literature frequently occurs substantially later than the date on which the underlying discoveries were made. Therefore, patent applications relating to products similar to our product candidates and any future products may have already been filed by others without our knowledge. In the event an infringement claim is brought against us, we may be required to pay substantial legal and other expenses to defend such a claim and, if we are unsuccessful in defending the claim, we may be prevented from pursuing related product development and commercialization and may be subject to damage awards.

 

Many of our competitors are large pharmaceutical companies that are able to sustain the costs of complex patent litigation more effectively than we can because they have substantially greater resources. In addition, any uncertainties resulting from the initiation and continuation of any litigation could impair our ability to raise the funds necessary to continue our operations, in-license technology that we need, out-license our existing technologies or enter into collaborations that would assist in bringing our product candidates to market.

 

We have in the past been, and may in the future be, subject to claims that we or our employees have wrongfully used or disclosed alleged trade secrets of their former employers.

 

As is common in the biotechnology and pharmaceutical industries, we employ individuals who were previously employed at other biotechnology or pharmaceutical companies, including our competitors or potential competitors. In September 2005, ActivX Biosciences, Inc., or ActivX, filed a complaint in the Superior Court of California in the County of San Diego alleging, among other things, that we and some of our employees who were previously employed with ActivX misappropriated trade secrets of ActivX relating to DPP-4 inhibitor technology. The litigation of those claims was costly and distractive to our management, and in August 2006, we settled the litigation on terms that have required, and will require, payments that have had, and will have, an impact on our financial resources. To date, we have paid ActivX $1.5 million, and we may have to make additional payments in connection with the achievement of certain development milestones, as well as royalty payments in an aggregate amount of up to $35.0 million on net sales of products covered under the agreement, which would include PHX1149. Under the license agreement, we granted to ActivX a fully paid-up, royalty-free, co-exclusive, worldwide license to develop and commercialize products under certain of our patents and patent applications not including those relating to PHX1149 and related analogs.

 

Although no similar claims against us are currently pending, we may be subject to additional future claims under which third parties allege that we or our employees have inadvertently or otherwise used or disclosed trade secrets or other proprietary information of their former employers. Litigation may be necessary to defend against

 

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these claims, and we may be required to settle such claims on terms that are not favorable to us. Even if we are successful in defending against these claims, litigation could result in substantial costs and be a distraction to management.

 

Risks Related to Our Finances and Capital Requirements

 

We expect our net operating losses to continue for at least several years, and we are unable to predict the extent of future losses.

 

We have not received FDA approval to market any of our product candidates, and we have not generated any revenues from the sale of any products to date. We have incurred losses in each year since our inception in July 2001. For the year ended December 31, 2007, we had a net loss of $36.9 million from continuing operations. As of March 31, 2008, we had an accumulated deficit of approximately $124.1 million. These losses, combined with expected future losses, have had and will continue to have a significant negative effect on our stockholders’ equity and working capital. We expect to continue to incur operating losses for at least the next several years as we pursue the clinical development and potential commercialization of PHX1149 and future product candidates, continue our preclinical and drug discovery programs and increase general and administrative expenses to comply with public company reporting requirements. Because of the numerous risks and uncertainties associated with our development efforts and other factors, we are unable to predict the extent of any future losses or when we will become profitable, if ever. In addition, even if we obtain regulatory approval for any of our product candidates, our losses may increase, at least initially, because we may incur significantly higher sales, marketing and outsourcing expenses, including those required to manufacture commercial supplies, as well as continued research and development expenses for other product candidates.

 

We will need substantial additional funding and may be unable to raise capital when needed on acceptable terms.

 

Our operations have consumed substantial amounts of cash since our inception in July 2001. To date, our sources of cash have been limited primarily to private placements of preferred stock and debt. We expect to continue to spend substantial amounts on development, including significant amounts on conducting clinical trials for PHX1149, preclinical studies and clinical trials for PHX1766, and expanding our drug discovery and development programs. Our cash flows used for operating activities in 2006 averaged approximately $2.2 million per month, compared to an average of approximately $2.8 million per month during the year ended December 31, 2007 and an average of approximately $4.8 million per month during the three months ended March 31, 2008. We expect that our monthly cash used by operations will continue to increase for the next several years and that increases will be significantly greater when we commence our planned Phase 3 clinical trials for PHX1149.

 

We do not believe our existing capital resources and the net proceeds from this offering will be sufficient to fund our operations through the successful development and commercialization of any of our product candidates. We anticipate that the net proceeds from this offering will enable us to fund, over the next two years, only a portion of the first Phase 3 clinical trial of PHX1149 that we plan to conduct, in addition to the extension phase of our Phase 2b clinical trial of PHX1149, and the development of PHX1766 only through Phase 1 clinical trials. We intend to fund our operations, at least in part, through one or more collaborative arrangements for the development and commercialization of our product candidates. To date, we have not entered into any of these types of arrangements and we may not be able to do so on terms that are acceptable to us. Because the economic terms of collaborative arrangements can vary significantly, we are unable to predict a meaningful range of additional funding needed at this time. In December 2007, we entered into an amendment to our existing loan and security agreement with Pinnacle Ventures, L.L.C., or Pinnacle, pursuant to which affiliates of Pinnacle have agreed to advance additional loans to us in an aggregate principal amount of up to $12.0 million on or before May 31, 2008. Under the terms of the loan and security agreement, however, we will not be able to borrow these additional amounts from Pinnacle if we are in default with respect to any outstanding loans or if there has been a material adverse effect on our business or financial condition.

 

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Until we can generate a sufficient amount of product revenues and achieve profitability, we expect to finance future cash needs through public or private equity offerings, debt financings or corporate collaboration and licensing arrangements, as well as through interest income earned on our cash balances. We cannot be certain that additional funding will be available on acceptable terms, or at all.

 

If we are unable to obtain additional funding on terms that are acceptable to us, we will need to delay, reduce or eliminate our research and development programs or commercialization efforts.

 

Our ability to obtain additional funding and the amount and timing of our future funding requirements will depend on many factors, including, but not limited to, the following:

 

   

the number, scope and progress of our planned Phase 3 clinical trials for PHX1149, including expenses to support the trials;

 

   

the costs and timing of regulatory approvals;

 

   

our progress in advancing PHX1766 and other programs through preclinical development into clinical trials;

 

   

the costs and timing of clinical and commercial manufacturing supply arrangements for our product candidates;

 

   

the costs of establishing sales or distribution capabilities;

 

   

the success of the commercialization of our products;

 

   

our ability to establish and maintain strategic collaborations, including licensing and other arrangements; and

 

   

the costs involved in enforcing or defending patent claims or other intellectual property rights.

 

If we are unable to raise additional capital when required or on acceptable terms, we may have to delay, scale back or discontinue one or more of our drug development programs. We also may be required to relinquish, license or otherwise dispose of rights to product candidates or products that we would otherwise seek to develop or commercialize on terms that are less favorable than might otherwise be available.

 

Raising additional funds by issuing securities or through licensing or lending arrangements may cause dilution to you, restrict our operations or require us to relinquish proprietary rights.

 

We may raise additional funds through public or private equity offerings, debt financings or licensing arrangements. To the extent that we raise additional capital by issuing equity or convertible debt securities, your ownership will be diluted and the terms may include liquidation or other preferences that adversely affect your rights as a stockholder. Debt financing, if available, may involve agreements that include covenants limiting or restricting our ability to take specific actions, such as incurring additional debt, making capital expenditures or entering into licensing arrangements. For example, our loan and security agreement with Pinnacle contains restrictions on our ability to grant security interests in or transfer our property, our ability to be acquired through a merger, consolidation or similar transaction without the prior written consent of Pinnacle and our ability to incur various types of additional indebtedness. If we raise additional funds through licensing arrangements, it may be necessary to relinquish potentially valuable rights to our product candidates or to grant licenses on terms that are not favorable to us. If adequate funds are not available, our ability to achieve profitability or to respond to competitive pressures would be significantly limited and we may be required to delay, significantly curtail or eliminate the development of one or more of our product candidates.

 

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Risks Related to This Offering and Ownership of Our Common Stock

 

The market price of our common stock may be highly volatile, and you may not be able to resell your shares at or above the initial public offering price.

 

Prior to this offering, there has not been a public market for our common stock. We cannot assure you that an active trading market for our common stock will develop following this offering. You may not be able to sell your shares quickly or at the market price if trading in our common stock is not active. The initial public offering price for the shares will be determined by negotiations between us and representatives of the underwriters and may not be indicative of prices that will prevail in the trading market.

 

The trading price of our common stock is likely to be highly volatile and could be subject to wide fluctuations in price in response to various factors, many of which are beyond our control, including:

 

   

actual or anticipated results from and any delays in our clinical trials;

 

   

actual or anticipated regulatory approvals, or other actions taken by regulatory agencies, with respect to our product candidates or competing products;

 

   

changes in laws or regulations applicable to our product candidates, including but not limited to clinical trial requirements for approvals;

 

   

the success of our preclinical development efforts and clinical trials;

 

   

actual or anticipated variations in our quarterly operating results;

 

   

disputes or other developments relating to proprietary rights, including patents, litigation matters and our ability to obtain patent protection for our technologies;

 

   

new technologies, products or services introduced or announced by us or our competitors and the timing of these introductions or announcements;

 

   

announcements by us or our competitors of collaborative arrangements, significant acquisitions or capital commitments;

 

   

additions or departures of key scientific or management personnel;

 

   

conditions or trends in the biotechnology and biopharmaceutical industries;

 

   

general economic and market conditions and other factors that may be unrelated to our operating performance or the operating performance of our competitors;

 

   

actual or anticipated changes in recommendations by securities analysts;

 

   

sales of common stock or other securities by us or our stockholders in the future; and

 

   

trading volume of our common stock.

 

In addition, the stock market in general and the market for biotechnology and biopharmaceutical companies in particular have experienced extreme price and volume fluctuations that have often been unrelated or disproportionate to the operating performance of those companies. These broad market and industry factors may seriously harm the market price of our common stock, regardless of our operating performance. In the past, following periods of volatility in the market, securities class-action litigation has often been instituted against companies. Such litigation, if instituted against us, could result in substantial costs and diversion of management’s attention and resources, which could materially and adversely affect our business and financial condition.

 

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Future sales of our common stock in the public market could cause our stock price to fall.

 

Sales of a substantial number of shares of our common stock in the public market after this offering, or the perception that these sales might occur, could depress the market price of our common stock and could impair our ability to raise capital through the sale of additional equity securities. After this offering, we will have             shares of common stock outstanding, or             shares if the underwriters exercise their over-allotment option in full.

 

The holders of substantially all of our outstanding capital stock are subject to lock-up agreements with the underwriters of this offering that generally restrict the stockholders’ ability to transfer shares of our common stock for at least 180 days from the date of this prospectus. The lock-up agreements, together with restrictions under the securities laws described in this prospectus under the caption “Shares Eligible for Future Sale,” limit the number of shares of common stock that may be sold immediately following the public offering.

 

All of the shares of common stock sold in this offering will be freely tradable without restrictions or further registration under the Securities Act of 1933, as amended, except for any shares purchased by our affiliates as defined in Rule 144 under the Securities Act of 1933, as amended. Substantially all of the remaining 32,767,461 shares of common stock outstanding after this offering, after giving effect to the conversion of all outstanding shares of our preferred stock into shares of common stock immediately prior to the completion of this offering, will be available for sale after the expiration of the contractual lock-up period, subject to volume limitations under Rule 144 under the Securities Act of 1933, as amended. In addition, as of March 31, 2008, there were 4,017,916 shares of common stock issuable upon the exercise of outstanding options and 957,440 shares of common stock issuable upon the exercise of outstanding warrants, substantially all of which, after expiration of the contractual lock-up period, will be available for sale subject to Rule 144. Morgan Stanley and Credit Suisse could release all or some portion of the shares subject to lock-up agreements prior to expiration of the lock-up period, although they currently have no plans, understandings or agreements to do so.

 

After this offering, the holders of approximately 33,022,060 shares of common stock, including 957,299 shares underlying outstanding warrants, will be entitled to rights with respect to registration of such shares under the Securities Act of 1933, as amended. If such holders, by exercising their registration rights, cause a large number of securities to be registered and sold in the public market, these sales could have an adverse effect on the market price for our common stock. If we were to initiate a registration and include shares held by these holders pursuant to the exercise of their registration rights, these sales may impair our ability to raise capital.

 

We have broad discretion to allocate the net proceeds of this offering.

 

We currently intend to use the proceeds from this offering to fund the first of our planned Phase 3 clinical trials of PHX1149 for the treatment of Type 2 diabetes, the repayment of amounts borrowed under our loan and security agreement with Pinnacle and our ongoing preclinical studies and planned Phase 1 clinical trials of PHX1766 for the treatment of HCV infection. We also intend to use the proceeds from this offering for other drug discovery and development programs and working capital and general corporate purposes. We may also use a portion of our net proceeds to obtain the right to use complementary technologies and product opportunities. Because of the numerous factors and uncertainties relating to our business, our use of proceeds may vary substantially from their currently anticipated use. As a result, management will have broad discretion in the use of the proceeds from this offering and could spend these proceeds in ways that do not generate revenues, make us profitable or enhance the value of our common stock.

 

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Some provisions of our charter documents and Delaware law may have anti-takeover effects that could discourage an acquisition of us by others, even if an acquisition would be beneficial to our stockholders.

 

Provisions in our certificate of incorporation and bylaws, as well as provisions of Delaware law, could make it more difficult for a third party to acquire us, even if doing so would benefit our stockholders. These provisions include:

 

   

a classified board of directors;

 

   

authorizing the issuance of “blank check” preferred stock, the terms of which may be established and shares of which may be issued without stockholder approval;

 

   

limiting the ability of our stockholders to remove directors without good cause;

 

   

prohibiting stockholder action by written consent, thereby requiring all stockholder actions to be taken at a meeting of our stockholders;

 

   

eliminating the ability of stockholders to call a special meeting of stockholders; and

 

   

establishing advance notice requirements for nominations for election to the board of directors or for proposing matters that can be acted upon at stockholder meetings.

 

In addition, we are subject to Section 203 of the Delaware General Corporation Law, which generally prohibits a Delaware corporation from engaging in any of a broad range of business combinations with an interested stockholder for a period of three years following the date on which the stockholder became an interested stockholder. This provision could have the effect of delaying or preventing a change of control, whether or not it is desired by, or beneficial to, our stockholders.

 

Our principal stockholders and management own a significant percentage of our stock and will be able to exercise significant influence over matters subject to stockholder approval.

 

Our executive officers, directors and principal stockholders, together with their respective affiliates, currently beneficially own approximately 93.7% of our voting stock, including shares subject to outstanding options and warrants, and we expect that upon completion of this offering, that same group will continue to hold at least     % of our outstanding voting stock. Accordingly, even after this offering, these stockholders will be able to exert a significant degree of influence over our management and affairs and over matters requiring stockholder approval, including the election of our board of directors and approval of significant corporate transactions. This concentration of ownership could have the effect of delaying or preventing a change in our control or otherwise discouraging a potential acquirer from attempting to obtain control of us, which in turn could have a material and adverse effect on the fair market value of our common stock.

 

Our ability to use net operating loss carryforwards may be subject to limitation.

 

Section 382 of the U.S. Internal Revenue Code of 1986, as amended, imposes an annual limit on the amount of net operating loss carryforwards that may be used to offset taxable income when a corporation has undergone significant changes in its stock ownership or equity structure. Our ability to use net operating losses may be limited by prior changes in our ownership, by the issuance of common stock in this offering, or by the consummation of other transactions. As a result, if we earn net taxable income, our ability to use net operating loss carryforwards to offset U.S. federal taxable income may become subject to limitations, which could potentially result in increased future tax liabilities for us.

 

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SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS

 

This prospectus contains forward-looking statements. Forward-looking statements relate to future events or our future financial performance. We generally identify forward-looking statements by terminology such as “may,” “will,” “should,” “expects,” “plans,” “anticipates,” “could,” “intends,” “target,” “projects,” “contemplates,” “believes,” “estimates,” “predicts,” “potential” or “continue” or the negative of these terms or other similar words. These statements are only predictions. We have based these forward-looking statements largely on our current expectations and projections about future events and financial trends that we believe may affect our business, financial condition and results of operations. The outcome of the events described in these forward-looking statements is subject to risks, uncertainties and other factors described in “Risk Factors” and elsewhere in this prospectus. Accordingly, you should not rely upon forward-looking statements as predictions of future events. We cannot assure you that the events and circumstances reflected in the forward-looking statements will be achieved or occur, and actual results could differ materially from those projected in the forward-looking statements.

 

The forward-looking statements made in this prospectus relate only to events as of the date on which the statements are made. We undertake no obligation to update any forward-looking statement to reflect events or circumstances after the date on which the statement is made or to reflect the occurrence of unanticipated events.

 

We may not actually achieve the plans, intentions or expectations disclosed in our forward-looking statements and you should not place undue reliance on our forward-looking statements. We have included important factors in the cautionary statements included in this prospectus, particularly in the section entitled “Risk Factors” that we believe could cause actual results or events to differ materially from the forward-looking statements that we make. Our forward-looking statements do not reflect the potential impact of any future partnerships, collaborations or other strategic transactions that we may enter into or investments we may make. We do not assume any obligation to update any forward-looking statements, whether as a result of new information, future events or otherwise, except as required by law.

 

This prospectus also contains estimates and other statistical data made by independent parties and by us relating to market size and growth and other industry data. Projections, assumptions and estimates of our future performance and the future performance of the industries in which we operate are necessarily subject to a high degree of uncertainty and risk due to a variety of factors, including those described in “Risk Factors,” “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and elsewhere in this prospectus. These and other factors could cause results to differ materially from those expressed in the estimates made by the independent parties and by us.

 

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USE OF PROCEEDS

 

We estimate that the net proceeds from the sale of the common stock that we are offering will be approximately $            million, or $            million if the underwriters exercise their over-allotment option in full, assuming an initial public offering price of $            per share, which is the midpoint of the range listed on the cover page of this prospectus, and after deducting estimated underwriting discounts and commissions and estimated offering expenses that we must pay.

 

A $1.00 increase (decrease) in the assumed initial public offering price of $            per share would increase (decrease) the net proceeds to us from this offering by approximately $            million, assuming the number of shares offered by us, as set forth on the cover page of this prospectus, remains the same and after deducting estimated underwriting discounts and commissions and estimated offering expenses payable by us.

 

Of the net proceeds received from this offering, we intend to use approximately $10.8 million for the repayment of amounts borrowed under our loan and security agreement with Pinnacle, assuming that we borrow the additional $12.0 million available on or before May 31, 2008 under a December 2007 amendment to the agreement.

 

Of the remaining proceeds, we intend to use approximately:

 

   

46% for the first of our planned Phase 3 clinical trials, the ongoing extension phase of our Phase 2b clinical trial and our other ongoing clinical trials of PHX1149 for the treatment of Type 2 diabetes, including the cost of producing clinical supplies of PHX1149; and

 

   

20% for our ongoing preclinical studies and planned Phase 1 clinical trials of PHX1766 for the treatment of HCV infection, including the cost of producing preclinical and clinical supplies of PHX1766.

 

We intend to use a substantial portion of the remainder of our net proceeds for our other drug discovery and development programs, working capital and general corporate purposes. We may also use a portion of our net proceeds to obtain the right to use complementary technologies and product opportunities. We have no current understandings, commitments, or agreements with respect to any acquisition of or investment in any technologies, products or companies.

 

Pursuant to the terms of our loan and security agreement with Pinnacle, affiliates of Pinnacle have made loans to us in an aggregate principal amount of $8.0 million. Under the terms of a December 2007 amendment to this agreement, the affiliates of Pinnacle have agreed to make additional term loans of up to $12.0 million to us on or before May 31, 2008. These loans all bear interest at a fixed rate equal to the prime rate in effect as of the date of each loan, plus two percent and are evidenced by secured promissory notes that mature 36 months from the date of the loan. All loan amounts currently outstanding under the agreement bear interest at an annual rate of 10.25%. Repayments on each loan include an interest-only period of six months, followed by 30 equal monthly installments of principal and interest. The proceeds have been and will be used for general corporate purposes.

 

As of the date of this prospectus, we cannot predict with certainty all of the particular uses for the proceeds from this offering, or the amounts that we will actually spend on the uses set forth above. The amounts and timing of our actual expenditures will depend upon numerous factors, including the progress of our development and commercialization efforts, the progress of our clinical trials, whether or not we enter into strategic collaborations or partnerships, and our operating costs and expenditures. Accordingly, our management will have significant flexibility in applying the net proceeds of this offering.

 

The costs and timing of drug development and regulatory approval, particularly in conducting clinical trials, are highly uncertain, are subject to substantial risks and can often change. Accordingly, we may change the allocation of these proceeds as a result of contingencies, such as the progress and results of our clinical trials and other development activities, the establishment of collaborations, our manufacturing requirements and regulatory or

 

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competitive developments. In addition, we do not believe our existing capital resources and the net proceeds from this offering will be sufficient to fund our operations through the successful development and commercialization of any of our product candidates. Accordingly, we expect that we will need to raise additional funds.

 

Pending use of the proceeds from this offering as described above or otherwise, we intend to invest the net proceeds in short-term interest-bearing, investment grade securities.

 

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DIVIDEND POLICY

 

We have never declared or paid dividends on our common or preferred stock. Our loan and security agreement with Pinnacle contains restrictions on our ability to pay dividends on our common stock. These restrictions, however, will terminate upon the effective date of this registration statement. Our board of directors will continue to have discretion in determining whether to declare or pay dividends, which will depend upon our financial condition, results of operations, capital requirements, contractual restrictions, restrictions imposed by applicable law and other factors that our board of directors deems relevant. We currently anticipate that we will retain future earnings, if any, for the development, operation and expansion of our business and the repayment of indebtedness. Accordingly, we do not anticipate declaring or paying any cash dividends for the foreseeable future.

 

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CAPITALIZATION

 

The following table sets forth our capitalization as of March 31, 2008:

 

   

on an actual basis; and

 

   

on a pro forma basis to reflect (i) the automatic conversion of all outstanding shares of our preferred stock into an aggregate of 32,006,100 shares of our common stock immediately prior to the completion of this offering and (ii) the receipt by us of net proceeds of $            million from the sale of the             shares of common stock offered by us in this offering at an assumed public offering price of $            per share, the midpoint of the range set forth on the cover of this prospectus, less estimated underwriting discounts and commissions and estimated offering expenses payable by us.

 

You should read the following table in conjunction with our consolidated financial statements and related notes and the sections entitled “Selected Financial Data” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” appearing elsewhere in this prospectus.

 

     As of March 31, 2008  
     Actual     Pro Forma(1)  
    

(unaudited)

    (unaudited)  
     (in thousands, except share
and per share data)
 

Notes payable

   $ 5,956     $ 5,956  

Stockholders’ equity:

    

Preferred stock, $.001 par value; 32,977,378 shares authorized, 32,006,100 shares issued and outstanding, actual;              shares authorized, no shares issued and outstanding, pro forma

     32        

Common stock, $.001 par value; 40,000,000 shares authorized, 761,361 shares issued and outstanding, actual;              shares authorized and             shares issued and outstanding, pro forma

     1    

Additional paid-in capital

     147,319    

Deficit accumulated during the development stage

     (124,105 )     (124,105 )
                

Total stockholders’ equity

     23,247    
                

Total capitalization

   $ 29,203     $    
                

 

  (1)   A $1.00 increase (decrease) in the assumed initial public offering price of $            per share would increase (decrease) each of cash and cash equivalents, additional paid-in capital, total stockholders’ equity and total capitalization by approximately $            million, assuming the number of shares offered by us, as set forth on the cover page of this prospectus, remains the same.

 

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DILUTION

 

If you invest in our common stock, your ownership interest will be diluted to the extent of the difference between the assumed initial offering price of $            per share of our common stock and the pro forma as adjusted net tangible book value per share of our common stock after the completion of this offering. As of March 31, 2008, we had a historical net tangible book value of $23.2 million, or approximately $30.54 per share of common stock, based on the number of shares of common stock outstanding as of March 31, 2008. Historical net tangible book value per share represents the amounts of our total tangible assets less our total liabilities, divided by the number of our common shares outstanding.

 

Our pro forma net tangible book value as of March 31, 2008 was $23.2 million, or approximately $.71 per share of common stock. Pro forma net tangible book value per share represents the historical net tangible book value per share, adjusted to give effect to the conversion of all outstanding shares of preferred stock as of March 31, 2008 into shares of common stock.

 

After giving effect to the sale by us of             shares of common stock in this offering at an assumed initial public offering price of $            per share, which is the midpoint of the range listed on the cover page of this prospectus, and after deducting estimated underwriting discounts and commissions and estimated offering expenses payable by us, our pro forma as adjusted net tangible book value as of March 31, 2008 would have been approximately $            million, or approximately $            per share. This amount represents an immediate increase in pro forma net tangible book value of $            per share to our existing stockholders and an immediate dilution in pro forma net tangible book value of approximately $            per share to new investors purchasing shares of common stock in this offering at the assumed initial public offering price. The following table illustrates this dilution on a per share basis:

 

Initial public offering price per share

     $             

Historical net tangible book value per share of common stock as of March 31, 2008

   $ 30.54    

Per share adjustment due to assumed conversion of preferred stock outstanding as of March 31, 2008 into common stock

     (29.83 )  
          

Pro forma net tangible book value as of March 31, 2008

   $ .71    

Increase per share attributable to new investors

    
          

Pro forma as adjusted net tangible book value per share after offering

    
        

Dilution of net tangible book value per share to new investors

     $  
        

 

A $1.00 increase (decrease) in the assumed initial public offering price of $            per share would increase (decrease) our pro forma as adjusted net tangible book value as of March 31, 2008 by approximately $            million, the pro forma as adjusted net tangible book value per share after this offering by $            and the dilution to new investors in this offering by $            per share, assuming the number of shares offered by us, as set forth on the cover page of this prospectus, remains the same and after deducting estimated underwriting discounts and commissions and estimated offering expenses payable by us.

 

If the underwriters exercise their over-allotment option in full, the pro forma as adjusted net tangible book value per share after this offering would be $            per share, the increase per share attributable to new investors would be $            per share and the dilution to new investors would be $            per share.

 

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The following table summarizes, as of March 31, 2008, the differences between the number of shares purchased from us, the total consideration paid to us and the average price per share that existing stockholders and new investors paid. The table gives effect to the conversion of all outstanding shares of our preferred stock as of March 31, 2008 into 32,006,100 shares of common stock, which will occur immediately prior to the completion of this offering. The calculation below is based on an assumed initial public offering price of $            per share, which is the midpoint of the range listed on the cover page of this prospectus, and before deducting estimated underwriting discounts and commissions and estimated offering expenses payable by us.

 

     Shares Purchased     Total Consideration     Average Price
Per Share
      Number    Percent     Amount    Percent    
     (in thousands, except per share amounts)

Existing stockholders

           %   $                          %   $             

New investors

            
                                

Total

   $      100 %   $      100 %   $  
                                

 

A $1.00 increase (decrease) in the assumed initial public offering price of $            per share would increase (decrease) total consideration paid to us by investors participating in this offering by approximately $            million, assuming the number of shares offered by us, as set forth on the cover page of this prospectus, remains the same and after deducting estimated underwriting discounts and commissions and estimated offering expenses payable by us.

