UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C.  20549

FORM 10-K

xANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the fiscal year ended December 31, 20112013
 
or
 
oTRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the transition period from                    to

Commission file number 000-26422

DISCOVERY LABORATORIES, INC.
(Exact name of registrant as specified in its charter)

Delaware
94-3171943
(State or other jurisdiction of incorporation or organization)
(I.R.S. Employer Identification Number)
 
2600 Kelly Road, Suite 100
Warrington, Pennsylvania 18976-3622
(Address of principal executive offices)

(215) 488-9300
(Registrant’s telephone number, including area code)

Securities registered pursuant to Section 12(b) of the Act:

Title of each class
Name of each exchange on which registered
 
Common Stock, $0.001 par valueThe Nasdaq Capital Market
Preferred Stock Purchase Rights

Securities registered pursuant to Section 12(g) of the Act:

None

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.  YES  oNO x

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Exchange Act.  YES  oNO 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 xNO o
 

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 xNO o

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 the 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.

Large accelerated filer o
o
Accelerated filero
x
Non-accelerated filer o
o
Smaller reporting companyx
o

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).
YES oNO x

The aggregate market value of shares of voting and non-voting common equity held by non-affiliates of the registrant computed usingon June 30, 2013 (based on the closing price for shares of the registrant’s common equitystock as reported on The Nasdaq Capital Market under the symbol DSCO on June 30, 2011, the last business day of the registrant’s most recently completed second fiscal quarter,that date was approximately $54$70 million.  For the purposes ofIn determining this amount, only, the registrant has defined affiliates to include: (a)assumed solely for this purpose that all of its directors, the executive officers named in Part III of this Annual Report on Form 10-K; (b) all directors of the registrant;10-K, and (c) each shareholder, if any, that has informed the registrant on or before March 15, 2012 that it is the beneficial owner ofpersons beneficially owning 10% or more of the outstanding shares of common stock of the registrant.registrant may be considered to be affiliates. This assumption shall not be deemed conclusive as to affiliate status for this or any other purpose.

As of March 21, 2012, 43,307,8677, 2014, 84,696,919 shares of the registrant’s common stock were outstanding.

DOCUMENTS INCORPORATED BY REFERENCE:

In accordance with General Instruction G(3) to the Annual Report on Form 10-K, portions of the information requiredregistrant’s definitive Proxy Statement for its 2014 Annual Meeting of Stockholders to be disclosedfiled with the Securities and Exchange Commission no later than 120 days, or April 30, 2014, after the registrant’s fiscal year ended December 31, 2013, and to be delivered to stockholders in connection with the 2014 Annual Meeting of Stockholders, are herein incorporated by reference in Part III of this Annual Report on Form 10-K is incorporated by reference from either (i) our definitive proxy statement, if filed with the Commission not later than 120 days after the end of our 2011 fiscal year, or (ii) if such definitive proxy statement is not filed with the Commission within such 120-day period, an amendment to this Annual Report on Form l0-K that will be filed with the Commission not later than the end of such 120-day period.
ii
10-K.

Unless the context otherwise requires, all references to “we,” “us,” “our,” and the “Company” include Discovery Laboratories, Inc., and its wholly-owned, presently inactive subsidiary, Acute Therapeutics, Inc.

FORWARD-LOOKING STATEMENTS
 
This Annual Report on Form 10-K contains “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934.  The forward-looking statements are only predictions and provide our current expectations or forecasts of future events and financial performance and may be identified by the use of forward-looking terminology, including thesuch terms as “believes,” “estimates,” “anticipates,” “expects,” “plans,” “intends,” “may,” “will” or “should” or, in each case, their negative, or other variations or comparable terminology, though the absence of these words does not necessarily mean that a statement is not forward-looking.  Forward-looking statements include all matters that are not historical facts and include, without limitation, statements concerning: our business strategy, outlook, objectives, future milestones, plans, intentions, goals, and future financial condition, including the period of time forduring which our existing resources will enable us to fund our operations;operations.  Forward-looking statements also include our financial, clinical, manufacturing and distribution plans, and our expectations related to the possibility,commercialization of SURFAXIN® and our development and potential regulatory plans to secure marketing authorization for our products under development, starting with AEROSURF®, if approved; our expectations, timing and outcomeanticipated outcomes of submitting regulatory filings for our products under development; our research and development programs, including planning for development activities, anticipated timing of clinical trials and potential development milestones, for our KL4 surfactant-basedsurfactant pipeline, and our capillary aerosol generator (CAG) and ventilator circuit / patient interface connectors for delivery of aerosolized medications, including planningmedications; plans for the manufacture of drug products, active pharmaceutical ingredients (APIs) and timing of any clinical trialsmaterials and potential development milestones; the development of financial, clinical, manufacturing and distribution plans related to the potential commercialization of our products, if approved;medical devices; and plans regarding potential strategic alliances and other collaborative arrangements with pharmaceutical companies and others to develop, manufacture and market our products.

