2. Summary of Significant Accounting Policies

Cash and Cash Equivalents and Short-Term Investments

The Company considers all highly liquid investments with an original maturity of three months or less at the time of purchase to be cash equivalents. The Company invests its available cash balances in bank deposits, money market funds, U.S. government securities and other investment grade debt securities that have strong credit ratings.

Management determines the appropriate classification of securities at the time of purchase. To date, all marketable securities have been classified as available-for-sale, and are carried at fair value as determined based on quoted market prices or other observable market inputs with unrealized gains and losses reported as a component of accumulated other comprehensive income (loss) in stockholders' deficit. The Company views its available-for-sale portfolio as available for use in current operations. Accordingly, the Company has classified all investments as short-term.

The amortized cost of debt securities is adjusted for amortization of premiums and accretion of discounts to maturity. Such amortization is included in interest income. Realized gains and losses and declines in value judged to be other-than-temporary for available-for-sale securities, if any, are included in other income (expense), net and have not been significant to date. Realized gains and losses are computed on a specific identification basis. Interest and dividends are included in interest income.

Concentrations of Credit Risk and Financial Instruments

The Company invests cash that is not currently being used for operational purposes in accordance with its investment policy. The policy allows for the purchase of low risk debt securities issued by U.S. government agencies and highly rated corporations subject to concentration limits of 10% of any one issuer or group of issuers at the time of purchase, with the exception of debt securities issued by U.S. government agencies where the Company is not subject to any concentration limit. The maturities of these securities on a weighted-average basis may be no longer than 12 months. The Company believes that it has established guidelines for investment of its excess cash that maintains safety and liquidity through its policies on diversification and investment maturity.

Financial instruments that potentially subject the Company to concentrations of credit risk consist of cash and cash equivalents and short-term investments, available for sale investment securities in high-credit quality corporate debt, and debt securities issued by the U.S. government and government-sponsored enterprises.

The Company utilizes a network of seven specialty distributors and specialty pharmacies to distribute Qutenza. For the year ended December 31, 2011, four of the distributors each accounted for 10% or more of the Company's 2011 gross product shipments. As of December 31, 2011, the Company had accounts receivable balances due from four of the distributors in amounts in excess of 10% of the Company's total accounts receivable balance and one such distributor's accounts receivable balance represented 43% of the total. If any of these distributors were to discontinue distributing Qutenza, the Company's product revenue could be negatively impacted, at least in the short term.

The Company currently depends on four contract manufacturers as single source suppliers for the components of Qutenza. The Company has entered into long-term commercial supply agreements for these components. In addition, the Company entered into a long-term agreement for the assembly of the Qutenza treatment kits in the United States. If relationships with any of these manufacturers is terminated, or if any manufacturer is unable to produce required quantities on a timely basis or at all, the Company's operations would be negatively impacted and our business harmed.

Trade Receivables

Trade accounts receivable are recorded net of allowances for customer chargebacks related to government rebate programs, doubtful accounts and sales returns. Estimates for customer chargebacks for government rebates and sales returns are based on contractual terms, historical trends and the Company's expectations regarding the utilization rates for these programs. The Company's estimate for allowance for doubtful accounts is determined based on existing contractual payment terms, historical payment patterns of its customers and individual customer circumstances. To date, sales returns and rebates have been insignificant, therefore, the Company has determined that an allowance for uncollectible accounts receivable is not required. The Company does not require collateral in support of its trade receivables.