 

Assuming the underwriters’ over-allotment option is exercised in full, sales by us in this offering will reduce the percentage of shares held by existing stockholders to     % and will increase the number of shares held by new investors to     , or     %.

 

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SELECTED CONSOLIDATED FINANCIAL DATA

 

The following tables summarize our consolidated financial data for the periods presented. You should read the following financial information together with the information under “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and our consolidated financial statements and the related notes to these consolidated financial statements appearing elsewhere in this prospectus. The selected consolidated statements of operations data for the fiscal years ended December 31, 2005, 2006 and 2007, and the selected consolidated balance sheet data as of December 31, 2006 and 2007 are derived from our audited consolidated financial statements, which are included elsewhere in this prospectus. The selected consolidated statements of operations data for the years ended December 31, 2003 and 2004, and the consolidated balance sheet data at December 31, 2003, 2004 and 2005 are derived from our audited consolidated financial statements not included in this prospectus. The selected consolidated balance sheet data as of March 31, 2008 and the selected consolidated statements of operations data for the period from July 30, 2001 (inception) through March 31, 2008 and for the three months ended March 31, 2007 and 2008 are derived from our unaudited consolidated financial statements appearing elsewhere in this prospectus. The unaudited consolidated financial statements have been prepared on the same basis as our audited financial statements and include, in the opinion of management, all adjustments that management considers necessary for a fair presentation of the financial information set forth in those statements. Operating results for these periods are not necessarily indicative of the operating results for a full year or in future periods.

 

    Years Ended December 31,     Three Months Ended
March 31,
    Period
from July 30,
2001
(inception)
through
March 31,
2008
 
    2003     2004     2005     2006     2007     2007     2008    
    (in thousands, except share and per share data)        
                                  (unaudited)     (unaudited)  

Operating expenses:

               

Research and development

  $ 2,751     $ 6,271     $ 11,075     $ 22,800     $ 31,329     $ 5,316     $ 14,777     $ 90,184  

General and administrative

    2,513       2,878       3,871       6,129       6,126       1,754       2,100       25,348  
                                                               

Total operating expenses

    5,264       9,149       14,946       28,929       37,455       7,070       16,877       115,532  
                                                               

Operating loss

    (5,264 )     (9,149 )     (14,946 )     (28,929 )     (37,455 )     (7,070 )     (16,877 )     (115,532 )

Interest income

    161       127       457       655       1,221       150       329       3,122  

Interest expense

    (103 )     (201 )     (456 )     (372 )     (709 )     (124 )     (230 )     (2,092 )

Other income (expense), net

    35       (81 )     (26 )     (47 )     (31 )     (13 )     (10 )     (141 )
                                                               

Loss from continuing operations

    (5,171 )     (9,304 )     (14,971 )     (28,693 )     (36,974 )     (7,057 )     (16,788 )     (114,643 )

(Loss) income from discontinued operations, net of tax

    (2,675 )     (2,840 )     304       915       95    

 

(43

)

    —         (6,374 )
                                                               
Net loss     (7,846 )     (12,144 )     (14,667 )     (27,778 )     (36,879 )     (7,100 )     (16,788 )     (121,017 )

Deemed dividend related to beneficial conversion feature on preferred stock

    —         —         —         —         —         —         (3,088 )     (3,088 )
                                                               

Net loss applicable to common stockholders

  $ (7,846 )   $ (12,144 )   $ (14,667 )   $ (27,778 )   $ (36,879 )   $ (7,100 )   $ (19,876 )   $ (124,105 )
                                                               

Loss per share from continuing operations, basic and diluted

  $ (122.10 )   $ (134.44 )   $ (81.89 )   $ (109.48 )   $ (137.71 )   $ (37.88 )   $ (30.47 )  

(Loss) income per share from discontinued operations, basic and diluted

    (63.17 )     (41.03 )     1.66       3.49       .35       (.23 )     —      
                                                         

Net loss per share, basic and diluted

    (185.27 )     (175.47 )     (80.23 )     (105.99 )     (137.36 )     (38.11 )     (30.47 )  

Loss per share from beneficial conversion feature

    —         —         —         —         —         —         (5.61 )  
                                                         

Net loss per share applicable to common stockholders

  $ (185.27 )   $ (175.47 )   $ (80.23 )   $ (105.99 )   $ (137.36 )   $ (38.11 )   $ (36.08 )  
                                                         

Weighted average shares, basic and diluted

    42,350       69,208       182,804       262,098       268,492       186,334       550,903    
                                                         

Pro forma loss per share from continuing operations, basic and diluted(1)

          $ (1.66 )     $ (.54 )  

Pro forma income per share from discontinued operations, basic and diluted(1)

            .01         —      
                           

Pro forma net loss per share, basic and diluted(1)

          $ (1.65 )     $ (.54 )  
                           

Pro forma weighted average shares outstanding, basic and diluted

            22,357,873         31,490,626    
                           

 

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  (1)   The pro forma net loss per share, basic and diluted, gives effect to the weighted average conversion of all outstanding shares of our preferred stock into 27,595,177 and 32,006,100 shares of our common stock as of December 31, 2007 and March 31, 2008, respectively.

 

     As of December 31,     As of
March 31,
2008
 
     2003     2004     2005     2006     2007    
     (in thousands)     (unaudited)  

Consolidated Balance Sheet Data:

            

Cash and cash equivalents

   $ 11,785     $ 9,042     $ 12,971     $ 6,291     $ 31,711     $ 34,377  

Working capital

     12,450       5,996       9,778       2,518       23,806       24,863  

Total assets

     16,676       13,821       17,553       8,378       34,593       37,480  

Notes payable

     1,444       6,886       4,472       3,346       6,648       5,956  

Deficit accumulated during the development stage

     (12,761 )     (24,905 )     (39,572 )     (67,350 )     (104,229 )     (124,105 )

Total stockholders’ equity

     14,030       4,018       9,056       1,387       21,152       23,247  

 

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MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION

AND RESULTS OF OPERATIONS

 

The following discussion and analysis should be read together with our consolidated financial statements that appear elsewhere in this prospectus. This discussion contains forward-looking statements reflecting our current expectations and involves risk and uncertainties. In some cases, you can identify forward-looking statements by terminology, such as “may,” “will,” “should,” “expect,” “plan,” “anticipate,” “believe,” “estimate,” “predict,” “intend,” “potential” or “continue” or the negative of these terms or other comparable terminology. For example, statements regarding our expectations as to future financial performance, expense levels and liquidity sources are forward-looking statements. Actual results and the timing of events could differ materially from those discussed in our forward-looking statements as a result of many factors, including those set forth under “Risk Factors” and elsewhere in this prospectus.

 

Overview

 

We are a biopharmaceutical company focused on the discovery and development of novel small-molecule product candidates directed toward clinically validated targets in significant therapeutic markets. Our goal is to design product candidates that have improved efficacy, safety or convenience relative to existing therapies and other product candidates in clinical development. Our lead product candidate, PHX1149, is a dipeptidyl peptidase-4, or DPP-4, inhibitor that we are developing as an oral, once-daily treatment for Type 2 diabetes. In our randomized, 422 patient Phase 2b clinical trial of PHX1149 completed in the first quarter of 2008, PHX1149 demonstrated statistically significant reductions in HbA1c when administered in combination with existing drugs for the treatment of Type 2 diabetes. We expect to commence Phase 3 clinical trials of PHX1149 in the second half of 2008. Our second product candidate, PHX1766, is a protease inhibitor currently in preclinical development for the treatment of hepatitis C virus, or HCV, infection. We expect to commence Phase 1 clinical trials of PHX1766 in the second half of 2008. We discovered our product candidates using our “fast-follower” strategy for drug discovery, which is directed toward clinically validated therapeutic targets for which the pharmacological effect of a product candidate can be demonstrated in early-stage clinical trials. Using this approach, we advanced PHX1149 into human clinical trials 27 months after initiating our DPP-4 inhibitor discovery program.

 

To date, we have devoted substantially all of our resources to our drug discovery and development efforts, comprising research and development, protecting our intellectual property and the general and administrative support of these operations. Since our inception in July 2001, we have not generated revenues from continuing operations, and we have funded our operations principally through the private placement of preferred stock and debt. We generated revenues in prior periods through an Australian subsidiary in connection with a collaboration agreement between us and Genentech, Inc., or Genentech. Upon the termination of this agreement in the third quarter of 2006, we closed our Australian subsidiary and reclassified the results of operations of the business to discontinued operations.

 

In December 2007, we entered into an amendment to our existing $8.0 million loan and security agreement with Pinnacle Ventures, L.L.C., or Pinnacle, pursuant to which affiliates of Pinnacle have agreed to make additional loans to us in principal amount of up to $12.0 million on or before May 31, 2008. These loans will bear interest at a fixed rate equal to the prime rate in effect as of the date of each loan, plus two percent. Repayments on each loan will include an interest-only period of six months, followed by 30 equal monthly installments of principal and interest. In connection with the amendment to the loan and security agreement, we issued to Pinnacle a warrant to purchase 115,384 shares of our Series C preferred stock at an exercise price of $4.16 per share. The warrant will become exercisable for up to an additional 57,693 shares of Series C preferred stock at an exercise price of $4.16 per share if we borrow the $12.0 million available to us under the amendment.

 

We have never been profitable, and, as of March 31, 2008, we had an accumulated deficit of approximately $124.1 million. We expect to incur significant and increasing operating losses for the foreseeable future as we

 

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advance our product candidates from discovery through preclinical studies and clinical trials to seek regulatory approval and eventual commercialization. We expect that research and development expenses will increase along with general and administrative costs, as we grow and operate as a public company. We will need to generate significant revenues to achieve profitability and we may never do so.

 

Financial Operations Overview

 

Revenue

 

We have not generated any revenues from continuing operations since our inception. We will seek to generate revenues from collaborative partners through a combination of research funding, up-front license fees, milestone payments and royalties, or revenue-sharing or profit-sharing.

 

Research and Development Expenses

 

Research and development expenses consist of: (i) license fees paid to third parties for use of their intellectual property; (ii) expenses incurred under agreements with contract research organizations and investigative sites, which conduct a substantial portion of our preclinical studies and all of our clinical trials; (iii) payments to contract manufacturing organizations, which produce our active pharmaceutical ingredients; (iv) payments to consultants; (v) employee-related expenses, which include salaries, benefits and stock-based compensation; and (vi) facilities, depreciation and other allocated expenses, which include direct and allocated expenses for rent and maintenance of facilities and equipment, depreciation of leasehold improvements and equipment and laboratory and other supplies. All research and development expenses are expensed as incurred.

 

The table below sets forth our research and development expenses by project since 2005 as a percentage of total research and development expenses for the applicable period. We commence separately tracking the costs for a project when it merits a substantial increase in the level of resources devoted to it.

 

     Percentage of Research and
Development by Project
 
   DPP-4     HCV     Other
Research
Programs(1)
    Total  

2005

   72 %   5 %   23 %   100 %

2006

   79     19     2     100  

2007

   71     24     5     100  

Three months ended March 31, 2008

   76     22     2     100  

 

  (1)   The costs of early-stage projects are not tracked separately and are included under “Other Research Programs.”

 

We estimate that over the next 24 months, it will cost approximately $48.9 million to fund the first of our Phase 3 clinical trials, the ongoing extension phase of our Phase 2b clinical trial and our other ongoing clinical trials of PHX 1149 under our DPP-4 inhibitor program. In addition, the development of PHX1149 will require significant additional resources that may not be available to us unless we are able to enter into collaborative arrangements pursuant to which our partner or partners fund all or part of the clinical trial costs. As a result, we expect that we will need to enter into one or more collaborative arrangements to successfully complete the development of PHX1149. Because the economic terms of any collaborative arrangement that we may enter into can vary significantly, we are unable to predict a meaningful range of additional funding needed at this time. We may not be able complete the development of PHX1149 in our expected time frame or at all if, among other things, our Phase 2b or Phase 3 trials are not successful, or we are unable to enter into a collaborative arrangement for the development of this product candidate. We do not expect to receive material revenues from the sale of PHX1149, if approved by the FDA, for the foreseeable future.

 

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We estimate that over the next 24 months, it will cost approximately $17.1 million to complete additional preclinical studies and Phase 1 clinical trials of PHX1766 under our HCV protease inhibitor program, not including the cost of Phase 2 studies. Continued development of our HCV protease inhibitor program is highly dependent on the successful completion of additional preclinical studies and Phase 1 clinical trials. If any of these studies or trials are not successful, we may decide not to continue the development of PHX1766. In order to achieve regulatory approval for PHX1766, we will need to successfully complete preclinical studies and Phase 1, 2 and 3 trials as well as other studies which may be required by the FDA and similar foreign regulatory authorities. Given that continued development of PHX1766 is based on successful completion of numerous clinical trials and we have yet to begin any clinical trials, we are unable to estimate the aggregate cost to complete development or the completion date. Accordingly, we do not expect to receive material revenues from the sale of PHX1766, if approved by the FDA, for the foreseeable future.

 

Due to the numerous risks and uncertainties associated with the development of our product candidates, we are unable to estimate accurately the costs and time necessary to complete the development of and to obtain regulatory approval for PHX1149, PHX1766 or any of our other potential product candidates in discovery and development. Our estimate of the timing and costs to complete development will depend on many factors, including, but not limited to:

 

   

the number, scope and progress of our planned Phase 3 clinical trials for PHX1149, including expenses to support the trials;

 

   

the costs and timing of regulatory approvals;

 

   

our progress in advancing PHX1766 and other programs through preclinical development into clinical trials;

 

   

the costs and timing of preclinical and clinical manufacturing supply arrangements for our product candidates;

 

   

our ability to establish and maintain strategic collaborations, including licensing and other arrangements and the terms and timing of any collaborative, licensing or other arrangements that we may establish;

 

   

the success of our research and development efforts;

 

   

the emergence of competing or complementary technological developments; and

 

   

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

 

General and Administrative Expenses

 

General and administrative expenses consist primarily of salaries and related expenses for personnel in administration, finance and business development. Other significant expenses include legal expenses to pursue patent protection of our intellectual property, allocated facility costs and professional fees for general legal services. We expect general and administrative expense to increase as our business grows and we begin operating as a public company. These increases likely will include salaries and related expenses, legal and consultant fees, accounting fees, director fees, increased directors’ and officers’ insurance premiums, fees for investor relations services and enhanced business systems.

 

Interest Expense

 

Interest expense consists primarily of interest paid on our notes payable balances and the amortization of debt discount costs as a result of warrants to purchase our common and preferred stock issued in connection with the notes.

 

Interest Income

 

Interest income consists primarily of interest earned on our cash, cash equivalents and short-term investments.

 

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Income Taxes

 

Due to our historical operating losses, we have not had to record a provision for income taxes. We had net operating loss carryforwards available to offset future federal and state taxable income of $97.6 million and $77.6 million, respectively, as of December 31, 2007, as well as federal and state research and development tax credit carryforwards of approximately $3.7 million and $1.4 million, respectively, available to offset future federal and state taxes. The net operating loss and credit carryforwards expire at various dates through 2021. Under the provisions of the Internal Revenue Code, certain substantial changes in our ownership may result in a limitation on the amount of net operating loss carryforwards and research and development carryforwards that could be utilized annually to offset future taxable income and taxes payable. At December 31, 2007, we recorded a 100% valuation allowance against our net deferred tax assets of approximately $43.3 million, as our management believes it is uncertain that they will be fully realized. If we determine in the future that we will be able to realize all or a portion of our net deferred tax assets, an adjustment to the valuation allowance will be made in the period in which we make such a determination.

 

Discontinued Operations

 

In the third quarter of 2006, we and Genentech, Inc. reached an agreement to terminate our collaboration agreement, which was entered into in July 2004. The collaboration related to our forward genetics technology, which we are no longer developing and which is unrelated to our product candidates and current strategy for drug discovery. In connection with the termination of this agreement, we closed our Australian subsidiary and reclassified the results of operations of the business to discontinued operations in accordance with SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets. We generated revenues through our subsidiary during 2004, 2005 and 2006 under the collaboration agreement and through a government grant. Operations of the subsidiary ceased in August 2006, and we dissolved the entity in October 2007.

 

Beneficial Conversion Feature

 

In January 2008, we completed a private financing transaction pursuant to which we issued an aggregate of 4,410,923 shares of Series C preferred stock, at $4.16 per share, for aggregate gross proceeds of $18.3 million. The Series C preferred stock was sold at a price per share below the estimated fair value of our common stock. Accordingly, pursuant to EITF Issue No. 00-27, Application of Issue No. 98-5 to Certain Convertible Instruments, we have recorded a charge of $3.1 million, or $.70 per share, to account for the beneficial conversion feature present at the date of the financing.

 

Critical Accounting Policies and Significant Judgments and Estimates

 

Our management’s discussion and analysis of financial condition and results of operations is based on our financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements, as well as the reported revenues and expenses during the reporting periods. On an ongoing basis, we evaluate our estimates and judgments related to nonclinical development costs, clinical development costs, and drug manufacturing costs. We base our estimates on historical experience and on various other factors that we believe are reasonable under the circumstances, the results of which form the basis for making judgments about the carrying value of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.

 

While our significant accounting policies are more fully described in Note 2 to our consolidated financial statements appearing elsewhere in this prospectus, we believe that the following accounting policies are critical to the process of making significant judgments and estimates in the preparation of our financial statements.

 

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Preclinical Study and Clinical Trial Accruals

 

We estimate preclinical study and clinical trial expenses based on the services received pursuant to contracts with research institutions and clinical research organizations that conduct and manage preclinical studies and clinical trials on our behalf. In accruing service fees, we estimate the time period over which services will be performed and the level of effort to be expended in each period. If the actual timing of the performance of services or the level of effort varies from the estimate, we adjust the accrual accordingly. The financial terms of these agreements vary from contract to contract and may result in uneven expenses and payment flows. Preclinical study and clinical trial expenses include:

 

   

fees paid to contract research organizations in connection with preclinical studies;

 

   

fees paid to contract research organizations and clinical research organizations in connection with clinical trials; and

 

   

fees paid to contract manufacturers and service providers in connection with the production and testing of active pharmaceutical ingredients and drug materials for preclinical studies and clinical trials.

 

Payments under some of these contracts depend on factors such as the milestones accomplished, successful enrollment of certain numbers of patients, site initiation and the completion of clinical trial milestones. To date, we have not experienced any events requiring us to make material adjustments to our accruals for service fees. If we do not identify costs that we have begun to incur or if we underestimate or overestimate the level of services performed or the costs of these services, our actual expenses could differ from our estimates. Adjustments to our estimates are recorded as they become evident.

 

Stock-Based Compensation

 

Through December 31, 2005, we accounted for stock-based employee compensation arrangements using the intrinsic value method in accordance with the recognition and measurement provisions of Accounting Principles Board Opinion, or APB, No. 25, Accounting for Stock Issued to Employees, and related interpretations. Under APB No. 25, compensation expense is based on the difference, if any, on the date of grant between the fair value of our common stock and the exercise price of the stock option. For periods prior to December 31, 2005, we have complied with the disclosure-only provisions required by Statement of Financial Accounting Standards, or SFAS, No. 123, Accounting for Stock-Based Compensation.

 

Under APB No. 25, stock-based compensation expense is recognized for employee stock options granted at exercise prices that, for financial reporting purposes, were determined to be below the fair value of the underlying common stock on the date of grant. No grants through December 31, 2005 were made at less than the fair value of the underlying common stock.

 

Effective January 1, 2006, we adopted SFAS No. 123R, Share-Based Payment, or SFAS No. 123R, which requires compensation costs related to share-based transactions, including employee stock options, to be recognized in the financial statements based on fair value. SFAS No. 123R revises SFAS No. 123 and supersedes APB No. 25. We adopted SFAS No. 123R using the prospective transition method. Under this method, compensation cost is measured and recognized for all share-based payments granted, modified and settled subsequent to December 31, 2005. In accordance with the prospective transition method, our financial statements for 2005 and prior periods have not been restated to reflect and do not include the impact of SFAS No. 123R.

 

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We selected the Black-Scholes valuation model as the most appropriate valuation method for stock option grants. We estimated the fair value of these stock options as of the date of grant using the Black-Scholes valuation model with the following weighted-average assumptions for stock options granted during 2006 and 2007, and for the three months ended March 31, 2008:

 

     Years Ended
December 31,
    Three Months
Ended
March 31,

2008
 
     2006     2007    

Risk-free interest rate

   5.16 %   4.43 %   2.90 %

Dividend yield

   .0 %   .0 %   .0 %

Weighted-average expected life (in years)

   6.08     6.08     6.08  

Volatility

   85.50 %   52.74 %   69.88 %

Estimated forfeitures

   5.00 %   4.36 %   4.00 %

 

Calculating the fair value of stock-based compensation requires the input of subjective assumptions. As allowed by SAB No. 107, Share-Based Payment, we have elected to use the simplified method for estimating the expected term of our options. We estimated the expected volatility of our common stock during 2006 and 2007 based on an average of the historical volatilities of publicly traded industry peers. These industry peers consist of seven public companies in the biopharmaceutical industry that we selected based on the following attributes:

 

   

the entity has completed an initial public offering after January 1, 2006;

 

   

the entity has published data from a Phase 2a clinical trial for its lead product candidate but has not completed enrollment in a Phase 3 clinical trial; and

 

   

the entity has a proprietary lead product candidate that is not subject to a partnering or collaboration agreement and that is directed toward indications generally treated other than by specialists, such as diabetes, obesity and cardiovascular indications.

 

The change in expected volatility from December 31, 2006 to December 31, 2007 reflects changes in the composition of our peer group during this period as we advanced our clinical program and progressed toward an initial public offering. We will continue to analyze the historical stock price volatility and expected life assumptions as more historical data for our common stock become available. The risk-free interest rate assumption was based on U.S. Treasury instruments whose term was consistent with the expected life of our stock options. We have never paid, and do not anticipate paying, any cash dividends in the foreseeable future and therefore used an expected dividend yield of zero in our option pricing model. In addition, SFAS No. 123R requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. We estimated forfeitures based on historical experience. Prior to the adoption of SFAS No. 123R, we accounted for forfeitures as they occurred.

 

We amortize the fair value of each option on a straight-line basis over the requisite service period which is generally the vesting period.

 

In connection with the preparation of the financial statements necessary for the filing of this registration statement, we have reassessed the fair value of our common stock at option grant dates from January 2006 to the present. We prepared a contemporaneous market-based valuation of our common stock as of December 2007 in order to reassess retrospectively the estimated fair value of our common stock for financial reporting purposes. Our selection of the market-based approach is consistent with the methods outlined in the American Institute of Certified Public Accountants Practice Aid Valuation of Privately-Held-Company Equity Securities Issued as Compensation, given our stage of development and near-term prospect of a liquidity event. Determining the fair value of our stock requires us to make complex and subjective judgments. These judgments and estimates include determinations of the appropriate valuation methods and, when utilizing a market-based approach, the selection and weighting of appropriate market comparables. For these and other reasons, the reassessed fair values that we used to compute stock-based compensation expense for financial reporting purposes may not

 

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reflect the fair values that would result from the application of other valuation methods, including accepted valuation methods for tax purposes. In addition, due to the retrospective nature of the analysis, any retrospective valuation includes substantial additional information that was not known or reasonably ascertainable at the time of the original valuation determinations, such as the probability of completing an initial public offering, a company’s actual performance, its ability to obtain required funding, the ability to mitigate potential risks and other factors.

 

Our reassessment considered the following significant events:

 

   

the release of data from our Phase 2a clinical trial of PHX1149 in January 2007;

 

   

our issuance of 6,610,577 shares of Series C preferred stock at $4.16 per share in February 2007;

 

   

the commencement of our Phase 2b clinical trial of PHX1149 in patients with Type 2 diabetes in April 2007;

 

   

our identification of PHX1766 as a development candidate for the treatment of HCV infection in June 2007;

 

   

the completion and report of long-term toxicology studies for PHX1149 in July 2007;

 

   

the convening of our end-of-Phase 2 meeting with the FDA to discuss the chemistry, manufacturing and control processes for PHX1149 in September 2007;

 

   

our issuance of 6,610,577 shares of Series C preferred stock at $4.16 per share in September 2007;

 

   

our issuance of 4,410,923 shares of Series C preferred stock at $4.16 per share in January 2008; and

 

   

the release of data from our Phase 2b clinical trial of PHX1149 in February 2008.

 

We utilized estimates of the probability of an initial public offering, acquisition or continued operation as a private company in preparing our contemporaneous market-based valuation. The initial public offering scenario estimated our enterprise value based on discussions with investment bankers and through the evaluation of the seven biopharmaceutical companies that we selected, based on the attributes described above in our discussion of the estimated expected volatility of our common stock.

 

We evaluated our enterprise value in the acquisition scenario by examining purchase prices in recently-completed mergers or acquisitions of nine companies at a similar stage of development. We evaluated our enterprise value in the stay-private scenario through a discounted cash flow approach. Using this market-based approach, we obtained a per share price for our common stock of $4.86 as of December 2007, which was calculated using our fully diluted capitalization prior to this offering. Considering our market-based determination of our enterprise value noted above, we then reassessed retrospectively the fair value of our common stock during prior periods.

 

For periods prior to January 1, 2007, we believe the estimated fair value determinations originally made by our board of directors remain appropriate due to the following:

 

   

during this time period, we had progressed only a single program to the clinical stages of development;

 

   

we closed our Australian subsidiary in the third quarter of 2006, upon the termination of our collaboration agreement with Genentech;

 

   

as of the end of 2006, we did not have results from our Phase 2a clinical study for PHX1149;

 

   

also at the end of 2006, we had limited working capital, and, even with the availability of $4.5 million from our venture debt facility with Pinnacle, we had less than one quarter’s remaining operating funds available to us; and

 

   

our ability to raise additional equity at a reasonable valuation hinged on the Phase 2a results for PHX1149, which did not occur until 2007.

 

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Even though we did not grant any options during the first quarter of 2007, we did consider events occurring during that period that would impact the value of our common stock. During the first quarter we received the results of our Phase 2a trial for PHX1149 and completed a $27.5 million Series C stock financing. These two events were significant milestones in our history. Accordingly, we believe that the best indication of fair value of our common stock in the first quarter of 2007 is the price paid for the 6,610,577 shares of our Series C preferred stock sold in February 2007. We believe that the financing was completed at terms equivalent to an arm’s length transaction, as 33% of the proceeds were received from a new investor. To arrive at our reassessed value of our common stock, we first allocated, from the unit price of $4.16, $.22 for the value of the warrants issued in connection with the February 2007 Series C stock financing as determined by the Black-Scholes method. Second, we applied a 10% discount to the preferred per share amount of $3.94 to account for the rights privileges and preferences of the preferred stock. The Series C preferred stock included liquidation and dividend preferences, antidilution protection and voting preferences. We considered these provisions to be significant on the date of issuance. Accordingly, we believe the 10% discount is reasonable, resulting in a reassessed fair value of $3.55.

 

For options granted on April 17, 2007 to purchase a total of 711,900 shares, we utilized a reassessed fair value of $3.55 because the options were granted in close proximity to the completion of the February 2007 Series C stock financing. Additionally, the options were granted out of the increase to the options available for grant under our 2001 employee stock option plan approved concurrent with that financing.

