10-K 1 form10k.htm ECHO THERAPEUTICS 10-K 12-31-2010 form10k.htm


UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549

Form 10-K

(Mark One)

x
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended: December 31, 2010

o
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

COMMISSION FILE NUMBER 000-23017

ECHO THERAPEUTICS, INC.
(Exact name of registrant as specified in its charter)

DELAWARE
 
41-1649949
(State or other jurisdiction of
incorporation or organization)
 
(I.R.S. Employer
Identification No.)
     
10 Forge Parkway, Franklin, Massachusetts
 
02038
(Address of principal executive offices)
 
(Zip Code)

(Registrant’s telephone number, including area code)
(508) 553-8850

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

Securities registered pursuant to Section 12(g) of the Act:
Common Stock, $.01 par value per share

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

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.
Yes £     No x

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

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes £     No £

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§ 229.405 of this chapter) is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. x

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):
 
Large accelerated filer £
Accelerated filer £
Non-accelerated filer £
Smaller reporting company x
   
(Do not check if a smaller reporting company)
 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). Yes £     No x

The approximate aggregate market value of the voting and non-voting common equity held by non-affiliates of the registrant as of June 30, 2010, based upon the closing price of such stock on that date, was approximately $36,354,000.

The number of shares of the registrant’s common stock outstanding as of March 16, 2011 was 33,601,131.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the definitive proxy statement (the “Proxy Statement”) to be filed with the Securities and Exchange Commission relative to the issuer’s 2011 Annual Meeting of Shareholders are incorporated by reference into Part III of this Form 10-K.
 


 
 

 

ECHO THERAPEUTICS, INC.
2010 Annual Report on Form 10-K

TABLE OF CONTENTS

Item
 
Page
 
PART I
 
1.
3
1A.
9
2.
19
3.
19
 
PART II
 
5.
19
7.
20
8.
32
9.
33
9A.
33
 
PART III
 
10.
34
11.
34
12.
34
13.
34
14.
34
 
PART IV
 
15.
34
35


In this report, the “Company”, “Echo,” “we,” “us,” and “our” refer to Echo Therapeutics, Inc. “Common Stock” refers to Echo’s Common Stock, $0.01 par value.

We own or have rights to various copyrights, trademarks and trade names used in our business, including the following: Symphony™ tCGM System, Prelude™ SkinPrep System, AzoneTS™ and Durhalieve™.

This Annual Report on Form 10-K contains forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), and Section 27A of the Securities Act of 1933, as amended, which involve risks and uncertainties. All statements other than statements of historical information provided herein may be deemed to be forward-looking statements. Without limiting the foregoing, the words “believes”, “anticipates”, “plans”, “expects” and similar expressions are intended to identify forward-looking statements. Factors that could cause actual results to differ materially from those reflected in the forward-looking statements include, but are not limited to, those discussed in “Risk Factors” and elsewhere in this report and the risks discussed in our other filings with the SEC. Readers are cautioned not to place undue reliance on these forward-looking statements, which reflect management’s analysis, judgment, belief or expectation only as of the date hereof. We undertake no obligation to publicly revise these forward-looking statements to reflect events or circumstances that arise after the date hereof.

PART I


We are a medical device and specialty pharmaceutical corporation formed in Delaware in 2007.  We are developing the Symphony™ transdermal continuous glucose monitoring (“tCGM”) System (“Symphony”) as a non-invasive, wireless, transdermal continuous glucose monitoring system for use in hospital critical care units and for patients with diabetes.  We are also developing our needle-free Prelude™ SkinPrep System (“Prelude”) as a platform technology for enhanced skin permeation for delivery of topical pharmaceuticals as well as for a wide range of transdermal reformulations of specialty pharmaceutical products previously approved by the United States Food and Drug Administration (“FDA”).

Medical Device Overview

We are a transdermal medical device company with deep expertise in advanced skin permeation technology. We are developing our Prelude System as a platform technology to allow for significantly enhanced and painless skin permeation that will enable two important applications:

 
Analyte extraction with Symphony for needle-free, continuous glucose monitoring of hospital patients (critical care) as the first application; and

 
Needle-free drug delivery, with the topical delivery of lidocaine as the first application.
 
Additional applications for painless, needle-free topical and systemic delivery of drugs are planned.
 
Prelude incorporates a patented, dynamic feedback control mechanism for optimal skin permeation control. Prelude allows for precise, highly effective and completely painless skin permeation prior to analyte extraction or topical drug delivery.

Utilizing the patented, core skin permeation technology found in Prelude, we are developing our needle-free Symphony tCGM System as a non-invasive, wireless,  monitoring and trending system for use in hospital critical care units and for people with diabetes. Symphony includes the Prelude SkinPrep System for needle-free skin permeation and our patented, non-invasive, continuous transdermal glucose biosensor. With Symphony, we are initially focused on the hospital critical care setting with technology designed to assist clinical professionals, improve patient compliance and achieve better overall glucose control in critically ill patients.  All existing FDA-approved continuous glucose monitoring (“CGM”) systems are needle-based, requiring insertion of a glucose sensor into the patient’s skin, which may give rise to risks of infection, inflammation or bleeding at the insertion site. None of these CGM systems are approved for use in a clinical setting.  Symphony is a non-invasive transdermal system that does not require insertion (via a needle) of its glucose sensor and thus does not give rise to the risks associated with needle-based CGM systems.
 
Prelude SkinPrep System

  We are developing Prelude as a safe, effective, easy-to-use and low-cost transdermal skin permeation device for our Symphony tCGM System to enhance the flow of interstitial fluids and molecules across the protective membrane of the stratum corneum, the outmost protective layer of the skin. Prelude incorporates our patented skin permeation control technology into a comfortable, hand-held device used to prepare a small area of the skin for the non-invasive sensor components of Symphony. We have successfully used Prelude to increase the permeability of the skin allowing for analyte extraction and small molecule drug delivery in both internal studies and external feasibility clinical studies for diabetics and for non-diabetics.
   
  We believe Prelude can also be positioned in the transdermal drug delivery market. We expect that the localized disruption of the stratum corneum created by Prelude will potentially allow transdermal drug delivery. In addition, Prelude has the potential to provide a safe and cost effective skin permeation process for the rapid delivery of topical anesthetic creams. We believe our Prelude skin permeation process has the potential to increase skin permeation up to 100 times greater than untreated skin, perhaps making it possible to deliver a wide array of large molecule drugs.

  The key feature of our skin permeation technology is our patented feedback mechanism to achieve optimal and pain-free skin preparation for our transdermal sensing technologies. Prelude’s proprietary, patented feedback control mechanism consists of software, microprocessor controlled circuit and measuring electrodes. While Prelude is in operation, the circuit measures the real-time electrical conductivity of the permeated skin site compared with the subject’s intact skin site. Prelude turns off automatically when the conductivity measurement reaches the effective output as established by the software, thus producing individualized, optimal skin permeation. As a result, Prelude only removes the outermost layer of the epidermis, the stratum corneum, which is about 0.01 mm thick and consists of only dry, dead skin cells. With the advantages of our proprietary feedback control mechanism, we believe the skin permeation process is safe, effective, and pain-free.
 
Partnership with Ferndale Pharma Group for Prelude for the Delivery of Lidocaine

During 2009, we entered into a licensing agreement with Ferndale Pharma Group, Inc. ("Ferndale"), a market leader in advanced skincare and topical therapeutic products. Under the terms of the agreement, we granted Ferndale the right to develop, market, sell and distribute Prelude for skin preparation prior to the application of topical anesthetics prior to a wide-range of needle-based medical procedures in North America and the United Kingdom. This partnership allows our skin permeation technology platform to be combined with Ferndale’s leadership in the topical anesthetic market.

Symphony tCGM System

Our lead medical device program involved with analyte extraction is our Symphony tCGM System, a non-invasive (needle-free), wireless, transdermal continuous glucose monitoring system designed to provide reliable, real-time blood glucose data conveniently, continuously and cost-effectively. Symphony incorporates Prelude (our proprietary skin permeation device), a transdermal sensor, a wireless transmitter and data display monitor.

Partnership with Handok Pharmaceutical for Symphony in South Korea

During 2009, we entered into a license agreement with Handok Pharmaceuticals Co., Ltd. (“Handok”), the largest diabetes care-focused pharmaceutical company in South Korea. Under the terms of the agreement, we granted Handok the right to develop, market, sell and distribute Symphony to medical facilities and diabetics in South Korea.
 
Symphony Market Opportunities

Importance of Continuous Blood Glucose Monitoring

We believe that continuous blood glucose monitoring can be an important part of a diabetes patient’s daily disease management program. Continuous blood glucose monitoring can help plan diabetes treatment, guide day-to-day choices about diet, exercise and insulin use, and avoid unwanted low blood glucose (hypoglycemia) and high blood glucose (hyperglycemia) events and the complications that they can cause. Blood glucose levels are affected by many factors such as the carbohydrate and fat content of food, exercise, stress, illness, and variability in insulin absorption among others; therefore, it is often challenging for diabetes patients to avoid frequent and unpredictable excursions above or below normal glucose levels. Patients are often unaware that their glucose levels are either too high or too low, resulting in their inability to tightly control their glucose levels and prevent the complications associated with unwanted glucose excursions.

In an attempt to achieve and maintain blood glucose levels within a desired range, diabetes patients must measure their glucose levels. The American Diabetes Association (“ADA”) recommends that patients test their blood glucose levels at least three or four times per day; however, despite evidence that intensive glucose management reduces the long-term complications associated with diabetes, industry sources estimate that people with diabetes test, on average, less than twice per day. We believe Symphony has the potential to improve patient compliance to frequent glucose testing, achieve better glucose control and make a positive impact on overall day-to-day diabetes management.


Hospital Critical Care Market

We believe Symphony has the potential to offer a non-invasive, wireless, tCGM solution for use in the rapidly emerging hospital critical care market. A primary cause of infection in critically ill patients is hyperglycemia which is a result of insulin resistance and total parenteral nutrition. Clinical studies have demonstrated that intensive insulin therapy to maintain tight glycemic control significantly reduces patient mortality, complications and infection rates, as well as hospital stays, services and overall hospital costs.

Regular monitoring of blood glucose levels is rapidly becoming a necessary procedure performed by hospital critical care personnel to achieve tight glycemic control and ensure improved patient outcomes. In a survey by Boston Biomedical Consultants of more than 60 hospital critical care unit managers and nurse clinicians in the United States, more than 90% of those surveyed acknowledged the benefits of tight glycemic control protocols in the hospital critical care setting. We believe that tight glycemic control protocols are becoming the new standard of care in hospital critical care units across the United States, for patients with and without diabetes.

Today, standard practice by critical care nurses is to measure blood glucose at the patient’s bedside periodically. We believe that a needle-free CGM system such as Symphony will save valuable nursing time and expense by avoiding the need for frequent blood glucose sampling, in addition to providing more clinically relevant, real-time glucose level and trending information needed to develop better control algorithms for insulin administration.

Diabetes Home Use Market

Diabetes is a chronic and life-threatening disease caused by the body’s inability to produce or properly use insulin, a key hormone the body uses to manage glucose, which fuels the cells in the body. According to the ADA, about 26 million people in the United States, or approximately eight percent (8%) of the population, have diabetes, including over 7 million people who remain unaware that they have the disease. In addition, before people develop type 2 diabetes (discussed below), they usually have “pre-diabetes,” or blood glucose levels that are higher than normal but not yet high enough to be diagnosed as diabetes. According to the ADA, there are 79 million people in the United States who have pre-diabetes.

When blood glucose levels are high, diabetes patients often administer insulin to reduce their blood glucose level. Unfortunately, insulin administration can reduce blood glucose levels below the normal range, causing hypoglycemia. In cases of severe hypoglycemia, diabetes patients risk severe and acute complications, such as loss of consciousness or death. Due to the drastic nature of acute complications associated with hypoglycemia, many diabetes patients are afraid of sharply reducing their blood glucose levels and often remain in a hyperglycemic state, exposing themselves to long-term complications of that condition.

According to the ADA, the cost of diabetes care in the United States in 2007 was more than $174 billion, including $116 billion in excess medical expenditures attributed to diabetes and $58 billion in reduced national productivity. The ADA estimates that people with diabetes, on average, have medical expenditures that are approximately 2.3 times higher than the expenditures would be in the absence of diabetes and that approximately $1 in $10 healthcare dollars is attributed to diabetes. A significant portion of overall diabetes care costs, approximately $7 billion according to industry sources, is attributable to costs associated with monitoring blood glucose levels, and that market segment is projected to grow substantially by 2011 as patients and their physicians seek ways to manage glucose levels more effectively.
 

Specialty Pharmaceutical Overview

Our specialty pharmaceuticals pipeline is based on our proprietary AzoneTS transdermal drug reformulation technology. AzoneTS is a nontoxic, nonirritating skin penetration enhancer that is intended to enable topical application of FDA-approved medications, including pharmaceutical products that previously could only be administered systemically. AzoneTS increases lipid membrane fluidity in the stratum corneum layer of the skin, thereby decreasing resistance to topically applied therapeutics. Our proprietary synergistic chemical combination enables AzoneTS to be a highly effective skin penetration enhancer at low concentration levels. When combined with AzoneTS, we believe the penetration of numerous commercially successful, FDA-approved drugs can be substantially improved. We believe that, despite their commercial success in large, chronic markets, many FDA-approved products with safety, efficacy and/or patient comfort and convenience issues that limit or prohibit their full commercial potential are amenable to our AzoneTS reformulation technology focused on improved dermal penetration.
 
Our most advanced drug candidate is Durhalieve, an AzoneTS formulation of triamcinolone acetonide, a widely-used, medium potency corticosteroid approved by the FDA for treatment of corticosteroid-responsive dermatoses. In addition to Durhalieve for the treatment of corticosteroid-responsive dermatoses, we believe that Durhalieve could be developed as a treatment for keloid scarring.

If Durhalieve is approved by the FDA for treatment of corticosteroid-responsive dermatoses, we believe we will be well-positioned to offer the pharmaceutical industry a highly efficient and relatively low cost, advanced topical alternative for several FDA-approved oral and injectable specialty pharmaceutical products.  Durhalieve has completed Phase 3 clinical trials and we are currently working to satisfy the remaining requirements that we believe are necessary to obtain FDA approval of Durhalieve.

Government Regulation

Government authorities in the United States, at the federal, state and local level, and other countries extensively regulate the research, development, testing, manufacture, labeling, promotion, advertising, distribution, marketing, export and import of products such as those we are developing. In the United States, pharmaceuticals, biologics and medical devices are subject to rigorous FDA regulation. Federal and state statutes and regulations govern, among other things, the testing, manufacture, safety, efficacy, labeling, storage, export, record keeping, approval, marketing, advertising and promotion of our potential products. The information that must be submitted to the FDA in order to obtain approval to market a new drug varies depending on whether the drug is a new product whose safety and effectiveness has not previously been demonstrated in humans, or a drug whose active ingredient(s) and certain other properties are the same as those of a previously approved drug. Drugs follow either the new drug application or biologics license application routes. Product development and approval within this regulatory framework takes a number of years and involves significant uncertainty combined with the expenditure of substantial resources.

FDA Approval Process for Medical Devices

Generally, medical devices require FDA approval or clearance before they may be marketed. There are two review procedures by which a product may receive such approval or clearance. Some products may qualify for clearance under a pre-market notification, or 510(k) procedure, in which the manufacturer provides to the FDA a pre-market notification that it intends to begin marketing the product, and demonstrates to the FDA’s satisfaction that the product is substantially equivalent to a legally marketed device. A product is considered substantially equivalent if it has the same intended use, and also has either the same technological characteristics (as defined in the Federal Food, Drug, and Cosmetic Act (“FD&CA”)), or if the product has different technological characteristics, the information submitted in the pre-market notification demonstrates that the product is as safe and effective as a legally marketed device and does not raise different questions of safety and effectiveness than a legally marketed device. Marketing may commence when the FDA issues a clearance letter. If a medical device does not qualify for the 510(k) procedure, the FDA must approve a pre-market approval application (“PMA”) before marketing can begin. PMA applications must demonstrate, among other matters, that the medical device is safe and effective. The PMA approval process is typically more comprehensive than the 510(k) process, and usually requires pre-clinical and extensive clinical studies. Further, before the FDA will approve a PMA, the manufacturer must pass an inspection demonstrating its compliance with the requirements of the FDA’s quality system regulations. FDA requests for additional studies during the review period are not uncommon and can significantly delay approvals.

In addition, a number of other FDA requirements apply to medical device manufacturers and distributors. Device manufacturers must be registered and their products listed with the FDA and certain adverse events and product malfunctions must be reported to the FDA. The FDA also prohibits an approved or cleared device from being marketed for unapproved or uncleared uses. Our product labeling, promotion and advertising will be subject to continuing FDA regulation. Manufacturers must comply with the FDA’s quality system regulation, which establishes extensive requirements for quality control and manufacturing procedures. The FDA periodically inspects facilities to ascertain compliance with these and other requirements. Thus, manufacturers and distributors must continue to spend time, money and effort to maintain compliance. Failure to comply with the applicable regulatory requirements may subject us to a variety of administrative and judicially imposed sanctions, including withdrawal of an approval or clearance, warning letters, product recalls, product seizures, total or partial suspension of production or distribution, injunctions, and civil and criminal penalties against us or our officers, directors or employees. Failure to comply with regulatory requirements could have a material adverse effect on our business, financial condition and results of operations.


In order to obtain marketing clearance for Symphony, we will be required to file a PMA that demonstrates the safety and effectiveness of the product.

FDA Approval Process for Pharmaceutical Products

In the United States, the FDA regulates drugs under FD&CA and implementing regulations. Before a drug may be marketed in the United States preclinical laboratory tests, animal studies and formulation studies must be conducted under the FDA’s current good laboratory practices, followed by submission to the FDA of an investigational new drug (“IND”) for human clinical testing, which must become effective before human clinical trials may begin and must include independent institutional review board approval at each clinical site before the trial is initiated.  
If clinical trials are permitted to commence, they are typically are conducted in three sequential phases, but the phases may overlap or be combined. Phase 1 trials usually involve the initial introduction of the investigational drug into humans to evaluate the product candidate’s safety, dosage tolerance and pharmacodynamics and, if possible, to gain an early indication of its effectiveness. Phase 2 trials usually involve controlled trials in a limited patient population to evaluate dosage tolerance and appropriate dosage, identify possible adverse effects and safety risks and evaluate the preliminary efficacy of the drug candidate for specific indications. Phase 3 trials usually further evaluate clinical efficacy and test further for safety in an expanded patient population. Phase 1, Phase 2 and Phase 3 testing may not be completed successfully within any specified period, if at all. Furthermore, the FDA or we may suspend or terminate clinical trials at any time on various grounds, including a finding that the subjects or patients are being exposed to an unacceptable health risk.

Assuming successful completion of the required clinical testing, the results of the preclinical studies and of the clinical studies, together with other detailed information, including information on the chemistry, manufacture and control criteria of the product, are submitted to the FDA in the form of a New Drug Application (“NDA”) requesting approval to market the product candidate for one or more indications. The FDA reviews a NDA to determine, among other things, whether a product candidate is safe and effective for its intended use and whether its manufacturing is current GMP-compliant to assure and preserve the product candidate’s identity, strength, quality and purity. The FDA may refuse to accept and review insufficiently complete applications.

Before approving a NDA, the FDA will inspect the facility or the facilities at which the product candidate is manufactured. If the FDA determines the application, manufacturing process or manufacturing facilities are not acceptable, it will outline the deficiencies in the submission and often will request additional testing or information. Notwithstanding the submission of any requested additional information, the FDA ultimately may decide that the application does not satisfy the regulatory criteria for approval.

The testing and approval process requires substantial time, effort and financial resources, and each may take several years to complete. The FDA may not grant approval on a timely basis, or at all. We may encounter difficulties or unanticipated costs in our efforts to secure necessary governmental approvals, which could delay or preclude us from marketing our products. The FDA may limit the indications for use or place other conditions on any approvals that could restrict the commercial application of the products. 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.

Foreign Regulation

In addition to regulations in the United States, we will 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.


Related Matters

From time to time, federal legislation is drafted, introduced and passed in the United States that could significantly change the statutory provisions governing the approval, manufacturing and marketing of products regulated by the FDA. In addition, 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 legislative changes will be enacted, or FDA regulations, guidance or interpretations changed, or what the impact of such changes, if any, may be.

Research and Development

A major portion of our operating expenses to date is related to our research and development (“R&D”) activities. R&D expenses generally consist of internal salaries and related costs, and third-party vendor expenses for product design and development, product engineering and contract manufacturing. In addition, R&D costs include regulatory consulting, feasibility product testing (internal and external) and conducting nonclinical and clinical studies. R&D expenses were approximately $2,579,000 and $2,807,000, for the years ended December 31, 2010 and 2009, respectively. We intend to maintain our strong commitment to R&D as an essential component of our product development efforts. Licensed or acquired technology developed by third parties may be an additional source of potential products; however, our ability to raise sufficient financing may impact our level of R&D spending.

Manufacturing

We do not have, and do not intend to establish in the near term, our own manufacturing capability for our medical device products or our pharmaceutical products or their APIs, or the capability to package any products we may sell in the future. We intend to rely on third-party manufacturers and suppliers to manufacture our medical devices and to produce and supply the APIs and drug products that we require to meet preclinical research, testing and clinical study requirements.

We currently have engaged a third-party contract manufacturer for the tooling, assembly and testing of our Prelude System for sale to our licensee, Ferndale.  Also, we have contracted with several engineering and product design firms related to the final product development of our Symphony System. Our policy is to use third-party manufacturers that comply with the FDA’s GMP requirements and other rules and regulations prescribed by domestic and foreign regulatory authorities.

If our product candidates are approved, we believe that qualified suppliers and manufacturers for such medical device products and pharmaceutical products will be available in the future, at a reasonable cost to us, although there can be no assurance that this will be the case.

Competition

The medical device and pharmaceutical industries are intensely competitive. Many companies, universities, and research organizations developing competing product candidates have greater resources and significantly greater experience in financial, research and development, manufacturing, marketing, sales, distribution, and technical regulatory matters than we have. In addition, many competitors have greater name recognition and more extensive collaborative relationships. Our competitors could commence and complete clinical testing of their product candidates, obtain regulatory approvals, and begin commercial-scale manufacturing of their products faster than we are able to for our products. They could develop products that would render our product candidates, and those of our collaborators, obsolete and noncompetitive. Our competitors may develop more effective or more affordable products or achieve earlier patent protection or product commercialization than we do.