i
We intend that all forward-looking statements be subject to the safe-harbor provisions of the Private Securities Litigation Reform Act of 1995.  Forward-looking statements are subject to many risks and uncertainties that could cause actual results to differ materially from any future results expressed or implied by the forward-looking statements.  We caution you therefore against relying on any of these forward-looking statements.  They are neither statements of historical fact nor guarantees or assurances of future performance.  Examples of the risks and uncertainties include, but are not limited to:
 
●
the risk that, if we are unable for any reason to introduce, or, if there is a significant delay in the commercial introduction of, SURFAXIN® and AFECTAIR® in the United States and other markets as planned, we may have difficulty securing additional capital to sustain our operations, which could have a material adverse effect on our ability to continue our marketing and distribution efforts, research and development programs and operations;
the risk that we will require in the near term, but may be unable to secure, significant additional capital to continue our operations, fund our debt service and support our research and development activities, including expensive and time-consuming clinical trials, until such time, if ever, that our revenues from all sources are sufficient to offset our cash outflows. To the extent that we raise such capital through additional financings, such additional financings could result in equity dilution;
 
●
the risk that we may be unable to enter into strategic alliances or collaboration agreements to support the development of our KL4 surfactant pipeline products,  beginning with SURFAXIN LS™ and AEROSURF®, and, if approved, commercialization of these products in markets outside the United States;
the risk that the initial and later phase of our AEROSURF phase 2 clinical program may be interrupted, delayed, or fail, which will harm our business;
●risks relating to our lack of marketing and distribution capabilities, which we will have to develop internally and secure through third-party strategic alliances and/or marketing alliances and/or distribution arrangements, that could require us to give up rights to our drug products, drug product candidates and drug delivery technologies;
●
risks relating to our ability to develop a successful sales and marketing organization to market SURFAXIN® and AFECTAIR® and our other product candidates, if approved, in a timely manner, if at all, and that we or our marketing and advertising consultants will not succeed in developing market awareness of our products or that our product candidates will not gain market acceptance by physicians, patients, healthcare payers and others in the medical community;

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●
risks relating to our ability to develop and manufacture drug products based on our KL4 surfactant technology, drug-device combination products that use our capillary aerosol generator (CAG) technology, and medical devices, including our CAG devices and novel ventilator circuit / patient interface connectors, for commercialization of our approved products and for preclinical and clinical studies of our product candidates;
●risks relating to the transfer of our manufacturing technology to third-party contract manufacturers and assemblers;
●
the risk that we, our contract manufacturers or any of our third-party suppliers may encounter problems or delays in manufacturing drug product substances, our drug products, CAG devices and ventilator circuit / patient interface connectors and related componentry, and other materials on a timely basis or in an amount sufficient to support the commercial introduction of SURFAXIN® and the AFECTAIR® devices, as well as our research and development activities for our other product candidates;
●risks relating to the rigorous regulatory approval processes, including pre-filing activities, required for approval of any drug, combination drug-device product or medical device that we may develop, whether independently, with strategic development partners or pursuant to collaboration arrangements;
●
risks related to our efforts to gain regulatory approval, in the United States and elsewhere, for our drug product and medical device candidates, including (i) drug and drug-device combination products that we are developing to address RDS in premature infants: SURFAXIN LS™ (our lyophilized (freeze-dried) dosage form of SURFAXIN®, and AEROSURF® (our initial aerosolized KL4 surfactant using our CAG technology); and (ii) AFECTAIR®, a series of our novel ventilator circuit / patient interface connectors that we plan to introduce commercially in fourth quarter of 2012;
●
the risk that we and the FDA or other regulatory authorities will not be able to agree on matters raised during the regulatory review process, or that we may be required to conduct significant additional activities to potentially gain approval of our product candidates, if ever;
●
the risk that the FDA or other regulatory authorities may not accept, or may withhold or delay consideration of, any applications that we may file, or may not approve our applications or may limit approval of our products to particular indications or impose unanticipated label limitations;
●
risks relating to our research and development activities, which involve time-consuming and expensive preclinical studies and other efforts, and potentially multiple clinical trials, which may be subject to potentially significant delays or regulatory holds, or fail, and which must be conducted using sophisticated and extensive analytical methodologies and quality control release and stability tests to satisfy the requirements of the regulatory authorities;
●
the risk that we may be unable to identify potential strategic partners or collaborators with whom we can develop and, if approved, commercialize our products in a timely manner, if at;
●
the risk that we or our strategic partners or collaborators will not be able to attract or maintain qualified personnel;
●
the risk that market conditions, the competitive landscape or other factors may make it difficult to launch and profitably sell our products;