 

For options granted on July 17, 2007 to purchase a total of 129,900 shares, we used the same methodology; however, we did not apply the 10% discount for the preferences, resulting in a reassessed fair value of $3.94. The incremental increase from April 17, 2007 is supported by the identification of PHX1766 as a development candidate in June 2007 and our further progression toward a potential liquidity event.

 

For options granted on September 18, 2007 and October 8, 2007 to purchase 1,103,250 and 437,000 shares, respectively, we believe the best indication of fair value is the completion of the September 2007 Series C stock financing, pursuant to which we sold an additional 6,610,577 shares of Series C preferred stock, at $4.16 per share for gross proceeds of $27.5 million.

 

For options to purchase 110,400 shares granted on January 22, 2008, we believe that the best indication of fair value is the $4.86 per share valuation obtained as a result of our contemporaneous market-based appraisal as of December 2007, which was prior to the receipt of the results of our Phase 2b clinical trial.

 

The following is a summary of the results of our common stock reassessment for financial reporting purposes at each issuance date in the reassessment period. The summary includes the reassessed value based on our retrospective reassessment and the number of equity instruments issued on the following dates:

 

    April 17,
2007
  July 17,
2007
  September 18,
2007
  October 8,
2007
  January 22,
2008

Reassessed fair value per share of common stock

  $ 3.55   $ 3.94   $ 4.16   $ 4.16   $ 4.86

Exercise price

    .43     .43     .66     .66     4.86
                             

Intrinsic value

  $ 3.12   $ 3.51   $ 3.50   $ 3.50   $

Options granted

    711,900     129,900     1,103,250     437,000     110,400

 

There were no adjustments made to the terms of existing grants that were a direct result of our reassessment process.

 

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As a result of our Black-Scholes option fair value calculations and the allocation of value to the vesting periods using the straight-line vesting attribution method, we recognized employee-stock based compensation in the statements of operations as follows (in thousands):

 

     Years Ended
December 31,
   Three Months
Ended
March 31,

2008
     2006    2007   

General and administrative expenses

   $ 12,000    $ 890,000    $ 356,000

Research and development expenses

   $ 7,000    $ 335,000    $ 181,000

 

The total compensation cost related to unvested stock option grants not yet recognized as of March 31, 2008 was $7.3 million, and the weighted-average period over which these grants are expected to vest is 3.04 years.

 

Based on an assumed initial public offering price of $            per share, the intrinsic value of stock options outstanding at March 31, 2008 was $            million, of which $            million and $            million related to stock options that were vested and unvested, respectively, at that date.

 

We record equity instruments issued to non-employees as expense at their fair value over the related service period as determined in accordance with SFAS No. 123R and EITF Issue No. 96-18, Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling Goods and Services, and we periodically revalue them as the equity instruments vest. As of March 31, 2008, we had outstanding equity instruments subject to vesting representing 12,500 shares of common stock issued to non-employees.

 

The 2008 stock option and incentive plan and 2008 employee stock purchase plan that are expected to be approved by our board of directors and stockholders prior to the completion of this offering would be considered compensatory plans and compensation expense would be recorded in accordance with the provisions of SFAS No. 123R. Compensation expense will depend on the level of enrollment in the 2008 employee stock purchase plan and assumptions used in the determination of the fair market value of the stock at date of grant.

 

Results of Operations

 

We expect to incur increasing research and development expenses in future periods as we conduct more research and perform preclinical studies and clinical trials for our product candidate pipeline. Our strategy includes entering into collaborations with third parties to participate in the development and commercialization of some of our product candidates. As a result, we cannot predict our future research and development expenses with any degree of certainty.

 

Comparison of the Three Months Ended March 31, 2007 and 2008

 

     Three Months
Ended March 31,
    Increase
(Decrease)
    %
Increase
(Decrease)
 
     2007     2008      
     (in thousands, except percentages)  

Research and development expenses

   $ 5,316     $ 14,777     $ 9,461     178 %

General and administrative expenses

     1,754       2,100       346     20  

Interest income

     150       329       179     119  

Interest expense

     (124 )     (230 )     106     85  

Other income (expense), net

     (13 )     (10 )     3     23  

Loss from discontinued operations, net

     (43 )           (43 )   (100 )

Deemed dividend

           (3,088 )     3,088     100  

 

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Research and development expenses. The increase in research and development expense was primarily the result of increased costs associated with the development of PHX1149 and PHX1766, including increases of $3.2 million in clinical costs related to the Phase 2b trial for PHX1149, $3.5 million in drug manufacturing costs for PHX1149 to be used in our clinical trials and $1.8 million in development costs related to PHX1766.

 

General and administrative expenses. The increase in general and administrative expenses was due primarily to $.3 million in payroll and related costs associated with increased headcount, $.4 million in stock-based compensation expense and $.3 million for legal and consulting expenses, offset by $.6 million in settlement fees associated with our litigation with ActivX Biosciences, Inc., or ActivX, paid in the three months ended March 31, 2007, compared to zero in the three months ended March 31, 2008. ActivX had filed a complaint in the Superior Court of California in the County of San Diego in September 2005 alleging, among other things, that we and some of our employees who were previously employed with ActivX misappropriated trade secrets of ActivX relating to DPP-4 inhibitor technology.

 

Interest income. The increase in interest income was attributable to higher average cash balances during the three months ended March 31, 2008, as a result of closing our Series C preferred stock financing in January 2008.

 

Interest expense. The increase in interest expense during the three months ended March 31, 2008 was attributable to higher average debt balances, as a result of our borrowing $4.5 million in 2007 under the $8.0 million loan and security agreement entered into with Pinnacle in November 2006.

 

Deemed dividend. The increase in deemed dividend expense during the three months ended March 31, 2008 was due to a $3.1 million non-cash charge for a beneficial conversion feature related to the Series C preferred stock issued in January 2008.

 

Comparison of the Years Ended December 31, 2006 and 2007

 

     Years Ended
December 31,
    Increase
(Decrease)
    % Increase
(Decrease)
     2006     2007      
     (in thousands, except percentages)

Research and development expenses

   $ 22,800     $ 31,329     $ 8,529     37%

General and administrative expenses

     6,129       6,126       (3 )  

Interest income

     655       1,221       566     86

Interest expense

     (372 )     (709 )     337     91

Other expense, net

     (47 )     (31 )     (16 )   (34)

Income from discontinued operations, net

     915       95       (820 )   (90)

 

Research and development expenses. The increase in research and development expenses was primarily the result of increased costs associated with the development of PHX1149, including increases of $6.5 million in clinical costs resulting from the commencement of the Phase 2b trial and $4.1 million in drug manufacturing costs, plus non-clinical study costs of $1.4 million associated with PHX1766. These increases were partially offset by a decrease in expenses during the year ended December 31, 2007 attributable to our payment during 2006 of $5.0 million in license fees.

 

General and administrative expenses. The decrease in general and administrative expenses for the year ended December 31, 2007 relative to the year ended December 31, 2006 was due primarily to a $1.1 million decrease in costs incurred during 2007 for legal expenses and settlement fees associated with our litigation with ActivX. This decrease was offset by increases in gross wages and non-cash stock-based compensation charges during the year ended December 31, 2007 relative to the year ended December 31, 2006 of $.2 million and $.9 million, respectively.

 

Interest income. The increase in interest income was attributable to higher average cash balances during 2007 as a result of our Series C preferred stock financings in February and September 2007.

 

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Interest expense. The increase in interest expense was attributable to higher average debt balances during 2007 as a result of our entering into the loan and security agreement with Pinnacle in November 2006 and borrowing $8.0 million in principal under this agreement from November 2006 through December 31, 2007.

 

Income from discontinued operations. Income from discontinued operations is comprised of the results of operations of our wholly owned Australian subsidiary, which was closed upon the termination of a collaboration agreement with Genentech in the third quarter of 2006. Income was derived in 2006 upon the recognition of deferred revenue balances associated with upfront payments less costs incurred to close the facility. Income was derived in 2007 upon the reversal of accruals no longer deemed necessary.

 

Comparison of the Years Ended December 31, 2005 and 2006

 

     Years Ended
December 31,
    Increase
(Decrease)
    % Increase
(Decrease)
     2005     2006      
     (in thousands, except percentages)

Research and development expenses

   $ 11,075     $ 22,800     $ 11,725     106%

General and administrative expenses

     3,871       6,129       2,258     58

Interest income

     457       655       198     43

Interest expense

     (456 )     (372 )     (84 )   (18)

Other expense, net

     (26 )     (47 )     21     81

Income from discontinued operations, net

     304       915       611     201

 

Research and development expenses. The increase in research and development expenses was primarily the result of increased costs associated with the development of PHX1149, including increases of $5.0 million in license and milestone fees, $3.9 million in clinical costs and $2.3 million in drug manufacturing costs.

 

General and administrative expenses. The increase in general and administrative expenses was due primarily to $1.7 million in costs incurred during 2006 for legal expenses and settlement fees associated with our litigation with ActivX.

 

Interest income. The increase in interest income was attributable to higher average cash balances during 2006 as a result of our Series B preferred stock financing in March 2006.

 

Interest expense. The increase in interest expense was attributable to lower average debt balances during 2006 as a result of the maturity of several notes payable.

 

Income from discontinued operations. Income from discontinued operations increased in 2006 as a result of the recognition of deferred revenue balances upon the termination of our collaboration with Genentech.

 

Liquidity and Capital Resources

 

We have incurred losses since our inception in July 2001 and, as of March 31, 2008, we have a deficit accumulated of $124.1 million. We anticipate that we will continue to incur losses for at least the next several years. We expect that our development and general and administrative expenses will continue to increase and, as a result, we will need to generate significant revenues from product sales or through a combination of research funding, up-front license fees, milestone payments and royalties, revenue-sharing or profit-sharing from collaborations.

 

Since our inception in July 2001 through March 31, 2008, we have funded our operations principally through the private placement of equity securities, which has provided aggregate gross proceeds of approximately $140.2 million. We also have generated funds from debt financings. In 2006 we entered into a loan agreement and, as of March 31, 2008, we had borrowed $8.0 million for use as working capital. As of

 

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March 31, 2008, we had cash and cash equivalents of approximately $34.4 million. Cash in excess of immediate requirements is invested in accordance with our investment policy primarily with a view to liquidity and capital preservation. Currently, our funds are invested in short-term obligations of United States government agencies and money market funds.

 

     Years Ended December 31,     Three Months Ended
March 31,
 
     2005     2006     2007     2007     2008  
     (in thousands)              

Cash Flows from Continuing Operations:

          

Net cash used in operating activities

   $ (13,167 )   $ (26,619 )   $ (33,085 )   $ (6,640 )   $ (14,541 )

Net cash used in investing activities

     (278 )     (173 )     (378 )     (26 )     (378 )

Net cash provided by financing activities

     17,355       19,265       58,752       27,375       17,585  
                                        

Net increase (decrease) in cash and cash equivalents from continuing operations

   $ 3,910     $ (7,527 )   $ 25,289     $ 20,709     $ 2,666  
                                        

 

During 2005, 2006 and 2007 and the three months ended March 31, 2007 and March 31, 2008, our operating activities used cash of $13.2 million, $26.6 million, $33.1 million, $6.6 million and $14.5 million, respectively. The use of cash in all periods primarily resulted from our net losses and changes in our working capital accounts. The increase in cash used in operations in all periods was due primarily to an increase in research and development activities.

 

During 2005, 2006 and 2007 and the three months ended March 31, 2007 and March 31, 2008, our investing activities used cash of $.3 million, $.2 million, $.4 million, $0 and $.4 million, respectively. The net cash used in 2005, 2006, 2007 and the three months ended March 31, 2007 and March 31, 2008, was attributable primarily to purchases of property and equipment.

 

During 2005, 2006 and 2007 and the three months ended March 31, 2007 and March 31, 2008, our financing activities provided net cash of $17.4 million, $19.3 million, $58.8 million, $27.4 million and $17.6 million, respectively. The net cash provided by financing activities in 2005 was primarily a result of the sale and issuance of 5,715,826 shares of Series B preferred stock in April 2005 for net proceeds of $19.8 million, which was partially offset by the repayment of notes payable in the amount of $2.4 million. The cash provided by financing activities in 2006 was primarily a result of the sale and issuance of 5,715,826 shares of Series B preferred stock in March 2006 for net proceeds of $20.0 million and $3.5 million in proceeds from the issuance of notes payable, which was partially offset by the payment and repayment of notes payable of $4.2 million. The net cash provided by financing activities in 2007 was primarily the result of the sale and issuance of a total of 13,221,154 shares of Series C preferred stock in February 2007 and September 2007 for net proceeds of $54.8 million. In addition, we received $4.5 million in proceeds from borrowings under our loan and security agreement with Pinnacle. These amounts were partially offset by the repayment of notes payable in the amount of $.8 million. In connection with the first closing of our Series C preferred stock financing in February 2007, we issued to investors warrants to purchase an aggregate of 661,058 shares of Series C preferred stock at an exercise price of $4.16 per share. The net cash provided by financing activities during the three months ended March 31, 2007 was primarily the result of the sale and issuance of 6,610,577 shares of Series C preferred stock in February 2007 for net proceeds of $27.4 million, which was partially offset by the payment and repayment of notes payable of $.1 million. The net cash provided by financing activities during the three months ended March 31, 2008 was primarily the result of the sale and issuance of 4,410,923 shares of Series C preferred stock in January 2008 for net proceeds of $18.3 million, which was partially offset by the payment and repayment of notes payable of $.8 million.

 

In December 2007, we entered into an amendment to our existing $8.0 million loan and security agreement with Pinnacle, pursuant to which affiliates of Pinnacle have agreed to make additional loans to us in an aggregate principal amount of up to $12.0 million on or before May 31, 2008. Borrowings under this amendment will bear

 

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interest at a fixed rate equal to the prime rate in effect as of the date of each loan, plus two percent. Repayments on each loan will include an interest-only period of six months, followed by 30 equal monthly installments of principal and interest. In connection with the amendment to the loan and security agreement, we issued to Pinnacle a warrant to purchase 115,384 shares of our Series C preferred stock at an exercise price of $4.16 per share. The warrant will become exercisable for up to an additional 57,693 shares of Series C preferred stock at an exercise price of $4.16 per share if we borrow the $12.0 million available to us under the amendment. To date, there have been no borrowings under this amendment, although we expect to borrow the $12.0 million available to us under the amendment before May 31, 2008.

 

In January 2008, we completed a private financing transaction, pursuant to which we issued an aggregate of 4,410,923 shares of Series C preferred stock, at $4.16 per share, for aggregate gross proceeds of $18.3 million. We have recorded a charge of $3.1 million, or $.70 per share, to account for the beneficial conversion feature present at the date of the financing.

 

Operating Capital Requirements. We anticipate we will continue to incur net losses for the next several years as we incur expenses to start our Phase 3 clinical trials for PHX1149, complete preclinical studies and clinical development of PHX1766, build commercial capabilities and expand our corporate infrastructure. We may not be able complete the development of these programs if, among other things, our preclinical research and clinical trials are not successful and the FDA does not approve these product candidates when we expect, or at all.

 

Based on our current operating plan, we believe our existing capital resources, including the $12.0 million in additional loans that we may borrow under the December 2007 amendment to our loan and security agreement with Pinnacle, the $18.3 million of proceeds from our issuance and sale of 4,410,923 shares of Series C preferred stock in January 2008 and the interest from our investments, will be sufficient to meet our currently anticipated cash requirements through the end of 2008. We have based this estimate on assumptions that may prove to be wrong, and we could utilize our available capital resources sooner than we currently expect. If we are unable to raise sufficient additional capital we may need to substantially curtail our planned operations. Our forecast of the period of time through which our financial resources will be adequate to support our operations is a forward-looking statement and involves risks and uncertainties, and actual results could vary as a result of a number of factors, including the factors discussed in “Risk Factors.”

 

We do not believe the net proceeds from this offering will be sufficient to fund our operations through the successful development and commercialization of any of our product candidates. As a result, we will need to raise additional capital following this offering to fund our operations and continue to conduct clinical trials to support potential regulatory approval of PHX1149 and our other product candidates. To raise additional capital, we may seek to sell additional equity or debt securities or obtain a credit facility. The sale of additional equity and debt securities may result in additional dilution to our stockholders. If we raise additional funds through the issuance of debt securities or preferred stock, these securities could have rights senior to those of our common stock and could contain covenants that would restrict our operations.

 

Because of the numerous risks and uncertainties associated with research, development and commercialization of pharmaceutical products, we are unable to estimate the exact amounts of our working capital requirements. Our future funding requirements will depend on many factors, including, but not limited to:

 

   

the progress of our clinical trials of PHX1149, including expenses to support the trials;

 

   

the costs and timing of regulatory approvals;

 

   

our progress in advancing PHX1766 through preclinical development into clinical trials;

 

   

the costs and timing of clinical and commercial manufacturing supply arrangements for our product candidates;

 

   

the costs of establishing sales or distribution capabilities;

 

   

the success of the commercialization of our products;

 

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our ability to establish and maintain strategic collaborations, including licensing and other arrangements; and

 

   

the costs involved in enforcing or defending patent claims or other intellectual property rights.

 

Off-Balance Sheet Arrangements

 

We do not have any off-balance sheet arrangements.

 

Contractual Obligations and Commitments

 

The following table summarizes our contractual obligations at March 31, 2008:

 

     Payments Due by Period
     Total    Less than 1
year
   1-3 years    4-5 years    More than 5
years

Debt(1)

   $ 7,246    $ 3,617    $ 3,629    $    $

Operating lease obligations(2)

     2,470      845      1,625          

Contract research commitments

     519      339      180          
                                  

Total(3)

   $ 10,235    $ 4,801    $ 5,434    $    $
                                  

 

  (1)   In November 2006, we entered into a loan and security agreement with Pinnacle to borrow up to $8.0 million. In connection with the loan and security agreement, we granted Pinnacle a first priority security interest in all of our assets, except our intellectual property. Borrowings under the loan and security agreement have an interest only period of six months followed by thirty equal payments of principal and interest. As of March 31, 2008, we had an outstanding principal balance of approximately $6.6 million bearing interest at 10.25% under the loan and security agreement. Through March 31, 2008, we had made payments totaling approximately $2.2 million on the notes. Our last payment on these notes will be made in June 2010. The amounts in the table above include interest and principal repayments on these notes. In December 2007, we entered into an amendment to our loan and security agreement with Pinnacle, pursuant to which affiliates of Pinnacle have agreed to make additional loans to us in aggregate principal amount of up to $12.0 million on or before May 31, 2008. To date, there have been no borrowings pursuant to this amendment. The amounts in the table above do not include any potential interest and principal repayments to Pinnacle for additional amounts we expect to borrow under the December 2007 amendment.
  (2)   Includes the minimum rental payments for our primary laboratory and office facility in San Diego, California expiring in January 2011. Also includes the minimum rental payments for an additional office facility pursuant to lease and sublease agreements entered into in January 2008, which will expire in January 2011. The rent for all of our facilities is subject to a 3.5% average annual increase for the duration of the applicable lease and sublease agreements.
  (3)   Excludes up to $7.5 million in milestone payments due upon our initiation of Phase 3 clinical trials for PHX1149 and our potential entry into a collaboration, strategic partnership or license transaction. Also excludes up to $8.5 million in potential additional payments due upon the achievement of regulatory and commercial milestones, the earliest of which would be payable upon the filing of an NDA.

 

Recent Accounting Pronouncements

 

In July 2006, the Financial Accounting Standards Board, or FASB, issued Interpretation No. 48, Accounting for Uncertainty in Income Taxes—An Interpretation of FASB Statement 109, (FIN 48) to create a single model to address accounting for uncertain tax positions. FIN 48 clarifies the accounting for income taxes by prescribing a minimum recognition threshold a tax position is required to meet before being recognized in the financial statements. FIN 48 also provides guidance on derecognition, measurement and classification of amounts relating

 

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to uncertain tax positions, accounting for and disclosure of interest and penalties, accounting in interim periods, disclosures and transition relating to the adoption of the new accounting standard. FIN 48 is effective for eligible nonpublic enterprises for fiscal years beginning after December 15, 2007.

 

We adopted the provisions of FIN 48 on January 1, 2008. As of the date of adoption, our unrecognized tax benefits totaled $1.3 million, $.8 million of which, if recognized at a time when the valuation allowance no longer exists, would affect the effective tax rate. The adoption of FIN 48 did not result in an adjustment to accumulated deficit. We will recognize interest and penalties related to unrecognized tax benefits as a component of income tax expense. We recognized no interest or penalties upon the adoption of FIN 48. We do not expect any significant increases or decreases to our unrecognized tax benefits within the next 12 months.

 

We are subject to U.S. federal and California income tax. Prior to 2007, we were subject to Australian income tax. We are no longer subject to U.S. federal, California or Australian income tax examinations for years before 2004, 2003 and 2002, respectively. However, to the extent allowed by law, the tax authorities may have the right to examine prior periods, where net operating losses or tax credits were generated and carried forward, and make adjustments up to the amount of the net operating loss or credit carryforward amount. We are not currently under Internal Revenue Service, California or Australian tax examinations.

 

In September 2006, the FASB issued SFAS No. 157, Fair Value Measurements, which defines fair value, establishes a framework for measuring fair value in accordance with GAAP and expands disclosures about fair value measurements. We adopted SFAS No. 157 in the first quarter of 2008. In February 2008, the FASB issued FASB Staff Position No. FAS 157-2, Effective Date of FASB Statement No. 157, which provides a one year deferral of the effective date of SFAS No. 157 for non-financial assets and non-financial liabilities, except those that are recognized or disclosed in the financial statements at fair value at least annually. Cash and cash equivalents are carried at fair value based on quoted market prices for identical securities (Level 1 inputs). The adoption of SFAS 157 had no effect on our consolidated financial position or results of operations.

 

In February 2007, the FASB issued SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities (SFAS 159). SFAS 159 permits entities to choose to measure certain financial instruments and other eligible items at fair value when the items are not otherwise currently required to be measured at fair value. We adopted SFAS 159 effective January 1, 2008. Upon adoption, we did not elect the fair value option for any items within the scope of SFAS 159 and, therefore, the adoption of SFAS 159 did not have an impact on our consolidated financial statements.

 

In June 2007, the EITF of the FASB reached a consensus on EITF Issue No. 07-03, Accounting for Nonrefundable Advance Payments for Goods or Services to Be Used in Future Research and Development Activities. Under EITF 07-03, nonrefundable advance payments for goods or services to be received in the future for use in research and development activities should be deferred and capitalized. Such amounts should be expensed as the related goods are delivered or services are performed. If we change our expectations such that we do not expect the goods to be delivered or services to be rendered, the capitalized advance payment should be charged to expense. EITF No. 07-03 is effective for new contracts entered into beginning January 1, 2008. The adoption of EITF No. 07-03 did not have an impact on our financial statements.

 

Quantitative and Qualitative Disclosure about Market Risk

 

Interest Rate Risk

 

We are exposed to market risk related to changes in interest rates, but we have taken steps intended to mitigate this risk by holding investments in less volatile securities. As of March 31, 2008, we had cash and cash equivalents of $34.4 million. Our primary exposure to market risk is interest income sensitivity, which is affected by changes in the general level of U.S. interest rates, particularly because our cash equivalents are in short-term marketable securities. Due to the short-term duration of our investment portfolio and the low risk profile of our

 

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investments, an immediate 10% change in interest rates would not have a material effect on the fair market value of our portfolio. Accordingly, we would not expect our operating results or cash flows to be affected to any significant degree by the effect of a sudden change in market interest rates on our securities portfolio.

 

Borrowings under our loan and security agreement with Pinnacle, as amended in December 2007, bear interest at a fixed rate equal to the prime rate in effect as of the date of each loan, plus two percent. As of March 31, 2008, we had an outstanding balance of $6.6 million under our loan and security agreement with Pinnacle. All currently outstanding amounts bear interest at a fixed rate of 10.25%. Because the rate of interest for borrowings under the loan and security agreement is fixed at the time of each loan, an increase in the prime rate would not result in any change to our interest obligations with respect to amounts currently outstanding, although it could make future borrowings more costly.

 

Foreign Currency Exchange Rate Risk

 

We are exposed to a number of risks relating to fluctuations in foreign currencies. We make payments in the ordinary course of business in non-U.S. dollar denominated amounts, including payments to clinical research sites. Fluctuations in the exchange ratio of the U.S. dollar and these foreign currencies will have the effect of increasing or decreasing our expenses even if there is a constant amount of expense in such foreign currencies. For example, if the U.S. dollar strengthens against a foreign currency, then our expenses will decrease given a constant payment amount in such foreign currency.

 

We do not currently hedge our foreign currency exchange rate risk. Because we have closed our wholly-owned Australian subsidiary and because most of our obligations to foreign contract research organizations are denominated in U.S. dollars, we do not believe that a change in the value of the U.S. dollar against foreign currencies would have a material impact on our operating results or financial condition.

 

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BUSINESS

 

Overview

 

We are a biopharmaceutical company focused on the discovery and development of novel small-molecule product candidates directed toward clinically validated targets in significant therapeutic markets. Our goal is to design product candidates that have improved efficacy, safety or convenience relative to existing therapies and other product candidates in clinical development. Our lead product candidate, PHX1149, is a dipeptidyl peptidase-4, or DPP-4, inhibitor that we are developing as an oral, once-daily treatment for Type 2 diabetes. We completed a four-week Phase 2a clinical trial for PHX1149, which demonstrated a statistically significant reduction in postprandial, or post-meal, blood glucose levels. In 12-week clinical trials of other DPP-4 inhibitors, postprandial glucose levels have been shown to be correlated with reductions in hemoglobin A1c, or HbA1c, a measure of blood glucose control. The FDA currently approves diabetes medications based primarily on safety and on effectiveness in lowering HbA1c levels. In our 12-week randomized, 422 patient Phase 2b clinical trial of PHX1149 completed in the first quarter of 2008, PHX1149 demonstrated statistically significant reductions in HbA1c when administered in combination with existing drugs for the treatment of Type 2 diabetes. PHX1149 also demonstrated statistically significant effects on secondary efficacy endpoints, including change in fasting blood glucose levels, change in postprandial blood glucose levels and achievement of a target HbA1c level of less than 7%. In addition, the safety and tolerability of PHX1149 were not substantially different from placebo in this Phase 2b clinical trial or in our earlier Phase 2a and Phase 1 clinical trials. We expect to commence Phase 3 clinical trials of PHX1149 in the second half of 2008. At an end-of-Phase 2 meeting held in April 2008, the FDA agreed that we could proceed with our planned Phase 3 clinical trials and confirmed the scope of the trials necessary to support a marketing application for PHX1149. The number of subjects required to be treated and the duration of the Phase 3 clinical trials that we will be required to conduct are consistent with draft guidelines for diabetes clinical trials published by the FDA in February 2008. The FDA did not request an outcome study at the end-of-Phase 2 meeting. We plan to conduct a safety and efficacy study of PHX1149 in patients with impaired kidney function, as required by the FDA. Our second product candidate, PHX1766, is a protease inhibitor currently in preclinical development for the treatment of hepatitis C virus, or HCV, infection. We expect to commence Phase 1 clinical trials of PHX1766 in the second half of 2008. We discovered our product candidates using our “fast-follower” strategy for drug discovery, which is directed toward clinically validated therapeutic targets for which the pharmacological effect of a product candidate can be demonstrated in early-stage clinical trials. Using this strategy, we are identifying additional product candidates that we expect to advance into clinical development. We currently retain worldwide rights to both of our product candidates.