We expect that any products that we develop will compete primarily on the basis of product efficiency, safety, patient convenience, reliability, availability and price; however, there can be no assurance that we will successfully develop technologies and products that are more effective, safer, more convenient, more reliable, more available or more affordable than those being developed by our current and future competitors. Please see “Risks related to competition” in Item 1A below.


Intellectual Property

We maintain a comprehensive US and international portfolio of intellectual property that we consider to be of material importance in protecting our technologies. Our success depends primarily on our ability to establish and maintain the proprietary nature of our technology through the patent process. In order to protect our proprietary technologies, we also rely on a combination of trademark, copyright and trade secret protection, as well as confidentiality agreements with employees, consultants and third parties.

Our intellectual property covers skin permeation control for enhanced drug delivery and transdermal diagnostics in the field of medical devices, and reformulations of topical products in the field of specialty pharmaceuticals.  We also have intellectual property in glucose sensor and hydrogel processes as they relate to analyte extraction.

These patents provide considerable protection from new entrants, and we focus our patent coverage only on aspects of our technologies that we believe will be significant and that could provide barriers to entry for our competition worldwide. Our success depends to a significant degree upon our ability to develop proprietary products and technologies and to obtain patent coverage for such products and technologies. We intend to continue our practice of filing patent applications covering newly developed products and technologies.

Employees

As of December 31, 2010, we had eleven (11) employees. Of these employees, six (6) are involved with finance and administration and five (5) are involved with research and development, clinical and regulatory matters. In addition to these individuals, we utilize outside contract engineering and contract manufacturing firms to support our operations. We have engaged a clinical research organization and several consulting firms involved with investor relations, regulatory strategy and clinical trial planning. We plan to increase the number of employees in the areas of clinical research and testing, engineering and administration.

As of December 31, 2009, we had nine (9) employees. Of these employees, five (5) were involved with finance and administration and four (4) were involved with research and development, clinical and regulatory matters.

Company Information

Our principal executive offices are located at 10 Forge Parkway, Franklin, Massachusetts 02038 and our telephone number is (508) 553-8850.   As of March 9, 2011, we entered into a lease for approximately 5,400 square feet of corporate office space in a single facility located in Philadelphia, Pennsylvania.
 
We make our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to those reports available through our website, free of charge, as soon as reasonably practicable after we file such material with, or furnish it to the SEC. Our OTC Bulletin Board symbol is “ECTE” and our corporate website is www.echotx.com. The contents of our website are not part of this Report, and our internet address is included in this document as an inactive textual reference only.


Risk Factors

We operate in a rapidly changing environment that involves a number of risks, some of which are beyond our control. Forward-looking statements in this document and those made from time to time by us through our senior management are made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. Forward-looking statements concerning the expected future revenues or earnings or concerning projected plans, performance, or development of products and services, as well as other estimates related to future operations, are necessarily only estimates of future results and there can be no assurance that actual results will not materially differ from expectations. Forward-looking statements represent management’s current expectations and are inherently uncertain. We do not undertake any obligation to update forward-looking statements. Factors that could cause actual results to differ materially from results anticipated in forward-looking statements include, but are not limited to, the following:


We continue to require substantial amounts of capital.

    Our development efforts to date have consumed and will continue to require substantial amounts of capital in connection with research and development of Symphony, Prelude and specialty pharmaceuticals programs. As we conduct more advanced development of our products, we will need significant funding to complete our product development programs and to pursue product commercialization. Our ability to meet our research, development and planned commercialization activities associated with our product pipeline is highly dependent on our ability to obtain sufficient financing.

We have a history of operating losses and we expect our operating losses to continue for the foreseeable future.

We have generated limited revenue and have had operating losses since inception, including a net loss of approximately $4,100,000 for the year ended December 31, 2010. As of December 31, 2010, we had an accumulated deficit of approximately $71,500,000. Losses have resulted principally from costs incurred in connection with our research and development activities and from general and administrative costs associated with our operations. We also expect to have negative cash flows for the foreseeable future as we fund our operating losses and capital expenditures. This will result in decreases in our working capital, total assets and shareholders’ equity, which may not be offset by future funding. It is possible that we will never generate sufficient revenue to achieve and sustain profitability. Even if we achieve profitability, we may not be able to sustain or increase profitability. We expect our operating losses to continue and increase for the foreseeable future as we continue to expend substantial resources to conduct research and development, seek to obtain regulatory approval for Symphony, Prelude, and Durhalieve, identify and secure collaborative partnerships, and manage and execute our obligations in possible strategic collaborations. These losses, among other things, have had and will continue to have an adverse effect on our stockholders’ equity.

Our principal shareholders own a significant percentage of our stock and will be able to exercise significant influence.

Our principal shareholders own a significant percentage of our outstanding capital stock. Accordingly, these shareholders may be able to determine the composition of a majority of our Board of Directors, retain the voting power to approve certain matters requiring shareholder approval, and continue to have significant influence over our affairs. This concentration of ownership could have the effect of delaying or preventing a change in our control. Furthermore, so long as the purchasers in our January 2007 strategic private placement own 20% of the shares purchased in that transaction, the purchasers have the right to designate one director for election to our Board of Directors. The candidate is designated by the purchaser holding at least a majority of the shares of Common Stock purchased in the January 2007 financing, and such holder is currently Sherbrooke Partners, LLC, a beneficial owner of approximately 5.92% of our outstanding Common Stock as of March 16, 2011. Additionally, this significant concentration of share ownership may adversely affect the trading price of our Common Stock because investors often perceive disadvantages in owning stock in companies with a concentration of ownership.

Our future success is dependent upon successful collaborations with strategic partners.

Our future success is dependent upon our ability to selectively enter into and maintain collaborative arrangements with third parties for technology research and development, clinical testing, product development and sales and marketing. If we are unable to enter into additional development agreements or collaborative arrangements with strategic partners, we will be required to internally fund all of our product development activities, significantly increasing business risk and capital requirements in the development, clinical testing, manufacturing, marketing and commercialization of new products. We could also encounter significant delays in introducing products into markets or find that the development, manufacture or sale of proposed products in such markets is adversely affected by the absence of those collaborative arrangements.

The process of establishing collaborative partners is difficult, time-consuming and involves significant uncertainty. Discussions with potential collaborators may not lead to the establishment of new collaborative relationships on favorable terms, if at all. If successful in establishing a collaborative agreement, such agreement may never result in the successful development of products or the generation of significant revenue. Any such agreements could limit our flexibility in pursuing alternatives for the development or commercialization of our products. Even if we were to enter into additional collaborative arrangements with third parties, there can be no assurance that our financial condition or results of operations will significantly improve.

Our stock price has been volatile and may fluctuate in the future.

 
 
 
The trading price of our Common Stock may fluctuate significantly. This price may be influenced by many factors, including:
 
 
our financial condition, performance and prospects;

 
the depth and liquidity of the market for our Common Stock;

 
our ability to enter into successful collaborative arrangements with strategic partners for research and development, clinical testing, and sales and marketing;

 
sales by selling shareholders of shares issued and issuable in connection with our private placements;

 
investor perception of us and the industry in which we operate;

 
general financial and other market conditions; and

 
domestic and international economic conditions.

Public stock markets have experienced extreme price and trading volume volatility, particularly in the technology and life sciences sectors of the market. This volatility has significantly affected the market prices of securities of many technology companies for reasons frequently unrelated to or disproportionately impacted by the operating performance of these companies. These broad market fluctuations may adversely affect the market price of our Common Stock. In addition, fluctuations in our stock price may have made our stock attractive to momentum, hedge or day-trading investors who often shift funds into and out of stocks rapidly, exacerbating price fluctuations in either direction particularly when viewed on a quarterly basis.

Securities we issue to fund our operations could dilute or otherwise adversely affect our shareholders.

We need to raise substantial additional funds through public or private equity or debt financings to fund our operations. If we raise funds by issuing equity securities, the percentage ownership of current shareholders will be significantly reduced and the new equity securities may have rights senior to those of the shares of our Common Stock. We may not obtain sufficient financing on terms that are favorable to current investors or us. We may delay, limit or eliminate some or all of our proposed operations if adequate funds are not available.

Risks related to our discovery, development and commercialization of new medical products

Our medical device products are based on new technologies and may not be successfully developed or achieve market acceptance.

Most of our products under development have a high risk of failure because they are based on new technologies. To date, we have tested the feasibility of Prelude for various applications, including continuous glucose monitoring and certain topical anesthetic applications. We have also tested the feasibility of Symphony for the monitoring of glucose on a continuous basis; however, to develop additional products or additional uses, substantial expenditures will be required, including for feasibility studies, pre-clinical studies and clinical testing. Projected costs for such development are difficult to estimate and they may change and increase frequently.

Our success is dependent on further developing new and existing products and obtaining favorable results from pre-clinical studies and clinical trials and satisfying regulatory standards and approvals required for the market introduction of such products, including skin permeation methods and Symphony. There can be no assurance that we will not encounter unforeseen problems in the development of Symphony and Prelude, or that we will be able to successfully address the problems that do arise. There can be no assurance that any of our potential products will be successfully developed, proven safe and efficacious in clinical trials, meet applicable regulatory standards, be capable of being produced in commercial quantities at acceptable costs, or be eligible for third-party reimbursement from governmental or private insurers. Even if we successfully develop new products, there can be no assurance that such products will be successfully marketed or achieve market acceptance, or that expected markets will develop for such products. If any of our development programs are not successfully completed, required regulatory approvals or clearances are not obtained, or potential products for which approvals or clearances are obtained are not commercially successful, our business, financial condition and results of operations would be materially adversely affected.


In addition, because our products are based on new technologies, they are subject to lengthy sales cycles and may take substantial time and effort to achieve market acceptance, especially at hospitals, which typically have a lengthy and rigorous approval process for adopting new technologies.

Our future success may be dependent in part upon successful development of Symphony for the hospital critical care market.

We have completed the initial prototypes and have conducted several feasibility human clinical studies at a leading Boston-area hospital, with a member of our Medical Advisory Board serving as principal investigator. Although we believe the clinical rationale exists for Symphony for the critical care market, there can be no assurance that such a market will be established, or that we will be able to successfully develop a product that will prove effective for this market or gain market acceptance should such a market develop. Our Symphony product development process may take several years and will require substantial capital outlays. If the critical care market does not develop as we expect, or if we are unable to successfully develop Symphony for such markets on a timely basis and within cost constraints, then our business and financial results will be materially adversely affected.

Our pharmaceutical products are in various stages of development and may not be successfully developed or obtain regulatory approval.

The product candidates in our AzoneTS pipeline are at various stages of developments. We have filed a NDA covering Durhalieve, our most advanced AzoneTS product candidate, for corticosteroid responsive dermatoses, with the FDA and we are now seeking to satisfy FDA manufacturing requirements necessary to secure market approval. We believe that the failure to advance Durhalieve beyond its current stage of development may have a material adverse effect on our financial condition and results of operations.

We cannot guarantee that we will be able to successfully complete clinical trials and other requirements needed to secure approval of our product candidates. As a result, our nonclinical and clinical development programs may be extended, delayed or terminated, and we may be unable to obtain regulatory approval or successfully commercialize our product candidates.

We may not be able to gain market acceptance of our product candidates, which would prevent us from becoming profitable.

Even if our product candidates receive regulatory approval, we cannot be certain that any of our product candidates will gain market acceptance among physicians, patients, healthcare payers, hospitals, pharmaceutical companies and the medical community in general. The degree of market acceptance will depend on a number of factors, including:

 
Our establishment and demonstration to the medical community of the clinical efficacy and safety of our product candidates;

 
Our ability to create products that are superior to alternatives currently on the market; and

 
Our ability to establish in the medical community the potential advantage of our treatments over alternative treatment methods.

These and other factors combined with obtaining regulatory approvals will not guarantee future revenues. Sales of medical products largely depend on the reimbursement of patients’ medical expenses by government healthcare programs and private health insurers. Governments and private insurers closely examine medical products to determine whether they should be covered by reimbursement and, if so, the level of reimbursement that will apply. We cannot be certain that third party payers will sufficiently reimburse sales of our products, or enable us to sell our products at profitable prices. Similar concerns could also limit the reimbursement amounts that health insurers or government agencies in other countries are prepared to pay for our products. In many areas where we plan to market our products, including Europe, Japan and Canada, the pricing of prescription drugs is controlled by the government or regulatory agencies. Government or other regulatory agencies in these countries could determine that the pricing for our products should be based on prices of other commercially available drugs for the same disease, rather than allowing us to market our products at a premium as new drugs.

Sales of medical products also depend on physicians’ willingness to prescribe the treatment, which is likely to be based on a determination by these physicians that the products are safe, therapeutically effective and cost-effective. We cannot predict whether physicians, other healthcare providers, government agencies or private insurers will determine that our products are safe, therapeutically effective and cost effective relative to competing treatments.


We may not be able to obtain and maintain the third party relationships that are necessary to develop, commercialize and manufacture some or all of our product candidates.

We expect to depend on collaborators, partners, licensees, contract research organizations, manufacturers and other third parties to support our efforts to develop and commercialize our product candidates, to manufacture clinical and commercial scale quantities of our product candidates and products and to market, sell, and distribute any products we successfully develop.

We cannot guarantee that we will be able to successfully negotiate agreements for or maintain relationships with collaborators, partners, licensees, clinical investigators, manufacturers and other third parties on favorable terms, if at all. If we are unable to obtain or maintain these agreements, we may not be able to clinically develop, formulate, manufacture, obtain regulatory approvals for or commercialize our product candidates, which will in turn adversely affect our business.

We expect to expend substantial management time and effort to enter into relationships with third parties and, if we successfully enter into such relationships, to manage these relationships. We must attract and retain collaborative partners and develop technologies and pipeline candidates that meet the requirements of prospective collaborative partners. In addition, substantial amounts of our expenditures will be paid to third parties in these relationships.

We cannot control the amount or timing of resources our contract partners will devote to our research and development programs, product candidates or potential product candidates, and we cannot guarantee that these parties will fulfill their obligations to us under these arrangements in a timely fashion, if at all. In addition, our contract partners will generally have the right to abandon research projects and terminate applicable agreements, including funding obligations, prior to or upon the expiration of agreed upon research terms. There can be no assurance that we will be successful in establishing multiple future collaborative arrangements on acceptable terms or at all, that current or future collaborative partners will not terminate funding before completion of projects, that our existing or future collaborative arrangements will result in successful product commercialization or that we will derive any revenues from such arrangements. Some or all of our collaborative partners may receive exclusive or co-exclusive rights to market products incorporating our technology in a particular field of use or a particular territory. The grant of such rights will limit our alternatives in commercializing certain of our products and technologies.

We have no experience in sales, marketing and distribution and may have to enter into agreements with third parties to perform these functions, which could prevent us from successfully commercializing our product candidates.

We currently have no sales, marketing or distribution capabilities. To commercialize our product candidates, we must either develop our own sales, marketing and distribution capabilities, which will be expensive and time consuming, or make arrangements with third parties to perform these services for us. If we enter into third party arrangements, the third parties may not be capable of successfully selling any of our products. If we decide to market any of our products on our own, we will have to commit significant resources to developing a marketing and sales force and supporting distribution capabilities. If we decide to enter into arrangements with third parties for performance of these services, we may find that they are not available on terms acceptable to us, or at all. If we are not able to establish and maintain successful arrangements with third parties or build our own sales and marketing infrastructure, we may not be able to commercialize our product candidates which would adversely affect our business and financial condition.

Disputes under key agreements or conflicts of interest with our scientific advisors, clinical investigators or other third party collaborators could delay or prevent development or commercialization of our product candidates.

Any agreements we have or may enter into with third parties, such as collaborators, licensees, suppliers, manufacturers, clinical research organizations, clinical investigators or clinical trial sites, may give rise to disputes regarding the rights and obligations of the parties. Disagreements could develop over rights to ownership or use of intellectual property, the scope and direction of research and development, the approach for regulatory approvals or commercialization strategy. We intend to conduct research programs in a range of therapeutic areas, but our pursuit of these opportunities could result in conflicts with the other parties to these agreements that may be developing or selling pharmaceuticals or conducting other activities in the same therapeutic areas. Any disputes or commercial conflicts could lead to the termination of our agreements, delay progress of our product development programs, compromise our ability to renew agreements or obtain future agreements, lead to the loss of intellectual property rights or result in costly litigation.

We collaborate with outside scientific advisors and collaborators at academic and other institutions that assist us in our research and development efforts. Our scientific advisors are not our employees and may have other commitments that limit their availability to us. If a conflict of interest between their work for us and their work for another entity arises, we may lose their services.


We may have challenges in managing our outside contractors for product and regulatory accomplishments.

We rely heavily upon and have relationships with outside contractors and consultants with expertise in drug development, regulatory strategy, manufacturing and other matters. These parties are not our employees and may have commitments to, or consulting or advisory contracts with, other entities that may limit their availability to us. We have limited control over the activities of consultants and outside contractors and, except as otherwise required by our collaboration and consulting agreements, can expect only limited amounts of their time to be dedicated to our activities. If any third party with whom we have or enter into a relationship is unable or refuses to contribute to projects on which we need their help, our ability to generate advances in our technologies and develop our product candidates could be significantly harmed.

Risks related to regulatory approvals

None of our product candidates has received regulatory approval. If we are unable to obtain regulatory approval to market one or more of our product candidates, our business will be adversely affected.

Most of our pharmaceutical product candidates are in early stages of development, and we do not expect these product candidates to be commercially available in the foreseeable future, if at all. Our product candidates are subject to strict regulation by regulatory authorities in the United States and in other countries. In particular, human pharmaceutical therapeutic product candidates are subject to rigorous preclinical and clinical testing and other requirements by the FDA in the United States and similar authorities in other countries in order to demonstrate safety and efficacy. Data obtained from preclinical studies and clinical trials are subject to varying interpretations that could delay, limit or prevent regulatory approval. In addition, failure to comply with regulatory requirements or inadequate manufacturing processes could also prevent product approval. Because our product candidates involve or are expected to involve the application of new technologies or are based upon a new therapeutic approach, they may be subject to substantial additional review by various governmental regulatory authorities and, as a result, the process of obtaining regulatory approval for them may proceed more slowly than for product candidates based upon more conventional technologies. Furthermore, we may encounter delays or rejections due to additional government regulation from future legislation, administrative action or changes in FDA policy. We do not know whether regulatory agencies will grant approval for any of our product candidates. Even if we complete preclinical studies and clinical trials successfully, we may not be able to obtain regulatory approval or we may not receive approval to make claims about our products that we believe to be necessary to effectively market our products.

We cannot market any product candidate until we have completed all necessary preclinical studies and clinical trials and have obtained the necessary regulatory approvals. Outside the United States, our ability to market any of our potential products is dependent upon receiving marketing approval from the appropriate regulatory authorities. These foreign regulatory approval processes include all of the risks associated with the FDA approval process described above plus additional risks. If we are unable to receive regulatory approval, we will be unable to commercialize our product candidates, and our business may fail.

If we are unable to successfully complete the preclinical studies or clinical trials necessary to support PMA or NDA submissions to the FDA, we may be unable to commercialize Symphony, Prelude or AzoneTS products under development, which could impair our financial position.

Before submitting a PMA application to the FDA for Symphony (which includes our Prelude SkinPrep System) or a NDA for an AzoneTS product candidate, we must successfully complete preclinical studies and clinical trials that we believe will demonstrate that our product is safe and effective. Product development, including preclinical studies and clinical trials, is a long, expensive and uncertain process and is subject to delays and failure at any stage. Furthermore, the data obtained from the studies and trial may be inadequate to support approval of a PMA or NDA, as the case may be. With respect to our medical device programs, while we have in the past obtained, and may in the future obtain, an Investigational Device Exemption, or IDE, prior to commencing clinical trials for Symphony, FDA approval of an IDE application permitting us to conduct testing does not mean that the FDA will consider the data gathered in the trial to be sufficient to support approval of a PMA application, even if the trial’s intended safety and efficacy endpoints are achieved.

The commencement or completion of any of our clinical trials may be delayed or halted, or be inadequate to support approval of a PMA or NDA, as the case may be, for numerous reasons, including, but not limited to, the following:
 
the FDA or other regulatory authorities do not approve a clinical trial protocol or a clinical trial, or place a clinical trial on hold;

 
patients do not enroll in clinical trials at the rate we expect;

 
patients do not comply with trial protocols;

 
patient follow-up is not at the rate we expect;

 
patients experience adverse side effects;

 
patients die during a clinical trial, even though their death may not be related to our products;

 
institutional review boards (“IRBs”) and third-party clinical investigators may delay or reject our trial protocol;

 
third-party clinical investigators decline to participate in a trial or do not perform a trial on our anticipated schedule or consistent with the investigator agreements, clinical trial protocol, good clinical practices or other FDA or IRB requirements;

 
third-party organizations do not perform data collection, monitoring and analysis in a timely or accurate manner or consistent with the clinical trial protocol or investigational or statistical plans;

 
regulatory inspections of our clinical trials or contract manufacturing facilities may, among other things, require us to undertake corrective action or suspend or terminate our clinical trials;

 
changes in governmental regulations or administrative actions;

 
the interim or final results of the clinical trial are inconclusive or unfavorable as to safety or efficacy; or

 
the FDA concludes that our trial design is inadequate to demonstrate safety and efficacy.

The results of preclinical studies do not necessarily predict future clinical trial results, and predecessor clinical trial results may not be repeated in subsequent clinical trials. Additionally, the FDA may disagree with our interpretation of the data from our preclinical studies and clinical trials, or may find the clinical trial design, conduct or results inadequate to prove safety or efficacy, and may require us to pursue additional pre-clinical studies or clinical trials, which could further delay the approval of our products. If we are unable to demonstrate the safety and efficacy of our products in our clinical trials, we will be unable to obtain regulatory approval to market our products. The data we collect from our current clinical trials, our pre-clinical studies and other clinical trials may not be sufficient to support FDA approval.

The regulatory approval process is costly and lengthy and we may not be able to successfully obtain all required regulatory approvals.

The preclinical development, clinical trials, manufacturing, marketing and labeling of medical devices and specialty pharmaceuticals are all subject to extensive regulation by numerous governmental authorities and agencies in the United States and other countries. We must obtain regulatory approval for each of our product candidates before marketing or selling any of them. It is not possible to predict how long the approval processes of the FDA or any other applicable federal or foreign regulatory authority or agency for any of our products will take or whether any such approvals ultimately will be granted. The FDA and foreign regulatory agencies have substantial discretion in the medical device and drug approval process, and positive results in preclinical testing or early phases of clinical studies offer no assurance of success in later phases of the approval process. Generally, preclinical and clinical testing of products can take many years and require the expenditure of substantial resources, and the data obtained from these tests and trials can be susceptible to varying interpretations that could delay, limit or prevent regulatory approval. If we encounter significant delays in the regulatory process that result in excessive costs, this may prevent us from continuing to develop our product candidates. Any delay in obtaining, or failure to obtain, approvals could adversely affect the marketing of our products and our ability to generate product revenue. The risks associated with the approval process include:

 
failure of our product candidates to meet a regulatory entity’s requirements for safety, efficacy and quality;


 
limitation on the indicated uses for which a product may be marketed;

 
unforeseen safety issues or side effects; and

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

If we fail to obtain adequate reimbursement for our product candidates, the use of our potential products could be severely limited.