Inventories

Inventories are determined at the lower of cost or market value with cost determined under the specific identification method. Inventories consist of raw materials, work-in-process and finished goods. Raw materials include certain starting materials used in the production of the active pharmaceutical ingredient of Qutenza. Work-in-process includes the bulk inventory of the active pharmaceutical ingredient, patches and cleansing gel of Qutenza that are in the process of being manufactured or have completed manufacture and are awaiting final packaging, including related internal labor and overhead costs. Finished goods include the final packaged kits that contain the Qutenza patch and cleansing gel and that are ready for commercial sale. Qutenza received FDA approval for sale in the United States during the fourth quarter of 2009; costs incurred prior to FDA approval had been recorded as research and development expense on the Company's consolidated statements of operations. On a quarterly basis, the Company analyzes its inventory levels and writes down inventory that has become obsolete, inventory that has a cost basis in excess of the expected net realizable value and inventory that is in excess of expected requirements based upon anticipated product revenues. For each of the years ended December 31, 2011 and 2010, the Company recorded a charge to Cost of goods sold of $0.4 million for Qutenza patches, which the Company does not expect to sell prior to their expiration date. As a result of the Company's re-organization in March 2012 which has resulted in a significant reduction of its expected revenue for United States Qutenza sales, the Company anticipates additional write-downs of inventory in the first quarter of 2012 to reflect these lower anticipated revenue levels. Expected inventory requirements based on product revenue and the timing of production runs are subject to significant judgment and management estimate. The Company expects that its sales forecast will change over time and thus it will continue to review the quantities of inventories on hand compared to the sales forecast.

Prepaid Collaboration Supplies

Costs to manufacture product under the supply agreement with Astellas, including internal labor costs and third-party manufacturing, packaging and transportation costs are classified as prepaid collaboration supplies, which are included in Prepaid expenses and other current assets on the Company's consolidated balance sheets, until such time as those supplies are delivered to Astellas.

Property and Equipment

Property and equipment are stated at cost, less accumulated depreciation. Depreciation is determined using the straight-line method and recorded over the estimated useful lives of the respective assets, generally three to five years. Leasehold improvements are amortized over the life of the lease or the useful economic life, whichever is shorter.

Product Revenue

In April 2010, the Company made Qutenza commercially available in the United States to its specialty distributor and specialty pharmacy customers. Under the Company's agreements with its customers, the customers take title to the product upon shipment and only have the right to return damaged product, product shipped in error and expired or short-dated product. As Qutenza is new to the marketplace, the Company is currently assessing the flow of product through its distribution channel, and cannot reasonably estimate returns. Until such time as an estimate of returns can be made, the Company is recognizing Qutenza product revenue, and related product costs, at the later of:

•

the time the product is shipped by the customer to healthcare professionals, and

•

the date of cash collection.

Healthcare professionals are generally ordering Qutenza in small quantities only after they have identified a patient for treatment. The Company believes that revenue recognition upon the later of customer shipment to the end user and the date of cash collection is appropriate until the Company has sufficient data on the cash collection and return patterns of its customers. The Company is performing additional procedures to further analyze shipments made by its customers by utilizing shipping data provided by its customers to determine when product is shipped by customers to healthcare professionals and are evaluating ending inventories at the Company's customers each month to assess the risk of product returns.

The Company has established terms pursuant to distribution agreements with its customers providing for payment within 120 days of the date of shipment to its specialty distributor customers and 30 days of the date of shipment to its specialty pharmacy customers. Such distribution agreements generally have a term of three years.

The application of the Company's revenue recognition policy resulted in the recognition of net revenue of $2.6 million from gross shipments of $3.4 million for the year ended December 31, 2011. The Company's gross shipments are reduced for chargebacks, certain fees paid to distributors and product sales allowances including rebates to qualifying federal and state government programs. At December 31, 2011, net deferred product revenue totaled $1.1 million.

Revenue from the Astellas Agreement

In June 2009, NeurogesX entered into the Astellas Agreement which provides for an exclusive license by the Company to Astellas for the promotion, distribution and marketing of Qutenza in the Licensed Territory, an option to license NGX-1998, a product candidate that is a non-patch liquid formulation of capsaicin, in the Licensed Territory, participation on a joint steering committee and, through a related supply agreement entered into with Astellas (the "Supply Agreement"), supply of product until direct supply arrangements between Astellas and third-party manufacturers are established. The Company anticipates certain of the direct supply arrangements will be established in the first half of 2012. Revenue under this arrangement includes upfront non-refundable fees and may also include additional option payments for the development of and license to NGX-1998, contingent event-based payments upon achievement of certain product sales levels and royalties on product sales.