 

We are developing PHX1149 for the treatment of Type 2 diabetes, a chronic disease associated with abnormally high levels of glucose in the blood. Type 2 diabetes affects more than 160 million people worldwide, including approximately 18 million people in the United States. According to the American Diabetes Association, direct and indirect expenditures related to diabetes comprise 11% of all U.S. healthcare expenditures. In 2006, worldwide sales of diabetes medications totaled approximately $21 billion, with approximately $12 billion spent on oral anti-diabetic medications, or OADs. Despite existing therapies and increasing awareness of the need for careful glucose control, according to the National Health and Nutrition Examination Surveys, nearly two-thirds of patients diagnosed with Type 2 diabetes do not achieve and maintain proper control of blood glucose, as measured by HbA1c. Furthermore, many existing therapies result in common side effects, including an increased risk of hypoglycemia, or abnormally low blood glucose levels, weight gain and gastrointestinal problems, as well as less common adverse events such as heart attacks and congestive heart failure. As a result, we believe there is a need for improved therapies for Type 2 diabetes.

 

DPP-4 inhibitors represent a new class of OADs that improve the control of blood glucose and have a favorable tolerability profile. Sitagliptin, marketed by Merck & Co., Inc. as Januvia and Janumet, is the first DPP-4 inhibitor approved by the U.S. Food and Drug Administration, or the FDA, and the European Agency for the Evaluation of Medicinal Products, or EMEA, for the treatment of Type 2 diabetes. From its commercial launch in October 2006 through March 2008, sitagliptin has generated over $1.1 billion in worldwide sales. Although sitagliptin represents a significant advancement in the treatment of Type 2 diabetes, its product label reports various common side effects, including upper respiratory tract infections, nasal congestion and headache, as well as rare adverse events such as serious allergic and hypersensitivity reactions.

 

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Sitagliptin and other DPP-4 inhibitors under development have exhibited similar efficacy profiles as measured by reductions in HbA1c. As a result, we believe DPP-4 inhibitors will be differentiated in the market primarily based on their tolerability and convenience. Based on the results of our preclinical studies and clinical trials, we believe PHX1149 has the potential to compete with sitagliptin and other DPP-4 inhibitors in development for the treatment of Type 2 diabetes. In our Phase 2 clinical trials, the overall safety profile of PHX1149 was not significantly different from placebo. We have designed our ongoing and future clinical trials of PHX1149 to determine the level of HbA1c reduction in patients treated with an oral, once-daily administration of PHX1149 in monotherapy or in combination with other Type 2 diabetes therapies, and to further define the safety and tolerability of PHX1149.

 

Our second product candidate, PHX1766, is an orally available NS3/4A protease inhibitor, which we are developing for the treatment of HCV infection. HCV is the most common chronic blood-borne viral infection in the United States and a leading cause of liver failure, liver transplants and liver cancer. The Centers for Disease Control and Prevention, or the CDC, estimate that approximately 3.2 million people in the United States are chronically infected with HCV. The current standard of care for the treatment of HCV infection is a combination therapy of injected pegylated interferon and orally-administered ribavirin. However, this combination therapy has been associated with side effects, including neuropsychiatric and autoimmune disorders, anemia that may lead to heart attacks and an increased risk of birth defects or death of an unborn child. The side effect profile of the standard of care, together with its long duration of therapy and the requirement that interferon be administered by injection, may reduce patients’ motivation to initiate or continue HCV therapy under the standard of care. Furthermore, among patients infected with HCV genotype 1, the most prevalent form of HCV in the United States, only 42% to 46% achieve a sustained viral response, or SVR, which is defined as the absence of a detectable amount of HCV in the blood six months after completion of therapy.

 

Unlike interferons, which work by stimulating the immune system’s response to viral infection, HCV protease inhibitors directly target the virus by inhibiting NS3/4A protease, an enzyme that is necessary for viral replication. When tested in Phase 2 clinical trials, HCV protease inhibitors have reduced the levels of virus in the blood and, when added to the standard of care, provided greater SVR rates and a shorter duration of therapy compared to the standard of care alone. Based on our preclinical data, we believe PHX1766 may offer advantages over other HCV protease inhibitors in development, including an improved dosing regimen, higher potency and greater selectivity. We expect to commence clinical trials of PHX1766 in the second half of 2008.

 

We have an active discovery program focused on enzyme targets, specifically proteases, kinases and polymerases, which play a role in human diseases. Our strategy focuses on identifying new chemical entities directed toward clinically validated targets and for which a pharmacological effect can be demonstrated in early-stage clinical trials. We believe that by pursuing this strategy, we can reduce the risk associated with novel targets and the time required to advance a product candidate into clinical trials. Using this approach, we advanced PHX1149 into human clinical trials 27 months after initiating our DPP-4 inhibitor discovery program.

 

PHX1149 for the Treatment of Type 2 Diabetes

 

Type 2 Diabetes Overview

 

Type 2 diabetes is a complicated metabolic disorder that involves multiple components, including loss of sensitivity to the effects of insulin, a decrease in the body’s ability to produce insulin and overproduction of glucose by the liver. Normally, insulin regulates blood glucose levels by stimulating uptake and utilization of blood glucose in muscle and fat. Obesity, physical inactivity, positive family history of diabetes and aging are associated with an increased risk of developing Type 2 diabetes. The disease begins with insulin resistance, where the cells do not respond to insulin properly, causing blood glucose levels to increase. Over time, uncontrolled blood glucose levels persist and worsen due to the creation of a cycle in which higher blood glucose levels put more demand on the pancreas to produce insulin, which eventually causes beta cells, the insulin-producing cells in the pancreas, to lose their ability to produce enough insulin to control blood sugar. Uncontrolled diabetes results in abnormally high blood sugar levels, a condition known as hyperglycemia.

 

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Long-term hyperglycemia causes damage to large and small blood vessels, leading to a significantly increased risk of cardiovascular events, impaired kidney function, blindness, and nerve damage with pain in the extremities and poor circulation, which may necessitate amputation.

 

According to the World Health Organization, Type 2 diabetes accounted for approximately 90% of all diagnosed cases of diabetes in the world as of September 2006. The World Health Organization has also estimated that more than 180 million people worldwide are afflicted with diabetes, and this figure is projected to more than double by 2030. According to the American Diabetes Association, there were approximately 24.1 million diabetics in the United States in 2007, comprising approximately 8% of the total U.S. population, and only 17.5 million of these individuals had been diagnosed. The American Diabetes Association also reports that in 2007, diabetes cost the American economy approximately $174 billion in medical expenditures and lost productivity, with $116 billion in direct medical expenditures attributable to diabetes.

 

Limitations of Current Therapies for Type 2 Diabetes

 

Treatment of Type 2 diabetes is a complex, multi-step behavioral and medical approach to manage a patient’s blood glucose levels. The difficulty of managing Type 2 diabetes increases over time due to the progressive nature of the disease. Physicians generally prescribe modified diet and increased exercise when a patient is first diagnosed with Type 2 diabetes. However, lifestyle modifications often fail to achieve or maintain the target HbA1c goal of less than 7%, as recommended by the American Diabetes Association, and most patients will require drug therapy.

 

Most Type 2 diabetes patients initiate drug therapy with metformin, which works by lowering glucose production by the liver. Metformin is recommended as the initial drug therapy for Type 2 diabetes because of its efficacy, relatively low risk of side effects and low cost. However, many patients who begin treatment with metformin alone fail to maintain acceptable levels of blood glucose. According to an article published in the New England Journal of Medicine, 21% of patients fail metformin monotherapy at five years after treatment initiation, with failure defined as fasting plasma glucose of more than 180 mg per deciliter. In addition, an uncommon, but potentially fatal, side effect of treatment with metformin is lactic acidosis, which is caused by a buildup of lactic acid in the blood.

 

Due to the heterogeneous nature of the Type 2 diabetes patient population, current treatment guidelines suggest a variety of options for add-on medical treatment beyond lifestyle modification and metformin. Most commonly, physicians prescribe one of two classes of OADs, sulfonylureas and thiazolidinediones, or TZDs, both of which present significant risk of adverse side effects. Sulfonylureas, which have been available since the 1950s, work by stimulating beta cells in the pancreas to produce insulin. Relative to other OADs, advantages of sulfonylureas include their low cost and ability to achieve a rapid lowering of blood sugar. However, sulfonylureas may cause side effects, including weight gain and hypoglycemia. In addition, sulfonylureas do not slow the loss of beta cell function and may actually accelerate the death of beta cells. TZDs include pioglitazone, marketed by Eli Lilly & Company and Takeda Pharmaceutical Company Limited as Actos, and rosiglitazone, marketed by GlaxoSmithKline PLC as Avandia. This class of drugs works by increasing glucose uptake by skeletal muscle. TZDs appear to preserve the function of beta cells in the pancreas, thereby slowing the progression of Type 2 diabetes. However, TZDs are also associated with an increased risk of certain side effects, such as edema, or fluid retention, which leads to significant weight gain, and congestive heart failure and other cardiovascular events which may be life-threatening, such as heart attacks.

 

For patients with significantly higher levels of blood glucose, such as those with HbA1c greater than 8.5%, some physicians may recommend injected insulin therapy in addition to lifestyle modification and OADs. Potential side effects of injected insulin include weight gain and a significant risk of hypoglycemia. In addition, frequent injections reduce patient acceptance of, and compliance with, this therapeutic approach.

 

Exenatide, marketed by Eli Lilly & Company and Amylin Pharmaceuticals, Inc. as Byetta, is the first in a new class of Type 2 diabetes drugs known as glucagon-like peptide-1, or GLP-1, analogs. GLP-1 is an incretin, a naturally

 

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occurring hormone produced in the digestive system. In the presence of elevated glucose levels, such as after a meal, GLP-1 slows the emptying of the stomach, causes the brain to produce satiety signals and increases insulin secretion by improving the response of pancreatic beta cells to glucose stimulus, which reduces blood glucose by stimulating glucose uptake in tissues. In addition, GLP-1 causes the pancreas to produce less glucagon, which in turn causes the liver to produce less glucose. However, naturally occurring GLP-1 lasts only a few minutes in the body before it is naturally broken down by the enzyme DPP-4. Exenatide is a synthetic protein that works by the same mechanism as GLP-1 but lasts longer in the body. Exenatide may preserve beta cell function and also promotes weight loss, an important benefit in Type 2 diabetes patients, many of whom are overweight. However, patients who are on exenatide must administer the drug as a twice-daily injection and also experience a high rate of nausea, contributing to the discontinuation of treatment by approximately 29% of patients.

 

Many Type 2 diabetes patients are treated with multiple drugs in an effort to lower blood glucose levels and thereby reduce the risk of complications from the disease. The choice of what drug or drugs a particular patient uses to treat Type 2 diabetes involves many factors, including efficacy, severity of disease, patient compliance and the presence and type of co-existing conditions in the patient. Despite the side effect profiles and other limitations of traditionally prescribed OADs, insulin and incretins, worldwide sales of diabetes therapies totaled approximately $21 billion in 2006.

 

DPP-4 Inhibitors: A New Class of Oral Anti-Diabetic Treatments

 

DPP-4 inhibitors represent the most recently approved class of agents for the treatment of Type 2 diabetes. DPP-4 inhibitors prevent the enzyme DPP-4 from breaking down GLP-1, thereby increasing the levels of this hormone in the digestive tract and the blood. The increased levels of intact GLP-1 stimulate insulin production by the pancreatic beta cells and reduce glucagon production by the pancreas, both of which result in reduced blood glucose levels. In clinical trials to date, DPP-4 inhibitors have been well tolerated and have provided clinically meaningful reductions in HbA1c when used as the sole medical treatment, as well as important incremental decreases in HbA1c when used in combination with other anti-diabetic medications. DPP-4 inhibitors also offer several advantages over other types of diabetes therapies, including:

 

   

Absence of weight gain and edema. Unlike insulin, TZDs and sulfonylureas, DPP-4 inhibitors have not been associated with weight gain or edema.

 

   

Low risk of hypoglycemia. GLP-1 is most active when blood glucose levels are elevated and loses its activity when blood glucose is in the normal range. Unlike insulin and sulfonylureas, DPP-4 inhibitors have no effect once glucose levels reach a normal range. As a result, patients treated with DPP-4 inhibitors do not face an increased risk of hypoglycemia, which can be life-threatening in diabetics, compared to patients treated with insulin and sulfonylureas.

 

   

Potential for improved beta cell function. The beneficial effects of DPP-4 inhibitors on beta cells are believed to be due to their ability to enhance beta cell regeneration and inhibit beta cell apoptosis, or cell death, as shown in published preclinical studies. As a result, DPP-4 inhibitors may maintain, or even improve, beta cell function, resulting in greater insulin production and addressing one of the underlying causes of Type 2 diabetes and its progression.

 

In clinical trials, DPP-4 inhibitors, administered as monotherapy or in combination with other OADs, generally have been well tolerated and significantly reduced HbA1c levels. DPP-4 inhibitors have a mechanism of action similar to GLP-1 analogs, but with the advantage of oral administration, while GLP-1 analogs must be administered by injection. In addition, DPP-4 inhibitors do not appear to cause nausea, which has been observed in patients treated with exenatide. Because of their novel mechanism of action relative to other OADs, their ability to be administered orally and their safety profile, DPP-4 inhibitors represent an attractive therapy for use either in combination with other OADs or as a standalone therapy.

 

Sitagliptin, approved by the FDA in October 2006 and by the EMEA in March 2007, is the first DPP-4 inhibitor to be commercialized for the treatment of Type 2 diabetes. The commercial launch of sitagliptin has been one of the

 

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most successful among OADs, with worldwide sales of over $1.1 billion from its October 2006 launch through March 2008. The commercial success of sitagliptin demonstrates the demand for new OADs and the importance of DPP-4 inhibitors as a new class of treatments for Type 2 diabetes. The use of sitagliptin, both in combination with other therapies and as a standalone treatment, has expanded as physician awareness of the advantages of DPP-4 inhibitors and safety concerns surrounding TZDs have increased.

 

While sitagliptin represents a significant improvement in the treatment of Type 2 diabetes, it has been associated with several complications. In particular, sitagliptin’s product label indicates that patients treated with the drug have experienced various common side effects, including upper respiratory tract infections, nasal congestion and headache, as well as rare adverse events such as serious allergic and hypersensitivity reactions; anaphylaxis, a severe, whole-body allergic reaction; angioedema, or swelling under the skin, and Stevens-Johnson Syndrome, a severe skin reaction involving blistering of the skin.

 

In February 2007, Novartis AG, or Novartis, received an “approvable” letter from the FDA for its DPP-4 inhibitor, vildagliptin, which means that the FDA is prepared to approve vildagliptin for marketing in the United States if certain conditions are met. However, we believe these conditions, which may include a large new clinical trial, make it unlikely that Novartis will seek approval for vildagliptin in the United States before 2010, or at all. In February 2008, the EMEA approved vildagliptin for commercial sale in Europe, but the product label recommends that liver monitoring should be conducted at the start of treatment, every three months for the first year and periodically thereafter due to observations of elevated levels of certain liver enzymes, which indicate adverse effects on the liver in patients treated with the once-daily higher dose. In January 2008, Takeda Pharmaceutical Company Limited announced the filing of a new drug application, or NDA, with the FDA for alogliptin, which, if approved by the FDA, will likely be the second DPP-4 inhibitor introduced into the U.S. market for Type 2 diabetes treatments.

 

PHX1149: Our DPP-4 Inhibitor

 

Our lead product candidate, PHX1149, is an oral, once-daily DPP-4 inhibitor for the treatment of Type 2 diabetes. Our 174 patient 28-day Phase 2a clinical trial of PHX1149 in patients with Type 2 diabetes, which demonstrated that PHX1149 was well tolerated and met its primary endpoint of reduction in postprandial glucose levels in the intent-to-treat population. In our 12-week Phase 2b clinical trial involving 422 randomized patients, PHX1149 demonstrated statistically significant reductions in HbA1c when administered in combination with existing drugs for the treatment of Type 2 diabetes. We expect to commence Phase 3 clinical trials of PHX1149 in the second half of 2008.

 

Our Phase 2 and preclinical data suggest that PHX1149 has the potential to compete favorably with sitagliptin and other DPP-4 inhibitors in development due to the following characteristics:

 

 

 

Efficacy. In our 12-week Phase 2b clinical trial, PHX1149 demonstrated statistically significant reductions in HbA1c, as well as statistically significant effects on secondary efficacy endpoints, including change in fasting blood glucose levels, change in postprandial blood glucose levels and achievement of a target HbA1c level of less than 7%. This is consistent with the results from our 28-day Phase 2a clinical trial, where patients treated with PHX1149 experienced increased levels of GLP-1 and statistically significant reductions in postprandial glucose levels, similar to other DPP-4 inhibitors.

 

   

Tolerability. Published preclinical studies have demonstrated that compounds that inhibit other DPP family members, in particular those that inhibit both DPP-8 and DPP-9, have significantly greater toxicity than inhibitors that are selective for DPP-4. In our preclinical studies, PHX1149 demonstrated low cross-reactivity with other cellular targets closely related to DPP-4. We believe this characteristic reduces the potential for off-target effects from PHX1149 relative to less selective DPP-4 inhibitors. PHX1149 was well tolerated in our Phase 2 clinical trials. Overall adverse events in patients treated with PHX1149 in the Phase 2a trial did not differ significantly from placebo.

 

   

Convenience. In our Phase 2a clinical trial, we observed that mean percent inhibition of the DPP-4 enzyme at 24 hours after administration in patients treated with PHX1149 was 53%, 73% and 78% in the 100 mg, 200 mg and 400 mg dose levels, respectively, and maximal DPP-4 inhibition exceeded 80%

 

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for all dose levels. We observed similar DPP-4 inhibition in our Phase 2b clinical trial, which included 200 mg and 400 mg dose groups. Based on these results, we believe PHX1149 will be suitable for oral, once-daily administration with no time-of-day restrictions. From our study of food interaction in our Phase 1 clinical trials, we also expect that PHX1149 can be administered without regard to the timing of meals.

 

We also believe PHX1149 may have an improved safety profile relative to other DPP-4 inhibitors due to the following combination of characteristics:

 

   

Stable concentration profile over time. In our Phase 2a clinical trial, the concentration of PHX1149 in the blood stayed within a five-fold range over a 24-hour period. The stable drug levels of PHX1149 in the blood over time may enable PHX1149 to avoid potential safety concerns relative to other DPP-4 inhibitors in development that have a more pronounced peak of concentration shortly after administration.

 

   

Limited distribution within the body. DPP-4 is expressed both in the blood and locally in tissues. In addition to degrading GLP-1, DPP-4 also degrades other proteins, such as Substance P, that are locally expressed in tissues and promote inflammation there. Due to their inhibition of the DPP-4 present in tissues, DPP-4 inhibitors that penetrate into tissues may increase the risk of unintended inflammatory effects, such as sinus inflammation, nasal congestion and headache. Our studies demonstrate that PHX1149 has a low volume of distribution and negligible penetration into cells. Thus, PHX1149 may have a more limited distribution within the body than other DPP-4 inhibitors. As a result, we believe that PHX1149 may be less likely to cause some of the adverse events that have been reported in patients treated with other DPP-4 inhibitors that penetrate into tissues.

 

   

Favorable metabolism and excretion profile. Because PHX1149 is not metabolized in the liver, it is not susceptible to potential issues related to chemical by-products, or metabolites, which typically occur when drugs are broken down by the liver. Furthermore, PHX1149 does not interfere with the liver enzymes that metabolize other drugs, which reduces the potential for drug-drug interactions. Additionally, our data indicate that PHX1149 is excreted through the kidneys by means of a passive transport process, which may be preferred to active transport in patients with impaired kidney function.

 

Development History and Status

 

After completing extensive preclinical testing in animal diabetes models and the toxicology studies required by the FDA, we began our Phase 1 clinical trial of PHX1149 in healthy volunteers in September 2005. We filed an investigational new drug application, or IND, which included data from our Phase 1 clinical trials, with the FDA in March 2006. We initiated our first clinical trial of PHX1149 in Type 2 diabetes patients in the United States, Mexico and Australia in April 2006 and completed data analysis of this 28-day trial in January 2007. In April 2007, we initiated our 12-week Phase 2b clinical trial of PHX1149 involving 422 randomized Type 2 diabetes patients. The primary endpoint in this trial was change in HbA1c when PHX1149 is administered in combination with existing drugs for the treatment of Type 2 diabetes. In the first quarter of 2008, we completed our Phase 2b clinical trial, in which PHX1149 demonstrated statistically significant reductions in HbA1c. The Phase 1 and Phase 2 trials that we have conducted to date involved only a limited number of patients and will provide only a portion of the data needed to seek FDA approval. The additional trials needed for seeking FDA approval will require us to test a much larger patient population in more extensive trials, and the results from our earlier trials may not be consistent with the results from these larger trials.

 

Phase 2b clinical trial results. In the first quarter of 2008, we completed a 12-week double-blind, placebo-controlled Phase 2b clinical trial of PHX1149 involving 422 randomized patients. A double-blind, placebo-controlled clinical trial is a trial in which some subjects receive an inactive substance, or placebo, while other subjects receive the drug candidate under investigation, and neither the clinical investigator nor the subject knows whether the subject received the placebo or the investigational drug. Our Phase 2b clinical trial was conducted at approximately 70 clinical sites in the United States, Canada, Mexico, India and Argentina, and compared PHX1149 in once-daily doses of 200 mg and 400 mg, in combination with existing drugs for the treatment of Type 2 diabetes, to placebo. The primary endpoint of this trial was change in HbA1c. PHX1149 demonstrated statistically significant reductions in

 

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HbA1c in both the 200 mg and 400 mg dose groups. PHX1149 also demonstrated statistically significant effects on secondary efficacy endpoints, including change in fasting blood glucose levels, change in postprandial blood glucose levels and achievement of a target HbA1c level of less than 7%.

 

Phase 2a clinical trial results. We conducted a multi-center, randomized, double-blind, placebo-controlled, four-week trial of PHX1149 in 174 Type 2 diabetes patients who had suboptimal metabolic control and a baseline HbA1c of 7.3% to 11.0%. The patients in our Phase 2a trial were randomized 1:1:1:1 to receive once-daily oral administrations of either PHX1149 (in 100, 200, or 400 mg doses) or placebo. Throughout the duration of the trial, patients also received a constant background therapy of either metformin alone, or metformin and a TZD. The primary endpoint of the trial was decrease in postprandial glucose, and the secondary endpoint of the trial was increase in postprandial GLP-1.

 

Treatment with PHX1149 at each of the three dose levels met the primary endpoint of the trial, demonstrating a statistically significant decrease in postprandial glucose as measured by area under the curve, or AUC, defined as total concentration in the blood during the two hours after administration of PHX1149 or placebo, on day 28 compared to day 1. Treatment with PHX1149 also met the secondary endpoint of GLP-1, as measured by AUC on day 28 compared to day 1, demonstrating a statistically significant increase in postprandial GLP-1 at the 200 mg and 400 mg dose levels. The table below highlights the results from our Phase 2a clinical trial across all patient cohorts:

 

     28 days of treatment
          PHX1149

Metabolic parameter(1)

   Placebo (n=40)    100 mg (n=40)    200 mg (n=41)    400 mg (n=45)

Postprandial glucose D AUC

(mmol/L*hour)

   0.11 ± 0.500    -2.08 ± 0.513

p=0.002(2)

   -1.73 ± 0.489

p=0.008(2)

   -1.88 ± 0.477

p=0.004(2)

     Placebo (n=41)    100 mg (n=43)    200 mg (n=44)    400 mg (n=46)

Postprandial GLP-1 D AUC

(pmol/L*hour)

   3.90 ± 2.83    11.63 ± 2.86

p=0.053(2)

   16.42 ± 2.72

p=0.001(2)

   15.75 ± 2.71

p=0.002(2)

 

  (1)   D represents change in the applicable metabolic parameter at day 28 of dosing relative to values measured at baseline, prior to initiation of dosing.
  (2)   p-values are for each group treated with PHX1149 compared to placebo. A p-value is a statistical measure, with smaller numbers indicating a more statistically significant result.

 

We also observed that DPP-4 inhibition on day 28 was 53%, 73%, and 78% at 24 hours after administration of PHX1149 in the patient groups treated with doses of 100, 200, and 400 mg, respectively.

 

LOGO

 

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Overall, we observed no meaningful differences in the number or types of adverse events experienced by patients who were treated with PHX1149 and patients who received placebo. In summary, our Phase 2a trial demonstrated that the addition of PHX1149 to a stable regimen of metformin or metformin and a TZD in patients with Type 2 diabetes was well tolerated and improved blood glucose control.

 

Phase 1 clinical trials. We initiated our PHX1149 clinical program with a single-dose, sequential ascending dose trial in healthy volunteers. Subsequently, we conducted four additional Phase 1 clinical trials in healthy volunteers, testing doses of up to 3,200 mg (single dose) and 400 mg (daily dose for up to 13 days). The main objectives of these trials were to study pharmacokinetics, or the body’s responses to the drug, and pharmacodynamics, or the effects of the drug on the body, as well as safety and tolerability. PHX1149 showed dose-proportional increases in maximum blood plasma concentration, or Cmax, and AUC across the dose ranges evaluated. Cmax was reached at approximately two to four hours after dosing. The average half life of PHX1149 was approximately 10 to 13 hours, and no drug accumulation was observed in our repeat dose Phase 1 study. PHX1149 also demonstrated dose-dependent durable ex vivo DPP-4 inhibition. At the 400 mg dose level in the multiple dose study, greater than 80% plasma DPP-4 inhibition was measured over the entire 24 hour period. Lastly, in our ancillary studies of food interaction, which tested the 200 mg and 400 mg dose levels of PHX1149, food intake did not show an appreciable impact on DPP-4 inhibition. Overall, the results from our Phase 1 clinical trials demonstrated that PHX1149 is a potent, durable, DPP-4-selective inhibitor suitable for a once-daily dosing regimen independent of food intake.

 

Ongoing clinical trials. Patients who completed our Phase 2b clinical trial were given the option to enroll in an extension phase of the trial and receive a once-daily 400 mg dose of PHX1149 for up to two years. More than 90% of these patients have elected to enroll in this extension of the trial, which will provide us with long-term safety data for PHX1149.

 

Ancillary studies. We recently completed a thorough QTc study, in which we evaluated the effects of PHX1149 on certain parameters of electrical conductivity in the heart in approximately 50 healthy volunteers tested with a dose of PHX1149 near the anticipated labeled dose (400 mg), a much higher dose (3,200 mg), a positive control (moxifloxacin, 400 mg) and a placebo control. A thorough QTc study assesses the potential of a product candidate to delay cardiac repolarization, or the heart’s return to a resting state, as measured by the QT interval on a surface electrocardiogram, and is a standard study required by the FDA before it grants approval for any new molecular entity. Our QTc study was a four-arm cross-over study in which each participant received each treatment once as a single dose. Analysis of electrocardiograms showed that PHX1149 did not prolong the QT interval.