Our ability to successfully commercialize our product candidates will depend significantly on our ability to obtain acceptable prices and the availability of reimbursement to the patient from third-party payors. Significant uncertainty exists as to the reimbursement status of newly-approved healthcare products. If our potential products are not considered cost-effective or if we fail to generate adequate third-party reimbursement for the users of our potential products and treatments, then we may be unable to maintain price levels sufficient to realize an appropriate return on our investment in product development. In both the United States and other markets, sales of our potential products, if any, will depend in part on the availability of reimbursement from third-party payors, examples of which include government health administration authorities, private health insurers, health maintenance organizations, and pharmacy benefit management companies.


Risks related to competition

We operate in highly competitive medical device and specialty pharmaceuticals markets and face competition from large, well-established companies with significantly more resources, and, as a result, we may not be able to compete effectively.

The industries in which we operate are extremely competitive. Many companies, universities, and research organizations developing competing product candidates have greater resources and significantly greater experience in financial, research and development, manufacturing, marketing, sales, distribution, and regulatory matters than we have. In addition, many competitors have greater name recognition and more extensive collaborative relationships. Our competitors could commence and complete clinical testing of their product candidates, obtain regulatory approvals, and begin commercial-scale manufacturing of their products faster than we are able to for our products. They could develop products that would render our product candidates and those of our collaborators obsolete and noncompetitive. Our competitors may develop more effective or more affordable products or achieve earlier patent protection or product commercialization than us. If we are unable to compete effectively against these companies, then we may not be able to commercialize our product candidates or achieve a competitive position in the market. This would adversely affect our ability to generate revenues.

The markets for glucose monitoring devices and specialty pharmaceuticals are intensely competitive, subject to rapid change and significantly affected by new product introductions and other market activities of industry participants. Several companies are developing or currently marketing (for diabetes home-use purposes) continuous glucose monitoring products that will compete directly with our Symphony tCGM System. To date, Abbott, Cygnus, DexCom and Medtronic have received approval from the FDA for continuous glucose monitors for diabetes home-use purposes. The product originally developed and marketed by Cygnus is no longer actively marketed. No company has received FDA approval for continuous glucose monitoring in a hospital setting but Edwards Lifesciences, Luminous Medical, Optiscan and Glumetrics are among those companies actively developing continuous or near-continuous glucose monitoring devices for use in critical care. Most of the companies developing or marketing competing glucose monitoring devices and specialty pharmaceuticals are publicly traded or divisions of publicly-traded companies and these companies enjoy several competitive advantages, including:

 
significantly greater name recognition;

 
established relations with healthcare professionals, customers and third-party payors;

 
established distribution networks;

 
additional lines of products, and the ability to offer rebates or bundle products to offer higher discounts or incentives to gain a competitive advantage;

 
greater experience in conducting research and development, manufacturing, clinical trials, obtaining regulatory approval for products and marketing approved products; and

 
greater financial and human resources for product development, sales and marketing, and patent litigation.

As a result, we may not be able to compete effectively against these companies or their products.

No continuous glucose monitoring system has yet received FDA clearance as a replacement for single-point finger stick devices, and Symphony may never be approved for that indication.

We do not expect Symphony to eliminate the need for single-point finger stick devices in the foreseeable future. At present, there is no established precedent for FDA approval of a continuous glucose monitoring system in a hospital environment or as a replacement technology for standard of care blood glucose monitoring.

Technological breakthroughs in the glucose monitoring market could render our product obsolete.

The glucose monitoring market is subject to rapid technological change and product innovation. Our product is based on our proprietary technology, but a number of companies and medical researchers are pursuing new technologies for the monitoring of glucose levels. FDA approval of a commercially viable continuous glucose monitor or sensor produced by one of our competitors could significantly reduce market acceptance of our system. Several of our competitors are in various stages of developing continuous glucose monitors or sensors, including non-invasive and invasive devices, and the FDA has approved four of these competing products. In addition, the National Institutes of Health and other supporters of diabetes research are continually seeking ways to prevent, cure or improve treatment of diabetes. As a result, our products may be rendered obsolete by technological breakthroughs in diabetes monitoring, treatment, prevention or cure.


Risks related to products liability exposure

We may have significant product liability exposure which may harm our business and our reputation.

We face exposure to product liability and other claims if our product candidates, products or processes are alleged to have caused harm. These risks are inherent in the testing, manufacturing, and marketing of human therapeutic products. Although we currently maintain product liability insurance, we may not have sufficient insurance coverage, and we may not be able to obtain sufficient coverage at a reasonable cost, if at all. Our inability to obtain product liability insurance at an acceptable cost or to otherwise protect against potential product liability claims could prevent or inhibit the commercialization of any products or product candidates that we develop. If we are sued for any injury caused by our products, product candidates or processes, our liability could exceed our product liability insurance coverage and our total assets. Claims against us, regardless of their merit or potential outcome, may also generate negative publicity or hurt our ability to obtain physician endorsement of our products or expand our business.

Risks related to our intellectual property

Our inability to adequately protect our intellectual property could allow our competitors and others to produce products based on our technology, which could substantially impair our ability to compete.

Our success and our ability to compete are dependent, in part, upon our ability to maintain the proprietary nature of our technologies. We rely on a combination of patent, copyright and trademark law, trade secrets and nondisclosure agreements to protect our intellectual property; however, such methods may not be adequate to protect us or permit us to gain or maintain a competitive advantage. Our patent applications may not issue as patents in a form that will be advantageous to us, or at all. Our issued patents, and those that may issue in the future, may be challenged, invalidated or circumvented, which could limit our ability to stop competitors from marketing related products.

To protect our proprietary rights, we may in the future need to assert claims of infringement against third parties to protect our intellectual property. The outcome of litigation to enforce our intellectual property rights in patents, copyrights, trade secrets or trademarks is highly unpredictable, could result in substantial costs and diversion of resources, and could have a material adverse effect on our financial condition and results of operations regardless of the final outcome of such litigation. In the event of an adverse judgment, a court could hold that some or all of our asserted intellectual property rights are not infringed, invalid or unenforceable, and could award attorney fees to the other party.

Despite our efforts to safeguard our unpatented and unregistered intellectual property rights, we may not be successful in doing so or the steps taken by us in this regard may not be adequate to detect or deter misappropriation of our technology or to prevent an unauthorized third party from copying or otherwise obtaining and using our products, technology or other information that we regard as proprietary. Additionally, third parties may be able to design around our patents. Furthermore, the laws of foreign countries may not protect our proprietary rights to the same extent as the laws of the United States. Our inability to adequately protect our intellectual property could allow our competitors and others to produce products based on our technology, which could substantially impair our ability to compete.

We are subject to claims of infringement or misappropriation of the intellectual property rights of others, which could prohibit us from commercializing our product candidates, require us to obtain licenses from third parties or to develop non-infringing alternatives, and subject us to substantial monetary damages and injunctive relief.

As is generally the case in the medical device and pharmaceutical industries in which we operate, third-parties may, in the future, assert infringement or misappropriation claims against us with respect to our current or future products. Whether a product infringes a patent involves complex legal and factual issues, the determination of which is often uncertain; therefore, we cannot be certain that we have not infringed the intellectual property rights of such third parties or others. Our competitors may assert that our product candidates, technologies and/or the methods we employ in the use of Symphony and/or AzoneTS pipeline candidates are covered by U.S. or foreign patents held by them. This risk is exacerbated by the fact that there are numerous issued patents and pending patent applications relating to self-monitored glucose testing systems in the medical technology field. Because patent applications may take years to issue, there may be applications now pending of which we are unaware that may later result in issued patents that our products infringe. There could also be existing patents of which we are unaware that one or more components of our system may inadvertently infringe. As the number of competitors in the market for continuous glucose monitoring systems and specialty pharmaceuticals grows, the possibility of inadvertent patent infringement by us or a patent infringement claim against us increases.


Any infringement or misappropriation claim could cause us to incur significant costs, place significant strain on our financial resources, divert management’s attention from our business and harm our reputation. If the relevant patents were upheld as valid and enforceable and we were found to infringe, we could be prohibited from selling our product that is found to infringe unless we obtain the right to use the technology covered by the patent or are able to design around the patent. We may be unable to obtain such rights on terms acceptable to us, if at all, and we may not be able to redesign our products to avoid infringement. Even if we are able to redesign our products to avoid an infringement claim, we may not receive FDA approval for such changes in a timely manner or at all. A court could also order us to pay compensatory damages and prejudgment interest for such infringement and could, in addition, treble the compensatory damages and award attorney fees. These damages could be substantial and could harm our reputation, business, financial condition and operating results. A court also could enter orders that temporarily, preliminarily or permanently enjoin us and our customers from making, using, selling or offering to sell our products, or could enter an order mandating that we undertake certain remedial activities. Depending on the nature of the relief ordered by the court, we could become liable for additional damages to third parties.


We lease approximately 13,000 square feet of research-scale manufacturing, laboratory and office space in a single facility located in Franklin, Massachusetts under a lease expiring March 31, 2014.  In addition, as of March 9, 2011, we entered into a lease for approximately 5,400 square feet of corporate office space in a single facility located in Philadelphia, Pennsylvania.
 

None.

PART II
 

Our Common Stock is currently traded through the OTC Bulletin Board (OTCBB) and is quoted under the symbol “ECTE”. The following table sets forth the range of high and low closing prices for our Common Stock for the periods indicated as reported by the OTCBB in 2009 and 2010.  The number of common shareholders of record of Echo as of March 16, 2011 was 178.
 
Fiscal Year Ended December 31, 2009 
 
High
   
Low
 
First Quarter
  $ 0.70     $ 0.25  
Second Quarter
  $ 1.69     $ 0.35  
Third Quarter
  $ 1.96     $ 1.36  
Fourth Quarter
  $ 1.70     $ 1.22  

Fiscal Year Ended December 31, 2010 
 
High
   
Low
 
First Quarter
  $ 2.02     $ 1.47  
Second Quarter
  $ 1.70     $ 1.16  
Third Quarter
  $ 1.32     $ 0.92  
Fourth Quarter
  $ 1.60     $ 0.92  

*
The quotations reflect inter-dealer prices, without retail mark-up, mark-down or commission, and may not represent actual transactions.

We have never paid or declared any cash or other dividends on our Common Stock.


Information regarding our equity compensation plans and the securities authorized for issuance hereunder is set forth in Note 10 and Items 11 and 12. Information regarding sales of unregistered securities is set forth in Item 7, Notes 8, 9 and 14.

We did not repurchase any shares of Common Stock during the year ended December 31, 2010.

During 2010, warrants to purchase 143,793 shares of our Common Stock were exercised voluntarily in cashless exercises, providing no gross proceeds.


The following discussion of our consolidated financial condition and results of operations should be read in conjunction with the consolidated financial statements and the related notes thereto included elsewhere in this Form 10-K. The matters discussed herein contain forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended, and Section 27A of the Securities Act of 1933, as amended, which involve risks and uncertainties. All statements other than statements of historical information provided herein may be deemed to be forward-looking statements. Without limiting the foregoing, the words “believes”, “anticipates”, “plans”, “expects” and similar expressions are intended to identify forward-looking statements. Factors that could cause actual results to differ materially from those reflected in the forward-looking statements include, but are not limited to, those discussed in “Risk Factors” and elsewhere in this report and the risks discussed in our other filings with the SEC. Readers are cautioned not to place undue reliance on these forward-looking statements, which reflect management’s analysis, judgment, belief or expectation only as of the date hereof. We undertake no obligation to publicly revise these forward-looking statements to reflect events or circumstances that arise after the date hereof.

Organization

We are a medical device and specialty pharmaceutical company. We are developing the Symphony™ transdermal continuous glucose monitoring (“tCGM”) System (“Symphony”) as a non-invasive, wireless, transdermal continuous glucose monitoring system for use in hospital critical care units and for patients with diabetes.  We are also developing our needle-free Prelude™ SkinPrep System (“Prelude”) as a platform technology for enhanced skin permeation for delivery of topical pharmaceuticals as well as for a wide range of transdermal reformulations of specialty pharmaceutical products previously approved by the United States Food and Drug Administration (“FDA”).

Operating Plan

We are principally involved with product development and clinical studies for our Symphony tCGM System using our Prelude SkinPrep System. Symphony is a next-generation, non-invasive (needle-free), wireless tCGM system designed to provide reliable, continuous blood glucose data conveniently and cost-effectively. We have completed our principal research and advanced our feasibility development of our Symphony prototype, including necessary product development for our proprietary Prelude SkinPrep System, and have engaged several product development, engineering, and contract manufacturing firms to assist us with all necessary efforts in connection with our plan to finalize product development and advance our regulatory approval process through the FDA. We have completed several clinical studies using Symphony in an acute care (hospital) environment, as well as in ambulatory settings for type 1 and type 2 diabetics and non-diabetics. In order to complete our product development, clinical development programs and to obtain regulatory approval for Symphony, we need to raise substantial additional financing.
 
In connection with a license agreement with Ferndale for Prelude, we have substantially completed product development and are currently working with our contract manufacturer regarding final manufacturing and product testing.
 
Our specialty pharmaceuticals pipeline is based on our proprietary AzoneTS transdermal drug reformulation technology. We believe that, despite their commercial success in large, chronic markets, many FDA-approved products are candidate for our AzoneTS reformulation technology that is focused on improved and enhanced dermal penetration. Our lead product candidate is Durhalieve, an AzoneTS topical reformulation of triamcinolone acetonide. Durhalieve is covered by our NDA on file with the FDA for treatment of corticosteroid-responsive dermatoses. Presently, we are working to satisfy the FDA’s remaining manufacturing and clinical study requirements necessary to secure FDA approval of Durhalieve. In order to complete our product development program and to continue efforts to obtain regulatory approval for Durhalieve, we need to raise substantial additional financing.
 
Research and Development

A significant portion of our research and development expenses includes salaries paid to personnel, outside product development design and engineering firms and other contract service providers, as well as for the allocation of facilities costs.

Our product development efforts are principally concentrated on Symphony and Prelude. While our medical device product development programs are progressing, financial constraints in both 2009 and 2010 have prevented us from advancing these programs in accordance with the timelines we had originally anticipated.

Due to financial constraints in 2009 and 2010, we have been unable to advance and finalize our AzoneTS product development programs as rapidly as we had originally anticipated. If we are unable to obtain sufficient funding necessary to complete our current planned development schedule for Durhalieve, then we may incur additional time and expenses to obtain approval for Durhalieve from the FDA and to commercialize Durhalieve. Should Durhalieve not receive FDA approval, then we may be required to write-off as an impairment charge all or a portion of the intangible assets acquired based on the specific facts and circumstances that will be evaluated at a future date.

Critical Accounting Policies and Estimates

Our consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these consolidated financial statements requires management 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 and the reported amounts of revenues and expenses during the reporting period.

On an ongoing basis, we evaluate our estimates and judgments for all assets and liabilities, including those related to stock-based compensation expense and, the fair value determined for stock purchase warrants classified as derivative liabilities. We base our estimates and judgments on historical experience, current economic and industry conditions and on various other factors that are believed to be reasonable under the circumstances. This forms the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. We believe the following critical accounting policies affect our more significant judgments and estimates used in the preparation of our consolidated financial statements.

Our significant accounting policies are described in “Item 8 — Financial Statements — Note 2 — Summary of Significant Accounting Policies.” We believe the critical accounting policies discussed below are those most important for an understanding of our financial condition and results of operations and require our most difficult, subjective or complex judgments.

Intangible Assets and Other Long-Lived Assets — We record intangible assets at acquisition date fair value. As a policy, we amortize our intangible assets using the straight-line method over their estimated useful lives, as follows: patents and licenses, two (2) to twenty (20) years; definite-lived core and developed technology, five (5) to twenty-five (25) years; and other intangible assets, over various periods. In connection with our acquisition of Durham Pharmaceuticals Ltd., a North Carolina corporation doing business as Echo Therapeutics, Inc. (the “ETI Acquisition”) in September 2007, intangible assets related to contractual arrangements were amortized over the estimated useful life of three (3) years and ended in 2010.  Intangible assets related to technology are expected to be amortized on a straight-line basis over the period ending 2018 when the underlying patents expire and will commence upon revenue generation.

Accounting for Impairment and Disposal of Long-Lived Assets — We review intangible assets subject to amortization quarterly to determine if any adverse conditions exist or a change in circumstances has occurred that would indicate impairment or a change in the remaining useful life. Conditions that would indicate impairment and trigger an impairment assessment include, but are not limited to, a significant adverse change in legal factors or business climate that could affect the value of an asset, or an adverse action or assessment by a regulator. If the carrying value of an asset exceeds its undiscounted cash flows, we write-down the carrying value of the intangible asset to its fair value in the period identified.


For purposes of this analysis, we estimate our cash flows using a projection period not exceeding ten years, market size based on estimated prescription volume, estimated market share, average pricing, estimated costs to complete product development, operating expenses and a blended tax rate. Generally, cash flow forecasts for purposes of impairment analysis are prepared on a consistent basis and using a consistent methodology as those prepared for the income approach used to initially estimate the intangible asset’s fair value.

If the carrying value of assets is determined not to be recoverable, we record an impairment loss equal to the excess of the carrying value over the fair value of the assets. Our estimate of fair value is based on the best information available to us, in the absence of quoted market prices.

We generally calculate fair value as the present value of estimated future cash flows that we expect to generate from the asset using the income approach as described above. Significant estimates included in the discounted cash flow analysis as consistent with those described above are used except that we introduce a risk-adjusted discount rate. The risk-adjusted discount rate is estimated using a weighted-average cost of capital analysis. If the estimate of an intangible asset’s remaining useful life is changed, we amortize the remaining carrying value of the intangible asset prospectively over the revised remaining useful life. For other long-lived assets, we evaluate quarterly whether events or circumstances have occurred that indicate that the carrying value of these assets may be impaired.

Share-based Payments — We record share-based payments at fair value. The grant date fair value of awards to employees and directors, net of expected forfeitures, is recognized as expense in the statement of operations over the requisite service period. The fair value of options is calculated using the Black-Scholes option pricing model. This option valuation model requires input of assumptions including the volatility of our stock price, the expected life of the option and the risk-free interest rate. We estimate the volatility of our stock price using historical prices. We estimate the expected life of our option using the average of the vesting period and the contractual term of the option. The estimated forfeiture rate is based on historical forfeiture information as well as subsequent events occurring prior to the issuance of the financial statements. Because our stock options have characteristics significantly different from those of traded options, and because changes in the input assumptions can materially affect the fair value estimate, the existing model may not necessarily provide a reliable single measure of fair value of our stock options.

Derivative Instruments — We generally do not use derivative instruments to hedge exposures to cash-flow or market risks; however, certain warrants to purchase Common Stock that do not meet the requirements for classification as equity are classified as liabilities. In such instances, net-cash settlement is assumed for financial reporting purposes, even when the terms of the underlying contracts do not provide for a net-cash settlement. Such financial instruments are initially recorded at fair value with subsequent changes in fair value charged (credited) to operations in each reporting period. If these instruments subsequently meet the requirements for classification as equity, we reclassify the fair value to equity.

Revenue Recognition — To date, we have generated revenue primarily from licensing agreements, including upfront, nonrefundable license fees, and from amounts reimbursed by licensees for third-party engineering services for product development. We recognize revenue when the following criteria have been met:

 
persuasive evidence of an arrangement exists;

 
delivery has occurred and risk of loss has passed;

 
the price to the buyer is fixed or determinable; and

 
collectability is reasonably assured.

In addition, when evaluating multiple element arrangements, we consider whether the components of the arrangement represent separate units of accounting. Multiple elements are divided into separate units of accounting if specified criteria are met, including whether the delivered element has stand-alone value to the customer and whether there is objective and reliable evidence of the fair value of the undelivered items. The consideration received is allocated among the separate units based on their respective fair values, and the applicable revenue recognition criteria are applied to each of the separate units. Otherwise, the applicable revenue recognition criteria are applied to combined elements as a single unit of accounting.


We typically receive upfront, nonrefundable payments for the licensing of our intellectual property upon the signing of a license agreement. We believe that these payments generally are not separable from the payments we receive for providing research and development services because the license does not have stand-alone value from the research and development services we provide under these agreements. Accordingly, we account for these elements as one unit of accounting and recognize upfront, nonrefundable payments as revenue on a straight-line basis over its contractual or estimated performance period. Revenue from the reimbursement of research and development efforts is recognized as the services are performed based on proportional performance adjusted from time to time for any delays or acceleration in the development of the product. We determine the basis of the estimated performance period based on the contractual requirements of its collaboration agreements. At each reporting period, we evaluate whether events warrant a change in the estimated performance period.

Other Revenue includes amounts earned and billed under the license and collaboration agreements for reimbursement for research and development costs for contract engineering services. For the services rendered, principally third-party contract engineering services, the revenue recognized approximates the costs associated with the services.

We believe that full consideration has been given to all relevant circumstances that we may be subject to, and the consolidated financial statements accurately reflect our best estimate of the results of operations, financial position and cash flows for the periods presented.

Results of Operations

Comparison of the years ended December 31, 2010 and 2009

Licensing Revenue — We signed two licensing agreements during the year ended December 31, 2009, each with a minimum term of ten years, that required up-front non-refundable license payments by the licensees. The up-front non-refundable license payments received in cash totaled $1,250,000. We are recognizing the up-front, non-refundable payments as revenue on a straight-line basis over our contractual or estimated performance period. During 2010, we adjusted our amortization period for revenue recognition for each of our license arrangements to reflect estimated timing of regulatory approval (or clearance).  Accordingly, we determined that approximately $226,000 and $536,000 of the non-refundable license revenue was recognizable in the years ended December 31, 2010 and 2009, respectively. Approximately $405,000 is recognizable over the next 12 months and is shown as current deferred revenue and approximately $82,000 is recognizable as revenue beyond the 12 month period and is classified as non-current.

