1. ORGANIZATION AND BASIS OF PRESENTATION

MELA Sciences, Inc., a Delaware corporation (the “Company”), is a medical device company focused on the commercialization of our flagship product, MelaFind^®, and the further design and development of MelaFind^® and our technology. MelaFind^® is a non-invasive, point-of-care (in the doctor’s office) instrument to aid in the detection of melanoma. MelaFind^® features a hand-held component that emits light of multiple wavelengths to capture digital data from clinically atypical pigmented skin lesions. The data are then analyzed utilizing sophisticated classification algorithms that were ‘trained’ on our proprietary database of melanomas and benign lesions, in order to provide information to assist in the management of the patient’s disease, including information useful in the decision of whether to biopsy the lesion.

The components of the MelaFind^® system include:

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a hand-held component, which employs high precision optics and multi-spectral illumination (multiple colors of light including near infra-red);

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a proprietary database of pigmented skin lesions, which we believe to be the largest in the U.S.;

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lesion classifiers, which are sophisticated mathematical algorithms that extract lesion feature information and classify lesions; and

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information, including imaging and metrics to help physicians use MelaFind^® as a clinical tool.

In November 2011, the Company received written approval from the U.S. Food and Drug Administration (“FDA”) for the MelaFind^® Pre-Market Approval (“PMA”) application and in September 2011 received Conformite Europeene (“CE”) Mark approval for MelaFind^® . On March 7, 2012, the Company installed the first commercial MelaFind^® systems, and proceeded with the commercial launch of its breakthrough product for melanoma detection.

The Company is continuing the controlled and deliberate commercial launch of MelaFind^® with a redirected emphasis which concentrates on large cancer centers and high risk patients, throughout the United States and Germany. Also during the current quarter, the Company continued its Post-Approval Study (“PAS”) evaluating the sensitivity of physicians in diagnosing melanomas and high-grade lesions and the false positive rate after using MelaFind^®. The Company anticipates that it will continue to incur net losses for the foreseeable future as it proceeds through the commercial launch of the MelaFind^® device and the PAS.

On October 17, 2013, the FDA sent us a letter stating that the information in our August 8, 2013 progress report with respect to the PAS was inadequate to allow the agency to complete its review and therefore the FDA asked for additional information. Because of rate of accrual issues, the FDA’s letter informed us that our study status was revised on the FDA’s website to “Progress Inadequate.” The letter requests a response within 30 days. We are currently working to address these issues in a timely response.

The unaudited condensed financial statements included herein have been prepared from the books and records of the Company pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”) for reporting on Form 10-Q. The information and note disclosures normally included in complete financial statements prepared in accordance with generally accepted accounting principles in the United States (“GAAP”) have been condensed or omitted pursuant to such rules and regulations. The interim financial statements should be read in conjunction with the audited financial statements and notes thereto included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2012.

The Company’s management is responsible for the financial statements included in this document. The Company’s interim financial statements are unaudited. Interim results may not be indicative of the results that may be expected for the year. However, the Company believes all adjustments considered necessary for a fair presentation of these interim financial statements have been included and are of a normal and recurring nature.

In June 2012, the Company entered into a sales agreement with Cowen and Company, LLC, to sell shares of the Company’s common stock through an “at-the-market” equity offering program (the “ATM Program”), which was terminated on February 15, 2013. During the quarter ended March 31, 2013, the Company sold approximately 4.7 million shares under the ATM Program for gross and net proceeds of approximately $8.8 million and $8.5 million, respectively. During the term of the ATM Program, the Company sold a total of approximately 6.6 million shares for aggregate gross and net proceeds of approximately $14.4 million and $13.8 million, respectively.