 

Future development plans. We anticipate that our Phase 3 clinical program for PHX1149 will be similar to those for other DPP-4 inhibitors and include approximately 2,500 patients treated with PHX1149 at the anticipated labeled dose. The Phase 3 program will consist of five or six registration trials of 24 weeks’ duration conducted at multiple worldwide sites. The primary endpoint of each of these trials will be reduction in HbA1c. In one of these trials, we will study patients who are not on background medications for Type 2 diabetes to support the use of PHX1149 as monotherapy. In the other trials, we will enroll patients on different background OADs such as metformin, sulfonylurea, TZDs and insulin to support the use of PHX1149 in combination with other OADs. As part of our Phase 3 program, we will also conduct a study to evaluate the safety and efficacy of PHX1149 in Type 2 diabetes patients with moderately to severely impaired kidney function. We expect to commence our Phase 3 trials in the second half of 2008.

 

PHX1766 for the Treatment of HCV Infection

 

HCV Overview

 

According to the CDC, HCV is the most common chronic blood-borne viral infection in the United States. The virus is a leading cause of liver failure, liver transplants and liver cancer. HCV is transmitted primarily through injection drug use and by pregnant women infected by the virus to their children in utero. In addition, HCV is often

 

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found among hemodialysis patients, hemophiliacs and recipients of blood transfusions before 1990. The World Health Organization estimates that nearly 180 million people worldwide, or approximately 3% of the world’s population, are infected with HCV. Of these individuals, 130 million are chronic HCV carriers with an increased risk of developing liver cirrhosis or liver cancer. According to the World Health Organization, HCV is responsible for more than half of all liver cancer cases and two-thirds of all liver transplants in the developed world, and it is estimated that three to four million people worldwide are newly infected each year, 70% of whom will develop chronic hepatitis C. The CDC estimate that approximately 3.2 million people in the United States are chronically infected with HCV. Because symptoms of the disease do not appear until its later stages, carriers often do not realize they are infected and serve as a source of transmission.

 

Limitations of Current Therapies for HCV Infection

 

The current standard of care for the treatment of HCV infection is a combination of a once-weekly injection of pegylated interferon and a twice-daily oral administration of ribavirin, an antiviral drug that interferes with viral replication. Pegylated interferon is a modified version of alpha-interferon, a protein that occurs naturally in the human body and stimulates the ability of the immune system to fight viral infections. Both pegylated interferon and ribavirin may cause side effects, the most common of which are flu-like symptoms, muscle pain, and headache for pegylated interferon, and anemia for ribavirin. In addition, the FDA has required that product labels for pegylated interferon and ribavirin include “black box” warnings due to their potential to cause serious side effects. These serious side effects include neuropsychiatric and autoimmune disorders in the case of pegylated interferon, and anemia that may lead to heart attacks in the case of ribavirin. Ribavirin also may cause birth defects or death of the fetus and is therefore not recommended for use by pregnant women. The side effect profile and long duration of therapy associated with the combination therapy of pegylated interferon and ribavirin, together with interferon’s administration by injection, may reduce patients’ motivation to initiate or continue HCV therapy under this standard of care.

 

In addition, according to an article published in Nature in 2005, only 42% to 46% of patients infected with HCV genotypes 1a and 1b who are treated with the standard of care respond with a sustained viral response, or SVR, defined as the absence of a detectable amount of the virus in the blood six months after the end of treatment. The same article reports that in the United States, HCV genotypes 1a and 1b are the two predominant strains of HCV and account for approximately 70% of HCV infections.

 

In response to the limitations of existing treatments for HCV infection, NS3/4A protease inhibitors have emerged as a potential alternative to the standard treatment. Unlike interferons, which work by stimulating the immune system’s response to viral infection, HCV protease inhibitors directly target the virus by inhibiting the NS3/4A protease. Accordingly, protease inhibitors may significantly improve treatment outcomes, when added to the standard of care in difficult-to-treat patients, including patients infected with HCV genotypes 1a and 1b, relative to treatment with the standard of care alone. The addition of protease inhibitors to the standard of care could also lead to shorter treatment duration, which could increase patient compliance. While NS3/4A protease inhibitors will likely initially be used in combination with pegylated interferon and ribavirin, it may be possible eventually to replace the treatment regimen under the current standard of care with a combination of oral therapies directed at HCV, including NS3/4A protease inhibitors.

 

The FDA has not approved any NS3/4A protease inhibitors for the treatment of HCV infection, but several pharmaceutical and biotechnology companies are developing product candidates that target the NS3/4A protease. The most advanced NS3/4A protease inhibitors are telaprevir and boceprevir, currently in advanced clinical trials by Vertex Pharmaceuticals Incorporated and Schering-Plough Corporation, respectively. Although these product candidates, when added to the standard of care, have demonstrated more favorable efficacy profiles in clinical trials relative to the standard of care alone, adverse events, including rash, in the case of telaprevir, and gastrointestinal discomfort, in the case of boceprevir, were observed in early clinical trials. In addition, telaprevir and boceprevir have been developed to date for dosing once every eight hours or once every 12 hours, which may prove to be an inconvenient treatment regimen for many patients.

 

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PHX1766: Our NS3/4A Protease Inhibitor

 

Our second product candidate, PHX1766, is an orally available NS3/4A protease inhibitor, which we are developing for the treatment of HCV infection. Under our HCV protease inhibitor program, initiated in April 2005, we initially characterized four internally discovered series of distinct chemical entities with a high level of structural and pharmacological diversity. We selected PHX1766 as a candidate for preclinical development in mid 2007. Subject to the results of our preclinical studies, we intend to initiate clinical trials of PHX1766 for the treatment of HCV infection in Europe in the second half of 2008.

 

We believe HCV protease inhibitors will be differentiated primarily based on their dosing regimen, potency, safety and tolerability. Based on our preclinical studies, we believe PHX1766 may offer the following advantages relative to other HCV protease inhibitors in development:

 

   

Improved dosing regimen. Our pharmacokinetic studies of PHX1766 in dogs demonstrated that a single dose produces and maintains concentration in the liver for 24 hours at levels much greater than the concentration levels required to inhibit replication of HCV genotype 1b in cell-based replicon assays. This suggests that PHX1766, if approved, may be administered once daily. In contrast, the most advanced NS3/4A protease inhibitors in development by others have been developed to date for dosing once every eight hours. We believe less frequent administration would increase patient compliance and could be an important commercial differentiator.

 

   

More potent inhibition of protease activity and viral replication. In our preclinical studies, PHX1766 demonstrated potent inhibition of the NS3/4A protease in all of the major HCV genotypes, 1a, 1b, 2a and 3a. In addition, data obtained in the standard laboratory cell-based replicon assays to determine anti-viral activity against HCV genotype 1b demonstrate that PHX1766 is greater than ten times more potent than either telaprevir or boceprevir in preventing replication of the virus. This feature, in addition to the pharmacokinetic properties of PHX1766 described above, may lead to a lower dose and less frequent administration than the most advanced treatments currently in development.

 

   

Greater selectivity against cellular targets. Some NS3/4A protease inhibitors inhibit certain cellular targets as much as they inhibit the intended viral target. In our preclinical studies, PHX1766 has demonstrated greater than 200 fold selectivity for the NS3/4A protease compared to other cellular targets. We expect that, due to its selectivity, PHX1766 may inhibit the NS3/4A protease without substantially inhibiting other cellular targets in patients infected with HCV, which may contribute to a favorable safety and tolerability profile.

 

Development Status

 

We have initiated toxicology studies of PHX1766. Subject to the results of these studies, we expect to initiate human clinical trials of PHX1766 in Europe in the second half of 2008. We anticipate the initial trial will be a traditional single dose, dose escalation study in healthy volunteers to gather safety and pharmacokinetic data. The next trial would include patients infected with HCV in a multi-dose trial to assess safety, tolerability and viral load reductions. We are also continuing to evaluate HCV protease inhibitors with chemical structures distinct from PHX1766 to identify second-generation product candidates.

 

Our Research Programs

 

We have focused our small-molecule drug discovery efforts on enzyme targets, including proteases, kinases and polymerases. Proteases are enzymes that break down specific proteins and are involved in various physiological reactions. Kinases are enzymes that add phosphate groups to certain amino acids within a protein, leading to various physiological reactions. Polymerases are enzymes that catalyze the formation of DNA or RNA using an existing strand of DNA or RNA as a template. We specifically direct our research efforts toward validated enzyme targets related to significant therapeutic markets and where we can identify chemistry improvements that we believe are not covered by existing patents. We are currently pursuing an NS5b polymerase inhibitor program for the treatment of HCV infection, a JAK-2/3 kinase inhibitor program for the

 

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treatment of myeloproliferative diseases or immune-related indications and a protease inhibitor program for the treatment of breast cancer, including treatment for patients with resistance to Herceptin and other similar drugs. Because the progress of these programs is highly uncertain, our portfolio of research programs is likely to change over time, and we may elect not to continue our drug discovery and development efforts for some or all of these targets.

 

Our discovery efforts begin with the selection of a biological target that has been validated through an existing marketed product or a product candidate under development that has demonstrated clinical effect in patients. In our target identification efforts, we also focus on biological targets in disease areas where we believe we can demonstrate some pharmacological activity in Phase 1 clinical trials and can therefore eliminate compounds with insufficient clinical activity early in development. Once we have identified a biological target to pursue, we conduct an extensive analysis of the patent landscape relevant to the target. If the patent situation appears to be sufficiently open, we formally initiate a research program for that drug target in order to identify new chemical entities for which we can file patent applications.

 

After we have selected an enzyme target of interest, we use our in-house chemistry capabilities to identify compounds that inhibit that target. We then optimize these compounds to improve the potency against the targeted enzyme, the selectivity against closely related proteins and the pharmacokinetics and pharmacodynamics of the compound. A key differentiator of our drug discovery and development capabilities is the degree to which we have successfully integrated potency and selectivity assays with pharmacokinetic and pharmacodynamic evaluations to identify clinical candidates. This is designed to ensure drug-like properties of our optimized lead compounds and increase the probability for successful development. We incorporate results from all of these assays to design subsequent potential drug compounds using an iterative approach. As a result, we are able to simultaneously improve multiple characteristics of our enzyme inhibitors to increase the quality of our product candidates and decrease the time required for our discovery efforts.

 

Our Strategy

 

Our goal is to become a leading biopharmaceutical company focused on the discovery, development and commercialization of novel small-molecule product candidates directed toward clinically validated targets that address significant therapeutic markets. The core elements of our strategy include:

 

   

Obtaining regulatory approval for our lead product candidate, PHX1149. We are devoting a significant portion of our financial resources and management efforts to advancing the development of PHX1149. We expect to initiate Phase 3 clinical trials of PHX1149 for treatment of Type 2 diabetes in the second half of 2008.

 

   

Advancing PHX1766 into clinical trials. We are conducting preclinical studies of PHX1766. Subject to the results of these studies, we expect to initiate Phase 1 clinical trials of PHX1766 for the treatment of HCV infection in the second half of 2008.

 

   

Expanding our product pipeline. We intend to use our “fast follower” strategy to expand our product pipeline. We believe that our discovery model is reproducible, scalable and sustainable because we focus our research efforts on validated biological targets. Through this strategy, we expect to be able to advance additional product candidates into preclinical and clinical development.

 

   

Retaining significant economic value for our product candidates. We intend to maximize the value of our product candidates through both independent development and licensing and other partnership opportunities. This may include co-development or co-marketing agreements or licensing agreements with pharmaceutical and biotechnology companies that possess established development and commercialization capabilities. To date, we have not entered into any of these types of arrangements. If the FDA approves any of our product candidates for marketing, we may also pursue direct commercialization by building our own sales and marketing force.

 

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Intellectual Property

 

We actively seek patent protection and regulatory exclusivity for the proprietary technology that we consider important to our business, including novel chemical scaffolds, compounds, compositions and formulations, their methods of use and processes for their manufacture. In addition to seeking patent protection in the United States, we generally file patent applications in Canada, Europe, Japan and other countries on a selective basis to protect the inventions that we consider important to the development of our business worldwide. We also rely on in-licensed technology, trade secrets, know-how and continuing technological innovation to develop and maintain our proprietary position. Our success depends in part on our ability to obtain and maintain proprietary protection for our product candidates, technology and know-how, to operate without infringing the proprietary rights of others, and to prevent others from infringing our proprietary rights.

 

We currently hold one issued U.S. patent related to the composition of matter and method of use of PHX1149. We have filed 13 U.S. patent applications (five of which are provisional applications) and 34 foreign and Patent Cooperation Treaty, or PCT, applications related to our DPP-4 inhibitor program, including 12 U.S. patent applications and 31 foreign and PCT applications that relate to PHX1149. These patent applications are intended to cover various aspects of PHX1149, including its composition, its methods of use, the use of PHX1149 both alone and in combination with other Type 2 diabetes drugs and the manufacture of PHX1149. Any patents that may be granted on our patent applications for our DPP-4 inhibitor program would be entitled to patent terms that extend until at least November 2023. In addition, we have licensed a total of seven U.S. patents and patent applications, and 41 U.S. foreign patents and patent applications. This license agreement is described below under “—Material Agreements—License Agreement relating to DPP-4.”

 

We have filed a total of nine U.S. patent applications and ten foreign and PCT applications related to chemical classes of molecules that we have identified as possible inhibitors of the NS3/4A protease. The claims in these applications are intended to cover composition of matter and therapeutic uses of certain compounds for the treatment of HCV infection, including PHX1766. Any patents that may be granted on these patent applications would be entitled to patent terms that extend until at least July 2026.

 

As we identify potential clinical candidates, we intend to file additional U.S. and foreign patent applications covering compositions of matter, therapeutic uses, combination therapies and methods of manufacture for these potential candidates.

 

In addition to patents, we may rely, in some circumstances, on trade secrets to protect our technology. We seek to protect the trade secrets in our proprietary technology and processes, in part, by entering into confidentiality agreements with employees, consultants, scientific advisors and other contractors and into invention assignment agreements with our employees and some of our consultants. These agreements are designed to protect our proprietary information and, in the case of the invention assignment agreements, to grant us ownership of the technologies that are developed.

 

Manufacturing

 

We do not own or operate manufacturing facilities for the production of our product candidates or preclinical compounds, nor do we have plans to develop our own manufacturing operations in the foreseeable future. We currently depend on third-party contract manufacturers for all of our requirements of raw materials, active pharmaceutical ingredients and finished product for our preclinical research and clinical trials. We do not have any current contractual arrangements for the manufacture of commercial supplies of any of our product candidates. If PHX1149 is approved by the FDA and we undertake efforts to commercialize it internally, we intend to enter into agreements with third-party contract manufacturers for the commercial production of PHX1149. We employ internal resources and third-party consultants to manage our manufacturing contractors.

 

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Competition

 

The biotechnology and pharmaceutical industries are highly competitive. There are many pharmaceutical companies, biotechnology companies, public and private universities and research organizations actively engaged in the research, development and commercialization of products that may be similar to our product candidates or are directed at similar therapeutic indications as our product candidates. Several multinational pharmaceutical companies are pursuing the development or marketing of pharmaceuticals that target diabetes or hepatitis C, and we expect the competition to commercialize products and therapies for the treatment of diabetes and hepatitis C will increase. Many of our existing or potential competitors have substantially greater financial, technical and human resources than we do and may be better equipped to develop, manufacture and market products. These companies may develop and introduce products and processes competitive with or superior to ours. In addition, other technologies or products may be developed that have an entirely different approach or means of accomplishing the intended purposes of our products, which might render our technology and products noncompetitive or obsolete.

 

In the market for Type 2 diabetes treatments, we expect to face direct competition from other companies that are developing and marketing DPP-4 inhibitors, including Merck & Co., Inc., which markets sitagliptin worldwide, Novartis AG, which recently received approval from the EMEA to market vildagliptin in Europe, and Takeda Pharmaceutical Company Limited, which recently submitted an NDA for alogliptin. We are aware that several other companies, including Amgen, Inc., Boehringer Ingelheim GmbH, and Bristol-Myers Squibb Company in collaboration with AstraZeneca PLC, also have DPP-4 inhibitors in various stages of development. We will also compete with companies that develop and market GLP-1 analogs, such as Amylin Pharmaceuticals, Inc. and Eli Lilly and Company, which currently market exenatide in the United States and Europe, and Novo Nordisk A/S, which is developing liraglutide. In addition, we will also face competition from developers and manufacturers of other Type 2 diabetes treatments, including TZDs and sulfonylureas. To a lesser extent, we may also compete with developers and manufacturers of biguanides, such as metformin, and insulins, which we believe might be used in combination with PHX1149, if approved, because control of diabetes often requires more than one medication.

 

A number of companies are pursuing the development or commercialization of pharmaceuticals that target HCV. These competitive products include several classes of products and product candidates that may be used either alone or in combination with other therapies. We expect to face direct competition from other companies that are developing NS3/4A protease inhibitors. While no NS3/4A protease inhibitors are currently approved for the treatment of HCV infection, several compounds are in clinical development, including telaprevir and boceprevir (currently in advanced clinical trials being conducted by Vertex Pharmaceuticals Incorporated and Schering-Plough Corporation, respectively), ITMN-191 (under development by InterMune, Inc. in collaboration with Hoffmann-La Roche Inc.) and TMC-435350 (under development by Medivir AB, in collaboration with Tibotec Pharmaceuticals Ltd., a subsidiary of Johnson & Johnson). To a lesser extent, we may also face competition from developers of NS5b polymerase inhibitors, which we believe might be used in combination with NS3/4A protease inhibitors to treat HCV infection because control of HCV infection may require more than one medication. While no NS5b polymerase inhibitors are currently approved for the treatment of HCV, several compounds are in clinical development, including R1626 (under development by Hoffmann-La Roche Inc.), PF-868554 (under development by Pfizer, Inc.), R-7128 (under development by Hoffmann-La Roche Inc. in collaboration with Pharmasset, Inc.), MK-0608 (under development by Merck & Co., Inc.) and GS-9190 (under development by Gilead Sciences, Inc.).

 

Material Agreements

 

License Agreement relating to DPP-4

 

In February 2006, we entered into a license agreement, pursuant to which we obtained a non-exclusive, royalty-bearing worldwide sublicense to intellectual property rights relating to certain DPP-4-inhibiting compounds for use in the treatment of diabetes or lowering glucose levels, licensed by our licensor from third

 

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parties. The license covers, among other things, the development and commercialization of PHX1149 alone or in combination with other drugs for treating diabetes in the licensed field. We may grant sublicenses under the license, subject to certain limitations. We do not have control over the preparation, filing, prosecution or maintenance of the licensed patent rights. These activities are controlled solely by the original licensors, subject to their obligations to our licensor.

 

Pursuant to the license agreement, we paid fees totaling $5.0 million in 2006. We will be required to make additional milestone payments to our licensor of up to $10.0 million upon the achievement of specified regulatory and commercial milestones with respect to PHX1149. We are also obligated to pay single-digit royalties on net sales of products covered by the license through the term of the agreement.

 

This license agreement will remain in effect until the expiration of the last-to-expire licensed patent right unless the agreement is earlier terminated. We have the right to terminate the license agreement for convenience upon 30 days’ prior written notice to the licensor. The licensor may terminate the agreement for our uncured material breach of the agreement or our uncured failure to make payments to the licensor when due. Additionally, the original licensors may terminate their licenses to our licensor, which would leave some of our existing development activities and product candidates unlicensed and potentially infringing on these third-party patents if we are unable to enter into license agreements directly with the original licensors.

 

Settlement and License Agreements with ActivX Biosciences, Inc.

 

In August 2006, we entered into settlement and license agreements with ActivX Biosciences, Inc., or ActivX, related to claims that we had misappropriated certain ActivX trade secrets related to DPP-4 inhibitor technology.

 

Under the settlement agreement, we have made payments to ActivX of $1.5 million. We will be required to make additional payments to ActivX of up to $6.0 million in connection with any collaboration, strategic partnership or license transactions that we may enter into with third parties, and the achievement of certain regulatory milestones, in each case with respect to PHX1149 and other compounds covered under our license grant to ActivX. We are also obligated under the settlement agreement to make royalty payments to ActivX in an aggregate amount of up to $35.0 million on net sales of products covered under the agreement, which would include PHX1149, so long as any of the products are covered by a valid claim of any U.S. or foreign patent or patent application contained within the subject patent rights. We have the right to stop payment of all fees and royalties owed to ActivX under the settlement agreement only if ActivX is in default of any material obligation under the agreement and fails to cure the default within 30 days of its receipt of written notice from us regarding the default.

 

Pursuant to the license agreement, we granted to ActivX a fully paid-up, royalty-free, co-exclusive, worldwide license to develop and commercialize products under certain of our patents and patent applications not including those relating to PHX1149 and related analogs. We control the filing, prosecution and maintenance of all patents and patent applications covered under the license agreement. If we elect not to pursue, or if we abandon the pursuit or maintenance of, a patent or patent application included within the licensed rights, ActivX will have the right, at its expense, to require us to file, pursue or maintain the applicable patents or patent applications in good faith. In addition, we are solely responsible for defending against any assertions of invalidity or unenforceability of the licensed rights, and we have the sole right to pursue actions against third parties for the infringement of these rights.

 

Our license agreement with ActivX will remain in effect until the expiration of the last-to-expire licensed patent right. We have the right to terminate the license agreement for ActivX’s uncured material breach of the license agreement or the settlement agreement, if ActivX is the subject of certain bankruptcy or insolvency proceedings, or if ActivX directly or indirectly challenges, or supports the challenge of, the validity of any of the patents or patent applications covered by the license agreement.

 

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Master Security Agreement with Oxford Finance Corporation

 

In March 2004, we entered into a master security agreement with Oxford Finance Corporation, or Oxford, under which Oxford has made loans to us in an aggregate principal amount of approximately $781,000 to finance capital equipment expenditures. As of March 31, 2008, there was $7,000 in principal outstanding under the loans from Oxford, all of which we repaid in April 2008. Under the master security agreement, we granted to Oxford a security interest in and against certain collateral to secure the payment of our indebtedness to Oxford, which is evidenced by promissory notes. Oxford is under no obligation to release the collateral unless and until all debts, obligations and liabilities have been paid and satisfied. In connection with the borrowings under the master security agreement, we have issued to Oxford warrants to purchase shares of our common stock. As of February 29, 2008, these warrants were exercisable for 141 shares of our common stock at an exercise price of $10.50 per share.

 

Loan and Security Agreement with Pinnacle Ventures, L.L.C.

 

In November 2006, we entered into a loan and security agreement with Pinnacle Ventures L.L.C., or Pinnacle, under which affiliates of Pinnacle have made loans to us in an aggregate principal amount of $8.0 million. As of March 31, 2008, there was $6.6 million in principal outstanding under this agreement. Under the terms of a December 2007 amendment to this agreement, the affiliates of Pinnacle have agreed to make additional term loans of up to $12.0 million to us on or before May 31, 2008. These loans all bear interest at a fixed rate equal to the prime rate in effect as of the date of each loan, plus two percent and are evidenced by secured promissory notes that mature 36 months from the date of the loan. Repayments on each loan include an interest-only period of six months, followed by 30 equal monthly installments of principal and interest. Under the terms of the original loan and security agreement, we issued to Pinnacle a warrant to purchase up to 137,143 shares of our Series B preferred stock at an exercise price of $3.50 per share. Under the terms of the December 2007 amendment, we issued to Pinnacle a warrant to purchase 115,384 shares of our Series C preferred stock at an exercise price of $4.16 per share. This warrant will become exercisable for up to an additional 57,693 shares of Series C preferred stock at an exercise price of $4.16 per share if we borrow the $12.0 million available to us under the amendment.

 

Regulatory Matters

 

Government Regulation and Product Approval

 

Government authorities in the United States, at the federal, state and local level, and other countries extensively regulate, among other things, the research, development, testing, manufacture, quality control, approval, labeling, packaging, storage, record-keeping, promotion, advertising, distribution, marketing and export and import of products such as those we are developing. Our product candidates must be approved by the FDA through the NDA process before they may be legally marketed in the United States.

 

U.S. Drug Development Process

 

In the United States, the FDA regulates drugs under the Federal Food, Drug, and Cosmetic Act, or FDCA, and implements regulations. The process of obtaining regulatory approvals and the subsequent compliance with appropriate federal, state, local, and foreign statutes and regulations require the expenditure of substantial time and financial resources. Failure to comply with the applicable U.S. requirements at any time during the product development process, approval process or after approval, may subject an applicant to administrative or judicial sanctions. These sanctions could include the FDA’s refusal to approve pending applications, withdrawal of an approval, a clinical hold, warning letters, product recalls, product seizures, total or partial suspension of production or distribution injunctions, fines, refusals of government contracts, restitution, disgorgement, or civil or criminal penalties. Any agency or judicial enforcement action could have a material adverse effect on us. The process required by the FDA before a drug may be marketed in the United States generally involves the following:

 

   

completion of preclinical laboratory tests, animal studies and formulation studies according to Good Laboratory Practices or other applicable regulations;

 

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submission to the FDA of an IND application which must become effective before human clinical trials may begin;

 

   

performance of adequate and well-controlled human clinical trials according to Good Clinical Practices to establish the safety and efficacy of the proposed drug for its intended use;

 

   

submission to the FDA of an NDA;

 

   

satisfactory completion of an FDA inspection of the manufacturing facility or facilities at which the drug is produced to assess compliance with current good manufacturing practice, or cGMP, to assure that the facilities, methods and controls are adequate to preserve the drug’s identity, strength, quality and purity; and

 

   

FDA review and approval of the NDA.

 

The testing and approval process requires substantial time, effort and financial resources, and we cannot be certain that any approvals for our product candidates will be granted on a timely basis, if at all.

 

Once a pharmaceutical candidate is identified for development, it enters the preclinical testing stage. Preclinical tests include laboratory evaluations of product chemistry, toxicity and formulation, as well as animal studies. An IND sponsor must submit the results of the preclinical tests, together with manufacturing information and analytical data, to the FDA as part of the IND. The sponsor will also include a protocol detailing, among other things, the objectives of the first phase of the clinical trial, the parameters to be used in monitoring safety, and the effectiveness criteria to be evaluated, if the first phase lends itself to an efficacy evaluation. Some preclinical testing may continue even after the IND is submitted. The IND automatically becomes effective 30 days after receipt by the FDA, unless the FDA, within the 30-day time period, places the clinical trial on a clinical hold. In such a case, the IND sponsor and the FDA must resolve any outstanding concerns before the clinical trial can begin. Clinical holds also may be imposed by the FDA at any time before or during studies due to safety concerns or non-compliance.

 

All clinical trials must be conducted under the supervision of one or more qualified investigators in accordance with good clinical practice regulations. These regulations include the requirement that all research subjects provide informed consent. Further, an institutional review board, or IRB, must review and approve the plan for any clinical trial before it commences at any institution. An IRB considers, among other things, whether the risks to individuals participating in the trials are minimized and are reasonable in relation to anticipated benefits. The IRB also approves the information regarding the trial and the consent form that must be provided to each trial subject or his or her legal representative and must monitor the study until completed.

 

Each new clinical protocol must be submitted to the IND for FDA review, and to the IRBs for approval. Protocols detail, among other things, the objectives of the study, dosing procedures, subject selection and exclusion criteria, and the parameters to be used to monitor subject safety.