Other Revenue — We retained contract engineering services in connection with our product development for one of our licensees and such costs are reimbursed and recorded as Other Revenue.  The significant amount of contract engineering services for this licensee occurred in 2009. Accordingly, Other Revenue of approximately $203,000 and $795,000 related to such services were recognized and received from our licensee during the years ended December 31, 2010 and 2009, respectively. The costs from the contract engineering services are included in Research and Development expenses on the Statements of Operations. There was no markup on the contract engineering services recorded as Other Revenue.

Research and Development Expenses — Research and development expenses decreased by approximately $228,000 to approximately $2,579,000 for the year ended December 31, 2010 from approximately $2,807,000 for the year ended December 31, 2009. Research and development expenses decreased primarily as a result of our decreased product and clinical development activity due to funding restrictions for Symphony, Prelude, and Azone product candidates. The cost for services from outside product development and design contractors decreased by approximately $292,000 and costs of our clinical studies decreased by approximately $79,000 compared with the prior year.  Our research and development employee costs (payroll and benefits) rose approximately $241,000 compared with the prior year. The legal costs in 2010 decreased by approximately $40,000 compared with 2009 due to a reduction in new filings. Our facility costs allocated to research and development were reduced by approximately $16,000 in 2010 compared to 2009 due to various costs savings including reduced lease costs in December 2010 as a result of entering into a facilities lease extension. Amortization of a long-term service contract for approximately $84,000 decreased approximately $35,000 in 2010 as a result of the end of the contract term. Other research and development costs went down approximately $7,000 in 2010.

 Research and development expenses amounted to approximately 48% of total operating expenses during both years ended December 31, 2010 and 2009, and included product development and regulatory consulting expenses for Prelude and Symphony. Product development and clinical expenses included in research and development expenses represented approximately 98% and 2%, respectively, of research and development expenses for the year ended December 31, 2010. Product development and clinical expenses included in research and development expenses represented approximately 95% and 5%, respectively, of research and development expenses for the year ended December 31, 2009.  We engaged several engineering and product development firms during the years ended December 31, 2010 and 2009 for product development of our Symphony System and product development and manufacturing of our Prelude System.


Selling, General and Administrative Expenses Selling, general and administrative expenses decreased by approximately $295,000 to approximately $2,760,000 for the year ended December 31, 2010 from approximately $3,055,000 for the year ended December 31, 2009. The primary decreases between 2010 and 2009 in selling, general and administrative expenses included decreases of approximately $1,213,000, $115,000, $239,000 and $25,000 in share-based compensation, legal fees, consulting fees and cash charitable contributions, respectively. The primary increases between 2010 and 2009 in selling, general and administrative expenses included approximately $113,000, $1,075,000 and $118,000 for non-cash charitable contributions, investor relations fees and payroll salaries and benefits, respectively.
 
Selling, general and administrative expenses represented 52% of total operating expenses during both years ended December 31, 2010 and 2009. We are not engaged in selling activities and, accordingly, general and administrative expenses relate principally to salaries and benefits for our executive, financial and administrative staff, public company reporting costs, investor relations, legal, accounting and media costs, capital-raising costs, and costs for general operations.
 
  Interest Income Interest income was approximately $2,000 for the years ended December 31, 2010 and 2009.

  Interest Expense — Interest expense was approximately $38,000 for the year ended December 31, 2010, compared to interest expense of approximately $332,000 for the year ended December 31, 2009, a decrease of approximately $294,000. The approximate net decrease in interest expense for each note payable obligation is shown in the table below:

 
 
Years ended
   
 
 
 
Note Payable Obligations
 
December 31, 2010
   
December 31, 2009
   
Increase (Decrease)
 
Senior convertible notes
  $     $ 55,000     $ (55,000 )
2008 Senior secured notes
          204,000       (204,000 )
2009 Senior secured note
          16,000       (16,000 )
Capitalized Leases
    1,000       1,000        
Other short-term financing
    37,000       56,000       (19,000 )
Total notes payable
  $ 38,000     $ 332,000     $ (294,000 )
Non-cash Interest included above
  $ 35,000     $ 313,000     $ (278,000 )

During 2010, substantially all debt was either repaid or converted into equity except for $100,000 in a short-term promissory note that was converted into equity during January 2011.
 
Grant income  Grants received are recognized as income when the related work is performed and the qualifying research and development costs are incurred and are presented as other income in our consolidated statement of operations. We received grants totaling approximately $245,000 under the Qualified Therapeutic Discovery Project Grants Program and all grant income was recognized in 2010. The Qualified Therapeutic Discovery Project Grants Program was included in the healthcare reform legislation and established a one-time pool of $1 billion for grants to small biotechnology companies developing novel therapeutics which show potential to: (a) result in new therapies that either treat areas of unmet medical need, or prevent, detect, or treat chronic or acute diseases and conditions; (b) reduce long-term health care costs in the United States; or (c) significantly advance the goal of curing cancer within a the 30-year period.
 
Gain (Loss) on Extinguishment of Debt — During the year ended December 31, 2009, we recorded a loss on extinguishment of debt in the amount of approximately $1,820,000 relating to the retirement of the 2009 Senior Secured Note in exchange for 200.6031 shares of Series B Perpetual Preferred Stock (“Series B Stock”) and 3,113.084 shares of Series C Preferred Stock (“Series C Stock”). Additionally in 2009, we recorded a loss on extinguishment of debt in the amount of approximately $32,000 relating to the 2008 Senior Secured Note.

On November 13, 2009, we recorded a loss on extinguishment when the remaining Senior Convertible Notes and accrued interest totaling $355,070 were exchanged for 284,056 shares of Common Stock and warrants. The loss of approximately $196,000 on extinguishment of these notes consisted of approximately $27,000 of unamortized deferred financing costs, $18,000 of unamortized discount and approximately $150,000 in excess fair value of the shares and warrants issued on extinguishment over that received under the original terms.


In September, 2010, we issued $250,000 of short-term notes to mature in 90 days.  The note holders were issued common stock in lieu of interest. The fair value of the common stock was recorded as deferred financing costs and amortized over the 90 day period. One note amounting to $100,000 was extended for up to two months in exchange for 5,000 shares of common stock at the end of each month. Total deferred finance cost for these notes was approximately $35,000.  One other note amounting to $50,000 was repaid in November, 2010 and we recognized approximately $4,000 as a loss on extinguishment of debt for the unamortized finance cost.  The final note amounting to $100,000 was extinguished early when the holder converted the note for the purchase of 100,000 shares of common stock in November 2010. Unamortized finance cost of approximately $12,000 was recognized as a loss on extinguishment of debt on this final note.

On September 30, 2009, we entered into the Letter with BHP extending the due date of the Fee payable by us to BHP in connection with placement agent services provided by BHP pursuant to an engagement letter dated June 30, 2009.  The Fee was originally due upon the earlier of (i) our net cash balance exceeding $2,000,000 or (ii) October 1, 2009.  The Letter provides that the Fee is due and payable by us upon the earlier of (i) our net cash balance exceeding $2,000,000 or (ii) June 30, 2010.  In March 2010, BHP agreed that we do not owe BHP any fees pursuant to any and all previous agreements between BHP and us. Accordingly, the Fee was waived and we recorded a gain on extinguishment of financing fee payable of $200,000 in 2010.

Derivative Gain (Loss) — At December 31, 2010 and 2009, we had outstanding warrants to purchase 10,336,292 and 7,356,502 shares, respectively, of our Common Stock. Included in these warrants are outstanding warrants to purchase 1,356,289 and 1,483,760 shares, respectively, that are considered to be derivative instruments since the agreements contain “down round” provisions whereby the number of shares covered by the warrants is subject to change in the event of certain dilutive stock issuances. The fair value of these derivative instruments at December 31, 2010 and 2009 was approximately $1,545,000 and $2,117,000, respectively, and is included in Derivative Warrant Liability, a current liability. Changes in fair value of the derivative financial instruments are recognized currently in the Consolidated Statement of Operations as a Derivative Gain (Loss). The primary underlying risk exposure pertaining to the warrants is the change in fair value of the underlying Common Stock. The Derivative gain on warrants subject to “down round” provisions for the year ended December 31, 2010 was approximately $371,000. The Derivative loss on warrants subject to “down round” provisions for the year ended December 31, 2009 amounted to approximately $4,050,000. During the year ended December 31, 2010, warrants to purchase 143,793 shares of Common Stock were exercised with anti-dilution provisions, which resulted in a reclassification to additional paid-in capital in the amount of approximately $200,000.  During the year ended December 31, 2009, warrants to purchase 1,584,515 shares of Common Stock were exercised, of which 664,397 shares included anti-dilution provisions, which resulted in a reclassification to additional paid-in capital in the amount of approximately $3,268,000.

Net Loss — As a result of the factors described above, we had a net loss of approximately $4,147,000 for the year ended December 31, 2010 compared to approximately $10,958,000 for the year ended December 31, 2009.

Liquidity and Capital Resources

We have financed our operations since inception primarily through private sales of our Common Stock and preferred stock, the issuance of convertible promissory notes, unsecured and secured promissory notes, up-front non-refundable payments received under license agreements and cash received in connection with exercises of Common Stock purchase options and warrants. As of December 31, 2010, we had approximately $1,342,000 of cash and cash equivalents, with no other short term investments.

Net cash used in operating activities was approximately $3,630,000 for the year ended December 31, 2010. The use of cash in operating activities was primarily attributable to the net loss of approximately $4,147,000, offset by non-cash expenses of approximately $109,000 for depreciation and amortization, $165,000 for share-based compensation expense, $995,000 for the fair value of stock, warrants and options issued for services, $113,000 for fair value of common stock issued as charitable contribution, and $35,000 in non-cash interest expense relating to short-term promissory notes.  Included in net loss is a non-cash derivative gain of approximately $371,000 and a non-cash gain on extinguishment of debt of approximately $184,000.  A decrease in accounts payable and deferred revenue relating to license agreements reduced used cash available for operations by approximately $320,000 and $226,000, respectively.  An increase in accounts receivable, net of a decrease in prepaid expenses and other assets provided approximately $22,000 of cash. An increase in accrued expenses and other liabilities provided approximately $179,000 of cash.


Net cash used in investing activities was approximately $280,000 for the year ended December 31, 2010. Cash of approximately $266,000 was used as result of an increase in restricted cash in escrow at December 31, 2010 related to a January 2011 finance closing. Cash was used to purchase approximately $14,000 in office equipment.

Net cash provided by financing activities was approximately $4,085,000 for the year ended December 31, 2010. The cash was primarily attributable to proceeds from the sale of common stock and warrants of approximately $3,887,000.   We had proceeds of $250,000 from short-term promissory notes, of which $50,000 was repaid in cash and $100,000 was converted into common stock in connection with the November 2009 Financing.  Principal payments on capitalized lease obligations used less than $2,000 during 2010.

At December 31, 2010, we had outstanding warrants to purchase 10,336,292 shares of Common Stock at exercise prices ranging from $0.50 to $5.80.

As of March 16, 2011, we had cash and cash equivalents of approximately $5,076,000.

We continue to aggressively pursue additional financing from existing relationships (prior shareholders, investors and lenders) and from new investors to support our product and clinical development programs, and operations. We engage investment banking firms to assist us with these efforts. During the period January 2011 through March, 16, 2011, we raised an approximately $4,652,000 in cash from our Common Stock and Warrant Offerings and through a new series of Convertible Preferred Stock.  In addition during that period, we received cash in the amount of approximately $465,000 as a result of common stock warrant exercises.

For additional information about our operating plan with respect to our products and product development, please see our Business discussion in Item 1 above.

We have demonstrated the ability to manage our costs aggressively and increase our operating efficiencies while advancing our medical device product development and clinical programs.  During the year ended December 31, 2010, we managed the extent of our medical device product development, clinical and operating costs while pursuing necessary funding. In order to advance our product development, clinical programs, establish contract manufacturing and support our Licensee for our Prelude System, pursue  FDA approval for our Symphony System and support our operating activities, we expect our monthly operating costs associated with salaries and benefits, regulatory and public company consulting, contract engineering and manufacturing, legal and other working capital costs to increase. In the past, we have relied primarily on raising equity capital in order to meet our operating budget and to achieve our business objectives, and we plan to continue that practice in the future. Although we have been successful in the past with raising sufficient capital, we will continue to vigorously pursue additional financing as necessary for meeting our business objectives.  However, there can be no guarantee that additional capital will be available in sufficient amounts on terms favorable to us, if at all.

The economic conditions during 2010, including the tightening of available funding in the financial markets, had a significant impact on our fund raising initiatives to fund our product development and clinical programs in accordance with our original projected level of operations. Although we have recently raised sufficient capital, we believe that uncertainties in the financial markets may occur in the future. The extent of our future product development, clinical programs and regulatory activities may be dependent on available additional funding from investors. Without sufficient funding for our programs, our plan to obtain regulatory approval for Symphony and Durhalieve may be delayed.

Our ability to fund our future operating requirements will depend on many factors, including the following:

 
our ability to obtain funding from third parties, including any future collaborative partners, on reasonable terms;

 
our progress on research and development programs;

 
the time and costs required to gain regulatory approvals;

 
the costs of manufacturing, marketing and distributing our products, if successfully developed and approved;

 
the costs of filing, prosecuting and enforcing patents, patent applications, patent claims and trademarks;

 
the status of competing products; and


 
the market acceptance and third-party reimbursement of our products, if successfully developed and approved.

During 2010 and through March 16, 2011, we have not redeemed any warrants.  During 2010, common stock warrants to purchase 143,793 shares were exercised through a cashless exercise provision and none were exercised for cash..  During 2011 and through March 16, 2011, common stock warrants to purchase 799,914 shares were exercised through a cashless exercise provision and 230,048 shares were exercised for cash providing gross proceeds to us of $465,279.

2009 Series A-2 Preferred Stock Financing — On April 8, April 24, April 28 and May 31, 2009, we entered into an Amended and Restated Stock and Warrant Purchase Agreement dated as of April 2, 2009 (the “A-2 Agreement”) with certain strategic institutional and accredited investors (the “A-2 Investors”) in connection with a private placement transaction (the “A-2 Financing”) in which the A-2 Investors purchased an aggregate of 640,000 shares of Series A-2 Stock at a price of $0.50 per share and received warrants to purchase 153,912 shares of Common Stock. The A-2 Financing provided us with gross proceeds of $700,000 and we used the net proceeds for working capital and general corporate purposes.  As of June 29, 2009 the Series A-2 Stock was exchanged for Common Stock (see below).

For the year ended December 31, 2009, we satisfied 8% quarterly dividend commitments for our Series A Stock, Series A-1 Stock and Series A-2 Stock with the issuance of additional preferred stock of 62,539 shares, 30,985 shares and 22,436 shares, respectively.

2009 Senior Secured Note — On June 1, 2009, we issued to Platinum Montaur Life Sciences, LLC (“Platinum”) a 10% Senior Secured Promissory Note (the “Platinum Note”) in the principal amount of $1,990,000. The outstanding principal of the Platinum Note accreted in value at an annual rate of 10%, compounded monthly.

The maturity date of the Platinum Note was June 29, 2009, which maturity date was subsequently extended to July 7, 2009. We used the net proceeds of the Platinum Note to pay a substantial portion of the Senior Secured Notes. As of June 30, 2009, we exchanged the Platinum Note and interest for 200.6031 shares of Series B Stock and 1,205.016 shares of Series C Stock.

Series A Preferred Stock Exchange — On June 29, 2009, we entered into an Exchange Agreement (the “Series A Exchange Agreement”) with all of the holders of the Series A Convertible Preferred Stock (collectively, the “Series A Holders”). The Series A Holders held an aggregate of 1,632,733 shares of Series A Stock, including paid-in-kind dividends accrued through June 29, 2009, constituting all of the issued and outstanding Series A Stock.

Under the terms of the Series A Exchange Agreement, we issued and delivered to the Series A Holders, in exchange for the cancellation of the Series A Stock, 2,938,920 shares of Common Stock. The Series A Exchange Agreement states that, if, as a result of this exchange transaction, any Series A Holder or any of its affiliates, individually or in the aggregate, would beneficially own more than 9.99% of our issued and outstanding Common Stock (the “Threshold Amount”), the Series A Holder would receive Common Stock rounded to the nearest whole share, up to the Threshold Amount, and the remaining Common Stock would be exchanged for Series C Stock convertible into the number of shares of Common Stock equal to the difference between the aggregate number of shares of Common Stock to be issued to the Series A Holder and the actual number of shares of Common Stock issued. As a result of this provision, one Series A Holder received 2,323.105 shares of Series C Stock instead of 2,323,105 shares of Common Stock. The remaining Series A Holders received 615,815 shares of Common Stock. As a result of the terms of the Series A Exchange Agreement, we do not have any shares of Series A Stock issued and outstanding.

In 2009, we recorded a deemed dividend on the beneficial conversion equal to the incremental fair value resulting from the reduction in the conversion price, or approximately $2,012,000. This deemed dividend is included in the Statement of Operations in arriving at Net Loss Applicable to Common Shareholders.

Series A-1 Preferred Stock Exchange — On June 29, 2009, we entered into an Exchange Agreement (the “A-1 Exchange Agreement”) with all of the holders of the Series A-1 Convertible Preferred Stock (collectively, the “A-1 Holders”). The A-1 Holders held an aggregate of 809,121 shares of our Series A-1 Stock, including paid-in-kind dividends accrued through June 29, 2009, constituting all of the issued and outstanding Series A-1 Stock.

Under the terms of the A-1 Exchange Agreement, we issued and delivered to the A-1 Holders, in exchange for the cancellation of the Series A-1 Stock, 1,078,828 shares of Common Stock. The A-1 Exchange Agreement states that, if, as a result of this exchange transaction, any A-1 Holder or any of its affiliates, individually or in the aggregate, would beneficially own more than the Threshold Amount, the A-1 Holder would receive Common Stock rounded to the nearest whole share, up to the Threshold Amount, and the remaining Common Stock would be exchanged for Series C Stock convertible into the number of shares of Common Stock equal to the difference between the aggregate number of shares of Common Stock to be issued to the A-1 Holder and the actual number of shares of Common Stock issued. As a result of this provision, one A-1 Holder received 280.993 shares of Series C Stock instead of 280,993 shares of Common Stock. The remaining A-1 Holders received 797,835 shares of Common Stock. As a result of the A-1 Exchange Agreement, we do not have any shares of Series A-1 Stock issued and outstanding.


In 2009, we recorded a deemed dividend on the beneficial conversion equal to the incremental fair value resulting from the reduction in the conversion price, or approximately $415,000. This deemed dividend is included in the Statement of Operations in arriving at Net Loss Applicable to Common Shareholders.

Series A-2 Preferred Stock Exchange — On June 29, 2009, we entered into an Exchange Agreement (the “A-2 Exchange Agreement”) with all of the holders of the Series A-2 Stock (collectively, the “A-2 Holders”). The A-2 Holders held an aggregate of 1,422,436 shares of the Series A-2 Stock, including paid-in-kind dividends accrued through June 29, 2009, constituting all of the issued and outstanding Series A-2 Stock.

Under the terms of the A-2 Exchange Agreement, we issued and delivered to the A-2 Holders, in exchange for the cancellation of the Series A-2 Stock, 1,422,436 shares of Common Stock. The A-2 Exchange Agreement states that, if, as a result of this exchange transaction, any A-2 Holder or any of its affiliates, individually or in the aggregate, would beneficially own more than the Threshold Amount, the A-2 Holder would receive Common Stock rounded to the nearest whole share, up to the Threshold Amount, and the remaining Common Stock would be exchanged for Series C Stock convertible into the number of shares of Common Stock equal to the difference between the aggregate number of shares of Common Stock to be issued to the A-2 Holder and the actual number of shares of Common Stock issued. As a result of this provision, one A-2 Holder received 508.986 shares of Series C Stock instead of 508,986 shares of Common Stock. As a result of the A-2 Exchange Agreement, we do not have any shares of Series A-2 Stock issued and outstanding. The remaining A-2 Holders received 913,450 shares of Common Stock.

Series B Perpetual Preferred Stock and Warrant Financing — On July 7, 2009, we entered into a Stock Purchase Agreement as of June 30, 2009 (the “Series B Agreement”) with Platinum in connection with our private placement (the “Series B Financing”) of 200.6031 shares of Series B Stock, together with 1,205,016 shares of Common Stock, for an aggregate price of $2,006,031. We received payment of the purchase price in the form of the extinguishment of the 2009 Senior Secured Note in the amount of $2,006,031, which amount included principal and interest accrued through June 30, 2009. As the Platinum Note was not originally convertible, we recognized a loss on the extinguishment of this debt of approximately $1,820,000 which represents the excess of the fair value of the Series B Stock and the Series C Stock over the carrying value of the Platinum Note.

The Series B Agreement states that the Series B Financing may not result in a purchaser or any of its affiliates, individually or in the aggregate, beneficially owning more than the Threshold Amount; provided, however, that a purchaser may waive the foregoing provision upon sixty-one (61) days’ advance written notice to us. If the Series B Financing would result in a purchaser owning Common Stock in excess of the Threshold Amount, then the purchaser would receive Common Stock rounded to the nearest whole share, up to the Threshold Amount, and the remaining Common Stock would be exchanged for Series C Stock convertible into the number of shares of Common Stock equal to the difference between the aggregate number of shares of Common Stock to be issued to the purchaser and the actual number of shares of Common Stock issued. As a result of this provision, Platinum received 1,205.016 shares of Series C Stock instead of 1,205,016 shares of Common Stock that it otherwise would have received pursuant to the Series B Agreement.

Pursuant to the terms of the Certificate of Designation, Preference and Rights of Series B Perpetual Preferred Stock (the “Series B Certificate”), the Series B Stock is redeemable under certain circumstances.

The Series B Stock yields a quarterly dividend commencing as of January 1, 2010, at an initial annual rate of 8%, which is payable in cash or in kind at our option on a quarterly basis. If the Series B Stock is outstanding on the twelve month anniversary of the Issuance Date (as defined in the Series B Certificate), the dividend rate shall increase to 10% per annum and, if the Series B Stock is outstanding on the eighteen month anniversary of the Issuance Date, then the dividend rate shall increase to 12% per annum.

In the event of any Liquidation Event (as defined in the Series B Certificate) the holders of the Series B Stock will be entitled to receive (subject to the rights of any securities designated as senior to the Series B Stock) a liquidation preference equal to the Face Amount thereof plus any accrued but unpaid dividends thereon. We cannot create or issue any security senior to the Series B Stock without the prior approval of the holders of at least 67% of the outstanding Series B Stock.


In accordance with redemption requirements, during the year ended December 31, 2009, the Company redeemed 59.3750 shares of Series B Stock at a cost of $593,750 in connection with the financings dated November 13, and December 3, 2009. Of this amount, $450,000 was satisfied by offsetting proceeds owed in connection with the 2009 November Financing (see Note 9) and $143,750 was included in Accrued Expenses.