On February 12, 2013 the Company entered into an underwriting agreement, relating to the public offering of 6.1 million shares of the Company’s common stock, at a price to the public of $1.30 per share. The gross proceeds to the Company from the sale of the common stock totaled $7.9 million. After deducting the underwriters’ discounts and commissions and other offering expenses payable by the Company, net proceeds were approximately $7.3 million. The offering closed on February 15, 2013. The common stock was offered and sold pursuant to the Company’s Prospectus dated June 1, 2010 and the Company’s Prospectus Supplement filed with the Securities and Exchange Commission (the “SEC”) on February 12, 2013, in connection with a takedown from the Company’s then current shelf registration statement on Form S-3 (File No. 333-167113) declared effective by the SEC on June 1, 2010.

On March 15, 2013, the Company executed loan documents with Hercules Technology Growth Capital Inc., a venture capital lender, whereby the Company borrowed $6 million (the “Loan”.) The Loan accrued interest at a rate of 10.45%. The term of the Loan was 42 months with interest payments only during the first 12 months. On September 10, 2013, the Company elected to prepay the Loan and paid Hercules approximately $6.4 million, including the $425,000 fee discussed below, to settle all obligations to Hercules. Hercules agreed to waive the prepayment penalty that was defined in the loan documents.

Upon executing the loan documents on March 15, 2013 the Company became obligated to issue to the Lender a warrant to purchase shares of the Company’s common stock upon approval by the Company’s stockholders of a proposal to increase the Company’s number of authorized shares of common stock at its 2013 Annual Meeting of Stockholders. The number of shares that could be acquired upon exercise of the warrant and the exercise price per share, were not fixed on March 15, 2013 but would be determined when the warrant was issued based on a defined formula using trading prices of the Company’s common stock during certain periods prior to the issuance of the warrant. The Company’s stockholders approved the increase in the number of authorized shares of common stock on April 25, 2013 and on April 26, 2013 the warrant was issued to the Lender. The terms of the warrant were fixed on the date of issuance whereby the Lender received a warrant to purchase 693,202 shares of common stock at an exercise price of approximately $1.12 per share (“Warrant”). The Warrant expires on April 26, 2018.

For financial reporting purposes, the $6 million funded by the Lender on March 15, 2013 was allocated first to the fair value of the Company’s obligation to issue the warrant (“Warrant Obligation”) that totaled approximately $563,000 and the balance was reduced further by the Lender’s costs and fees (“Costs”), resulting in an initial carrying value of the loan of approximately $5.3 million. The Company used a Level 3 fair value measurement to determine fair value of the Warrant Obligation, which has significant unobservable inputs as defined in Accounting Standards Codification 820 “Fair Value Measures”. During the period from the loan inception date until the Warrant Obligation was fulfilled and the Warrant was issued, the Warrant Obligation was reflected as a long-term liability at fair value. Changes in the fair value (“mark-to-market adjustments”) of the Warrant Obligation were included in operating results. The fair value of the Warrant Obligation was determined using the Monte Carlo pricing model that used various assumptions that included: a stock prices ranging from $1.16 to $1.18 per share, volatility of 77%, time to maturity of 5 years, exercise prices ranging from $1.15 to $1.16 and a risk free interest rate of return of .84%. Due to the nature of the Monte Carlo model, a 10% change in the underlying unobservable inputs would not have a significant impact on the fair value.

The value of the Warrant Obligation combined with the Costs resulted in an initial loan discount of approximately $727,000. The terms of the Loan required the Company to pay the Lender a fee of $425,000 at the maturity of the Loan (referred to as “Fee” or “Long-term interest payable”). The loan discount and the Fee were being amortized as additional interest expense over the life of the loan using the interest method. As discussed above, prior to the terms of the warrant being fixed on April 26, 2013, the Warrant Obligation fell within the scope of Accounting Standards Codification 815 “Derivatives and Hedging” (“ASC 815”) and therefore the Warrant Obligation was accounted for as a derivative reflected as a long-term liability until the Warrant was issued on April 26, 2013. The terms of the Warrant upon issuance no longer required derivative accounting under ASC 815 and therefore the fair value of the Warrant was classified within stockholders equity.

As the result of Company electing to prepay the Loan on September 10, 2013, the unamortized loan discount, Fee and deferred financing costs were expensed resulting in a loss on early extinguishment of debt of approximately $1 million.