 

Human clinical trials are typically conducted in three sequential phases that may overlap or be combined:

 

   

Phase 1: The drug is initially introduced into healthy human subjects and tested for safety, dosage tolerance, absorption, metabolism, distribution and excretion. In the case of some products for severe or life-threatening diseases, especially when the product may be too inherently toxic to ethically administer to healthy volunteers, the initial human testing is often conducted in patients.

 

   

Phase 2: Involves studies in a limited patient population to identify possible adverse effects and safety risks, to preliminarily evaluate the efficacy of the product for specific targeted diseases and to determine dosage tolerance and optimal dosage.

 

   

Phase 3: Clinical trials are undertaken to further evaluate dosage, clinical efficacy and safety in an expanded patient population at geographically dispersed clinical trial sites. These studies are intended to establish the overall risk-benefit ratio of the product and provide, if appropriate, an adequate basis for product labeling.

 

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Progress reports detailing the results of the clinical trials must be submitted at least annually to the FDA and written IND safety reports must be submitted to the FDA and the investigators for serious and unexpected adverse events or any finding from tests in laboratory animals that suggests a significant risk for human subjects. Phase 1, Phase 2 and Phase 3 testing may not be completed successfully within any specified period, if at all. The FDA or the sponsor may suspend a clinical trial at any time on various grounds, including a finding that the research subjects or patients are being exposed to an unacceptable health risk. Similarly, an IRB can suspend or terminate approval of a clinical trial at its institution if the clinical trial is not being conducted in accordance with the IRB’s requirements or if the drug has been associated with unexpected serious harm to patients.

 

Concurrent with clinical trials, companies usually complete additional animal studies and must also develop additional information about the chemistry and physical characteristics of the drug and finalize a process for manufacturing the product in commercial quantities in accordance with cGMP requirements. The manufacturing process must be capable of consistently producing quality batches of the product candidate and, among other things, the manufacturer must develop methods for testing the identity, strength, quality and purity of the final drug. Additionally, appropriate packaging must be selected and tested and stability studies must be conducted to demonstrate that the product candidate does not undergo unacceptable deterioration over its shelf life.

 

U.S. Review and Approval Processes

 

The results of product development, preclinical studies and clinical trials, along with descriptions of the manufacturing process, analytical tests conducted on the chemistry of the drug, proposed labeling, and other relevant information are submitted to the FDA as part of an NDA requesting approval to market the product. The submission of an NDA is subject to the payment of user fees; a waiver of such fees may be obtained under certain limited circumstances.

 

In addition, under the Pediatric Research Equity Act of 2003, or PREA, an NDA or supplement to an NDA must contain data to assess the safety and effectiveness of the drug for the claimed indications in all relevant pediatric subpopulations and to support dosing and administration for each pediatric subpopulation for which the drug is safe and effective. The FDA may grant deferrals for submission of data or full or partial waivers. Unless otherwise required by regulation, PREA does not apply to any drug for an indication for which orphan designation has been granted.

 

The FDA reviews all NDAs submitted to ensure that they are sufficiently complete for substantive review before it accepts them for filing. The FDA may request additional information rather than accept an NDA for filing. In this event, the NDA must be resubmitted with the additional information. The resubmitted application also is subject to review before the FDA accepts it for filing. Once the submission is accepted for filing, the FDA begins an in-depth substantive review. The FDA may refer the NDA to an advisory committee for review, evaluation and recommendation as to whether the application should be approved and under what conditions. The FDA is not bound by the recommendation of an advisory committee, but it generally follows these recommendations. The approval process is lengthy and difficult, and the FDA may refuse to approve an NDA if the applicable regulatory criteria are not satisfied or may require additional clinical or other data and information. Even if such data and information are submitted, the FDA may ultimately decide that the NDA does not satisfy the criteria for approval. Data obtained from clinical trials are not always conclusive and the FDA may interpret data differently than we interpret the same data and may use alternative statistical methods as measures to calculate efficacy and safety. The FDA may issue an approvable letter, which may require additional clinical or other data or impose other conditions that must be met in order to secure final approval of the NDA. The FDA reviews an NDA to determine, among other things, whether a product is safe and effective for its intended use and whether its manufacturing is cGMP-compliant to assure and preserve the product’s identity, strength, quality and purity. Before approving an NDA, the FDA will inspect the facility or facilities where the product candidate is manufactured.

 

NDAs receive either standard or priority review. A product candidate representing a significant improvement in treatment, prevention or diagnosis of disease or providing treatment where no adequate therapy

 

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exists may receive priority review. In addition, product candidates studied for their safety and effectiveness in treating serious or life-threatening illnesses and that provide meaningful therapeutic benefit over existing treatments may receive accelerated approval and may be approved on the basis of adequate and well-controlled clinical trials establishing that the drug product has an effect on a surrogate endpoint that is reasonably likely to predict clinical benefit or on the basis of an effect on a clinical endpoint other than survival or irreversible morbidity. As a condition of approval, the FDA may require that a sponsor of a product candidate receiving accelerated approval perform adequate and well-controlled post-marketing clinical trials. Priority review and accelerated approval do not change the standards for approval, but may expedite the approval process. If a product candidate receives regulatory approval, the approval may be significantly limited to specific diseases and dosages or the indications for use may otherwise be limited, which could restrict the commercial value of the product. In addition, the FDA may require us to conduct Phase 4 testing which involves clinical trials designed to further assess a drug’s safety and effectiveness after NDA approval, and may require testing and surveillance programs to monitor the safety of approved products which have been commercialized.

 

Patent Term Restoration and Marketing Exclusivity

 

Depending upon the timing, duration and specifics of FDA approval of the use of our product candidates, some of our U.S. patents may be eligible for limited patent term extension under the Drug Price Competition and Patent Term Restoration Act of 1984, referred to as the Hatch-Waxman Amendments. The Hatch-Waxman Amendments permit a patent restoration term of up to five years as compensation for patent term lost during product development and the FDA regulatory review process. However, patent term restoration cannot extend the remaining term of a patent beyond a total of 14 years from the product’s approval date. The patent term restoration period is generally one-half the time between the effective date of an IND and the submission date of an NDA, plus the time between the submission date of an NDA and the approval of that application. Only one patent applicable to an approved drug is eligible for the extension and the extension must be applied for prior to expiration of the patent. The U.S. Patent and Trademark Office, in consultation with the FDA, reviews and approves the application for any patent term extension or restoration. In the future, we intend to apply for restorations of patent terms for some of our currently owned or licensed patents to add patent life beyond their current expiration dates, depending on the expected length of clinical trials and other factors involved in the filing of the relevant NDA.

 

Market exclusivity provisions under the FDCA also can delay the submission or the approval of certain applications. The FDCA provides a five-year period of non-patent marketing exclusivity within the U.S. to the first applicant to gain approval of an NDA for a new chemical entity. A drug is a new chemical entity if the FDA has not previously approved any other new drug containing the same active moiety, which is the molecule or ion responsible for the action of the drug substance. During the exclusivity period, the FDA may not accept for review an abbreviated new drug application, or ANDA, or a 505(b)(2) NDA submitted by another company for another version of such drug where the applicant does not own or have a legal right of reference to all the data required for approval. However, an application may be submitted after four years if it contains a certification of patent invalidity or non-infringement. The FDCA also provides three years of marketing exclusivity for an NDA, 505(b)(2) NDA or supplement to an existing NDA if new clinical investigations, other than bioavailability studies, that were conducted or sponsored by the applicant are deemed by FDA to be essential to the approval of the application; for example, for new indications, dosages, or strengths of an existing drug. This three-year exclusivity covers only the conditions associated with the new clinical investigations and does not prohibit the FDA from approving ANDAs for drugs containing the original active agent. Five-year and three-year exclusivity will not delay the submission or approval of a full NDA; however, an applicant submitting a full NDA would be required to conduct or obtain a right of reference to all of the preclinical studies and adequate and well-controlled clinical trials necessary to demonstrate safety and effectiveness.

 

Pediatric exclusivity is another type of exclusivity in the U.S. Pediatric exclusivity, if granted, provides an additional six months to an existing exclusivity or statutory delay in approval resulting from a patent certification. This six-month exclusivity, which runs from the end of other exclusivity protection or patent delay,

 

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may be granted based on the voluntary completion of a pediatric study in accordance with an FDA-issued “Written Request” for such a study. The pediatric exclusivity provision was reauthorized on September 27, 2007.

 

Post-Approval Requirements

 

Once an approval is granted, the FDA may withdraw the approval if compliance with regulatory standards is not maintained or if problems occur after the product reaches the market. Later discovery of previously unknown problems with a product may result in restrictions on the product or even complete withdrawal of the product from the market. After approval, some types of changes to the approved product, such as adding new indications, manufacturing changes and additional labeling claims, are subject to further FDA review and approval. Drug manufacturers and other entities involved in the manufacture and distribution of approved drugs are required to register their establishments with the FDA and certain state agencies, and are subject to periodic unannounced inspections by the FDA and certain state agencies for compliance with cGMP and other laws. We rely, and expect to continue to rely, on third parties for the production of clinical and commercial quantities of our products. Future FDA and state inspections may identify compliance issues at the facilities of our contract manufacturers that may disrupt production or distribution, or require substantial resources to correct.

 

Any drug products manufactured or distributed by us pursuant to FDA approvals are subject to continuing regulation by the FDA, including, among other things, record-keeping requirements, reporting of adverse experiences with the drug, providing the FDA with updated safety and efficacy information, drug sampling and distribution requirements, complying with certain electronic records and signature requirements, and complying with FDA promotion and advertising requirements. The FDA strictly regulates labeling, advertising, promotion and other types of information on products that are placed on the market. Drugs may be promoted only for the approved indications and in accordance with the provisions of the approved label.

 

From time to time, legislation is drafted, introduced and passed in Congress that could significantly change the statutory provisions governing the approval, manufacturing and marketing of products regulated by the FDA. For example, on September 27, 2007, the Food and Drug Administration Amendments Act of 2007 was enacted, giving the FDA enhanced postmarket authority, including the authority to require postmarket studies and clinical trials, labeling changes based on new safety information, and compliance with a risk evaluation and mitigation strategy approved by the FDA. The FDA’s postmarket authority takes effect 180 days after the enactment of the law. Failure to comply with any requirements under the new law may result in significant penalties. The new law also authorizes significant civil money penalties for the dissemination of false or misleading direct-to-consumer advertisements, and allows the FDA to require companies to submit direct-to-consumer television drug advertisements for FDA review prior to public dissemination. Additionally, the new law expands the clinical trial registry so that sponsors of all clinical trials, except for Phase 1 trials, are required to submit certain clinical trial information for inclusion in the clinical trial registry data bank. In addition to new legislation, FDA regulations and guidance are often revised or reinterpreted by the agency in ways that may significantly affect our business and our products. It is impossible to predict whether further legislative changes will be enacted, or FDA regulations, guidance or interpretations changed or what the impact of such changes, if any, may be.

 

Foreign Regulation

 

In addition to regulations in the United States, we expect to be subject to a variety of foreign regulations governing clinical trials and commercial sales and distribution of our products. Whether or not we obtain FDA approval for a product, we must obtain approval of a product by the comparable regulatory authorities of foreign countries before we can commence clinical trials or marketing of the product in those countries. The approval process varies from country to country and the time may be longer or shorter than that required for FDA approval. The requirements governing the conduct of clinical trials, product licensing, pricing and reimbursement vary greatly from country to country.

 

Under European Union regulatory systems, we may submit marketing authorization applications either under a centralized or decentralized procedure. Use of the centralized procedure is mandatory for drugs

 

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developed by means of certain biotechnological processes; orphan drugs; and drugs containing a new active substance, if the substance has not been authorized in the Community before November 20, 2005, and the therapeutic indication is AIDS, cancer, a neurodegenerative disorder, or diabetes. It is optional for new active substances or products that constitute a significant therapeutic, scientific, or technical innovation, or if the granting of a single authorization is in the interest of patients; and for generic or similar biological medicinal products. For drugs without a marketing authorization in any member state, the decentralized procedure provides for approval by one or more member states of an assessment of an application performed by one member state, known as the reference member state. Under this procedure, an applicant submits an application, or dossier, and related materials (draft summary of product characteristics, draft labeling and package leaflet) to the reference member state and concerned member states. The reference member state prepares a draft assessment and drafts of the related materials within 120 days after receipt of a valid application. Within 90 days of receiving the reference member state’s assessment report, each concerned member state must decide whether to approve the assessment report and related materials. If a member state cannot approve the assessment report and related materials on the grounds of potential serious risk to public health, the disputed points may eventually be referred to the European Commission, whose decision is binding on all member states.

 

Reimbursement

 

Sales of pharmaceutical products depend in significant part on the availability of third-party reimbursement. Third-party payors include government health administrative authorities, managed care providers, private health insurers and other organizations. We anticipate third-party payors will provide reimbursement for our products. However, these third-party payors are increasingly challenging the price and examining the cost-effectiveness of medical products and services. In addition, significant uncertainty exists as to the reimbursement status of newly approved healthcare products. We may need to conduct expensive pharmacoeconomic studies in order to demonstrate the cost-effectiveness of our products. Our product candidates may not be considered cost-effective. It is time consuming and expensive for us to seek reimbursement from third-party payors. Reimbursement may not be available or sufficient to allow us to sell our products on a competitive and profitable basis.

 

The passage of the Medicare Prescription Drug, Improvement, and Modernization Act of 2003, or the MMA, imposes new requirements for the distribution and pricing of prescription drugs for Medicare beneficiaries, and includes a major expansion of the prescription drug benefit under a new Medicare Part D, which went into effect on January 1, 2006. Under Part D, Medicare beneficiaries may enroll in prescription drug plans offered by private entities which will provide coverage of outpatient prescription drugs. Part D plans include both stand-alone prescription drug benefit plans and prescription drug coverage as a supplement to Medicare Advantage plans. Unlike Medicare Part A and B, Part D coverage is not standardized. Part D prescription drug plan sponsors are not required to pay for all covered Part D drugs, and each drug plan can develop its own drug formulary in which it indicates which drugs it will cover and at what tier or level. However, Part D prescription drug formularies must include drugs within each therapeutic category and class of covered Part D drugs, though not necessarily all the drugs in each category or class. Any formulary used by a Part D prescription drug plan must be developed and reviewed by a pharmacy and therapeutic committee.

 

It is not clear what effect the MMA has had and will have on the prices paid for currently approved drugs and the pricing options for new drugs approved after January 1, 2006. Government payment for some of the costs of prescription drugs may increase demand for products for which we receive marketing approval. However, any negotiated prices for our products covered by a Part D prescription drug plan will likely be lower than the prices we might otherwise obtain. Moreover, while the MMA applies only to drug benefits for Medicare beneficiaries, private payors often follow Medicare coverage policy and payment limitations in setting their own payment rates. Any reduction in payment that results from the MMA may result in a similar reduction in payments from non-governmental payors.

 

We expect that there will continue to be a number of federal and state proposals to implement governmental pricing controls and limit the growth of healthcare costs, including the cost of prescription drugs. At the present

 

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time, Medicare is prohibited from negotiating directly with pharmaceutical companies for drugs. However, Congress is currently considering passing legislation that would lift the ban on federal negotiations. While we cannot predict whether such legislative or regulatory proposals will be adopted, the adoption of such proposals could have a material adverse effect on our business, financial condition and profitability.

 

In addition, in some foreign countries, the proposed pricing for a drug must be approved before it may be lawfully marketed. The requirements governing drug pricing vary widely from country to country. For example, the European Union provides options for its member states to restrict the range of medicinal products for which their national health insurance systems provide reimbursement and to control the prices of medicinal products for human use. A member state may approve a specific price for the medicinal product or it may instead adopt a system of direct or indirect controls on the profitability of the company placing the medicinal product on the market. There can be no assurance that any country that has price controls or reimbursement limitations for pharmaceutical products will allow favorable reimbursement and pricing arrangements for any of our products.

 

Facilities

 

We lease approximately 16,603 square feet of office and laboratory space at 5871 Oberlin Drive, San Diego, California. In January 2008, we entered into a lease and a sublease for a total of approximately 9,630 square feet of office space located at 5930 Cornerstone Court West, San Diego, California. We expect to expense approximately $799,000 in 2008 under the lease and sublease agreements for these facilities. We conduct our operations from these two locations. Our leases expire in January 2011 and are subject to periodic increases in lease rates. We may require additional space as our business expands.

 

Employees

 

As of April 30, 2008, we had 49 employees, 31 of whom were engaged in research and product development activities, including one with a medical degree, one with a Pharm. D. degree and 14 with Ph.D. degrees. Our employees are not represented by a collective bargaining agreement. We believe our relations with our employees are good.

 

Legal Proceedings

 

From time to time, we may be subject to legal proceedings and claims in the ordinary course of our business. We are not currently aware of any such proceedings or claims that we believe will have, individually or in the aggregate, a material adverse effect on our business, financial condition or results of operations.

 

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MANAGEMENT

 

Executive Officers and Directors

 

The following table sets forth information regarding our executive officers and directors, including their ages as of May 16, 2008:

 

Name

   Age   

Position

Laura K. Shawver, Ph.D.

   50    Chief Executive Officer and Director

Julie Cherrington, Ph.D.

   50    President

Christopher L. Burnley

   46    Executive Vice President and Chief Operating Officer

John E. Crawford

   53    Chief Financial Officer

Hans-Peter Guler, M.D.

   59    Vice President, Clinical Development

David Campbell, Ph.D.

   49    Vice President, Drug Discovery and Preclinical Sciences

Srinivas Akkaraju, M.D., Ph.D.(2)

   40    Director

John Diekman, Ph.D.(1)

   65    Director

James Harper(3)

   60    Director

William Harris(1)

   50    Director

Daniel Janney(2)(3)

   42    Director

Arlene Morris(2)

   56    Director

Deepika R. Pakianathan, Ph.D.(1)(3)

   43    Director

 

  (1)   Member of the audit committee.
  (2)   Member of the compensation committee.
  (3)   Member of the nominating and corporate governance committee.

 

Laura K. Shawver, Ph.D. has served as our Chief Executive Officer and a member of our board of directors since June 2002. In addition, she served as our President until October 2007. Prior to joining us, Dr. Shawver was the President of SUGEN, Inc. from October 2000 to May 2002, after holding various positions there since June 1992. SUGEN, Inc., a biopharmaceutical company focused on the discovery and development of small molecule drugs which target specific cellular signal transduction pathways, was acquired by Pharmacia Corporation in 1999, which was subsequently acquired by Pfizer, Inc. in 2002. Prior to her employment at SUGEN, Inc., Dr. Shawver was employed at Berlex Biosciences, formerly known as Triton Biosciences, from August 1989 to June 1992. She currently serves as a director of Antipodean Pharmaceuticals, a privately held clinical-stage pharmaceutical company. Dr. Shawver received a Ph.D. degree in Pharmacology and a B.S. degree in Microbiology, both from the University of Iowa.

 

Julie Cherrington, Ph.D. has served as our President since October 2007. From May 2004 to October 2007, Dr. Cherrington served as our Executive Vice President, Research and Development. From November 2003 to October 2006, Dr. Cherrington also served as the President of our wholly-owned subsidiary, Phenomix Australia, Pty Ltd. Prior to joining us, Dr. Cherrington was employed with SUGEN, Inc. from October 1998 to October 2003, most recently serving as its Vice President, Preclinical Research and Exploratory Development. Prior to her tenure at SUGEN, Inc., Dr. Cherrington held various positions of increasing responsibility at Gilead Sciences, Inc., culminating in her position as director of virology. Dr. Cherrington is a member of the board of directors of Chemgenex Pharmaceuticals Limited, a publicly traded pharmaceutical development company. Dr. Cherrington received a Ph.D. degree in Microbiology from the University of Minnesota, with Ph.D. thesis research conducted at Stanford University, and an M.S. degree in Microbiology and a B.S. degree in Biology, both from the University of California, Davis.

 

Christopher L. Burnley has served as our Executive Vice President and Chief Operating Officer since September 2007. From May 2003 to September 2007, Mr. Burnley served as our Chief Business Officer. From May 1996 to December 2002, Mr. Burnley was employed in various capacities by The Monsanto Company, a multinational agricultural biotechnology corporation, where he most recently served as the Vice President, Business and Operations, of Monsanto’s Genomics Unit. From May 1987 to April 1996, Mr. Burnley was

 

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employed by the Boston Consulting Group, a multinational corporate strategy consulting firm. Mr. Burnley received an M.B.A. degree from the Harvard Business School and a B.S. degree in Economics and Political Science from Southern Methodist University.

 

John E. Crawford has served as our Chief Financial Officer since October 2007. Prior to joining Phenomix, Mr. Crawford served as the Chief Financial Officer of NovaCardia, Inc., a specialty pharmaceutical company that was acquired by Merck & Co. Inc., from January 2007 to September 2007. From May 2006 to December 2006, Mr. Crawford served as the Chief Financial Officer of Cabrellis Pharmaceutical Corporation, a specialty pharmaceutical company that was acquired by Pharmion Corporation. From January 2006 to May 2006, Mr. Crawford served as the Chief Financial Officer of Conforma Therapeutics Corporation, a specialty pharmaceutical company that was acquired by Biogen Idec. From 1997 to December 2005, Mr. Crawford was a consultant to life sciences and technology firms. During this time, Mr. Crawford served on the board of directors of several private companies and was a consultant to Archimedes Technology Group, LLC. Mr. Crawford was the founding President of Corvas International, Inc., and held various positions with that biotechnology company from 1987 to 1999, including that of Chief Financial Officer. From 1981 to 1987, he served as Vice President of International Genetic Engineering, Inc., with responsibility for finance. Mr. Crawford is a member of the board of directors of Lipid Sciences, Inc., a publicly traded biotechnology company. Mr. Crawford received an M.B.A. degree from the University of Chicago and a B.S. degree in Mathematical Sciences from Stanford University.

 

Hans-Peter Guler, M.D. has served as our Vice President, Clinical Development since August 2004. Prior to joining Phenomix, Dr. Guler served as Vice President, Clinical Sciences of Regeneron Pharmaceuticals, Inc., a biopharmaceutical company, which he joined in April 1998. Before that, Dr. Guler held positions with increasing responsibilities in various therapeutic indications in clinical development at Chiron Corp. from 1994 to 1998 and at Ciba-Geigy (now Novartis) from 1989 to 1994. Dr. Guler received an M.D. degree from the University of Zurich.

 

David Campbell, Ph.D. has served as our Vice President, Drug Discovery and Preclinical Sciences since January 2005. From May 2003 to January 2005, Dr. Campbell served as our Vice President, Drug Discovery. Prior to joining Phenomix, Dr. Campbell served as the Senior Vice President, Chemical Sciences of ActivX Biosciences, Inc., a biopharmaceutical company, from January 2003 until May 2003. Prior to his tenure at ActivX, Dr. Campbell was the Director of Discovery Chemistry at Bayer Corporation, and held positions of increasing responsibility at Affymax Research Institute, culminating in his position as Director of Discovery Chemistry. Dr. Campbell received a Ph.D. and M.S. degrees in Chemistry from Cornell University and a B.S. degree in Chemistry from Harvey Mudd College.

 

Srinivas Akkaraju, M.D., Ph.D. has served as a member of our board of directors since April 2005. Since August 2006, Dr. Akkaraju has been a Managing Director at Panorama Capital, LLC, a venture capital firm founded by the former venture capital investment team of J.P. Morgan Partners, LLC. Prior to that, from April 2001 to August 2006, he was with J.P. Morgan Partners, LLC, of which he became a Partner in January 2005. Dr. Akkaraju also serves as a member of the board of directors of Seattle Genetics, Inc., a publicly traded biotechnology company, Barrier Therapeutics, Inc., a publicly traded biopharmaceutical company and Pharmos Corporation, a biopharmaceutical company that discovers and develops novel therapeutics to treat a range of diseases of the nervous system, as well as several privately held companies. Dr. Akkaraju received an M.D. degree and a Ph.D. degree in Immunology from Stanford University, and B.S. degrees in Biochemistry and Computer Science from Rice University.

 

John Diekman, Ph.D. has served as a member of our board of directors since February 2002. Dr. Diekman has served as a managing director of 5AM Ventures, a life sciences investment partnership, since July 2002. From June 1998 to June 2002, Dr. Diekman served as a managing director of Bay City Capital, a life sciences merchant bank. Dr. Diekman also serves as a member of the board of directors and the nominating and corporate governance committee of Affymetrix, Inc., a publicly traded life sciences company, as well as a member of the board of directors of several privately held companies. Dr. Diekman received a Ph.D. degree in Chemistry from Stanford University and a B.A. degree in Chemistry from Princeton University.

 

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James Harper has served as a member of our board of directors since July 2007. Mr. Harper has spent 30 years in the pharmaceutical and healthcare industries, all in positions with Eli Lilly and Company, from which he retired in 2004. Mr. Harper served as Group Vice President and Chief Marketing Officer from 2001 to 2004 and as President, Diabetes and Growth Disorders Business Unit / Product Group from 1994 to 2001. Mr. Harper also serves as member of the board of directors and compensation committee of Zymogenetics, Inc., a publicly traded biotechnology company, a member of the board of directors and compensation committee of Corcept Therapeutics, Inc., a publicly traded pharmaceutical company, and a member of the board of directors of Anesiva, Inc., a publicly traded biopharmaceutical company. Mr. Harper received an M.B.A. degree from The Wharton School of Business and a B.A. degree in Biology from Vanderbilt University.

 

William Harris has served as a member of our board of directors since July 2007. Since November 2001, Mr. Harris has served as the Senior Vice President of Finance and Chief Financial Officer of Xenoport, Inc., a publicly traded biopharmaceutical company focused on developing a portfolio of internally discovered product candidates for the potential treatment of central nervous system disorders. From 1996 to 2001, he held several positions with Coulter Pharmaceutical, Inc., a biotechnology company engaged in the development of novel therapies for the treatment of cancer and autoimmune diseases, the most recent of which was Senior Vice President and Chief Financial Officer. Corixa Corp., a developer of immunotherapeutic products, acquired Coulter Pharmaceutical in 2000. Mr. Harris received an M.B.A. degree from Santa Clara University, Leavey School of Business and Administration and a B.A. degree in Economics from the University of California, San Diego.

 

Daniel Janney has served as a member of our board of directors since February 2002. Since February 1996, Mr. Janney has been a managing director of Alta Partners, a venture capital firm investing in information technologies and life science companies. Prior to joining Alta Partners, Mr. Janney was a Vice President in the health care and biotechnology investment banking group of Montgomery Securities from 1993 to 1996. Mr. Janney is a member of the board of directors and the compensation committee of Chemgenex Pharmaceuticals Limited, a publicly traded pharmaceutical development company, and also serves on the boards of directors of several privately held companies. Mr. Janney received an M.B.A. degree from the Anderson School at the University of California, Los Angeles and a B.A. degree in History from Georgetown University.

 

Arlene Morris has served as a member of our board of directors since October 2007. Ms. Morris has served as the President and Chief Executive Officer and as a member of the board of directors of Affymax, Inc., a publicly traded biopharmaceutical company, since June 2003. From 2001 to 2003, Ms. Morris served as President and Chief Executive Officer at Clearview Projects, an advisory firm to biopharmaceutical and biotechnology companies on strategic transactions. From 1996 to 2001, Ms. Morris served as Senior Vice President of Business Development at Coulter Pharmaceutical, which was acquired by Corixa Corp. in 2000. From 1993 to 1996, Ms. Morris served as Vice President of Business Development at Scios, Inc., a biopharmaceutical company. From 1977 to 1993, Ms. Morris held positions of increasing responsibility at Johnson & Johnson, including Vice President of Business Development for McNeil Pharmaceutical. Ms. Morris also serves as a member of the board of directors of MediciNova, Inc., a publicly traded biopharmaceutical company, and as a member of the board of directors of the Biotechnology Industry Organization. Ms. Morris received a B.A. degree from Carlow College and studied marketing at Western New England College.