On January 19, 2010, we entered into a letter agreement with the sole holder of Series B Stock (the “Series B Holder”) regarding the payment to the Series B Holder of $143,750 (the “Redemption Amount”) for the redemption of 14.375 shares of Series B Stock in connection with the 2009 November Financing and 2009 December Financing. The Series B Holder waived payment of the Redemption Amount until we has a net cash balance in excess of $3,000,000. In consideration for the deferral, we agreed that, upon the closing of its next equity offering with gross proceeds of less than $5,000,000, it would use 25% of the gross proceeds to redeem Series B Stock (the “25% Redemption”).

On March 16, 2010, we entered into an additional agreement with the Series B Holder pursuant to which the Series B Holder waived both the 25% Redemption identified in the January 19, 2010 letter and the redemption required by the Series B Certificate with respect to amounts received in the February Financing through March 16, 2010. Accordingly, a redemption in the amount of approximately $614,000 was waived by the Series B Holder in connection with the February 2010 Financing.

  On November 10, 2010, we entered into a letter agreement (the “November Letter”) with the Series B Holder pursuant to which the Series B Holder waived the 25% Redemption triggered by the 2010 November Financing (see Note 9) and any subsequent equity or equity-linked financing conducted by us up to an aggregate of $1,000,000 of gross proceeds from all such financings.  In consideration for the waiver in the November Letter, we issued to the Series B Holder 125,000 Series-1 Warrants and 125,000 Series-2 Warrants with a combined fair value of $185,000 which was recorded as a non-cash stock issuance cost.

On December 29, 2010, we entered into a letter agreement (the “December Letter”) with the Series B Holder pursuant to which the Series B Holder waived the 25% Redemption triggered by the 2010 November Financing and any subsequent equity or equity-linked financing conducted by us for gross proceeds from the 2010 November Financing.

We paid approximately $132,000 of dividends by issuing approximately 13 shares of Series B Stock during 2010. This dividend is included in the Statements of Operations in arriving at Net Loss Applicable to Common Shareholders.  In accordance with the Series B Preferred Stock Agreement there were no dividends due for the year ended December 31, 2009.

Series C Preferred Stock — We authorized 10,000 shares of Series C Stock, $0.01 par value, of which 4,918.1 shares were issued and outstanding as of December 31, 2010 and 2009, respectively. The Series C Stock was created on June 30, 2009.  Pursuant to the terms of the Certificate of Designation, Preference and Rights of Series C Preferred Stock (the “Series C Certificate”), each share of Series C Stock is initially convertible into one thousand shares of Common Stock, subject to adjustment for stock splits, combinations or similar events. Each holder who receives Series C Stock may convert its Series C Stock at any time following its issuance. In the event of any Liquidation Event (as defined in the Series C Certificate), the holders of Series C Stock will be entitled to receive (subject to the rights of any securities designated as senior to the Series C Stock) a per share liquidation preference equal to an amount calculated by taking the total amount available for distribution to holders of all outstanding Common Stock before deduction of any preference payments for the Series C Stock, divided by the total of (x) all of the then outstanding shares of Common Stock, plus (y) all of the shares of Common Stock into which all of the outstanding shares of the Series C Stock can be converted, in each case prior to any distribution to the holders of Common Stock or any other securities designated as junior to the Series C Stock.

November 2009 Common Stock and Warrant Financing — On November 13, 2009, we entered into a Common Stock and Warrant Purchase Agreement (the “November Agreement”) with certain strategic institutional and accredited investors (the “November Investors”) in connection with our private placement (the “November Financing”) of 1,969,056 shares of Common Stock at a price of $1.25 per share (the “November Shares”) together with warrants to purchase 2,398,339 shares of Common Stock.  The November Financing provided us with gross proceeds of $3,211,320. Of this amount, we received payment of a portion of the purchase price in the form of the extinguishment of the Gemini Notes in the approximate amount of $355,000 which amount included principal and interest accrued through November 13, 2009. We used the net proceeds of the November Financing primarily for working capital and general corporate purposes.


December 2009 Common Stock and Warrant Financing — On December 3, 2009, we closed on a Common Stock and Warrant Purchase Agreement dated November 30, 2009 (the “December Agreement”) with certain strategic institutional and accredited investors in connection with the private placement (the “December Financing”) of 450,000 shares of Common Stock at a price of $1.25 per share (the “December Shares”) together with warrants to purchase 315,000 shares of Common Stock. In connection with the December Financing, we received proceeds of $562,500 and we used the net proceeds primarily for working capital and general corporate purposes.

February 2010 Common Stock and Warrant Financing On February 4, 2010, we entered into a Common Stock and Warrant Purchase Agreement (the “February Agreement”) with certain strategic institutional and accredited investors in connection with our private placement (the “February Financing”) of shares of Common Stock, at a price of $1.50 per share (the “February Shares”). Under the terms of the February Agreement, each investor received warrants to purchase a number of shares of Common Stock with an exercise price of $2.25 per share equal to fifty percent (50%) of the number of February Shares purchased by such investor (the “February Warrants”).  We issued 1,636,739 shares of Common Stock and received gross proceeds of approximately $2,455,000 in connection with the February Financing.

Pursuant to the February Agreement, we issued an aggregate of 818,362 February Warrants to the investors with a fair value of approximately $943,000. The February Warrants are immediately exercisable and expire no later than five (5) years from the date of issuance. The exercise price is subject to adjustment for stock splits, combinations or similar events. The February Warrants allow for cashless exercise. An exercise under the February Warrants may not result in the holder beneficially owning more than 4.99% or 9.99%, as applicable, of all of the Common Stock outstanding at the time; provided, however, that a holder may waive the foregoing provision upon sixty-one (61) days’ advance written notice to us.

November 2010 Common Stock and Warrant Financings — In November 2010, we initiated a private placement (the “November 2010 Financing”) of up to 120 units (each, a “Unit” and together, the “Units”) or partial Units at a price per Unit of $25,000.  Each Unit consists of (i) 25,000 shares of Common Stock, $0.01 par value, (ii) Series-1 warrants to purchase 12,500 shares of Common Stock, $0.01 par value with an exercise price of $1.50 per share (the “Series-1 Warrants”), and (iii) Series-2 warrants to purchase 12,500 shares of Common Stock with an exercise price of $2.50 per share (the “Series-2 Warrants”).

Through December 31, 2010, we had entered into subscription agreements with certain strategic institutional and accredited investors in connection with the November 2010 financing for a total of 68.8 units.  We received gross proceeds from these subscriptions in the amount of $1,720,000.   We received proceeds of $100,000 in the form of extinguishment of a Promissory Note issued by us on September 28, 2010, which included principal and interest.  Additionally, we received a commitment for an additional 11.4 units in which the proceeds of $285,000 were not received as of December 31, 2010.  This is treated as stock subscription receivable as of December 31, 2010.  The proceeds of $285,000 were received in January and February 2011.

Pursuant to the November 2010 Financings noted above, including the commitment for 11.4 units as of December 31, 2010, we issued an aggregate of 1,002,500 Series-1 Warrants and 1,002,500 Series-2 Warrants to the investors.  These warrants are immediately exercisable and expire three years after issuance. The exercise price is subject to adjustment for stock splits, combinations or similar events.  An exercise under these warrants may not result in the holder beneficially owning more than 4.99% or 9.99%, as applicable, of all of the Common Stock outstanding at the time; provided, however, that a holder may waive the foregoing provision upon sixty-one (61) days’ advance written notice to us.

As of December 31, 2010, the November 2010 Financing remained open and we entered into additional Subscription Agreements with certain strategic institutional and accredited investors  for a total of 35.66 units.  We received proceeds from these subscriptions in the amount of $891,500.   Pursuant to these subscriptions we issued an aggregate of 445,750 Series-1 Warrants and 445,750 Series-2 Warrants to the investors.

8% Senior Promissory Note - On January 5, 2011, we issued an 8% Senior Promissory Note to Platinum Montaur Life Sciences, LLC (“Montaur”) in the amount of $1,000,000.  The outstanding principal balance of this Note, together with all accrued and unpaid interest, shall be due and payable in full on February 1, 2011 and later extended to February 8, 2011 by agreement of the parties.

Series D Convertible Preferred Stock Purchase - On February 8, 2011 we entered into a Series D Convertible Preferred Stock Purchase Agreement (the “Series D Agreement”) dated as of February 7, 2011 with Montaur and certain other strategic accredited investors (each, an “Investor” and collectively, the “Investors”) in connection with the Company’s private placement (the “Series D Financing”) of Series D Convertible Preferred Stock (“Series D Stock”) at a price per share of $1.00. For every $100,000 face value of Series D Stock purchased in the Series D Financing, the Investor was issued (i) Series 1 warrants to purchase 50,000 shares of Common Stock, $0.01 par value (“Common Stock”) with an exercise price of $1.50 per share (the “Series 1 Warrants”), and (ii) Series 2 warrants to purchase 50,000 shares of Common Stock with an exercise price of $2.50 per share (the “Series 2 Warrants” and, together with the Series 1 Warrants, the “Warrants”).


On February 8, 2011, there was a closing in connection with the Series D Agreement and we received proceeds of $3,506,000 for the purchase of 3,506,000 shares of Series D Stock. We received payment of a portion of the proceeds in the form of the extinguishment of an 8% Senior Promissory Note issued on January 5, 2011 in the principal amount of $1,000,000, which amount included principal and interest accrued through February 8, 2011 in the amount of $6,000. We intend to use the net proceeds of the Series D Financing primarily for working capital and general corporate purposes.

We issued an aggregate of 1,753,000 Series 1 Warrants and 1,753,000 Series 2 Warrants to the Investors pursuant to the Agreement.  The Warrants are immediately exercisable and expire on February 7, 2013; however, if the Warrants are not exercised in full by February 7, 2013 by virtue of the application of a beneficial ownership blocker (described below), then the term of the Warrants shall be extended for thirty (30) days past the date on which the beneficial ownership blocker is no longer applicable. The exercise price is subject to adjustment for stock splits, business combinations or similar events.  An exercise under the Warrants may not result in the holder beneficially owning more than 4.99% or 9.99%, as applicable, of all of the Common Stock outstanding at the time; provided, however, that a holder may waive the foregoing provision upon sixty-one (61) days’ advance written notice to us.

Pursuant to the Certificate of Designation, Preferences and Rights of Series D Convertible Preferred Stock, the shares of Series D Stock are initially convertible into shares of Common Stock at a price per share equal to $1.00, subject to adjustment for stock splits, business combinations or similar events, and shall have a liquidation preference equal to their stated value.  Each holder who receives Series D Stock may convert it at any time following its issuance.   The Series D Stock does not pay a dividend and is not redeemable.

In accordance with (i) the Certificate of Designation, Rights and Preferences of the Series B Stock and (ii) a letter agreement dated January 19, 2010 between us and the sole holder of the Series B Perpetual Preferred Stock, we were obligated to use 25% of the gross proceeds from the Series D Financing to redeem Series B Stock. On February 4, 2011, we entered into a letter agreement (the “Letter”) with the sole holder of the Series B Perpetual Preferred Stock pursuant to which the Series B share holder waived the redemption of shares of the Series B Perpetual Preferred Stock triggered by the Series D Financing.

Facilities, Property and Equipment — We conduct our operations in leased facilities and have agreed to a lease through March 2014. Our property and equipment does not include manufacturing machinery and is limited to laboratory testing equipment, office furniture and computer systems (network hardware, software and employee desk top systems).   As of March 9, 2011, we entered into a lease for approximately 5,400 square feet of corporate office space in a single facility located in Philadelphia, Pennsylvania. The lease is for a period through April 30, 2014. Except for the purchase (possibly through capital lease financing) of tooling, molds and dies in connection with product development and manufacturing of Symphony and Prelude, we do not anticipate any significant purchases or sales of property and equipment during the next 12 months.

Off-Balance Sheet Arrangements

We have no off-balance sheet arrangements, including unrecorded derivative instruments that have or are reasonably likely to have a current or future material effect on our financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources. We have certain warrants and options outstanding but we do not expect to receive sufficient proceeds from the exercise of these instruments unless and until the trading price of our Common Stock is significantly greater than the applicable exercise prices of the options and warrants and mainly following any necessary registering of underlying securities.

Effect of Inflation and Changes in Prices

Management does not believe that inflation and changes in price will have a material effect on our operations.



INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
Echo Therapeutics, Inc. Consolidated Financial Statements

 
Page
Report of Independent Registered Public Accounting Firm
F-1
Consolidated Balance Sheets as of December 31, 2010 and 2009
F-2
Consolidated Statements of Operations for the years ended December 31, 2010 and 2009
F-3
Consolidated Statements of Changes in Stockholders’ Equity for the years ended December 31, 2010 and 2009
F-4
Consolidated Statements of Cash Flows for the years ended December 31, 2010 and 2009
F-5
Notes to Consolidated Financial Statements
F-7



REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the Board of Directors of
Echo Therapeutics, Inc.
Franklin, Massachusetts

We have audited the accompanying consolidated balance sheets of Echo Therapeutics, Inc. as of December 31, 2010 and 2009, and the related consolidated statements of operations, changes in stockholders’ equity and cash flows for the years then ended. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.

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

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Echo Therapeutics, Inc. as of December 31, 2010 and 2009, and the results of its operations and its cash flows for the years then ended in conformity with U.S. generally accepted accounting principles.


/s/ WOLF & COMPANY, P.C.

Boston, Massachusetts
March 18, 2011


Echo Therapeutics, Inc.
Consolidated Balance Sheets

   
As of,
 
   
December 31,
2010
   
December 31,
2009
 
ASSETS
           
Current Assets:
           
Cash and cash equivalents
  $ 1,342,044     $ 1,166,858  
Accounts receivable
    141,488       130,036  
Stock subscriptions receivable
    285,000        
Prepaid expenses and other current assets
    195,205       226,641  
Total current assets
    1,963,737       1,523,535  
                 
Property and Equipment, at cost:
               
Computer equipment
    265,862       262,278  
Office and laboratory equipment (including assets under capitalized leases)
    626,823       618,723  
Furniture and fixtures
    17,019       14,288  
Manufacturing equipment
    129,320       129,320  
Leasehold improvements
    177,768       177,768  
      1,216,792       1,202,377  
Less-Accumulated depreciation and amortization
    (1,168,758 )     (1,143,167 )
Net property and equipment (including assets under capitalized leases)
    48,034       59,210  
                 
Other Assets:
               
Restricted cash
    275,249       9,749  
Intangible assets, net of accumulated amortization
    9,625,000       9,708,822  
Deposits and other assets
    250       2,000  
Total other assets
    9,900,499       9,720,571  
Total assets
  $ 11,912,270     $ 11,303,316  
LIABILITIES AND STOCKHOLDERS’ EQUITY
               
Current Liabilities:
               
Accounts payable
  $ 605,634     $ 948,712  
Deferred revenue
    405,454       591,051  
Current portion of notes payable and capital lease obligation, net of discounts
    102,071       1,874  
Derivative warrant liability
    1,544,996       2,116,696  
Accrued expenses and other liabilities
    463,475       481,679  
Total current liabilities
    3,121,630       4,140,012  
Notes Payable and capital lease obligation, net of current portion and discounts
    6,176       8,247  
Deferred Revenue, net of current portion
    82,180       122,451  
Total liabilities
    3,209,986       4,270,710  
                 
Commitments
               
                 
Stockholders’ Equity:
               
Perpetual, Redeemable Preferred Stock:
               
Series B, $0.01 par value, authorized 40,000 shares, issued and outstanding 154.3940 and 141.2281 at December 31, 2010 and 2009, respectively (preference in liquidation of $1,543,939 at December 31, 2010)
    2       2  
Convertible Preferred Series:
               
Series C, $0.01 par value, authorized 10,000 shares, issued and outstanding 4,918.1 at December 31, 2010 and 2009
    49       49  
Common stock, $0.01 par value, authorized 100,000,000 shares at December 31, 2010 and 2009, issued and outstanding 31,126,245 and 27,045,792 shares at December 31, 2010 and 2009, respectively
    311,264       270,459  
Additional paid-in capital
    79,646,385       74,155,716  
Common stock subscribed for but not paid for or issued, 285,000 shares
    285,000        
Accumulated deficit
    (71,540,416 )     (67,393,620 )
Total stockholders’ equity
    8,702,284       7,032,606  
Total liabilities and stockholders’ equity
  $ 11,912,270     $ 11,303,316  

See notes to the consolidated financial statements.


Echo Therapeutics, Inc.
Consolidated Statements of Operations

 
 
 
For the Years ended
December 31,
 
 
 
2010
   
2009
 
Licensing revenue
  $ 225,868     $ 536,497  
Other revenue
    202,592       795,424  
Total Revenues
    428,460       1,331,921  
Operating Expenses:
               
Research and development
    2,578,852       2,807,405  
Selling, general and administrative
    2,760,062       3,054,984  
Total operating expenses
    5,338,914       5,862,389  
Loss from operations
    (4,910,454 )     (4,530,468 )
Other Income (Expense):
               
Interest income
    1,519       1,562  
Interest expense
    (37,549 )     (331,500 )
Qualified therapeutic research grant
    244,480        
Gain (loss) on extinguishment of debt
    183,863       (2,047,292 )
Derivatives gain (loss)
    371,345       (4,050,443 )
Other income (expense), net
    763,658       (6,427,673 )
Net loss
    (4,146,796 )     (10,958,141 )
Deemed dividend on beneficial conversion of Series A and A-1 Preferred Stock
          (2,426,876 )
Accretion of dividends on Convertible Perpetual Redeemable Preferred Stock
    (131,659 )      
Accretion of dividends on Convertible Preferred Stock
          (126,676 )
Net loss applicable to common shareholders
  $ (4,278,455 )   $ (13,511,693 )
Net loss per common share, basic and diluted
  $ (0.15 )   $ (0.61 )
Basic and diluted weighted average common shares outstanding
    29,031,158       22,290,956  

See notes to the consolidated financial statements.



Echo Therapeutics, Inc.
Consolidated Statements of Changes in Stockholders’ Equity
Years Ended December 31, 2010 and 2009

 
   
Preferred Stock
   
Common Stock
                         
   
Number of
Shares
   
Carrying
Value
   
Number of
Shares
   
Carrying
Value
    Additional
Paid-in
Capital
    Common
Stock
Subscribed
   
Accumulated
Deficit
    Total
Stockholders’
Equity
 
Balance at December 31, 2008
    2,348,330     $ 23,483       19,095,838     $ 190,960     $ 64,668,550     $     $ (58,281,663 )   $ 6,601,330  
Reclassification of warrants to derivative liability
                            (2,926,302 )             1,846,184       (1,080,118 )
Issuance of Series A-2 Preferred Stock
    1,400,000       14,000                   685,576                   699,576  
Dividends on Series A, A-1 and A-2 Preferred Stock
    115,960       1,160                   (1,206 )                 (46 )
Exercise of warrants
                1,211,704       12,117       (12,117 )                  
Share-based payments — restricted stock, net of forfeitures
                1,992,094       19,921       289,837                   309,758  
Share-based payments — options, net of forfeitures
                            1,298,789                   1,298,789  
Fair value of warrants issued for services
                            173,726                   173,726  
Redemption of Series B Preferred Stock
    (59 )     (1 )                 (593,749 )                 (593,750 )
Issuance of Common Stock and Series C Preferred Stock, net of cash issuance costs of $229,048
    600       6       2,419,056       24,190       3,670,774                   3,694,970  
Exchange of Series A, A-1 and A-2 Preferred Stock for Series C Preferred Stock and common stock
    (3,861,178 )     (38,611 )     2,327,100       23,271       15,340                    
Exchange of Senior Secured Note and accrued interest for Series B and C Preferred Stock, net of cash issuance costs of $207,148
    1,406       14                   3,618,445                   3,618,459  
Fair value of derivative warrant liabilities reclassified to additional paid-in capital
                            3,268,053                   3,268,053  
Net Loss
                                        (10,958,141 )     (10,958,141 )
Balance at December 31, 2009
    5,059       51       27,045,792       270,459       74,155,716             (67,393,620 )     7,032,606  
Exercise of warrants
                35,714       357       (357 )                  
Share-based payments — restricted stock, net of forfeitures
                363,000       3,630       389,619                   393,249  
Share-based payments — options, net of forfeitures
                            164,810                   164,810  
Fair value of warrants issued for services
                            616,634                   616,634  
Fair value of options issued for services
                            59,471                   59,471  
Common Stock issued to charitable organization
                60,000       600       112,800                   113,400  
Issuance of Common Stock, net of cash issuance costs of $188,333 and non-cash costs of $468,741
                3,356,739       33,568       3,484,485                   3,518,053  
Fair value of fully vested Common Stock issued for services
                265,000       2,650       462,850                   465,500  
Fair value of derivative warrant liabilities reclassified to additional paid-in capital
                            200,357                   200,357  
Common stock subscription, 285,000 shares
                                  285,000             285,000  
Dividends on Series B preferred stock
    13                                            
Net Loss
                                        (4,146,796 )     (4,146,796 )
Balance at December 31, 2010
    5,072     $ 51       31,126,245     $ 311,264     $ 79,646,385     $ 285,000     $ (71,540,416 )   $ 8,702,284  

See notes to the consolidated financial statements.
 

Echo Therapeutics, Inc
Consolidated Statements of Cash Flows

 
 
Years Ended December 31,
 
 
 
2010
   
2009
 
Cash Flows From Operating Activities:
           
Net loss
  $ (4,146,796 )   $ (10,958,141 )
Adjustments to reconcile net loss to net cash used in operating activities:
               
Depreciation and amortization
    109,413       158,618  
Share-based compensation
    164,810       1,298,789  
Fair value of common stock and warrants issued for services
    935,144       429,093  
Fair value of common stock issued as charitable contribution
    113,400        
Fair value of derivative warrant liability issued for services
          245,369  
Fair value of options issued for services
    59,471        
Derivative (gain) loss
    (371,344 )     4,050,443  
Non-cash (gain) loss on extinguishment of debt
    (183,863 )     2,024,031  
Non-cash interest expense
    35,190       312,652  
Other non-cash expense
          64,136  
Changes in assets and liabilities:
               
Accounts receivable
    (11,452 )     (130,036 )
Prepaid expenses and other current assets
    31,436       (209,509 )
Deposits and other assets
    1,750        
Accounts payable
    (320,078 )     (229,007 )
Deferred revenue
    (225,868 )     713,502  
Accrued expenses and other liabilities
    178,969       (43,986 )
Net cash used in operating activities
    (3,629,819 )     (2,274,046 )
Cash Flows from Investing Activities:
               
Purchase of property and equipment
    (14,415 )     (20,938 )
Decrease (increase) in restricted cash
    (265,500 )     501  
Net cash used in investing activities
    (279,915 )     (20,437 )
Cash Flows From Financing Activities
               
Proceeds from short-term  notes
    250,000       125,000  
Repayment of short-term notes
    (50,000 )     (125,000 )
Proceeds from the sale of Series A-2 preferred stock, net of expenses
          699,576  
Proceeds from the sale of common stock and warrants, net of cash expenses
    3,886,794       2,739,703  
Principal payments for capital lease obligations
    (1,874 )     (866 )
Proceeds from Senior Secured Note
          1,990,000  
Proceeds (payments) from (on) Senior Secured Convertible Notes and Warrants
          (2,209,426 )
Deferred financing costs
          (467 )
Dividends paid in cash on Series A, A-1 and A-2 preferred stock
          (46 )
Net cash provided by financing activities
    4,084,920       3,218,474  
Net Increase in Cash and Cash Equivalents
    175,186       923,991  
Cash and Cash Equivalents, beginning of period
    1,166,858       242,867  
Cash and Cash Equivalents, end of period
  $ 1,342,044     $ 1,166,858  

See notes to the consolidated financial statements.