The Company analyzes multiple-element arrangements, such as the Astellas Agreement, to determine whether the various performance obligations, or elements, can be separated or whether they must be accounted for as a single unit of accounting. The determination of whether an element can be separated or accounted for as a single unit of accounting is based on the availability of evidence with regard to standalone value of each delivered element. If the fair value of all undelivered performance obligations can be determined, then all obligations would then be accounted for separately as performed. If any delivered element is considered to either: 1) not have standalone value or 2) have standalone value but the fair value of any of the undelivered performance obligations are not determinable, then any delivered elements of the arrangement would be accounted for as a single unit of accounting and the multiple elements would be grouped and recognized as revenue over the longest estimated performance obligation period.

Significant management judgment is required in determining the level of effort required under an arrangement and the period over which the performance obligations are estimated to be completed. In addition, if the Company is involved in a joint steering committee as part of a multiple-element arrangement that is accounted for as a single unit of accounting, an assessment is made as to whether the involvement in the steering committee constitutes a performance obligation or a right to participate.

Revenue recognition of non-refundable upfront license fees commences when there is a contractual right to receive such payment, the contract price is fixed or determinable, the collection of the resulting receivable is reasonably assured and there are no further performance obligations under the license agreement.

The Company views the Astellas Agreement and related agreements, as a multiple-element arrangement with the key deliverables consisting of an exclusive license to Qutenza in the Licensed Territory, an obligation to conduct certain development activities associated with NGX-1998, participation on a joint steering committee and supply of Qutenza components to Astellas until such time that Astellas can establish a direct supply relationship with product vendors. Because not all of these elements have both standalone value and objective and reliable evidence of fair value, the Company is accounting for such elements as a single unit of accounting. Further, the agreement provides for the Company's mandatory participation in a joint steering committee, which the Company believes represents a substantive performance obligation and also the estimated last delivered element under the Astellas Agreement and related agreements. Therefore, the Company is recognizing revenue associated with upfront payments and license fees ratably over the term of the joint steering committee performance obligation. The Company estimates this performance obligation will be delivered ratably through June 2016.

At the inception of the Astellas Agreement, the upfront license fees were subject to a refund right, which expired upon transfer of the Company's MA for Qutenza in the European Union to Astellas. In September 2009, the transfer of the MA to Astellas was completed and, therefore, the upfront license fees became non-refundable and revenue recognition of the upfront license fees commenced.

In the accompanying financial statements, Collaboration revenue represents revenue associated with the Astellas Agreement and related agreements. Deferred collaboration revenue arises from the excess of cash received or receivable over cumulative revenue recognized for the period.

Under the terms of the Astellas Agreement, the Company earns royalties based on each sale of Qutenza into the Licensed Territory. The royalty rate is tiered based on the level of sales achieved. These royalties are considered contingent consideration as there is no remaining contract performance obligation of the Company and, therefore, the royalties are excluded from the single unit of accounting treatment discussed above. The Company reports royalty revenue based upon Astellas' reported net sales of Qutenza in the Licensed Territory. The Company recognizes royalty revenue from Astellas on a quarter lag basis due to the timing of Astellas reporting such royalties to the Company.

Additionally, the Company can earn contingent event-based payments from Astellas if Astellas achieves certain sales levels as outlined in the Astellas Agreement. As these payments are contingent on Astellas' performance, they are excluded from the single unit of accounting treatment discussed above. The contingent event-based payments will be recorded as revenue when earned as there is no remaining contractual performance obligation of the Company.

The Company recognizes revenue net of related costs for collaboration supplies sold to Astellas upon product being delivered to Astellas. The revenue and related costs of the product supplied to Astellas are included in Collaboration revenue. Prior to delivery to Astellas, the costs accumulated for the manufacturing of the collaboration supplies are included as Prepaid expenses and other current assets on the Company's consolidated balance sheets.