 

Deepika R. Pakianathan, Ph.D. has served as a member of our board of directors since April 2005. Since June 2001, Dr. Pakianathan has served as a managing member at Delphi Ventures, a venture capital firm focusing on healthcare investments. From 1998 to 2001, Dr. Pakianathan was a senior biotechnology banker at JP Morgan. Dr. Pakianathan also serves as a member of the board of directors of Alexza Pharmaceuticals, Inc., a publicly traded emerging pharmaceutical company, as well as various private healthcare companies. Dr. Pakianathan received a Ph.D. degree in Immunology and an M.S. degree in Biology from Wake Forest University, and an M.Sc. degree in Biophysics and a B.Sc. degree from the University of Bombay.

 

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Board of Directors

 

We currently have eight directors. Upon the completion of this offering, the board of directors will be divided into three classes and will consist of three Class I directors (                    ,                     and                    ), three Class II directors (                    ,                     and                    ) and two Class III directors (                    and                    ), whose initial terms will expire at the annual meetings of stockholders held in 2008, 2009 and 2010, respectively. At each annual meeting of stockholders held after the initial classification, the successors to directors whose terms then expire will serve until the third annual meeting following their election.

 

Our bylaws provide that any vacancies in our board of directors and newly created directorships may be filled only by our board of directors and that the authorized number of directors may be changed only by our board of directors. Any additional directorships resulting from an increase in the number of directors will be distributed among the three classes, so that, as nearly as possible, each class will consist of one-third of the total number of directors. Our classified board could have the effect of making it more difficult for a third party to acquire control of us. These provisions of our bylaws and the classification of the board of directors may have the effect of delaying or preventing changes in the control or management of our company.

 

Our board of directors has considered the relationships of all directors and, where applicable, the transactions involving them described below under “Certain Relationships and Related Transactions,” and determined that each of Srinivas Akkaraju, John Diekman, James Harper, William Harris, Daniel Janney, Arlene Morris and Deepika Pakianathan does not have any relationship that would interfere with the exercise of independent judgment in carrying out his or her responsibility as a director and qualifies as an independent director under the applicable rules of the NASDAQ Global Market.

 

Board Committees

 

Our board of directors has established an audit committee, a compensation committee and a nominating and corporate governance committee, each of which operates pursuant to a separate charter adopted by our board of directors. The composition and function of all of our committees will comply with all applicable requirements of the Sarbanes-Oxley Act of 2002, the NASDAQ Global Market and SEC rules and regulations.

 

Audit Committee

 

The audit committee is comprised of William Harris, John Diekman and Deepika Pakianathan, with Mr. Harris serving as the chairman. In addition, Mr. Harris qualifies as an “audit committee financial expert” for purposes of the Securities Exchange Act of 1934, as amended, or the Exchange Act. The audit committee’s responsibilities include:

 

   

appointing, approving the compensation of, and assessing the independence of our independent registered public accounting firm;

 

   

pre-approving auditing and permissible non-audit services, and the terms of such services, to be provided by our independent registered public accounting firm;

 

   

reviewing and discussing with management and the independent registered public accounting firm our annual and quarterly financial statements and related disclosures;

 

   

coordinating the oversight and reviewing the adequacy of our internal control over financial reporting;

 

   

reviewing and approving all related party transactions for potential conflict of interest situations;

 

   

establishing policies and procedures for the receipt and retention of accounting related complaints and concerns; and

 

   

preparing the audit committee report required by SEC rules to be included in our annual proxy statements.

 

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Compensation Committee

 

The compensation committee is comprised of Daniel Janney, Srinivas Akkaraju and Arlene Morris, with Mr. Janney serving as the chairman. The compensation committee’s responsibilities include:

 

   

annually reviewing and approving corporate goals and objectives relevant to compensation of our chief executive officer;

 

   

evaluating the performance of our chief executive officer in light of such corporate goals and objectives and determining the compensation of our chief executive officer;

 

   

reviewing and approving the compensation of all of our other officers;

 

   

overseeing and administering our employment agreements, severance arrangements, compensation, welfare, benefit and pension plans and similar plans;

 

   

reviewing and making recommendations to the board with respect to director compensation;

 

   

reviewing and recommending the Company’s Compensation Discussion and Analysis for inclusion in our annual proxy statements; and

 

   

preparing the compensation committee report required by SEC rules to be included in our annual proxy statements.

 

Nominating and Corporate Governance Committee

 

The nominating and corporate governance committee is comprised of Deepika Pakianathan, James Harper and Daniel Janney, with Dr. Pakianathan serving as the chairman. The nominating and corporate governance committee’s responsibilities include:

 

   

developing and recommending to the board criteria for selecting board and committee membership;

 

   

establishing procedures for identifying and evaluating director candidates, including nominees recommended by stockholders;

 

   

identifying individuals qualified to become board members;

 

   

recommending to the board the persons to be nominated for election as directors and to each of the board’s committees;

 

   

developing and recommending to the board a code of business conduct and ethics and a set of corporate governance guidelines; and

 

   

overseeing the evaluation of the board, its committees and management.

 

Compensation Committee Interlocks and Insider Participation

 

None of our executive officers serves as a member of the board of directors or compensation committee, or other committee serving an equivalent function, of any other entity that has one or more of its executive officers serving as a member of our board of directors or who will serve on our compensation committee. None of the members of our compensation committee has ever been one of our employees.

 

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COMPENSATION DISCUSSION AND ANALYSIS

 

Overview

 

We believe that the compensation of our named executive officers should focus executive behavior on the achievement of near-term corporate targets as well as long-term business objectives and strategies. We place significant emphasis on pay-for-performance compensation programs, which reward our executives when we achieve certain financial and business goals and create stockholder value. We use a combination of base salary, annual cash incentive compensation programs, a long-term equity incentive compensation program and a broad-based benefits program to create a competitive compensation package for our executive management team. We describe below our compensation philosophy, policies and practices with respect to our chief executive officer, our president, our executive vice president and chief operating officer, our chief financial officer, our vice president, clinical development and our vice president, drug development and preclinical sciences, who are collectively referred to as our named executive officers. Prior to October 2007, we did not have a chief financial officer. We hired John Crawford to serve as our chief financial officer in October 2007.

 

Administration and Objectives of Our Executive Compensation Program

 

Our compensation committee is responsible for establishing and administering our policies governing the compensation of our named executive officers, including salaries, cash incentives and equity incentive compensation. Our compensation committee consists of three independent directors, all with extensive experience in the industry.

 

Our compensation committee has designed our overall executive compensation program to achieve the following objectives:

 

   

attract and retain talented and experienced executives;

 

   

motivate and reward executives whose knowledge, skills and performance are critical to our success;

 

   

provide a competitive compensation package that aligns the interests of our named executive officers and stockholders by including a significant variable component that is tied to the achievement of performance objectives;

 

   

ensure fairness among the executive management team by recognizing the contributions each executive makes to our success; and

 

   

foster a shared commitment among executives by aligning their individual goals with our corporate goals.

 

We use a mix of short-term compensation (base salaries and cash incentive bonuses) and long-term compensation (equity incentive compensation) to provide a total compensation structure that is designed to achieve these objectives. The compensation committee uses its judgment and experience and the recommendations of the chief executive officer (except as to her own compensation) to determine the appropriate mix of compensation for each individual.

 

For our fiscal year ended December 31, 2007, our compensation committee considered data purchased from a leading life science compensation survey of public and private biotechnology companies based on factors such as size, product development status and geographic location to help guide its executive compensation decisions at the time of hiring and to determine annual increases. Our compensation committee also based its recommendations with respect to executive compensation in 2007 and prior periods on the committee members’ general understanding of executive compensation in the biotechnology industry. In determining whether to adjust the compensation of any one of our named executive officers, we annually take into account the following:

 

   

market compensation levels for each position;

 

   

the contributions and performance of each named executive officer;

 

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the increase or decrease in responsibilities and role of each named executive officer;

 

   

the criticality of the role of each named executive officer; and

 

   

the ability and readiness of each named executive officer to assume greater responsibility within the organization.

 

In addition, with respect to newly hired named executive officers, we take into account their prior base salary and annual incentive awards, their expected contribution and our business needs.

 

In addition, beginning in late 2007, our compensation committee retained an independent compensation consultant, Radford Surveys + Consulting, a business unit of Aon Consulting, Inc., to assist the committee in developing our overall executive compensation and director compensation program. We engaged this independent compensation consultant also to develop a competitive peer group analysis for our compensation committee for benchmarking purposes for our 2008 fiscal year.

 

With the assistance of our independent compensation consultant, our compensation committee has determined that the following companies, which we refer to as the Phenomix Peer Group, constitute an appropriate and competitive peer group for benchmarking purposes for our 2008 fiscal year: Acorda Therapeutics, Inc.; Affymax, Inc.; Altus Pharmaceuticals, Inc.; Amicus Therapeutics, Inc.; Anadys Pharmaceuticals, Inc.; ARYx Therapeutics, Inc.; Biodel Inc.; Cadence Pharmaceuticals, Inc.; Elixir Pharmaceuticals, Inc.; MAP Pharmaceuticals, Inc.; Metabasis Therapuetics, Inc.; Molecular Insight Pharmaceuticals, Inc.; Neurocrine Biosciences, Inc.; NeurogesX, Inc.; Orexigen Therapeutics, Inc.; Osiris Therapeutics, Inc.; Pharmasset, Inc.; Sirtris Pharmaceuticals, Inc.; Somaxon Pharmaceuticals, Inc.; and Synta Pharmaceuticals Corp. The companies in the Phenomix Peer Group were selected on the basis of the following criteria:

 

   

companies in the biotechnology industry who are similar to us in size and complexity and who compete with us in the labor market;

 

   

clinical development stage companies working towards bringing a product to market;

 

   

companies with fewer than 150 employees; and

 

   

companies with market values generally between $100 million and $500 million.

 

Our compensation committee believes the Phenomix Peer Group is an appropriate comparator because it includes companies with whom we compete for executive talent and companies that face challenges similar to ours.

 

Executive Compensation Components

 

Our executive compensation program is composed of base salary, annual incentive cash compensation and equity compensation. Our compensation committee has not adopted a formal policy for allocating between various forms of compensation. However, we generally strive to provide our named executive officers with a balance of short-term and long-term incentives to encourage consistently strong performance. We have historically relied upon base salary as the primary mechanism to attract members of our management team. As a result, the amount of each executive officer’s initial base salary reflects, in part, the competitive landscape for talent at the time he or she joined us. In years subsequent to their hiring, we have generally provided small increases in base salary and relied on annual incentive cash compensation to incentivize each executive to contribute to the achievement of our corporate goals. While we believe that our annual incentive cash component of compensation encourages our executives to focus on near-term performance, generally performance over a one-year period, we rely upon equity-based awards, specifically stock option grants, to encourage our executives to focus on our performance over several years. In addition, we provide our executives with benefits that are generally available to our salaried employees, including medical, dental, group life and accidental death and

 

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dismemberment insurance and our 401(k) plan. We have entered into employment offer letter agreements with each of our named executive officers, which set forth their respective salaries and bonuses, and, in certain cases, stock option awards, severance and change in control provisions.

 

Within the context of the overall objectives of our compensation programs, we determined the specific amounts of compensation, including base salary, incentive cash compensation and equity compensation, to be paid to each of our executives for our fiscal year ended December 31, 2007 based on a number of factors, including:

 

   

our understanding of compensation generally paid by similarly situated companies to their executives with similar roles and responsibilities;

 

   

the roles and responsibilities of our executives;

 

   

overall corporate performance objectives for the year;

 

   

the individual experience and skills of, and expected contributions from, our executives; and

 

   

the provisions of applicable employment offer letter agreements.

 

In addition to the criteria above, the actual amount and allocation of total compensation (base salary, variable annual bonus compensation and equity awards) paid or issued to our named executive officers also reflects the timing and circumstances of when the executive joined us.

 

Although no formal policy for allocating between various forms of compensation had been adopted prior to this offering, our compensation committee has, with the assistance of our independent compensation consultant, developed the Phenomix Peer Group, a peer group of comparable companies for benchmarking purposes for each element of the compensation packages for our named executive officers for fiscal 2008. In February 2008, based on the recommendations of our compensation committee, our board of directors approved increased base salaries and established corporate and individual performance goals, as well as targets for each named executive officer within these goals, for fiscal 2008.

 

Historically, we have also relied on purchased market data and compensation data available to our compensation committee through some of our board members’ affiliations with venture capital investors in comparable private companies and their service on the boards of these companies to help guide our compensation committee’s determination of appropriate annual base salaries and incentive cash compensation amounts. The market data that we purchased consisted of survey results from a broad group of biopharmaceutical and biotechnology companies. We have the ability to analyze subsets of this data, including, for example, data for employees working in San Diego, California or in companies with fewer than 50 employees. Due to the varied types and stages of companies included in this survey, the compensation data ranges were wide. For 2007 and prior periods, this survey data was adequate for our purposes because it indicated the ranges of compensation paid by the companies with which we competed for executive talent. We operate in California and compete with large and small companies at various stages of product development to attract and retain talented employees.

 

Through our recently engaged compensation consultant, we have obtained access to more refined data to compare compensation for our named executive officers with compensation paid to officers in the similarly sized public and private biopharmaceutical and biotechnology companies, including those comprising the Phenomix Peer Group. Overall, for fiscal 2007, our named executive officers’ base salaries approximated the 60th percentile, and their target cash bonus opportunities were below the 50th percentile, when compared to pre-IPO companies included in the Phenomix Peer Group.

 

We discuss each of the primary elements of our executive compensation in detail below. While we have identified particular compensation objectives that each element of executive compensation serves, our compensation programs complement each other and collectively serve all of our executive compensation objectives described above. Accordingly, whether or not specifically mentioned below, we believe that, as a part of our overall executive compensation, each element to a greater or lesser extent serves each of our objectives.

 

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Base salary

 

Our compensation committee annually reviews salary ranges and individual salaries for our named executive officers. We have historically established base salaries for each of our executives based on the following factors:

 

   

each executive’s level and breadth of responsibilities, number of years’ experience and performance rating over time in his or her position;

 

   

competition in the marketplace to hire and retain executives;

 

   

the experience of our directors and management team with respect to salaries and compensation of executives in similarly situated companies in the biopharmaceutical industry; and

 

   

our desire to hire and retain our management team in an extremely competitive environment.

 

Based on the factors listed above, the compensation committee established annual base salaries for our fiscal year ended December 31, 2007 for each of our named executive officers as follows:

 

Name

   Base Salary

Laura K. Shawver, Ph.D.

   $ 375,000

Julie Cherrington, Ph.D.

     295,000

Christopher L. Burnley

     275,000

John E. Crawford

     240,000

Hans-Peter Guler, M.D.

     325,000

David Campbell, Ph.D.

     247,000

 

We believe that the base salaries paid to our named executive officers during our fiscal year ended December 31, 2007 achieve our executive compensation objectives and are competitive with those of similarly situated private companies. We base this belief, in part, on our comparison of these base salaries to the base salaries paid by pre-IPO companies included in the Phenomix Peer Group, our review of the results of a leading life sciences compensation survey and compensation information available to our compensation committee through some of our board members’ affiliations with venture capital investors in comparable private companies and their service on the boards of these companies.

 

Annual cash incentive program

 

We designed our cash incentive program for the year ended December 31, 2007 to reward our named executive officers based upon our achievement of certain corporate goals, as approved in advance by our compensation committee and board of directors, as well as for their individual performance. Our cash incentive program emphasizes pay-for-performance and is intended to align executive compensation with achievement of certain operating results. The compensation committee communicates the bonus criteria to the named executive officers at the beginning of the fiscal year. The performance goals established by the compensation committee are based on our business strategy and the objective of building stockholder value. For our fiscal year ended December 31, 2007, our compensation committee (with board approval) set corporate goals and objectives in the following areas:

 

   

commencing Phase 2b clinical trials of PHX1149;

 

   

preparing for Phase 3 clinical trials of PHX1149;

 

   

selecting a clinical candidate for our HCV program;

 

   

advancing our HCV preclinical development program;

 

   

maximizing value by evaluating strategic opportunities;

 

   

completing our Series C preferred stock financing;

 

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achieving cash flow from partnering arrangements, if appropriate;

 

   

advancing an additional program to the development candidate stage;

 

   

identifying opportunities for growth through collaborative arrangements or licensing; and

 

   

planning for an initial public offering.

 

Given the nature of these goals and the development stage of our company, our compensation committee makes a qualitative assessment as to the extent that the corporate goals have been satisfied. Our chief executive officer makes recommendations to the compensation committee regarding the compensation of the other named executive officers based on their individual performance. The compensation committee makes this same determination with respect to our chief executive officer.

 

The compensation committee also established target bonus levels for each of the named executive officers based on the compensation committee members’ general understanding of annual cash incentive payments to executives in the biotechnology industry. For our fiscal year ended December 31, 2007, the target cash bonus opportunities for each of our named executive officers, as a percentage of base salary and as a fixed dollar amount, were as follows:

 

Name

   Target Cash Bonus
As a Percentage of
Base Salary
    Target Cash Bonus
As a Fixed Dollar
Amount

Laura K. Shawver, Ph.D.

   25 %   $ 93,750

Julie Cherrington, Ph.D.

   20       59,000

Christopher L. Burnley

   20       55,000

John E. Crawford

   20       48,000

Hans-Peter Guler, M.D.

   10       32,500

David Campbell, Ph.D.

   10       24,700

 

These targets represent a significant percentage of our named executive officers’ base salaries and vary depending on position of the named executive officer, with our chief executive officer having the highest percentage of her compensation tied to our corporate goals and objectives because she has the greatest influence over our success. We believe that structuring our cash incentive program this way appropriately aligns our executives’ compensation to our performance and creation of stockholder value.

 

In December 2007, the compensation committee evaluated our overall performance and the performance of each executive and made determinations regarding the cash bonuses to be paid to each of our named executive officers. In making these determinations, our compensation committee determined that most of the corporate goals viewed as critical to our business strategy in 2007 had been substantially achieved and considered the extent to which each executive contributed to the achievement of these goals and the recommendations of our chief executive officer with respect to each executive other than herself. The committee also considered the chief executive officer’s recommendation, based upon the compensation data received from Radford, that the bonuses paid for performance during 2007 be adjusted to provide total cash compensation closer to the 60th percentile of the Phenomix Peer Group. Based on that evaluation and determination, we awarded cash bonuses to each of our named executive officers as follows:

 

Name

   Amount of
Cash Bonus

Laura K. Shawver, Ph.D.

   $ 87,000

Julie Cherrington, Ph.D.

     52,000

Christopher L. Burnley

     51,000

John E. Crawford

     10,000

Hans-Peter Guler, M.D.

     30,000

David Campbell, Ph.D.

     20,000

 

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Mr. Crawford’s cash bonus was pro-rated to reflect his joining our company in October 2007.

 

We engaged an independent compensation consultant to assist our compensation committee to establish the parameters of our annual cash incentive program for fiscal year 2008. Accordingly, target bonuses and bonus criteria for our fiscal year ended December 31, 2007 may not be indicative of the targets established for 2008 and future years as our mix of compensation elements and our overall corporate and individual performance objectives may change after we become a public company. With the assistance of our compensation consultant, our board of directors, upon the recommendation of the compensation committee, has established an annual cash incentive program for fiscal 2008, which includes both corporate goals and individual performance targets in the following areas:

 

   

advancing the development of PHX1149;

 

   

expanding our product portfolio through the development of PHX1766 and the selection of a backup candidate for our HCV program;

 

   

financing our continued operations;

 

   

securing strategic alternatives to maximize the value of our product candidates, such as through collaborative arrangements; and

 

   

engaging in other activities directed toward future growth of our company.

 

Equity compensation

 

We also use stock options to attract, retain, motivate and reward our employees, including the named executive officers. Through our equity-based grants, we seek to align the interests of our named executive officers with our stockholders, reward and motivate both near-term and long-term executive performance and provide an incentive for retention. Our decisions regarding the amount and type of equity incentive compensation, the allocation of equity and relative weighting of these awards within total executive compensation have been based on our understanding and individual experiences of market practices of similarly-situated companies and our negotiations with our executives in connection with their initial employment or promotion. Equity-based incentive awards are intended to be the longer-term components of our overall executive compensation program. While annual incentive cash compensation is designed to encourage shorter-term performance (generally over a one-year period), equity-based awards are designed to encourage our named executives’ performance over several years.

 

Substantially all of our employees, including our named executive officers, receive stock option grants under our 2001 Stock Option Plan, or the 2001 Plan. We grant stock option awards to our employees generally upon the commencement of their employment, upon a promotion and from time to time based on level of equity ownership, performance and expected future contribution, as part of our overall compensation program. Stock option awards provide our named executive officers with the right to purchase shares of our common stock at a fixed exercise price typically for a period of up to 10 years, subject to continued employment with our company. Stock options are earned on the basis of continued service to us and generally vest over four years, either pro rata on a monthly basis or beginning with 25% vesting one year after the vesting commencement date, then vesting in equal monthly installments thereafter. In addition, certain of the stock options granted to our named executive officers vest upon the achievement of milestones. Some of our stock option awards also include an early exercise provision that allows for immediate exercise of the stock option. In the event of an early exercise, the shares of common stock issued upon exercise of the option that have not yet vested will be subject to repurchase by us at the exercise price paid by the executive upon any termination event. The vesting of the shares underlying these option grants to our named executive officers is the same as the vesting for stock option awards generally. Thus, while the executive is able to exercise the options immediately to take advantage of beneficial tax treatment in certain circumstances, the continued vesting of the shares so exercised and the executive’s ability to retain the shares and any appreciation in the value of these shares are still dependent upon the executive’s continued

 

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service. As a result, these grants continue to align the interests of the executive with those of our stockholders. Our compensation committee has recommended these equity awards to provide for an additional long-term incentive and to facilitate the long-term tax planning of the named executives.

 

To date, all grants of stock options to our named executive officers have been subject to approval by the board of directors. The date of grant and the fair market value of the award are based upon the date of the board meeting approving such grant. The following factors are considered in determining the amount of equity incentive awards, if any, to grant to our named executive officers:

 

   

the number of shares subject to, and exercise prices of, outstanding options, both vested and unvested, held by our executives;

 

   

the vesting schedule of the unvested stock options held by our executives;

 

   

the amount of equity incentive awards granted to executives by companies with which we compete for management personnel; and

 

   

the amount and percentage of our total equity on a diluted basis held by our executives.

 

All historical stock option grants were made at what our board of directors determined to be the fair market value of shares of our common stock on the respective grant dates. In contemplation of this initial public offering, we reexamined the valuations of our common stock in December 2007. In connection with that reexamination, we prepared retrospective valuations of the fair value of our common stock for financial reporting purposes as of September 30, 2007. We believe that the valuation methodologies used in the retrospective valuations are reasonable and that the preparation of the retrospective valuations was necessary due to the fact that the timeframe for a potential initial public offering had accelerated significantly since the contemporaneous valuations were prepared.

 

We recognize stock-based compensation expense under SFAS No. 123R using the fair-value based method for all awards granted on or after the date of our adoption and these values have since been reflected in our consolidated financial statements.

 

Based on the factors listed above, on April 17, 2007, our board of directors granted time-based options to purchase shares of our common stock to each of our named executive officers as follows:

 

Name

   Number of Shares
Underlying Options

Laura K. Shawver, Ph.D.

   230,000

Julie Cherrington, Ph.D.

   140,000

Christopher L. Burnley

   45,000

Hans-Peter Guler, M.D.

   80,000

David Campbell, Ph.D.

   80,000

 

Each of these stock options vests in equal monthly installments over four years from the vesting commencement date of February 28, 2007. Our board of directors granted these stock options primarily to ensure that management was adequately incentivized after the dilution of their individual equity holdings as a result of the private financing transaction completed in February 2007, in which we issued 6,610,577 shares of Series C preferred stock.

 

On April 17, 2007, the board also granted performance-based stock options to each of Dr. Shawver and Mr. Burnley for the purchase of 90,000 and 45,000 shares of our common stock, respectively, which were to vest and become exercisable upon our execution of a partnering, licensing or collaboration agreement relating to our DPP-4 inhibitor or HCV protease inhibitor development programs or an affirmative determination by our board of directors not to partner, license or enter into collaborations relating to these programs. These performance-

 

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based stock options were granted to Dr. Shawver and Mr. Burnley in recognition of the importance of their roles in assisting us to achieve a partnering, licensing or collaboration agreement. All of the stock options granted on April 17, 2007 had an exercise price of $.43, the fair market value of our common stock on the date of grant, as determined by our board of directors.

 

On September 18, 2007, our board of directors granted time-based stock options to each of our named executive officers as follows:

 

Name

   Number of Shares
Underlying Options

Laura K. Shawver, Ph.D.

   310,000

Julie Cherrington, Ph.D.

   135,000

Christopher L. Burnley

   120,000

Hans-Peter Guler, M.D.

   90,000

David Campbell, Ph.D.

   93,000

 

Each of these stock options vests in equal monthly installments over four years from the vesting commencement date of September 4, 2007. Our board of directors granted these stock options primarily to restore management’s equity positions in our company to previous levels following the completion of a private financing transaction in September 2007, in which we issued 6,610,577 shares of Series C preferred stock. All of the stock options granted on September 18, 2007 had an exercise price of $.66, the fair market value of our common stock on the date of grant, as determined by our board of directors. Additionally, on September 18, 2007, our board of directors affirmatively determined, based on its decision not to pursue partnering, licensing or collaboration opportunities at that time, that the performance objective had been met, and the April 2007 performance-based stock options granted to Dr. Shawver and Mr. Burnley should be deemed fully vested.

 

The relative size of all of our stock option awards is primarily driven by the position and level of responsibility the grantee currently holds, his or her expected future position and level within our organization and his or her individual performance. The stock option grants to Dr. Shawver during the fiscal year ended December 31, 2007 were substantially larger than to each of our other named executive officers in consideration of Dr. Shawver’s critical role as our chief executive officer and comparisons made by the board to other chief executive officers in our industry.

 

On October 8, 2007, our board of directors granted Mr. Crawford a time-based stock option to purchase 425,000 shares of our common stock in connection with his hiring. This stock option vests over four years, beginning with 25% vesting one year after the grant date, then vesting in equal monthly installments thereafter. Mr. Crawford’s stock option award has an early exercise provision allowing for the immediate exercise of the option, and Mr. Crawford exercised the option with respect to 200,000 shares in October 2007. Our board made this stock option grant to Mr. Crawford for two reasons. First, it wanted to provide him with an appropriate long-term incentive through time-based vesting, to encourage retention. Second, it made this grant as part of Mr. Crawford’s initial compensation package in order to provide him with an equity award that is comparable to what he could receive from companies with which we compete for talent, based on the board’s understanding of the equity awards made to similar executives by such companies. We granted this stock option at an exercise price of $.66 per share, the fair market value on the date of grant, as determined by our board of directors.