Echo Therapeutics, Inc
Consolidated Statements of Cash Flows
 
 
 
Years Ended December 31,
 
 
 
2010
   
2009
 
Supplemental Disclosure of Cash Flow Information and Non Cash Financing Transactions:
           
Cash paid for interest
  $ 2,124     $ 18,848  
Accretion of dividend on Series A, A-1 and A-2 Convertible Preferred Stock
  $     $ 126,676  
Derivative warrant liability reclassified from stockholders’ equity
  $     $ 1,080,118  
Senior Convertible Notes issued for accrued interest
  $     $ 23,622  
Fair Value of common stock issued for interest on short-term notes payable
  $ 48,500     $  
Accretion of dividend on Series B Perpetual Redeemable Preferred Stock
  $ 131,659     $  
Issuance of common stock in settlement of accounts payable and accrued expenses
  $ 23,000     $ 83,000  
Deemed dividend on beneficial conversion of Series A and A1 Preferred Stock
  $     $ 2,426,876  
Conversion of Senior Secured Note to Series B and Series C preferred
  $     $ 2,006,031  
Redemption of Series B Preferred Stock included in accrued expenses
  $     $ 143,750  
Redemption liability satisfied through offset of proceeds due in connection with November 2009 Financing
  $     $ 450,000  
Conversion of short-term note to common stock in connection with the November 2010 Financing
  $ 100,000     $  
Senior Convertible Note exchanged for Common Stock and warrants
  $     $ 355,070  
Reclassification of derivative liability to additional paid-in capital
  $ 200,357     $ 3,268,053  
Fair value of warrants included in stock issuance costs
  $ 468,741     $ 869,484  
Exchange of Series A, A-1 and A-2 Preferred Stock to Series C Preferred Stock and common stock
  $     $ 3,724,529  
Asset acquired under Capital Lease Agreement
  $     $ 10,988  
Common stock subscriptions receivable
  $ 285,000     $  
 
See notes to the consolidated financial statements.


ECHO THERAPEUTICS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Years Ended December 31, 2010 and 2009

(1) ORGANIZATION, BASIS OF PRESENTATION

Echo Therapeutics, Inc. is a transdermal medical device company with deep expertise in advanced skin permeation technology that is initially focused on continuous glucose monitoring and needle-free drug delivery.  Echo is developing its Prelude™ SkinPrep System as a platform technology to allow for significantly enhanced and painless skin permeation that will enable two important applications:

 
·
Analyte extraction, with the Symphony™ tCGM System for needle-free, continuous glucose monitoring in hospital patients and diabetics as the first application.

 
·
Needle-free drug delivery, with the topical delivery of lidocaine as the first application. Additional applications for painless, needle-free delivery of drugs are planned.

The accompanying consolidated financial statements include the accounts of the Company and its wholly-owned subsidiary, Sontra Medical, Inc., a Delaware corporation. All significant inter-company balances and transactions have been eliminated in consolidation.

(2) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

The accompanying consolidated financial statements reflect the application of the following accounting policies:

The accompanying consolidated financial statements have been prepared in accordance with the Financial Accounting Standards Board (“FASB”) “FASB Accounting Standard Codification™” (the “Codification”) which is the source of authoritative accounting principles recognized by the FASB to be applied by nongovernmental entities in the preparation of financial statements in conformity with generally accepted accounting principles (“GAAP”) in the United States.

Use of Estimates

The preparation of financial statements in conformity with GAAP requires management to make judgments, estimates and assumptions that affect the amounts reported in the Company’s consolidated financial statements and accompanying notes. Actual results could differ materially from those estimates.

Cash and Cash Equivalents

The Company considers all highly liquid investments with maturities of ninety days or less to be cash equivalents. Cash equivalents consisted of money market funds as of December 31, 2010 and 2009. The Company maintains its cash in bank deposit accounts which, at times, may exceed the federally insured limits. Restricted cash represents a security deposit on the Company’s leased offices and cash in escrow related to the November 2010 Common Stock and Warrant Financings completed in February 2011 (see Note 14).

Accounts Receivable

Accounts receivable represent amounts billed by the Company. The balance as of December 31, 2010 also includes an amount due to the Company related to an insurance claim approved by the insurance carrier.  An allowance for doubtful accounts is determined based on management’s best estimate of probable losses inherent in the accounts receivable balance. Amounts determined to be uncollectible are written off against the allowance. Management assesses the allowance based on information regarding nature of the receivables and historical experience. No allowance was deemed necessary as of December 31, 2010 and 2009.

Intangible Assets and Other Long-Lived Assets


The Company records intangible assets at the acquisition date fair value. As a policy, the Company amortizes its intangible assets using the straight-line method over their estimated useful lives, as follows: patents and licenses, two (2) to twenty (20) years; definite-lived core and developed technology, five (5) to twenty-five (25) years; and other intangible assets over various periods. In connection with the acquisition of Durham Pharmaceuticals Ltd., a North Carolina corporation doing business as Echo Therapeutics, Inc. (the “ETI Acquisition”), intangible assets related to contractual arrangements were amortized over the estimated useful life of three (3) years and ended in 2010.  Intangible assets related to technology are expected to be amortized on a straight-line basis over the period ending 2018 and will commence upon revenue generation.

The Company reviews intangible assets subject to amortization quarterly to determine if any adverse conditions exist or a change in circumstances has occurred that would indicate impairment or a change in the remaining useful life of any intangible asset. Conditions that would indicate impairment and trigger an impairment assessment include, but are not limited to, a significant adverse change in legal factors or business climate that could affect the value of an asset, or an adverse action or assessment by a regulator. If the carrying value of an asset exceeds its undiscounted cash flows, the Company writes down the carrying value of the intangible asset to its fair value in the period identified.

For other long-lived assets, the Company evaluates quarterly whether events or circumstances have occurred that indicate that the carrying value of these assets may be impaired.

The Company generally calculates fair value as the present value of estimated future cash flows it expects to generate from the asset using a risk-adjusted discount rate. If the estimate of an intangible asset’s remaining useful life is changed, the Company amortizes the remaining carrying value of the intangible asset prospectively over the revised remaining useful life.

The Company performs a regular review of the underlying assumptions, circumstances, time projections and revenue and expense estimates to decide if there is a possible impairment. In reviewing the long-lived assets relating to the ETI Acquisition as of December 31, 2010, the Company concluded that there was no impairment of the carrying value of such long-lived assets. No impairment losses were recorded for the years ended December 31, 2010 and 2009.

Depreciation and Amortization

The Company provides for depreciation and amortization by charges to operations for the cost of assets using the straight-line method based on the estimated useful lives of the related assets, as follows:

Asset Classification
 
Estimated Useful Life
Computer equipment.
 
3 years
Office and laboratory equipment
 
3-5 years
Furniture and fixtures.
 
7 years
Manufacturing equipment.
 
5 years
Leasehold improvements.
 
Life of lease

Share-Based Payments

The Company recognizes compensation costs resulting from the issuance of stock-based awards to employees and directors as an expense in the statement of operations over the service period based on a measurement of fair value for each stock award. The Company’s policy is to grant employee and director stock options with an exercise price equal to or greater than the fair value of the Common Stock at the date of grant.

The Company recognizes compensation costs resulting from the issuance of stock-based awards to non-employees as an expense in the statement of operations over the service period based on a measurement of fair value for each stock award.

Derivative Instruments

The Company generally does not use derivative instruments to hedge exposures to cash-flow or market risks; however, certain warrants to purchase Common Stock that do not meet the requirements for classification as equity are classified as liabilities. In such instances, net-cash settlement is assumed for financial reporting purposes, even when the terms of the underlying contracts do not provide for a net-cash settlement. Such financial instruments are initially recorded at fair value with subsequent changes in fair value charged (credited) to operations in each reporting period. If these instruments subsequently meet the requirements for classification as equity, the Company reclassifies the fair value to equity.


Concentration of Credit Risk

The Company has no significant off-balance-sheet risk. Financial instruments, which subject the Company to credit risk, principally consist of cash and cash equivalents. The Company mitigates its risk by maintaining the majority of its cash and equivalents with high-quality financial institutions.

Financial Instruments

The estimated fair value of the Company’s financial instruments, which include cash and cash equivalents, restricted cash, accounts receivable, accounts payable and capital lease obligation, approximates their carrying value due to the short-term nature of these instruments and their market terms.

Net Loss per Common Share

Basic and diluted net loss per share of Common Stock has been computed by dividing the net loss applicable to common stockholders in each period by the weighted average number of shares of Common Stock outstanding during such period. For the periods presented, options, warrants and convertible securities were anti-dilutive and therefore excluded from diluted loss per share calculations.

Segment Information

Operating segments are identified as components of an enterprise about which separate discrete financial information is available for evaluation by the chief operating decision maker, or decision making group, in making decisions regarding resource allocation and assessing performance. To date, the Company has viewed its operations and manages its business as principally one operating segment, which is the development of transdermal skin permeation and diagnostics medical devices and, specialty pharmaceutical drugs. As of December 31, 2010 and 2009, all of the Company’s assets were located in the United States.

Research and Development Expenses

The Company charges research and development expenses to operations as incurred. Research and development expenses primarily consist of salaries and related expenses for personnel and outside contractor and consulting services. Other research and development expenses include the costs of materials and supplies used in research and development, prototype manufacturing, clinical studies, related information technology and an allocation of facilities costs.

Grant income

Grants received are recognized as income when the related work is performed and the qualifying research and development costs are incurred and are presented as Other Income on the Company’s consolidated statements of operations. The Company received a grant totaling approximately $244,500 under the Qualified Therapeutic Discovery Project Grants Program during 2010. The Qualified Therapeutic Discovery Project Grants Program was included in the healthcare reform legislation and established a one-time pool of $1 billion for grants to small biotechnology companies developing novel therapeutics which show potential to: (a) result in new therapies that either treat areas of unmet medical need, or prevent, detect, or treat chronic or acute diseases and conditions; (b) reduce long-term health care costs in the United States; or (c) significantly advance the goal of curing cancer within a the 30-year period.

Income Taxes

The Company is primarily subject to U.S. federal, Massachusetts and New Jersey state income tax. Tax years subsequent to 2006 remain open to examination by U.S. federal and state tax authorities.

For federal and state income taxes, deferred tax assets and liabilities are recognized based upon temporary differences between the financial statement and the tax basis of assets and liabilities. Deferred income taxes are based upon prescribed rates and enacted laws applicable to periods in which differences are expected to reverse. A valuation allowance is recorded when it is more likely than not that some portion or all of the deferred tax assets will not be realized. Accordingly, since the Company cannot be assured of realizing the deferred tax asset, a full valuation allowance has been provided.


When tax returns are filed, it is highly certain that some positions taken would be sustained upon examination by the taxing authorities, while others are subject to uncertainty about the merits of the position taken or the amount of the position that would be ultimately sustained. The benefit of a tax position is recognized in the financial statements in the period during which, based on all available evidence, management believes it is more likely than not that the position will be sustained upon examination, including the resolution of appeals or litigation processes, if any. Tax positions taken are not offset or aggregated with other positions. Tax positions that meet the more-likely-than-not recognition threshold are measured as the largest amount of tax benefit that is more than 50% likely of being realized upon settlement with the applicable taxing authority. The portion of the benefits associated with tax positions taken that exceeds the amount measured as described above is reflected as a liability for unrecognized tax benefits in the accompanying balance sheet along with any associated interest and penalties that would be payable to the taxing authorities upon examination. There was no uncertain tax position liabilities recorded at December 31, 2010.

The Company’s policy is to recognize interest and penalties related to income tax matters in income tax expense. As of December 31, 2010 and 2009, the Company had no accruals for interest or penalties related to income tax matters.

Licensing and Other Revenue Recognition

To date, the Company has generated revenue primarily from licensing agreements, including upfront, nonrefundable license fees, with collaborators and licensees. The Company recognizes revenue when the following criteria have been met:

 
persuasive evidence of an arrangement exists;

 
delivery has occurred and risk of loss has passed;

 
the price to the buyer is fixed or determinable; and

 
collectability is reasonably assured.

In addition, when evaluating multiple element arrangements, the Company considers whether the components of the arrangement represent separate units of accounting. Multiple elements are divided into separate units of accounting if specified criteria are met, including whether the delivered element has stand-alone value to the customer and whether there is objective and reliable evidence of the fair value of the undelivered items. The consideration received is allocated among the separate units based on their respective fair values, and the applicable revenue recognition criteria are applied to each of the separate units. Otherwise, the applicable revenue recognition criteria are applied to combined elements as a single unit of accounting.

The Company typically receives upfront, nonrefundable payments for the licensing of its intellectual property upon the signing of a license agreement. The Company believes that these payments generally are not separable from the payments it receives for providing research and development services because the license does not have stand-alone value from the research and development services it provides under its agreements. Accordingly, the Company accounts for these elements as one unit of accounting and recognizes upfront, nonrefundable payments as revenue on a straight-line basis over its contractual or estimated performance period. Revenue from the reimbursement of research and development efforts is recognized as the services are performed based on proportional performance adjusted from time to time for any delays or acceleration in the development of the product and is included in Other Revenue. The Company determines the basis of the estimated performance period based on the contractual requirements of its collaboration agreements. At each reporting period, the Company evaluates whether events warrant a change in the estimated performance period.

Other Revenue includes amounts earned and billed under the license and collaboration agreements for reimbursement of research and development costs for contract engineering services. For the services rendered, principally third-party contract engineering services, the revenue recognized approximates the costs associated with the services.


 
Recent Accounting Pronouncements
 
In January 2010, the FASB issued ASU 2010-06, Fair Value Measurements and Disclosures (Topic 820), Improving Disclosures about Fair Value Measurements.  This Update requires new disclosures and clarifies existing disclosures regarding recurring and nonrecurring fair value measurements to provide increased transparency to users of the financial statements.  The new disclosures and clarification of existing disclosures are effective for interim and annual periods beginning after December 15, 2009, except for the disclosures pertaining to the roll forward of activity for Level 3 fair value measurements, which are effective for fiscal years beginning after December 15, 2010, and for interim periods within those fiscal years.  The adoption of this Update on January 1, 2010 did not have a material impact on the Company’s financial statements.
 
(3) INTANGIBLE ASSETS

As of December 31, 2010 and 2009, intangible assets related to the ETI Acquisition are as follows:

 
         
2010
   
2009
 
 
Estimated
Life
 
Cost
   
Accumulated
Amortization
   
Net
   
Net
 
Contract related intangible asset:
                         
Cato Research discounted contract
3 years
  $ 355,000     $ 355,000     $     $ 83,822  
Technology related intangible assets:
                                 
Patents for the AzoneTS-based product candidates and formulation
6 years
    1,305,000             1,305,000       1,305,000  
Drug Master Files containing formulation, clinical and safety documentation used by the FDA
6 years
    1,500,000             1,500,000       1,500,000  
In-process pharmaceutical products for two (2) indications
6 years
    6,820,000             6,820,000       6,820,000  
Total technology related intangible assets
      9,625,000             9,625,000       9,625,000  
Total
    $ 9,980,000     $ 355,000     $ 9,625,000     $ 9,708,822  

Intangible assets related to technology are expected to be amortized on a straight-line basis over the period ending 2018 when the underlying patents expire and will commence upon revenue generation, which the Company has estimated to be during 2013.  The contract related intangible asset was amortized over a 3 year period and ended in 2010. Amortization expense relating to the contract was approximately $84,000 and $118,000 for the years ended December 31, 2010 and 2009, respectively, and is included in research and development in the Consolidated Statement of Operations.

Estimated amortization expense for each of the next five years is as follows:

 
 
Year Ending December 31:
 
Estimated
Amortization
Expense
 
       
2011
  $  
2012
     
2013
    1,604,000  
2014
    1,604,000  
2015
    1,604,000  

(4) OPERATING AND CAPITAL LEASE COMMITMENTS

Operating Lease — The Company leases approximately 13,000 square feet of manufacturing, laboratory and office space in a single facility located in Franklin, Massachusetts under a lease expiring March 31, 2014. Future minimum lease payments under this operating lease are approximately as follows:

For the years ended December 31,
   
Amount
 
       
2011
  $ 144,000  
2012
    144,000  
2013
    144,000  
2014
    36,000  
Total
  $ 468,000  


The Company’s facilities lease expense was approximately $169,000 and $185,000 for the years ended December 31, 2010 and 2009, respectively.

Capital Lease — In July 2009, the Company entered into a five-year lease of an office copier which is included with the Office and Laboratory Equipment. The value of the equipment capitalized was approximately $11,000. The lease payments of $234 per month, payable in arrears, reflect a 10% interest rate. Accumulated depreciation on the leased copier as of December 31, 2010 was approximately $3,300. During the years ended December 31, 2010 and 2009, interest expense related to the capital lease obligation was approximately $500 in both years.

(5) NOTES PAYABLE AND CAPITAL LEASE OBLIGATION

Notes payable and capital lease obligations at December 31, 2010 and 2009 consisted of the following:

 
 
2010
   
2009
 
Short-term Notes
  $ 100,000     $ --  
Capital lease obligation
    8,247       10,121  
Total notes payable and capital lease obligation
    108,247       10,121  
Less current portion of notes payable and capital lease obligation
    102,071       1,874  
Notes Payable and capital lease obligation, net of current portion
  $ 6,176     $ 8,247  

2008 Senior Secured Note and Warrant Financing

On March 24, 2008, the Company entered into a Secured Note financing with Imperium Master Fund, Ltd. (“Imperium”), providing for, at the Company’s option, the issuance of up to an aggregate $2,000,000 of original issue discount senior secured notes (the “Secured Notes”) in four equal tranches, together with warrants (the “Imperium Warrants”) that include an anti-dilution feature relating to exercise price and the number of warrant shares. On March 24, 2008, the Company drew down the initial $500,000 in gross proceeds and issued the Imperium Warrants upon execution of the agreement. The Company also issued additional Secured Notes and drew down $500,000 in gross proceeds on each of April 24, 2008, June 2, 2008 and June 24, 2008, completing the financing for $2,000,000.  On June 2, 2009, the Company paid all of the outstanding Secured Notes and accrued interest.  Interest expense related to the Secured Notes in the year ended December 31, 2009 was approximately $204,000.

2009 Senior Secured Note

On June 1, 2009, the Company issued to Platinum Montaur Life Sciences, LLC (“Platinum”) a 10% Senior Secured Promissory Note (the “Platinum Note”) in the principal amount of $1,990,000. The outstanding principal of the Platinum Note accreted in value at an annual rate of 10%, compounded monthly.

The Company used the net proceeds of the Platinum Note to pay a substantial portion of the 2008 Senior Secured Notes. As of June 30, 2009, the Company exchanged the Platinum Note and accrued interest for 200.6031 shares of Series B Perpetual Preferred Stock (“Series B Stock”) and 1,205.016 shares of Series C Preferred Stock (“Series C Stock”) (see Note 8). The Company recognized a loss of approximately $1,820,000 from the extinguishment of this debt. During the year ended December 31, 2009, interest expense related to the 2009 Senior Secured Note, including amortization of discounts and deferred financing costs was approximately $16,000.

2009 Promissory Demand Notes

On October 6, 2009, the Company issued Promissory Demand Notes (collectively, the “2009 Notes”) in the aggregate amount of $125,000 to three payees. In connection with the loan evidenced by each 2009 Note, the Company was required to issue each payee 1,000 unregistered shares of common stock for every $10,000 of principal invested for each week such 2009 Note remains outstanding. Each 2009 Note was due and payable upon the earlier of (i) a demand of payment made any time after October 31, 2009 or (ii) the acceleration of obligations under the terms of the 2009 Note. A total of 37,500 shares with a fair value of approximately $54,000 were issued in October 2009 pursuant to the 2009 Notes which was included in interest expense. The 2009 Notes were paid in full on October 31, 2009.


2010 Short-term Notes

In September 2010, the Company issued $250,000 of short-term notes, maturing in 90 days.  In lieu of interest, the note holders were issued 2,000 unregistered shares of the Company’s common stock for every $10,000 of principal loaned.  A total of 50,000 shares with a fair value of approximately $48,500 were issued in September 2010 pursuant to these short-term notes.  The fair value of the stock was amortized over the 90 day term.  One short-term note in the amount of $100,000 was extended for one month on December 23, 2010 in exchange for 5,000 shares of common stock issued in January 2011.  Another short-term note for $50,000 was repaid in November 2010. Unamortized interest cost of approximately $4,000 was recognized as a loss on extinguishment of debt.  The final short-term note for $100,000 was converted into the November 2010 Common Stock and Warrant offering (see Note 9) on November 5, 2010. Unamortized interest cost of approximately $12,000 was recognized as a loss on extinguishment of debt.

Total non-cash interest expense for the 2010 short-term notes was approximately $35,000.
 
(6) DERIVATIVE INSTRUMENTS

Derivative financial instruments are recognized as a liability on the consolidated balance sheet and measured at fair value.

At December 31, 2010 and 2009, the Company had outstanding warrants to purchase 10,336,292 and 7,356,502 shares of its common stock, respectively. Included in these outstanding warrants at December 31, 2010 are warrants to purchase 1,356,289 shares that are considered to be derivative instruments since the agreements contain “down round” provisions whereby the number of shares covered by the warrants is subject to change in the event of certain dilutive stock issuances. The fair value of these derivative instruments at December 31, 2010 and 2009 was approximately $1,545,000 and $2,117,000, respectively, and is included in Derivative Warrant Liability, a current liability. Changes in fair value of the derivative financial instruments are recognized currently in the Statements of Operations as a Derivatives Gain or Loss. The changes in the fair value of the derivative warrant liability in the years ended December 31, 2010 and 2009 resulted in a gain of approximately $371,000 and a loss of approximately $4,050,000, respectively.