On October 29, 2013, the Company entered into a securities purchase agreement with certain accredited investors in connection with a $6.0 million registered offering of 4,228,181 shares of the Company’s common stock, fully paid prefunded warrants (“Series B Warrants”) to purchase up to 4,343,247 shares of its common stock and additional warrants (“Series A Warrants”) to purchase up to 6,857,142 shares of its common stock. The Series A Warrants are exercisable beginning on May 1, 2014 at a price of $0.85 per share and expire on May 1, 2019. The Series B Warrants are exercisable immediately for no additional consideration. These securities were offered and sold pursuant to the Company’s Prospectus dated October 25, 2013 and the Company’s Prospectus Supplement filed with the Securities and Exchange Commission (the “SEC”) on October 30, 2013, in connection with a takedown from the Company’s shelf registration statement on Form S-3 (File No.333-189118) post-effectively declared effective by the SEC on October 25, 2013. The offering closed on October 31, 2013. The approximately $5.5 million in net proceeds from the offering will be used to continue the commercial launch of MelaFind^® in the U.S. and the European Union, for continued research and development activities and for general corporate purposes including working capital.

The Company faces certain risks and uncertainties which are present in many emerging medical device companies regarding future profitability, ability to obtain future capital, protection of patents and intellectual property rights, competition, rapid technological change, government regulations, changing health care marketplace, recruiting and retaining key personnel, and reliance on third party manufacturing organizations.

LIQUIDITY

The Company has experienced recurring losses and negative cash flow from operations and management expects these conditions to continue for the foreseeable future. As the result of these factors, the Company has been and continues to be dependent on raising capital from the sale of securities in order to continue to operate and to meet its obligations in the ordinary course of business. Management recently put in place a cost reduction program that included staff reductions, the elimination or deferral of all nonessential projects and activities and the scaling back or discontinuance of general corporate activities (referred to as “Cost Reduction Plan”) to preserve liquidity. In addition, as discussed above, in October 2013 the Company raised net proceeds of approximately $5.5 million from the sale of common stock and warrants to strengthen the Company’s financial position.

Since the beginning of the year, we have continued to incur net losses. These net losses and the $6.4 million payment to Hercules made in September have had a significant negative impact on our working capital and financial position and may impact our future ability to meet our obligations in the ordinary course of business. As a result, management believes that, even with cash and cash equivalents held at September 30, 2013, together with the net proceeds from the October 2013 offering and estimated revenue, there is significant doubt about our ability to continue as a going concern. We continue to assess the effects of our previously announced cost reduction plan and are prepared to reduce various operational costs. Although we have no specific arrangements or plans, we will need additional capital during the next 12 months, which may take the form of equity or debt, on either a loan or convertible basis. However, under the terms of the securities purchase agreement entered into in connection with our October 2013 offering, we are prohibited from issuing (or entering into any agreement to issue) any equity securities in connection with a financing until January 31, 2014.

In addition, the Company anticipates that long-term it will need to raise substantial funds to broaden the commercialization of MelaFind^®, including further development of a direct sales force and expansion of the Company’s operations. The timing and amount of any additional funding the Company may require will be affected by numerous factors many of which are not in the control of the Company including the market acceptance of MelaFind^®. Examples of potential funding sources could be in the form of either the issuance of equity or debt securities or in exchange for product rights in all or certain geographies.

There can be no assurances that the Company will be able to raise additional financing in the future. Additional funds may not become available on acceptable terms, and there can be no assurance that any additional funding that the Company does obtain will be sufficient to meet the Company’s financing needs. Any additional funding that the Company may obtain in the future could be dilutive to common stockholders, could provide new investors with rights and preferences senior to common stockholders and may provide for restrictive covenants that could limit the Company’s ability to take certain actions. Unless we are able to generate sufficient revenues or are able to raise additional capital near-term, operations would need to be either further scaled back to maintain only vital activities or discontinued.