Cost of Goods Sold

Cost of goods sold includes costs to procure, manufacture and distribute Qutenza including certain shipping and handling costs incurred in the distribution channel, as well as royalties payable to The Regents of the University of California, or UC, and Lohmann Therapie-Systeme AG or LTS. Costs associated with the manufacture of Qutenza prior to FDA approval were previously expensed as research and development in the period incurred. Cost of goods sold associated with deferred product revenue will be deferred and recognized in the same period as the associated product revenue. At December 31, 2011, the Company had deferred Cost of goods sold of $0.1 million.

During the years ended December 31, 2011 and 2010, the Company recorded charges of $0.4 million and $0.4 million, respectively, for Qutenza patches which the Company does not expect to sell prior to their expiration date.

Research and Development

The Company expenses research and development costs as incurred. Research and development expenses include personnel and personnel related costs, costs associated with pre-clinical and clinical development activities, such as clinical trials, including amounts paid to clinical research organizations and clinical investigators; product and manufacturing costs, such as process development, clinical product supply costs and the cost of commercially saleable product that is manufactured prior to market approval for that product candidate; internal and external costs associated with the Company's regulatory compliance and quality assurance functions including the costs of outside consultants and contractors that assist in the process of submitting and maintaining regulatory filings; and overhead costs including allocated facility and related expenses.

Clinical Trials

The Company accrues and expenses costs for clinical trial activities performed by third parties, including clinical research organizations and clinical investigators, based upon estimates of the work completed over the life of the individual study in accordance with agreements established with contract research organizations and clinical trial sites. The Company determines these estimates through discussion with internal personnel and outside service providers as to progress or stage of completion of trials or services pursuant to contracts with numerous clinical trial centers and clinical research organizations and the agreed upon fee to be paid for such services.

Advertising Costs

The Company expenses both the production costs and the placement costs of advertising as incurred. Advertising expense which includes Qutenza's website development, eLearning, eMarketing, media campaigns, patient testimonial videos and other items was $2.3 million, $5.8 million and $0.7 million for the years ended December 31, 2011, 2010 and 2009, respectively.

Interest Expense

Interest expense is comprised of interest relating to the Company's long-term obligations, the accretion of the debt discount, and the amortization of debt issuance costs recorded as Prepaid expenses and other current assets and Other assets on the consolidated balance sheets. Interest expense includes both currently payable interest charges and interest charges that accrue but are not currently due as a result of the terms of the underlying debt agreement. See Note 7 for a discussion of the Cowen Healthcare Royalty debt facility.

Other Income (Expense), Net

Other income (expense), net, in 2011 was a net expense of $0.1 million primarily related to investment advisory fees. Other income (expense), net, was a net income of $0.6 million in 2010 that resulted primarily from income tax credits earned under Section 48D of the Internal Revenue Code (as enacted on March 23, 2010 by the "Patient Protection and Affordable Care Act"). The Company applied for a credit based upon certain of its 2009 and 2010 research and development activities. The payment for the 2009 credit of $0.4 million was received in 2010 whereas the payment for the 2010 credit of $0.2 million was received in 2011.

Income Taxes

The Company utilizes the liability method of accounting for income taxes. Under this method, deferred tax assets and liabilities are determined based on differences between financial reporting and tax reporting bases of assets and liabilities and are measured using enacted tax rates and laws that are expected to be in effect when the differences are expected to reverse. Uncertain tax positions are evaluated and if appropriate, the amount of unrecognized tax benefits are recorded within deferred tax assets, as further described in Note 12. Valuation allowances are established when necessary to reduce deferred tax assets to the amounts expected to be realized. Currently, there is no provision for income taxes as the Company has incurred operating losses to date.

Comprehensive (Loss)/Income

Comprehensive (loss)/income includes net loss and other comprehensive (loss)/income. For each of the years ended December 31, 2011, 2010 and 2009, the difference between comprehensive loss and net loss represented net unrealized gains or losses on available-for-sale securities.

Net Loss Per Share

Basic and diluted net loss per share is calculated by dividing the net loss attributable to common stockholders by the weighted-average number of common shares outstanding during the period less the weighted-average unvested common shares subject to repurchase. For purposes of this calculation, warrants and options to purchase common stock are considered to be common stock equivalents but have been excluded from the calculation of diluted net loss per share as their effect is anti-dilutive.