The primary underlying risk exposure pertaining to the warrants is the change in fair value of the underlying common stock for each reporting period. Of the total warrants exercised in 2010, warrants to purchase 143,793 shares of common stock were exercised per a cashless exercise provision. For the years ended December 31, 2010 and 2009, warrants with down round provisions to purchase 143,793 and 1,572,015 shares, respectively, were exercised and certain anti-dilution rights were waived (see Note 11) which resulted in a reclassification to additional paid-in capital in the amount of approximately $200,000 and $3,268,000, respectively.

(7) FAIR VALUES OF ASSETS AND LIABILITIES

The Company groups its financial assets and financial liabilities generally measured at fair value in three levels, based on the markets in which the assets and liabilities are traded and the reliability of the assumptions used to determine fair value.

    Level 1 – Valuation is based on quoted prices in active markets for identical assets or liabilities. Level 1 assets and liabilities generally include debt and equity securities that are traded in an active exchange market. Valuations are obtained from readily available pricing sources for market transactions involving identical assets or liabilities.

    Level 2 – Valuation is based on observable inputs other than Level 1 prices, such as quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities. For example, Level 2 assets and liabilities may include debt securities with quoted prices that are traded less frequently than exchange-traded instruments or mortgage loans held for sale, for which the fair value is based on what the securitization market is currently offering for mortgage loans with similar characteristics.

    Level 3 – Valuation is based on unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities. Level 3 assets and liabilities include financial instruments whose value is determined using pricing models, discounted cash flow methodologies, or similar techniques, as well as instruments for which the determination of fair value requires significant management judgment or estimation. This category generally includes certain asset-backed securities, certain private equity investments, residential mortgage servicing rights, and long-term derivative contracts.


The following methods and assumptions were used by the Company in estimating fair value for the warrants considered to be derivative instruments.

The Company uses valuation methods and assumptions that consider among other factors the fair value of the underlying stock, risk-free interest rate, volatility, expected life and dividend rates in estimating fair value for the warrants considered to be derivative
instruments.

Assets and Liabilities Measured at Fair Value on a Recurring Basis

Assets and liabilities measured at fair value on a recurring basis are summarized below:

   
December 31, 2010
 
 
 
Level 1
   
Level 2
   
Level 3
   
Fair Value
 
Liabilities:
                       
Derivative warrant liability
  $     $ 1,544,996     $     $ 1,544,996  

 
 
December 31, 2009
 
 
 
Level 1
   
Level 2
   
Level 3
   
Fair Value
 
Liabilities:
                       
Derivative warrant liability
  $     $ 2,116,696     $     $ 2,116,696  

The Company may also be required, from time to time, to measure certain other financial assets at fair value on a nonrecurring basis. These adjustments to fair value usually result from application of lower-of-cost-or-market accounting or write-downs of individual assets. There were no such adjustments in the years ended December 31, 2010 and 2009.

(8) PREFERRED STOCK

The Company is authorized to issue up to 40,000,000 shares of preferred stock with such rights, preferences and privileges as are fixed by the Board of Directors.

 Series A Preferred Stock Exchange

On June 29, 2009, the Company entered into an Exchange Agreement (the “Series A Exchange Agreement”) with all of the holders of the Series A Stock (collectively, the “Series A Holders”). The Series A Holders held an aggregate of 1,632,733 shares of the Series A Stock, including paid-in-kind dividends accrued through June 29, 2009, constituting all of the issued and outstanding Series A Stock. The Series A Stock was initially convertible into shares of Common Stock at the option of the holder at a price per share of $1.35, subject to adjustment for stock splits, combinations or similar events and subject to customary weighted average anti-dilution adjustments.

Under the terms of the Series A Exchange Agreement, the Company issued and delivered to the Series A Holders, in exchange for the cancellation of the Series A Stock, 2,938,920 shares of Common Stock. The Series A Exchange Agreement states that, if, as a result of this exchange transaction, any Series A Holder or any of its affiliates, individually or in the aggregate, would beneficially own more than 9.99% of the Company’s issued and outstanding Common Stock (the “Threshold Amount”), the Series A Holder would receive Common Stock rounded to the nearest whole share, up to the Threshold Amount, and the remaining Common Stock would be exchanged for Series C Stock convertible into the number of shares of Common Stock equal to the difference between the aggregate number of shares of Common Stock to be issued to the Series A Holder and the actual number of shares of Common Stock issued. As a result of this provision, one Series A Holder received 2,323.105 shares of Series C Stock instead of 2,323,105 shares of Common Stock. The remaining Series A Holders received 615,815 shares of Common Stock.

As a result of the terms of the Series A Exchange Agreement, the Company does not have any shares of Series A Stock issued and outstanding.

In 2009, the Company recorded a deemed dividend on the beneficial conversion equal to the incremental fair value resulting from the reduction in the conversion price, or approximately $2,012,000. This deemed dividend is included in the Consolidated Statement of Operations in arriving at Net Loss Applicable to Common Shareholders.


Series A-1 Preferred Stock Exchange

On June 29, 2009, the Company entered into an Exchange Agreement (the “Series A-1 Exchange Agreement”) with all of the holders of the Series A-1 Convertible Preferred Stock (collectively, the “Series A-1 Holders”). The Series A-1 Holders held an aggregate of 809,121 shares of the Company’s Series A-1 Convertible Preferred Stock (“Series A-1 Stock”), including paid-in-kind dividends accrued through June 29, 2009, constituting all of the issued and outstanding Series A-1 Stock. The Series A-1 Stock was initially convertible into shares of Common Stock at the option of the holder at a price per share of $1.00, subject to adjustment for stock splits, combinations or similar events and subject to customary weighted average anti-dilution adjustments.

Under the terms of the Series A-1 Exchange Agreement, the Company issued and delivered to the Series A-1 Holders, in exchange for the cancellation of the Series A-1 Stock, 1,078,828 shares of Common Stock. The Series A-1 Exchange Agreement states that, if, as a result of this exchange transaction, any Series A-1 Holder or any of its affiliates, individually or in the aggregate, would beneficially own more than the Threshold Amount, the Series A-1 Holder would receive Common Stock rounded to the nearest whole share, up to the Threshold Amount, and the remaining Common Stock would be exchanged for Series C Stock convertible into the number of shares of Common Stock equal to the difference between the aggregate number of shares of Common Stock to be issued to the Series A-1 Holder and the actual number of shares of Common Stock issued. As a result of this provision, one Series A-1 Holder received 280.993 shares of Series C Stock instead of 280,993 shares of Common Stock. The remaining Series A-1 Holders received 797,835 shares of Common Stock.

As a result of the Series A-1 Exchange Agreement, the Company does not have any shares of Series A-1 Stock issued and outstanding.

In 2009, the Company recorded a deemed dividend on the beneficial conversion equal to the incremental fair value resulting from the reduction in the conversion price, or approximately $415,000. This deemed dividend is included in the Statements of Operations in arriving at Net Loss Applicable to Common Shareholders.

Series A-2 Preferred Stock Financing and Exchange

On April 8, April 24, April 28 and May 31, 2009, the Company entered into an Amended and Restated Stock and Warrant Purchase Agreement dated as of April 2, 2009 (the “A-2 Purchase Agreement”) with certain strategic institutional and accredited investors (the “A-2 Investors”) in connection with the private placement (the “A-2 Financing”) of 1,200,000 shares of our Series A-2 Convertible Preferred Stock (the “Series A-2 Stock”) at a price of $0.50 per share together with warrants to purchase a number of shares of Common Stock equal to (i) thirty-five percent (35%), or (ii) for investments of $250,000 or more, fifty percent (50%), of the number of shares of Series A-2 Stock purchased by each A-2 Investor (the “A-2 Warrants”) in the A-2 Financing. The Company received gross proceeds of $700,000 from the A-2 Financing and used the net proceeds for working capital and general corporate purposes.

Pursuant to the A-2 Purchase Agreement, the Company issued A-2 Warrants to the A-2 Investors to purchase up to 640,000 shares of Common Stock. The A-2 Warrants were immediately exercisable at a price per share of $0.75, subject to adjustment for stock splits, combinations or similar events, and will expire no later than February 28, 2014. The A-2 Warrants allow for cashless exercise. In addition, the Company has the option to redeem the A-2 Warrants, in whole but not in part, upon satisfaction of certain conditions, including (i) the availability of an effective registration statement or Rule 144 exemption for any resale by the holder, (ii) the shares of Common Stock trading at a price per share in excess of 200% of the then-applicable exercise price for ten (10) trading days out of a period of fifteen (15) consecutive trading days prior to the redemption, and (iii) an average daily trading volume during such fifteen (15) consecutive trading days of at least 50,000 shares of Common Stock. Finally, an exercise under the A-2 Warrants may not result in the holder beneficially owning more than 4.99% or 9.99%, as applicable, of all of the Common Stock outstanding at the time; provided, however, that a holder may waive the foregoing provision upon sixty-one (61) days’ advance written notice to us.

As of June 29, 2009 the Series A-2 Stock was exchanged for Common Stock (see below).

On June 29, 2009, the Company entered into an Exchange Agreement (the “A-2 Exchange Agreement”) with all of the holders of the A-2 Investors. The A-2 Investors held an aggregate of 1,422,436 shares of the Series A-2 Stock, including paid-in-kind dividends accrued through June 29, 2009, constituting all of the issued and outstanding Series A-2 Stock.


Under the terms of the A-2 Exchange Agreement, the Company issued and delivered to the A-2 Investors, in exchange for the cancellation of the Series A-2 Stock, 1,422,436 shares of Common Stock. The A-2 Exchange Agreement states that, if, as a result of this exchange transaction, any A-2 Investor or any of its affiliates, individually or in the aggregate, would beneficially own more than the Threshold Amount, the A-2 Investor would receive Common Stock rounded to the nearest whole share, up to the Threshold Amount, and the remaining Common Stock would be exchanged for Series C Stock convertible into the number of shares of Common Stock equal to the difference between the aggregate number of shares of Common Stock to be issued to the A-2 Investor and the actual number of shares of Common Stock issued. As a result of this provision, one A-2 Investor received 508.986 shares of Series C Stock instead of 508,986 shares of Common Stock.

As a result of the A-2 Exchange Agreement, the Company does not have any shares of Series A-2 Stock issued and outstanding. The remaining A-2 Investors received 913,450 shares of Common Stock.

Series B Perpetual Redeemable Preferred Stock and Warrant Financing

The Company has authorized 40,000 shares of non-convertible Series B Stock, $0.01 par value, of which 154.3940 and 141.2281 shares were issued and outstanding as of December 31, 2010 and 2009, respectively. The Series B Stock was issued on June 30, 2009.

On July 7, 2009, the Company entered into a Stock Purchase Agreement as of June 30, 2009 (the “Series B Agreement”) with Platinum in connection with the Company’s private placement (the “Series B Financing”) of 200.6031 shares (10,000 to 1 conversion) of Series B Stock, together with 1,205,016 shares of Common Stock, for an aggregate price of $2,006,031. The Company received payment of the purchase price in the form of the extinguishment of the Platinum Note (see Note 5) in the amount of $2,006,031, which amount included principal and interest accrued through June 30, 2009. As the Platinum Note was not originally convertible, the Company recognized a loss on the extinguishment of this debt of approximately $1,820,000 which represents the excess of the fair value of the Series B Stock and the Series C Stock over the carrying value of the Platinum Note.

The Series B Agreement states that the Series B Financing may not result in a purchaser or any of its affiliates, individually or in the aggregate, beneficially owning more than the Threshold Amount; provided, however, that a purchaser may waive the foregoing provision upon sixty-one (61) days’ advance written notice to the Company. If the Series B Financing would result in a purchaser owning Common Stock in excess of the Threshold Amount, then the purchaser would receive Common Stock rounded to the nearest whole share, up to the Threshold Amount, and the remaining Common Stock would be exchanged for Series C Stock convertible into the number of shares of Common Stock equal to the difference between the aggregate number of shares of Common Stock to be issued to the purchaser and the actual number of shares of Common Stock issued. As a result of this provision, Platinum received 1,205.016 shares (1,000 to 1 conversion) of Series C Stock instead of 1,205,016 shares of Common Stock that it otherwise would have received pursuant to the Series B Agreement.

Pursuant to the terms of the Company’s Certificate of Designation, Preference and Rights of Series B Perpetual Preferred Stock (the “Series B Certificate”), the Series B Stock is redeemable under certain circumstances.

The Series B Stock will yield a quarterly dividend, at an initial annual rate of 8%, which is payable in cash or in kind at the option of the Company. If the Series B Stock is outstanding on the twelve month anniversary of the Issuance Date (as defined in the Series B Certificate), the dividend rate shall increase to 10% per annum and, if the Series B Stock is outstanding on the eighteen month anniversary of the Issuance Date, then the dividend rate shall increase to 12% per annum.

In the event of any Liquidation Event (as defined in the Series B Certificate) the holders of the Series B Stock will be entitled to receive (subject to the rights of any securities designated as senior to the Shares) a liquidation preference equal to the Face Amount thereof plus any accrued but unpaid dividends thereon. The Company cannot create or issue any security senior to the Series B Stock without the prior approval of the holders of at least 67% of the Company’s outstanding Series B Stock.

In accordance with redemption requirements, during the year ended December 31, 2009, the Company redeemed 59.3750 shares of Series B Stock at a cost of $593,750 in connection with the financings dated November 13, and December 3, 2009. Of this amount, $450,000 was satisfied by offsetting proceeds owed in connection with the 2009 November Financing (see Note 9) and $143,750 was included in Accrued Expenses.

On January 19, 2010, the Company entered into a letter agreement with the sole holder of Series B Stock (the “Series B Holder”) regarding the payment to the Series B Holder of $143,750 (the “Redemption Amount”) for the redemption of 14.375 shares of Series B Stock in connection with the 2009 November financing and 2009 December financing. The Series B Holder waived payment of the Redemption Amount until the Company has a net cash balance in excess of $3,000,000. In consideration for the deferral, the Company agreed that, upon the closing of its next equity offering with gross proceeds of less than $5,000,000, it would use 25% of the gross proceeds to redeem Series B Stock (the “25% Redemption”).


On March 16, 2010, the Company entered into an additional agreement with the Series B Holder pursuant to which the Series B Holder waived both the 25% Redemption identified in the January 19, 2010 letter and the redemption required by the Series B Certificate with respect to amounts received in the February 2010 financing through March 16, 2010. Accordingly, redemption in the amount of approximately $614,000 was waived by the Series B Holder in connection with the February 2010 financing.

On November 10, 2010, the Company entered into a letter agreement (the “November Letter”) with the Series B Holder pursuant to which the Series B Holder waived the 25% Redemption triggered by the November 2010 Financing (see Note 9) and any subsequent equity or equity-linked financing conducted by the Company up to an aggregate of $1,000,000 of gross proceeds from all such financings.  In consideration for the waiver in the November Letter, the Company issued to the Series B Holder 125,000 Series-1 Warrants and 125,000 Series-2 Warrants with a combined fair value of $185,000 which was recorded as non-cash stock issuance cost.

On December 29, 2010, the Company entered into a letter agreement (the “December Letter”) with the Series B Holder pursuant to which the Series B Holder waived the 25% Redemption triggered by the November 2010 Financing and any subsequent closings of the November 2010 Financing.

The Company paid approximately $132,000 of dividends by issuing approximately 13 shares of Series B Stock during 2010. This dividend is included in the Statements of Operations in arriving at Net Loss Applicable to Common Shareholders.  In accordance with the Series B Preferred Stock Agreement there were no dividends due for the year ended December 31, 2009.

Series C Preferred Stock

The Company has authorized 10,000 shares of Series C Stock, $0.01 par value, of which 4,918.1 shares were issued and outstanding as of December 31, 2010 and 2009, respectively. The Series C Stock was created on June 30, 2009.  Pursuant to the terms of the Certificate of Designation, Preference and Rights of Series C Preferred Stock (the “Series C Certificate”), each share of Series C Stock is initially convertible into one thousand shares of Common Stock, subject to adjustment for stock splits, combinations or similar events. Each holder who receives Series C Stock may convert its Series C Stock at any time following its issuance. In the event of any Liquidation Event (as defined in the Series C Certificate), the holders of Series C Stock will be entitled to receive (subject to the rights of any securities designated as senior to the Series C Stock) a per share liquidation preference equal to an amount calculated by taking the total amount available for distribution to holders of all the Company’s outstanding Common Stock before deduction of any preference payments for the Series C Stock, divided by the total of (x) all of the then outstanding shares of Common Stock, plus (y) all of the shares of Common Stock into which all of the outstanding shares of the Series C Stock can be converted, in each case prior to any distribution to the holders of Common Stock or any other securities designated as junior to the Series C Stock.

(9) COMMON STOCK

The Company has authorized 100,000,000 shares of Common Stock, $0.01 par value per share, of which 31,126,245 and 27,045,792 shares were issued and outstanding as of December 31, 2010 and 2009, respectively.

November 2009 Common Stock and Warrant Financing

On November 13, 2009, the Company entered into a Common Stock and Warrant Purchase Agreement (the “November Agreement”) with certain strategic institutional and accredited investors in connection with the private placement (the “November Financing”) of shares of Common Stock at a price of $1.25 per share (the “November Shares”). Under the terms of the November Agreement, each investor shall receive warrants to purchase a number of shares of Common Stock with an exercise price of $2.00 per share equal to (i) seventy percent (70%) of the number of November Shares purchased by such investor or, (ii) for those investors who purchased November Shares for a purchase price of at least $750,000, one hundred percent (100%) of the number of November Shares purchased by such investor (the “November Warrants”). In addition, each investor who purchased November Shares for a purchase price of at least $1,000,000 shall receive November Warrants with an exercise price of $1.60 per share.


The Company received proceeds of $3,211,320 in connection with the November Financing. The Company received payment of a portion of the proceeds in the form of the extinguishment of Promissory Notes (together with additional notes issued as payment for accrued interest) in the approximate amount of $355,000, which amount included principal and interest accrued through November 13, 2009 (see Note 5). A portion of one investor’s purchase price was comprised of the investment of $450,000 of the funds payable to such investor by the Company for the redemption of a portion of the Series B Stock owned by such investor upon the closing of the November Financing. Of the total proceeds, the Company received approximately $2,461,000 for the issuance of 1,969,056 shares of Common Stock and $750,000 for 600 shares of Series C stock issued to an investor due to ownership limitations.

Pursuant to the Purchase Agreement, the Company issued November Warrants to purchase an aggregate of 2,398,339 shares of Common Stock to the investors, of which 1,598,339 shares have an exercise price equal to $2.00 per share and 800,000 shares have an exercise price equal to $1.60 per share. The Company issued warrants to purchase 256,906 shares at $0.50 per share to the placement agent and its assignees. The warrants are immediately exercisable and expire no later than November 13, 2014. The exercise price is subject to adjustment for stock splits, combinations or similar events. The November Warrants allow for cashless exercise. An exercise under the November Warrants may not result in the holder beneficially owning more than 4.99% or 9.99%, as applicable, of all of the Common Stock outstanding at the time; provided, however, that a holder may waive the foregoing provision upon sixty-one (61) days’ advance written notice to the Company.

December 2009 Common Stock and Warrant Financing

On December 3, 2009, the Company closed on a financing pursuant to a Common Stock and Warrant Purchase Agreement dated as of November 30, 2009 (the “December Agreement”) with certain strategic institutional and accredited investors in connection with the private placement (the “December Financing”) of shares of Common Stock at a price of $1.25 per share (the “December Shares”). Under the terms of the December Agreement, each investor shall receive warrants to purchase a number of shares of Common Stock with an exercise price of $2.00 per share equal to (i) seventy percent (70%) of the number of December Shares purchased by such investor or, (ii) for those investors who purchased December Shares for a purchase price of at least $750,000, one hundred percent (100%) of the number of December Shares purchased by such investor (the “December Warrants”). In addition, the December Warrants issued to each investor who purchased December Shares for a purchase price of at least $1,000,000 have an exercise price of $1.60 per share.

The Company received proceeds of $562,500 in connection with the December Financing.

Pursuant to the December Agreement, the Company issued 450,000 shares of common stock, an aggregate of 315,000 December Warrants to the investors and 45,000 warrants to the placement agent and its assignees. The December Warrants are immediately exercisable and expire no later than December 3, 2014. The exercise price is subject to adjustment for stock splits, combinations or similar events. The December Warrants allow for cashless exercise. An exercise under the December Warrants may not result in the holder beneficially owning more than 4.99% or 9.99%, as applicable, of all of the Common Stock outstanding at the time; provided, however, that a holder may waive the foregoing provision upon sixty-one (61) days’ advance written notice to the Company.

February 2010 Common Stock and Warrant Financing

On February 4, 2010, the Company entered into a Common Stock and Warrant Purchase Agreement (the “February Agreement”) with certain strategic institutional and accredited investors in connection with the Company’s private placement (the “February Financing”) of shares of its Common Stock, at a price of $1.50 per share (the “February Shares”). Under the terms of the February Agreement, each investor received warrants to purchase a number of shares of Common Stock with an exercise price of $2.25 per share equal to fifty percent (50%) of the number of February Shares purchased by such investor (the “February Warrants”).  The Company issued 1,636,739 shares of Common Stock and received gross proceeds of approximately $2,455,000 in connection with the February Financing. Total cost to issue the shares was $361,111 which included non-cash costs of $217,141.

Pursuant to the February Agreement, the Company issued an aggregate of 818,362 February Warrants to the investors and 128,899 warrants to the placement agent and its assignees. The February Warrants are immediately exercisable and expire no later than five (5) years from the date of issuance. The exercise price is subject to adjustment for stock splits, combinations or similar events. The February Warrants allow for cashless exercise. An exercise under the February Warrants may not result in the holder beneficially owning more than 4.99% or 9.99%, as applicable, of all of the Common Stock outstanding at the time; provided, however, that a holder may waive the foregoing provision upon sixty-one (61) days’ advance written notice to the Company.

November 2010 Common Stock and Warrant Financings

In November 2010, the Company initiated a private placement (the “November 2010 Financing”) of up to 120 units (each, a “Unit” and together, the “Units”) or partial Units at a price per Unit of $25,000.  Each Unit consists of (i) 25,000 shares of the Company’s Common Stock, (ii) Series-1 warrants to purchase 12,500 shares of the Company’s Common Stock with an exercise price of $1.50 per share (the “Series-1 Warrants”), and (iii) Series-2 warrants to purchase 12,500 shares of Common Stock with an exercise price of $2.50 per share (the “Series-2 Warrants”).