 

Other benefits

 

We believe that establishing competitive benefit packages for our employees is an important factor in attracting and retaining highly qualified personnel. Named executive officers are eligible to participate in all of our employee benefit plans, such as medical, dental, group life and accidental death and dismemberment insurance and our 401(k) plan, in each case on the same basis as other employees. In 2007, we began matching up to the first $1,000 contributed by each of our employees to the 401(k) plan. With the exception of our 401(k) plan, we do not offer retirement benefits. Consistent with our compensation philosophy, we intend to continue to

 

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maintain our current benefits for our named executive officers. The compensation committee in its discretion may revise, amend or add to the officer’s executive benefits and perquisites if it deems it advisable.

 

Historically, we made housing relocation loans to Dr. Shawver, Dr. Cherrington and Mr. Burnley in connection with each of their employment arrangements in order to recruit these executives from outside the San Diego area to join our company in San Diego, where housing costs are high. We lent the following principal amounts to these officers pursuant to promissory notes on the dates set forth below:

 

Name

   Loan Amount    Date

Laura K. Shawver, Ph.D.

   $ 600,000    June 14, 2002

Julie Cherrington, Ph.D.

     150,000    July 22, 2004

Christopher L. Burnley

     200,000    June 12, 2003

 

These loans and our forgiveness of the remaining outstanding amounts under the promissory notes are more fully described below under “Certain Relationships and Related Person Transactions—Loans to Executive Officers.” In addition, in connection with our forgiveness of the remaining outstanding amounts under Dr. Cherrington’s loan, we agreed to pay Dr. Cherrington an additional $13,290 during fiscal 2008. Under our original arrangement with Dr. Cherrington, we would have forgiven the remaining outstanding amount of her loan over a period of two years from 2008 through 2009. Our decision to forgive all of the outstanding balance in 2008 resulted in an additional tax burden to Dr. Cherrington for that year. Accordingly, we paid the additional $13,290 to Dr. Cherrington to offset tax consequences associated with the accelerated forgiveness of the loan.

 

Section 162(m) of the Internal Revenue Code places a limit of $1 million on the amount of compensation that a public company may deduct in any one year with respect to certain of its named executive officers. Certain performance-based compensation approved by stockholders is not subject to this deduction limit. Our compensation committee’s strategy in this regard is to be cost and tax efficient. Therefore, the compensation committee intends to preserve corporate tax deductions, while maintaining the flexibility in the future to approve arrangements that it deems to be in our best interests and the best interests of our stockholders, even if these arrangements do not always qualify for full tax deductibility.

 

Severance and change of control benefits

 

Based on our recent experience hiring executive officers and comparable benefits offered by companies with which we compete for experienced management personnel, our compensation committee recommended that our board of directors adopt a change of control policy providing for specific benefits to officers at the levels of vice president and above, which includes each of our named executive officers, upon a change of control of our company.

 

In October 2007, upon the recommendation of our compensation committee, our board of directors approved and adopted a change of control policy pursuant to which each of our officers at the levels of vice president and above will be entitled to full acceleration of all options held by them, such that all of these options will be immediately exercisable, in the event they are involuntarily terminated within 90 days before or 365 days after a “change of control” or a “fundamental transaction,” as these terms are defined in the 2001 Plan. For purposes of the change of control policy, our board of directors determined that the following circumstances would constitute an involuntary termination:

 

   

the individual’s termination without “cause,” as defined in the 2001 Plan; or

 

   

the individual’s resignation due to:

 

   

the assignment to him or her of any duties or a reduction in his or her duties, either of which results in a significant diminution in his or her responsibilities with our company;

 

   

a material reduction in his or her base salary as in effect immediately before such reduction;

 

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a material reduction in the kind or level of employee benefits to which the individual is entitled immediately prior to such reduction, with the result that his or her overall benefits package is substantially reduced, except for any across-the-board reduction similarly affecting all or substantially all management; or

 

   

the relocation of the individual’s employment to a facility or location more than 50 miles from the location where he or she is principally employed by us, if the individual does not approve the relocation.

 

Our goal in adopting this change of control policy is to further align the interests of our executives with the interests of our stockholders by providing the executives with an equity-based incentive to focus on the requirements of our business, particularly in connection with a change of control, regardless of any potential implications for his or her position.

 

The terms of the severance and any cash benefits in connection with a change of control currently in place with certain of our named executive officers were negotiated on a person-by-person basis at the time of their hiring. The negotiated position was dictated, in part, by our board’s understanding of market norms at the time of the hiring and the importance of each named executive officer’s role in our organization and, in part, by each named executive officer’s individual expectations. In August 2005, our board of directors adopted a policy providing that each executive officer would be entitled to a cash severance equal to six months’ base salary if he or she is involuntarily terminated in the event of a change of control, as defined in the 2001 Plan. Our current severance and cash-based change of control benefits to our named executive officers are more fully described below under “—Employment Agreements and Severance Agreements” with respect to each named executive officer.

 

Summary Compensation Table

 

The following table summarizes the compensation earned during the fiscal year ended December 31, 2007, for our named executive officers.

 

Name and Principal Position

   Salary    Bonus    Option
Awards(1)
   All Other
Compensation
    Total

Laura K. Shawver, Ph.D.

Chief Executive Officer

   $ 375,000    $ 87,000    $ 521,000    $ 340,000 (3)   $ 1,323,000

Julie Cherrington, Ph.D.

President

     295,000      52,000      127,000      33,000 (3)     507,000

Christopher L. Burnley

Executive Vice President and Chief Operating Officer

     275,000      51,000      211,000      54,000 (3)     591,000

John E. Crawford

Chief Financial Officer(2)

     50,000      10,000      104,000            164,000

Hans-Peter Guler, M.D.

Vice President, Clinical Development

     325,000      30,000      76,000            431,000

David Campbell, Ph.D.

Vice President, Drug Discovery and Preclinical Sciences

     247,000      20,000      77,000            344,000

 

  (1)   Stock-based compensation expense for these awards was calculated in accordance with SFAS No. 123R and is being amortized over the vesting period of the related award. The amounts reflected in this table exclude the estimate of forfeitures applied by us under SFAS No. 123R when recognizing stock-based compensation expense for financial statement reporting purposes for fiscal 2007. For a discussion of the valuation assumptions used in calculating this amount, please refer to “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Critical Accounting Policies and Estimates—Stock-based Compensation.”

 

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  (2)   Mr. Crawford was hired as our chief financial officer in October 2007. As a result, his salary in the above table represents a pro-rated percentage of his annual base salary of $240,000 for the fiscal year ended December 31, 2007; his bonus was similarly pro-rated.
  (3)   “All Other Compensation” represents (i) $325,000 in principal and $15,000 in accrued interest forgiven by us under a relocation loan to Dr. Shawver, (ii) $30,000 in principal and $3,000 in accrued interest forgiven by us under a relocation loan to Dr. Cherrington and (iii) $50,000 in principal and $4,000 in accrued interest forgiven by us under a relocation loan to Mr. Burnley. The terms of these relocation loans and our forgiveness of the amounts due under them are more fully described below under “Certain Relationships and Related Transactions—Loans to Executive Officers.”

 

Grants of Plan-Based Awards—2007

 

The following table sets forth certain information with respect to awards under our non-equity incentive plan and equity incentive plan made by us to our named executive officers during the fiscal year ended December 31, 2007:

 

Name

   Grant Date    Number of
Securities
Underlying
Options(1)
    Exercise or Base
Price of Option
Awards
   Grant Date Fair
Value of Option
Awards

Laura K. Shawver, Ph.D.

   4/17/2007    230,000 (2)   $ .43    $ 718,000
   4/17/2007    90,000 (3)     .43      281,000
   9/18/2007    310,000 (2)     .66      1,085,000

Julie Cherrington, Ph.D.

   4/17/2007    140,000 (2)     .43      437,000
   9/18/2007    135,000 (2)     .66      473,000

Christopher L. Burnley

   4/17/2007    45,000 (2)     .43      140,000
   4/17/2007    45,000 (3)     .43      140,000
   9/18/2007    120,000 (2)     .66      420,000

John E. Crawford

   10/8/2007    425,000 (4)     .66      1,785,000

Hans-Peter Guler, M.D.

   4/17/2007    80,000 (2)     .43      250,000
   9/18/2007    90,000 (2)     .66      315,000

David Campbell, Ph.D.

   4/17/2007    80,000 (2)     .43      250,000
   9/18/2007    93,000 (2)     .66      326,000

 

  (1)   All option awards were granted under the 2001 Plan and are subject to the related award agreements.
 

(2)

 

Option shares subject to time-based vesting criteria. One forty-eighth (1/48th) of the total number of shares underlying this option vests on a monthly basis over four years from the vesting commencement date.

  (3)   Option shares subject to performance-based vesting criteria. All of these options vested in full upon the board’s determination on September 18, 2007 that the performance criteria had been met.
 

(4)

 

This option is subject to an early exercise provision and was fully exercisable upon grant. Twenty-five percent of the shares underlying this option vest on the first anniversary of the vesting commencement date, and one forty-eighth (1/48th) of the original number of shares vests at the end of each successive month thereafter until the fourth anniversary of the vesting commencement date.

 

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Outstanding Equity Awards at December 31, 2007

 

The following table sets forth certain information regarding equity awards granted to our named executive officers outstanding as of December 31, 2007:

 

     Option Awards

Name

   Number of Securities
Underlying
Unexercised Options

Exercisable
    Number of Securities
Underlying
Unexercised Options

Unexercisable
    Option Exercise
Price
    Option Expiration
Date

Laura K. Shawver, Ph.D.

   1,500 (1)       $ 10.50 (2)   6/16/2012
   200 (3)         10.50 (2)   6/17/2012
   1,000 (4)         10.50 (2)   10/1/2013
   3,000 (3)         10.50 (2)   10/1/2013
   3,000 (3)         10.50 (2)   10/1/2013
   349,877 (5)         .35     5/5/2015
   87,626 (6)   159,791 (6)     .35     7/18/2016
   25,000 (7)   75,000 (7)     .35     12/12/2016
   47,916 (6)   182,084 (6)     .43     4/17/2017
   90,000 (3)         .43     4/17/2017
   19,375 (6)   290,625 (6)     .66     9/18/2017

Julie Cherrington, Ph.D.

   4,000 (8)         10.50 (2)   10/31/2013
   458 (7)   42 (7)     10.50 (2)   4/20/2014
   1,000 (3)         10.50 (2)   4/20/2014
   103,077 (6)   20,616 (6)     .35     5/5/2015
   41,043 (6)   52,770 (6)     .35     7/18/2016
   21,250 (7)   63,750 (7)     .35     12/12/2016
   29,166 (6)   110,834 (6)     .43     4/17/2017
   8,437 (6)   126,563 (6)     .66     9/18/2017

Christopher L. Burnley

   3,620 (9)         10.50 (2)   5/12/2013
   2,042 (7)   238 (7)     10.50 (2)   5/12/2014
   1,000 (10)         10.50 (2)   7/8/2014
   12,298 (6)   15,370 (6)     .35     5/5/2015
   13,102 (6)   58,959 (6)     .35     7/18/2016
   5,209 (7)   37,500 (7)     .35     12/12/2016
   6,563 (6)   35,625 (6)     .43     4/17/2017
   45,000 (3)         .43     4/17/2017
   7,500 (6)   112,500 (6)     .66     9/18/2017

John E. Crawford

   225,000 (11)         .66     10/8/2017

Hans-Peter Guler, M.D.

   2,187 (7)   813 (7)     10.50 (2)   8/10/2014
   64,424 (6)   23,929 (6)     .35     5/5/2015
   21,956 (6)   40,040 (6)     .35     7/18/2016
   12,500 (7)   37,500 (7)     .35     12/12/2016
   16,666 (6)   63,334 (6)     .43     4/17/2017
   5,625 (6)   84,375 (6)     .66     9/18/2017

David Campbell, Ph.D.

   3,000 (12)         10.50 (2)   5/4/2013
   2,000 (3)         10.50 (2)   4/20/2014
   375 (7)   125 (7)     10.50 (2)   12/31/2014
   27,894 (6)   11,965 (6)     .35     5/5/2015
   30,732 (6)   39,513 (6)     .35     7/18/2016
   10,000 (7)   30,000 (7)     .35     12/12/2016
   16,666 (6)   63,334 (6)     .43     4/17/2017
   5,812 (6)   87,188 (6)     .66     9/18/2017

 

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  (1)   This option was subject to early exercise upon grant.
  (2)   These stock options were originally granted at an exercise price of $.105 per share. The exercise price and share number reflect a 100-to-1 reverse split of our common stock in April 2005.
  (3)   This option vested and became fully exercisable based on performance criteria established by the board of directors.
  (4)   This option was fully vested and exercisable upon grant.
  (5)   This option vested and became fully exercisable on December 14, 2007.
 

(6)

 

One forty-eighth (1/48th) of the original number of shares underlying this option vests on a monthly basis over four years from the vesting commencement date.

 

(7)

 

Twenty-five percent (25%) of the original number of shares underlying this option vested on the first anniversary of the vesting commencement date, and one forty-eighth (1/48th) of the original number of shares vests at the end of each successive month thereafter until the fourth anniversary of the vesting commencement date.

  (8)   This option vested and became fully exercisable on October 31, 2007.
  (9)   This option vested and became fully exercisable on May 12, 2007.
  (10)   This option vested and became fully exercisable on July 22, 2004.
 

(11)

 

This option was subject to early exercise upon grant. Twenty-five percent (25%) of the original number of shares underlying this option vests on the first anniversary of the vesting commencement date of October 8, 2007, and one forty-eighth (1/48th) of the original number of shares vests at the end of each successive month thereafter until the fourth anniversary of the vesting commencement date. Mr. Crawford exercised a portion of this option for 200,000 shares on October 15, 2007.

  (12)   This option vested and became fully exercisable on May 4, 2007.

 

Option Exercises and Stock Vested—2007

 

The following table provides certain information regarding the number of stock options exercised under the 2001 Plan and the corresponding amounts realized by the named executive officers during the year ended December 31, 2007. None of our named executive officers held any other stock awards that were subject to vesting during the year ended December 31, 2007.

 

2007 Option Exercises and Stock Vested Table

 

     Option Awards

Name

   Number of Shares
Acquired on
Exercise(1)
    Value Received
on Exercise(2)

Laura K. Shawver, Ph.D.

       $

Julie Cherrington, Ph.D.

        

Christopher L. Burnley.

   162,738       584,004

John E. Crawford

   200,000 (3)     700,000

Hans-Peter Guler, M.D.

        

David Campbell, Ph.D.

   75,000       338,250

 

  (1)   All option awards were granted under the 2001 Plan pursuant to related stock option agreements.
  (2)   There was no public market for our common stock in 2007. We have estimated the value realized on exercise based on the reassessed fair value on the date of grant, less the option exercise price. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Stock-Based Compensation” for a discussion on estimated fair value.
  (3)   The shares, which were acquired upon Mr. Crawford’s early exercise of his stock option, have not vested and are subject to our right of repurchase.

 

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Stock and Benefit Plans

 

2001 Stock Option Plan

 

Our 2001 Stock Option Plan, or the 2001 Plan, was adopted by our board of directors and approved by our stockholders in October 2001. Most recently, the 2001 Plan was amended in September 2007 to increase the number of shares of common stock reserved for issuance under the plan. We currently have reserved a total of 5,037,222 shares of our common stock for issuance under our 2001 Plan. As of March 31, 2008, 4,017,916 of these shares were subject to outstanding options and 341,302 of these shares were available for issuance.

 

The 2001 Plan is administered by our board of directors. The administrator of the 2001 Plan has the authority to select the participants to whom options are granted, to determine the times at which options are granted, to determine the number of shares subject to each option, to determine the types of payment that may be used to exercise options, to determine the effect of a change of control or similar transaction on the treatment of options and otherwise to determine the specific terms and conditions of each option, subject to the provisions of the 2001 Plan.

 

The 2001 Plan provides for the grant of incentive stock options, as defined under Section 422 of the Internal Revenue Code, to employees and for the grant of non-statutory stock options to employees, consultants and non-employee directors. Stock options granted under the 2001 Plan have a maximum term of ten years from the date of grant; provided that incentive stock options granted to any holder of stock representing more than 10% of our voting power have a maximum term of five years from the date of grant. All non-qualified stock options granted under the 2001 Plan must have an exercise price no less than 85% of the fair market value of our common stock on the date of grant, and all incentive stock options must have an exercise price of no less than 100% of the fair market value of our common stock on the date of grant. In addition, the exercise price of all stock options intended to qualify as “qualified incentive-based compensation” under Section 162(m) of the Internal Revenue Code of 1986 must be no less than the fair market value of the common stock on the date of grant, and the exercise price of any stock option granted to any optionee who owns stock representing more than 10% of our voting power must be no less than 110% of the fair market value of our common stock on the grant date.

 

In general, if an optionee’s service terminates for any reason other than death, disability or cause, the optionee may exercise his or her vested options prior to the earlier of their expiration date or 30 days following the date of termination. If the optionee’s service terminates as a result of the optionee’s death or disability, the options vested as of the date of death or disability may be exercised before the earlier of their expiration date or one year after the optionee’s death or disability. If an optionee’s service is terminated for cause, all outstanding options held by the optionee will automatically terminate and cease to be exercisable at the time of the termination for cause. The 2001 Plan defines “cause” as dishonesty, fraud, misconduct, disclosure or misuse of confidential information, conviction of, or a plea of guilty or no contest to, a felony or similar offense, habitual absence from work for reasons other than illness, intentional conduct that could cause significant injury to our company or an affiliate, or habitual abuse of alcohol or a controlled substance, in each case as determined by our board of directors.

 

The 2001 Plan defines a “fundamental transaction” as a merger in which our company is not the surviving entity, or any other transaction or event the result of which other securities are substituted for shares of our common stock. In the event of a fundamental transaction, the board may provide for the substitution of options outstanding under the 2001 Plan for options to purchase securities other than our common stock, accelerate the vesting of outstanding options under the 2001 Plan and provide for their termination upon the closing of the fundamental transaction if not previously exercised, cancel options outstanding under the 2001 Plan in exchange for cash payments to the optionees, arrange for any company repurchase rights applicable to the common stock underlying the options to apply to securities issued in substitution for such common stock or terminate any company repurchase rights applicable to the shares of common stock underlying the options. The board may designate certain other transactions, such as a transaction in which the beneficial holders of our securities

 

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immediately before the transaction own 50% or less of our voting power immediately after the transaction, as a “change of control.” In connection with a change of control, the board may take any of the actions described above for a fundamental transaction, and the board may extend the date for exercise of options granted under the 2001 Plan (but not beyond their original expiration date). The board may also designate certain sales or transfers of our equity securities or assets to a third party as a “divestiture.” In connection with a divestiture, the board may take any of the actions described above for a change of control with respect to options held by optionees whose employment or service relationship with our company is terminated as a result of the divestiture.

 

In connection with the adoption of our 2008 Stock Option and Incentive Plan, or the 2008 Plan, which is discussed below, our board of directors has determined not to grant any further awards under the 2001 Plan after this offering. However, all options previously granted under the 2001 Plan will remain outstanding and will be administered under the terms and conditions of the 2001 Plan.

 

2008 Stock Option and Incentive Plan

 

Our 2008 Plan was adopted by our board of directors and approved by our stockholders in                     . The 2008 Plan permits us to make grants of incentive stock options, non-qualified stock options, stock appreciation rights, deferred stock awards, restricted stock awards, unrestricted stock awards, cash-based awards, performance share awards and dividend equivalent rights. We have initially reserved             shares of our common stock for the issuance of awards under the 2008 Plan. The 2008 Plan provides that the number of shares reserved and available for issuance under the plan will automatically increase each January 1, beginning in 2009, by     % of the outstanding number of shares of common stock on the immediately preceding December 31 or a lesser amount as may be determined by the board of directors. This number is subject to adjustment in the event of a stock split, stock dividend or other change in our capitalization. Generally, shares that are forfeited or canceled from awards under the 2001 Plan after this registration statement becomes effective and shares that are forfeited or cancelled from awards under the 2008 Plan also will be available for future awards. Awards will not be granted under the 2008 Plan prior to the effectiveness of the registration statement of which this prospectus is a part.

 

The 2008 Plan will be administered by either a committee of at least two non-employee directors, our compensation committee or our full board of directors, or the administrator. The administrator has full power and authority to select the participants to whom awards will be granted, to make any combination of awards to participants, to accelerate the exercisability or vesting of any award and to determine the specific terms and conditions of each award, subject to the provisions of the 2008 Plan.

 

All full-time and part-time officers, employees, non-employee directors and other key persons (including consultants and prospective employees) are eligible to participate in the 2008 Plan, subject to the discretion of the administrator. There are certain limits on the number of awards that may be granted under the 2008 Plan. For example, no more than             shares of common stock may be granted in the form of stock options or stock appreciation rights to any one individual during any one-calendar-year period and no more than             shares may be granted in the form of incentive stock options.

 

The exercise price of stock options awarded under the 2008 Plan may not be less than the fair market value of our common stock on the date of the option grant and the term of each option may not exceed ten years from the date of grant. The administrator will determine at what time or times each option may be exercised. Subject to the provisions of the 2008 Plan, the period of time, if any, after retirement, death, disability or other termination of employment during which options may be exercised will be set forth in the applicable stock option agreements.

 

To qualify as incentive options, stock options must meet additional federal tax requirements, including a $100,000 limit on the value of shares subject to incentive options which first become exercisable in any one calendar year, and a shorter term and higher minimum exercise price in the case of certain large stockholders. To the extent that any portion of an incentive stock option award fails to qualify as such, that portion will be treated as a non-qualified stock option.

 

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Stock appreciation rights may be granted under our 2008 Plan. Stock appreciation rights allow the recipient to receive the appreciation in the fair market value of our common stock between the exercise date and the date of grant. The administrator determines the terms of stock appreciation rights, including when such rights become exercisable and whether to pay the increased appreciation in cash or with shares of our common stock, or a combination thereof.

 

Restricted stock may be granted under our 2008 Plan. Restricted stock awards are shares of our common stock that vest in accordance with terms and conditions established by the administrator. The administrator will determine the number of shares of restricted stock granted to any employee. The administrator may impose whatever conditions to vesting it determines to be appropriate. For example, the administrator may set restrictions based on the achievement of specific performance goals. Shares of restricted stock that do not vest are subject to our right of repurchase.

 

Deferred and unrestricted stock awards may be granted under our 2008 Plan. Deferred stock awards are units entitling the recipient to receive shares of stock paid out on a deferred basis, and are subject to such restrictions and conditions as the administrator shall determine. Our 2008 Plan also gives the administrator discretion to grant stock awards free of any restrictions.

 

Cash-based awards may be granted under our 2008 Plan. Each cash-based award shall specify a cash-denominated payment amount, formula or payment ranges as determined by the administrator. Payment, if any, with respect to a cash-based award may be made in cash or in shares of stock, as the administrator determines.

 

Performance shares may be granted under our 2008 Plan. Performance shares are awards entitling the grantee to receive shares of our common stock upon the attainment of pre-established performance goals. The administrator determines the performance goals with respect to awards of performance shares. If the performance goals are not attained, no shares will be granted to the recipient.

 

Dividend equivalent rights may be granted under our 2008 Plan. Dividend equivalent rights are awards entitling the grantee to current or deferred payments equal to dividends on a specified number of shares of stock. Dividend equivalent rights may be settled in cash or shares and are subject to other conditions as the administrator shall determine.

 

Unless the administrator provides otherwise, our 2008 Plan does not allow for the transfer of awards and only the recipient of an award may exercise an award during his or her lifetime.

 

In the event of a merger, sale or dissolution, or a similar “sale event,” unless assumed or substituted, all stock options and stock appreciation rights granted under the 2008 Plan will automatically become fully exercisable, all other awards granted under the 2008 Plan will become fully vested and non-forfeitable and awards with conditions and restrictions relating to the attainment of performance goals may become vested and non-forfeitable in connection with a sale event in the administrator’s discretion. Upon the effective time of any such sale event, the 2008 Plan and all awards will terminate unless the parties to the transaction, in their discretion, provide for appropriate substitutions or assumptions of outstanding awards.

 

No awards may be granted under the 2008 Plan after                     2018. In addition, our board of directors may amend or discontinue the 2008 Plan at any time and the administrator may amend or cancel any outstanding award for the purpose of satisfying changes in law or for any other lawful purpose. No such amendment may adversely affect the rights under any outstanding award without the holder’s consent. Other than in the event of a necessary adjustment in connection with a change in our stock or a merger or similar transaction, the administrator may not “reprice” or otherwise reduce the exercise price of outstanding stock options or stock appreciation rights. Further, amendments to the 2008 Plan will be subject to approval by our stockholders if the amendment (i) increases the number of shares available for issuance under the 2008 Plan, (ii) expands the types of awards available under, the eligibility to participate in, or the duration of, the plan, (iii) materially changes the

 

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method of determining fair market value for purposes of the 2008 Plan, (iv) is required by the NASDAQ Global Market rules, or (v) is required by the Internal Revenue Code of 1986, as amended, or the Code, to ensure that incentive options are tax-qualified.

 

2008 Employee Stock Purchase Plan

 

Our 2008 Employee Stock Purchase Plan, or 2008 ESPP, was adopted by our board of directors and approved by our stockholders in                     2008 and will become effective upon the completion of this offering. We have reserved a total of             shares of our common stock for issuance to participating employees under the 2008 ESPP.

 

All of our employees, including our directors who are employees and all employees of any of our participating subsidiaries, who have been employed by us for at least six months prior to enrolling in the 2008 ESPP, who are employees on the first day of the offering period, and whose customary employment is for more than twenty hours a week and have completed at least six months of employment, will be eligible to participate in the 2008 ESPP. Employees who would, immediately after being granted an option to purchase shares under the 2008 ESPP, own 5% or more of the total combined voting power or value of all of classes of stock of our company or any subsidiary, may not be granted any option under the 2008 ESPP.

 

We will make one or more offerings to our employees to purchase stock under the 2008 ESPP. The first offering will begin on the first day of this offering and end on the following December 31. Subsequent offerings will begin on each January 1, or the first business day thereafter and end on the last business day occurring on or before December 31. During each offering period, payroll deductions will be made and held for the purchase of common stock at the end of the offering period.

 

On the first day of a designated payroll deduction period, or offering period, we will grant to each eligible employee who has elected to participate in the 2008 ESPP an option to purchase shares of our common stock. The employee may authorize deductions from 1% to 25% of his compensation for each payroll period during the offering period. On the last day of the offering period, the employee will be deemed to have exercised the option, at the option exercise price, to the extent of accumulated payroll deductions; provided that, with respect to the first offering, the exercise of each option shall be conditioned on the closing of this offering. Under the terms of the 2008 ESPP, the option exercise price shall be equal to 85% of the closing price on the first day of the applicable offering or the exercise date, whichever is less.

 

An employee who is not a participant on the last day of the offering period will not be entitled to exercise any option and the employee’s accumulated payroll deductions will be refunded. An employee’s rights under the 2008 ESPP will terminate upon voluntary withdrawal from the 2008 ESPP at any time, or when the employee ceases employment for any reason, except that upon termination of employment because of death, the balance in the employee