	Year Ended December 31,
	2011			2010			2009
	(in thousands except share and per share data)
Numerator:
Net loss	$	(49,545	)	$	(44,516	)	$	(21,867	)

Denominator:
Weighted-average common shares outstanding		23,011,015			17,768,881			17,611,189
Less: Weighted-average unvested common shares subject to repurchase		—			—			(393	)

Denominator for basic and diluted net loss per share		23,011,015			17,768,881			17,610,796

Basic and diluted net loss per share	$	(2.15	)	$	(2.51	)	$	(1.24	)

Outstanding securities not included in diluted net loss per share:
Options to purchase common stock		3,037,039			3,002,493			2,264,535
Warrants outstanding		7,932,295			1,265,846			1,265,846
Restricted stock units		781,000			—			—

		11,750,334			4,268,339			3,530,381

Recently Issued and Adoption of New Accounting Standards

Not Yet Adopted

In June 2011, the Financial Accounting Standards Board ("FASB") issued Accounting Standards Update ("ASU") No. 2011-05, "Presentation of Comprehensive Income" an update to Accounting Standards Codification ("ASC") Topic 220, "Comprehensive Income". The amendments of this update require that comprehensive income be presented either in a single continuous statement of comprehensive income or in two separate but consecutive statements. This update is to be applied retroactively and is effective for financial statements issued for fiscal years, and interim periods within those years, beginning after December 15, 2011, and interim and annual periods thereafter. This update will be effective for the Company January 1, 2012. The Company does not expect the adoption of this guidance to have a material impact on its consolidated financial statements.

Adopted in 2011

In October 2009, FASB issued ASU No. 2009-13, Revenue Recognition (ASC Topic 605)—Multiple-Deliverable Revenue Arrangements. This guidance modifies previous guidance for multiple element arrangements by allowing the use of the "best estimate of selling price" in the absence of vendor-specific objective evidence ("VSOE") or third-party evidence ("TPE") of selling price for determining the selling price of a deliverable. A vendor is now required to use its best estimate of the selling price when VSOE or TPE of the selling price is not available. In addition, the residual method of allocating arrangement consideration is no longer permitted. This ASU is effective for revenue arrangements entered into or materially modified in fiscal

years beginning on or after June 15, 2010 and early adoption was permitted. The Company adopted this ASU on January 1, 2011 on a prospective basis and the adoption of the new guidance did not have a material impact on the Company's consolidated financial statements. The Company currently only has one revenue agreement with multiple elements, the Astellas Agreement. If the Company was to enter into new multiple element arrangements or make a material modification to the Astellas Agreement after January 1, 2011, the contract would be accounted for under the provisions of ASU No. 2009-13.

In April 2010, the FASB issued ASU No. 2010-17, Revenue Recognition—Milestone Method (ASC Topic 605): Milestone Method of Revenue Recognition ("ASU No. 2010-17"). This ASU codifies the consensus reached in EITF Issue No. 08-9, "Milestone Method of Revenue Recognition." The amendments to the Codification provide guidance on defining a milestone and determining when it may be appropriate to apply the milestone method of revenue recognition for research or development transactions. Consideration that is contingent on the achievement of a milestone in its entirety may be recognized as revenue in the period in which the milestone is achieved only if the milestone is judged to meet certain criteria to be considered substantive. Milestones should be considered substantive in their entirety and may not be bifurcated. An arrangement may contain both substantive and non-substantive milestones, and each milestone should be evaluated individually to determine if it is substantive. ASU No. 2010-17 is effective for fiscal years, and interim periods within those years, beginning on or after June 15, 2010, and may be applied prospectively to milestones achieved after the adoption date or retrospectively for all periods presented. On January 1, 2011, the Company prospectively adopted and elected the Milestone Method of Revenue Recognition as its accounting policy for substantive milestones achieved after the adoption date. The adoption of the new guidance did not have a material impact on the Company's consolidated financial statements.