Through December 31, 2010, the Company had entered into subscription agreements with certain strategic institutional and accredited investors in connection with the November 2010 Financing for a total of 68.8 units.  The Company received gross proceeds from these subscriptions in the amount of $1,720,000.   The Company received proceeds of $100,000 in the form of extinguishment of a Short-Term Note issued by the Company on September 28, 2010 (see Note 5), which included principal and interest.  Additionally, the Company had received a commitment for an additional 11.4 Units for which the expected proceeds of $285,000 had not been received as of December 31, 2010.  This was treated as a stock subscription receivable as of December 31, 2010.  The proceeds of $285,000 were received in January and February 2011.

As of December 31, 2010, the Company issued an aggregate of 1,720,000 shares of Common Stock and under commitments for an additional 11.4 Units is obligated to issue an additional 285,000 shares and an aggregate of 1,002,500 Series-1 Warrants and 1,002,500 Series-2 Warrants to the Investors.   These warrants are immediately exercisable and expire three years after issuance. The exercise price is subject to adjustment for stock splits, combinations or similar events.  An exercise under these warrants may not result in the holder beneficially owning more than 4.99% or 9.99%, as applicable, of all of the Common Stock outstanding at the time; provided, however, that a holder may waive the foregoing provision upon sixty-one (61) days’ advance written notice to the Company.

As of December 31, 2010, the November 2010 Financing remained open.  Additional Units were sold in 2011 (see Note 14).

Burnham Hill Partners Engagement Letters

On June 30, 2009, the Company entered into an engagement letter with Burnham Hill Partners LLC (“BHP LLC”) pursuant to which BHP LLC provided placement agent services to the Company in connection with the Series B Financing (see Note 8). The Company agreed to pay BHP LLC a cash fee of $200,000 (the “Series B Fee”) which was due and payable upon the earlier of (i) the Company having a net cash balance in excess of $2,000,000 or (ii) October 1, 2009; and (b) warrants to acquire 400,000 shares of Common Stock, with a term of five years, an exercise price per share equal to 105% of the closing bid price of Common Stock on June 30, 2009. On September 30, 2009, the Company and BHP LLC entered into a letter agreement (the “Letter”) extending the due date of the Series B Fee. The Letter provides that the Fee is due and payable by the Company upon the earlier of (i) the Company having a cash balance in excess of $2,000,000 or (ii) March 31, 2010. On March 16, 2010, BHP LLC agreed that the Company does not owe BHP any fees that may have been payable pursuant to any and all previous agreements between BHP and the Company. Accordingly, the Company recorded a gain on extinguishment of financing fee payable of $200,000 in 2010.  As a result of the Series B Financing, the Company issued to BHP LLC and/or its designees and assignees warrants to purchase 400,000 shares of Common Stock at an exercise price of $1.59. The fair value of these warrant shares was determined to be approximately $557,000 as of June 30, 2009 which was recorded as both a debit and credit to additional paid-in capital as a stock issuance cost.

On October 13, 2009, the Company entered into an engagement letter with BHP LLC pursuant to which BHP LLC provided placement agent services to the Company in connection with the November Financing. BHP LLC received a cash placement fee of $168,438 and the Company issued to BHP LLC and/or its designees and assignees warrants to purchase 256,906 shares of Common Stock at an exercise price of $1.50. The fair value of these warrant shares was determined to be approximately $263,000 as of November 13, 2009 which was recorded as both a debit and credit to additional paid-in capital as a stock issuance cost.
   
  On February 4, 2010, the Company entered into an engagement letter with BHP LLC pursuant to which BHP LLC provided placement agent services to the Company in connection with the February Financing.  The Company agreed to pay BHP LLC for its services as follows: (a) a cash fee equal to seven percent (7%) of the gross cash proceeds received by the Company in connection with the February Financing from investors BHP LLC directly introduced to the February Financing; and (b) warrants to acquire a number of shares of Common Stock equal to 10% of the number of Shares issued to the investors directly introduced to the February Financing by BHP LLC at a per share exercise price equal to the exercise price of the Warrants and with such other terms and conditions as are equal or substantially similar to those included in the Warrants.  The Company also agreed to pay BHP LLC’s reasonable out of pocket expenses incurred in connection with the February Financing in an amount not to exceed $5,000. BHP LLC received a cash placement fee of $29,925 and the Company issued to BHP LLC and/or its designees and assignees warrants to purchase 28,500 shares of Common Stock. The fair value of these warrant shares was determined to be approximately $48,000 as of February 3, 2010 which was recorded as both a debit and credit to additional paid-in capital as a stock issuance cost.


Boenning & Scattergood Engagement Letter

On October 13, 2009, the Company entered into an engagement letter with Boenning & Scattergood, Inc. (“Boenning”) pursuant to which Boenning provided placement agent services to the Company in connection with the December Financing. The Company agreed to pay Boenning for its services as follows: (a) a cash fee equal to seven percent (7%) of the gross cash proceeds received by the Company in connection with the December Financing; and (b) warrants to acquire a number of shares of Common Stock equal to 10% of the number of December Shares issued to the investors at a per share exercise price equal to the greater of (i) 110% of the purchase price of the December Shares issued or (ii) the closing price of the Common Stock on the closing date. As a result of the December Financing, Boenning received a cash placement fee of $39,375 and the Company issued to Boenning and/or its designees and assignees warrants to purchase 45,000 shares of Common Stock at an exercise price of $1.38. The fair value of these warrant shares was determined to be approximately $49,950 as of December 3, 2009 which was recorded as both a debit and credit to additional paid-in capital as a stock issuance cost.
 
  On February 4, 2010, the Company entered into an engagement letter with Boenning pursuant to which Boenning provided placement agent services to the Company in connection with the February Financing.  The Company agreed to pay Boenning for its services as follows: (a) a cash fee equal to seven percent (7%) of the gross cash proceeds received by the Company in connection with the February Financing from investors Boenning directly introduced to the February Financing; and (b) warrants to acquire a number of shares of Common Stock equal to 10% of the number of Shares issued to the investors directly introduced to the February Financing by Boenning at a per share exercise price equal to the exercise price of the Warrants and with such other terms and conditions as are equal or substantially similar to those included in the Warrants.  The Company also agreed to pay Boenning’s reasonable out of pocket expenses incurred in connection with the February Financing in an amount not to exceed $5,000.  Boenning received a cash placement fee of $110,410 and the Company issued to Boenning and/or its designees and assignees warrants to purchase 100,399 shares of Common Stock. The fair value of these warrant shares was determined to be approximately $169,000 as of February 3, 2010 which was recorded as both a debit and credit to additional paid-in capital as a stock issuance cost.

LifeTech Capital Engagement Letter

As of September 15, 2010, the Company retained LifeTech Capital, a division of Aurora Capital, LLC, as a placement agent (“LifeTech”).  The Company agreed to pay LifeTech for its services as follows: (a) a cash fee equal to seven percent (7%) of the gross cash proceeds in excess of $150,000 received by the Company in connection with the November 2010 Financing from investors introduced to the November 2010 Financing by LifeTech; and (b) warrants to acquire a number of shares of Common Stock equal to 10% of the securities sold to investors introduced to the November 2010 Financing by LifeTech.  The warrants are identical to those issued to the investors in the November 2010 Financing, except that they include a cashless exercise provision.  LifeTech also received an up-front cash fee of $10,000 for financial advisory services.  In connection with the November 2010 Financing, the Company issued LifeTech warrants to purchase 13,750 shares of Common Stock at an exercise price of $1.50 per share and 13,750 shares of Common Stock at an exercise price of $2.50 per share with a combined fair value of approximately $25,000 which was recorded as non-cash stock issuance cost.
 

Monarch Capital Group Engagement Letter

In December 2010, the Company also retained Monarch Capital Group, LLC, as a placement agent (“Monarch”).  The Company agreed to pay Monarch for its services as follows: (a) a cash fee equal to seven percent (7%) of the gross cash proceeds received by the Company in connection with the November 2010 Financing from investors introduced to the November 2010 Financing by Monarch; and (b) warrants to acquire a number of shares of Common Stock equal to 10% of the securities sold to investors introduced to the November 2010 Financing by Monarch.  The warrants are identical to those issued to the investors in the November 2010 Financing.  The Company has issued Monarch warrants to purchase 21,250 shares of Common Stock at an exercise price of $1.50 per share and 21,250 shares of Common Stock at an exercise price of $2.50 per share pursuant to this arrangement with a combined fair value of approximately $42,000 which was recorded as  non-cash stock issuance cost.

2010 Exercise of Common Stock Warrants

During 2010, warrants to purchase 143,793 shares of Common Stock were voluntarily exercised per a cashless process, resulting in the issuance of 35,714 common shares of the Company.

Common Stock Reserves

As of December 31, 2010, the Company had the following reserves established for the future issuance of Common Stock as follows:

Reserve for exercise of warrants
    10,336,292  
Reserve for the issuance of stock options outside of a qualified plan
    1,650,000  
Reserve for the exercise of stock options
    6,518,138  
Total Reserves
    18,504,430  

(10) STOCK OPTION PLANS

In 1997, the Company adopted its 1997 Long-Term Incentive and Stock Option Plan (the “1997 Plan”). Pursuant to the 1997 Plan, the Company’s Board of Directors (or committees and/or executive officers delegated by the Board of Directors) may grant incentive and nonqualified stock options to the Company’s employees, officers, directors, consultants and advisors. As of December 31, 2010, there were options to purchase an aggregate of 25,000 shares of Common Stock outstanding under the 1997 Plan and no shares available for future grants under the 1997 Plan.

In connection with the Company’s strategic merger with ChoiceTel in 2002, the Company assumed all outstanding options under the 1999 Sontra Medical, Inc. Stock Option and Incentive Plan (the “1999 Plan”). The Company may not grant any additional options under the 1999 Plan. The Company assumed options to purchase an aggregate of 86,567 shares of Common Stock under the 1999 Plan. As of December 31, 2009, there were options to purchase an aggregate of 5,780 shares of Common Stock outstanding under the 1999 Plan and none available for future grants.

In March 2003, the Company’s shareholders approved its 2003 Stock Option and Incentive Plan (the “2003 Plan”). Pursuant to the 2003 Plan, the Company’s Board of Directors (or committees and/or executive officers delegated by the Board of Directors) may grant incentive and nonqualified stock options, restricted stock and other stock-based awards to the Company’s employees, officers, directors, consultants and advisors. As of December 31, 2010, the maximum aggregate number of shares that may be authorized for issuance under the 2003 Plan for all periods is 1,600,000. As of December 31, 2010, there were restricted shares of Common Stock and options to purchase an aggregate of 1,529,500 shares of Common Stock outstanding under the 2003 Plan and 57,500 shares available for future grants under the 2003 Plan.

On May 20, 2008, the Company’s shareholders approved the Echo Therapeutics, Inc. 2008 Equity Compensation Plan (the “2008 Plan”). The 2008 Plan provides for grants of incentive stock options to employees and nonqualified stock options and restricted Common Stock to employees, consultants and non-employee directors of the Company. On July 12, 2010, the shareholders of the Company voted in favor of the Board of Directors’ recommendation to increase the number of shares authorized for issuance under the 2008 Plan from 2,700,000 shares to 4,700,000 shares. As of December 31, 2010, the number of shares authorized for issuance under the 2008 Plan was 4,700,000 shares. As of December 31, 2010, there were restricted shares of Common Stock and options to purchase an aggregate of 1,919,750 shares of Common Stock outstanding under the 2008 Plan and 2,780,250 shares available for future grants under the 2008 Plan.


Share-Based Compensation - Options

For options issued and outstanding during the years ended December 31, 2010 and 2009, the Company recorded additional paid-in capital and non-cash compensation expense of $164,810 and $1,298,789, respectively, each net of estimated forfeitures

The fair value of each option award is estimated on the date of grant using the Black-Scholes option pricing model that uses the assumptions noted in the following table. Expected volatilities are based on historical volatility of the Common Stock using historical periods consistent with the expected term of the options. The Company uses historical data, as well as subsequent events occurring prior to the issuance of the consolidated financial statements, to estimate option exercise and employee termination within the valuation model. The expected term of options granted under the Company’s stock plans, all of which qualify as “plain vanilla,” is based on the average of the contractual term (generally 10 years) and the vesting period (generally 24 — 42 months) as permitted under SEC Staff Accounting Bulletin Nos. 107 and 110. The risk-free rate is based on the yield of a U.S. Treasury security with a term consistent with the option. Restricted stock grants are valued based on the closing market price for the Common Stock on the grant date.

The assumptions used principally for options granted to employees in the years ended December 31, 2010 and 2009 were as follows

 
 
2010
   
2009
 
Risk-free interest rate
    2.43% - 3.96 %     2.43% - 2.78 %
Expected dividend yield
           
Expected term (employee grants)
 
6.75 years
   
6 years
 
Forfeiture rate (excluding fully vested options)
    0%-37 %     12.54 %
Expected volatility
    142% - 150 %     150% - 151 %

A summary of option activity under the Company’s stock plans and options granted to officers of the Company outside any plan as of December 31, 2010 and changes during the year then ended is presented below:

 
 
 
 
Options
 
 
 
 
Shares
   
Weighted-
Average
Exercise
Price
 
Weighted-
Average
Remaining
Contractual
Term
 
 
Aggregate
Intrinsic
Value
 
Outstanding at January 1, 2010
    2,924,530     $ 0.90          
Granted
    125,000     $ 1.56          
Exercised
        $          
Forfeited or expired
    (20,500 )   $ 9.60          
Outstanding at December 31, 2010
    3,029,030     $ 0.87  
6.82 years
  $ 2,756,550  
Exercisable at December 31, 2010
    2,841,516     $ 0.86  
6.85 years
  $ 2,624,732  

The weighted-average grant-date fair value of options granted during the year ended December 31, 2010 was $1.56 per share. As of December 31, 2010, there was approximately $122,000 of total unrecognized compensation expense related to non-vested share-based option arrangements. With the exception of the unrecognized share-based compensation related to certain restricted stock grants to officers and employees that contain performance conditions  related to United States Food and Drug Administration (“FDA”) approval for Symphony or the sale of substantially all of the stock or assets of the Company, unrecognized compensation is expected to be recognized over the next 12 months.

In the year ended December 31, 2010, the Company issued options to purchase a total of 125,000 shares of Common Stock at prices between $1.00 and $1.70 to vendors for investor relations services.  The fair value of these options was approximately $178,000.  During the year ended December 31, 2010, the Company recorded approximately $60,000 of selling, general and administrative expense related to these options.

On February 20, 2009, the Compensation Committee of the Board of Directors of the Company approved a reduction of the exercise price of options for certain officers of the Company to purchase an aggregate of 1,300,000 shares of Common Stock to $0.55 per share. Prior to the repricing, the exercise price of such options was $1.39 per share. The Company also repriced options held by certain employees and consultants for the purchase of 550,000 shares of Common Stock with original exercise prices of between $0.61 and $2.25 to an exercise price of $0.40. All other terms of the options remained the same. In addition, the Compensation Committee also approved the cancellation of stock options for certain officers of the Company to purchase 1,250,000 shares of Common Stock that were granted on September 14, 2007 at an exercise price per share equal to $2.39. The excess of the fair value of the modified options over the fair value of the original options immediately prior to modification, or approximately $35,000, will be charged to expense over the remaining vesting period of the options.


On June 3, 2009, the Compensation Committee of the Board of Directors of the Company approved a reduction of the exercise price of options for a certain consultant of the Company to purchase 25,000 shares of Common Stock to $0.80 per share. Prior to the repricing, the exercise price of such options was $1.95 per share. All other terms of the options remained the same. The incremental fair value resulting from the repricing was immaterial.

Share-Based Compensation – Restricted Stock

For restricted stock issued and outstanding during the years ended December 31, 2010 and 2009, the Company incurred non-cash compensation expense of $393,249 and $309,758, respectively, each net of estimated forfeitures

As of December 31, 2010, the Company had outstanding restricted stock grants (including 601,250 shares issued and outstanding under the 2003 Plan) amounting to 2,446,094 shares at a weighted-average grant-date fair value of $1.20 per share. Of the outstanding restricted stock grants, 806,500 shares have not been registered. A summary of the status of the Company’s nonvested restricted stock grants as of December 31, 2010, and changes during the year ended December 31, 2010, is presented below:

 
 
 
Nonvested Shares 
 
 
 
 
Shares
   
Weighted-
Average
Grant-Date
Fair Value
 
Nonvested at January 1, 2010
    1,779,594     $ 1.13  
Granted
    363,000     $ 1.03  
Vested
    (513,000 )   $ 1.17  
Forfeited
    -    
           -
 
Nonvested at December 31, 2010
    1,629,594     $ 1.12  
Vested at December 31, 2010
    816,500     $ 1.36  


As of December 31, 2010, there was approximately $2,298,000 of total unrecognized compensation expense related to nonvested share-based restricted stock arrangements granted under the Company’s stock plans. As of December 31, 2010, the Company cannot estimate the timing of completion of performance vesting requirements required by these restricted stock grant arrangements.

During  2009, the Company granted an aggregate of 1,569,750 restricted shares of the Company’s Common Stock with a fair value of approximately $1,750,000 to certain employees, officers and directors of the Company pursuant to Restricted Stock Agreements under the 2003 Plan (225,000 shares) and the 2008 Plan (1,344,750 shares) (the “Restricted Share Grants”).  Subject to the terms and conditions of the Restricted Stock Agreements, the restricted shares will vest upon the first to occur of (i) FDA approval of Symphony; or (ii) the sale of all or substantially all of the assets of the Company or all or substantially all of the outstanding capital stock of the Company in exchange for Liquid Proceeds.  For the purposes of the Restricted Share Grants, “Liquid Proceeds” means (a) cash; (b) securities which can be sold immediately on NYSE or NASDAQ; (c) securities which are or will be registered such that they can be sold upon on NYSE or NASDAQ upon termination of a lock-up period not to exceed one hundred eighty (180) days; or (d) or a combination of cash and the foregoing securities.  The Restricted Share Grants were effected under Section 4(2) of the Securities Act.
 

Compensation expense related to the Restricted Share Grants will be recognized when the Company concludes that achievement of the performance vesting conditions is probable. Through December 31, 2010, the Company has not concluded that achievement of the performance conditions related to the Restricted Share Grants was probable.

During 2009, the Company issued 125,000 shares of its unregistered common stock with the fair value of approximately $189,100, to vendors in consideration for investor relations and other services. The issuance of the shares outside any stock option plan was made in a transaction not involving any public offering pursuant to an exemption from registration under Section 4(2) of the Securities Act.

During October 2009, the Company issued 37,500 shares of its unregistered common stock with the fair value of approximately $54,000, to three lenders for interest on the 2009 Promissory Demand Notes (see Note 5).  The fair value was recorded as a non-cash interest expense in the consolidated financial statements.   The issuance of the shares outside any stock option plan was made in a transaction not involving any public offering pursuant to an exemption from registration under Section 4(2) of the Securities Act.

On December 4, 2009, the Company issued 200,000 shares of its unregistered common stock with a fair value of approximately $250,000 to a vendor in consideration for investor relations services.  Under the terms of the agreement, only 50,000 shares vested as of December 31, 2009 with a fair value of approximately $63,000, and the remaining shares vested in 2010.  The issuance of the shares outside any stock option plan was made in a transaction not involving any public offering pursuant to an exemption from registration under Section 4(2) of the Securities Act.
 
On December 11, 2009, the Company issued 64,844 shares of its unregistered common stock with a fair value of approximately $83,000 to a member of the Company’s Board of Directors in consideration for past services to the Company.  Under the terms of the agreement, the shares vest when the Company concludes that achievement of the performance vesting conditions is probable.  The issuance of the shares outside of any stock option plan was made in a transaction not involving any public offering pursuant to an exemption from registration under Section 4(2) of the Securities Act.

In the year ended December 31, 2010, the Company issued 363,000 of fully vested Common Stock with a fair value of approximately $171,000 to vendors for various services.  Included in these amounts are 50,000 shares of Common Stock with a fair value of approximately $49,000 issued in payment of accrued interest in the Short-term Notes (see Note 5) and 23,000 shares of Common Stock with a fair value of approximately $23,000 issued to a vendor in lieu of a cash payment for previously provided services.   In April 2010, the Company considered as vested 150,000 shares of previously granted restricted common stock, with a fair value of approximately $222,000 to a vendor in consideration for investor relations services.

In January 2010, the Company issued 60,000 shares of its common stock with a fair value of approximately $113,000 as a charitable contribution which was charged to selling, general and administrative expense. The shares were issued in a transaction not involving any public offering pursuant to an exemption from registration under Section 4(2) of the Securities Act.

In January 2010, the Company issued 265,000 shares of its common stock with a fair value of approximately $466, 000 to three vendors in consideration for various consulting services. The fair value of these common shares is charged to selling, general and administrative expenses. A total of 165,000 and 100,000 shares were issued under the 2003 Plan and 2008 Plan, respectively.

(11) WARRANTS

The Company uses valuation methods and assumptions that consider among other factors the fair value of the underlying stock, risk-free interest rate, volatility, expected life and dividend rates in estimating fair value for the warrants considered to be derivative instruments.  The following assumptions were utilized by the Company:

   
2010
   
2009
 
Risk-free interest rate
    2.58% -3.71 %     2.87% - 3.80 %
Expected dividend yield
           
Expected term (contractual term)
 
2 - 5 years
   
3 - 5 years
 
Forfeiture rate
    0 %     0 %
Expected volatility
    141% - 150 %     150% - 153 %

Expected volatilities are based on historical volatility of the Common Stock using historical periods consistent with the expected term of the warrant. The risk-free rate is based on the yield of a U.S. Treasury security with a term consistent with the warrant.

In the years ended December 31, 2010 and 2009, the Company issued warrants with a fair value of approximately $617,000 and $174,000, respectively.  Included in the 2010 warrant fair value are warrants with a fair value of approximately $469,000 recorded as a debit and credit to additional paid-in capital as stock issuance costs related to the February 2010 Financing and November 2010 Financing (see Note 9).  The warrants issued in the years ended December 31, 2010 and 2009 generally have a term of two (2) to five (5) years, a non-redeemable feature and a cashless exercise provision. Certain warrants have a standard weighted average anti-dilution protection and piggy back registration rights.

 
At December 31, 2010, the Company had the following outstanding warrants:

   
Number of
Shares
Exercisable
   
Exercise
Price
 
Date of Expiration
Granted to investors and placement agent in private placement.
    476,830     $ 5.80  
3/07/2011