●
risks that reimbursement and health care reform may adversely affect us or that our products will not be accepted by physicians and others in the medical community;
 
the risk that, if we fail to successfully commercialize SURFAXIN as planned, and if we do not achieve revenues consistent with our expectations, it may be more difficult to secure the additional capital we will require when needed, if at all, whether from strategic alliances or other sources, to continue our commercial and medical affairs activities, as well as our research and development programs and our operations would be impaired, which ultimately could have a material adverse effect on our business, financial condition and results of operations;
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risks relating to the ability of our sales and marketing organization to effectively introduce SURFAXIN in the United States (U.S.) and, if approved, our other product candidates, in a timely manner, if at all; and that we may not succeed in developing sufficient market awareness of our products or that our product candidates may not gain market acceptance by physicians, patients, healthcare payers and others in the medical community;
risks relating to the transfer of our manufacturing technology to contract manufacturing organizations (CMOs) and assemblers;
ii
the risk that we may be unable to enter into strategic alliances and/or collaboration agreements that would assist and support us in markets outside the U.S. with the development of our KL4 surfactant pipeline products, beginning with AEROSURF, including development of our lyophilized KL4 surfactant, and, if approved, commercialization of AEROSURF in markets outside the U.S.; support the commercialization of SURFAXIN in countries where regulatory approval is facilitated by the information contained in the SURFAXIN new drug application (NDA) approved by the U.S. Food and Drug Administration (FDA); and potentially support the development and, if approved, commercialization, of our other pipeline products;
risks relating to our plans potentially  to secure marketing and distribution capabilities in certain markets through third-party strategic alliances and/or marketing alliances and/or distribution arrangements, that could require us to give up rights to our drug products, drug product candidates and drug delivery technologies;
risks relating to our ability to manage growth effectively and timely modify our business strategy as needed to respond to developments in our commercial operations and research and development activities, as well as our business, our industry and other factors;
risks relating generally to our research and development activities, which among other things may involve time-consuming and expensive preclinical studies and potentially multiple clinical trials that may be subject to potentially significant delays or regulatory holds or fail;
risks related to our efforts to gain regulatory approval, in the U.S. and elsewhere, for our drug products, medical device and combination drug/device product candidates, including AEROSURF, and our lyophilized KL4 surfactant that we expect will be the drug component of AEROSURF and potentially be developed as a life cycle extension of SURFAXIN under the name SURFAXIN LS™ ;
risks relating to the rigorous regulatory approval processes, including pre-filing activities, required for approval of any drug, combination drug-device product or medical device that we may develop, whether independently, with strategic development partners or pursuant to collaboration arrangements;
the risk that the FDA or other regulatory authorities may not accept, or may withhold or delay consideration of, any applications that we may file, or may not approve our applications or may limit approval of our products to particular indications or impose unanticipated label limitations;
the risk that we and the FDA or other regulatory authorities will not be able to agree on matters raised during the regulatory review process, or that we may be required to conduct significant additional activities to potentially gain approval of our product candidates, if ever;
risks relating to our and our CMOs' ability to manufacture our KL4 surfactant, in liquid and lyophilized dosage forms, which must be processed in an aseptic environment and tested using sophisticated and extensive analytical methodologies and quality control release and stability tests, for both commercial and research and development activities;
risks relating to our and our CMOs’ ability to develop and manufacture combination drug/device products based on our CAG technology, for preclinical and clinical studies of our product candidates and, if approved, for commercialization;
the risk that we, our CMOs or any of our third-party suppliers, many of which are single-source providers, may encounter problems in manufacturing our KL4 surfactant drug products and the APIs used in the manufacture of our drug products, CAG devices and other materials on a timely basis or in an amount sufficient to support our needs;
 
●
the risk that changes in the national or international political and regulatory environment may make it more difficult to gain FDA or other regulatory approval of our drug product and medical device candidates;
risks relating to our pledge of substantially all of our assets to secure our obligations under our loan facility (Deerfield Loan) with affiliates of Deerfield Management Company, L.P., which could make it more difficult for us to secure additional capital to satisfy our obligations and require us to dedicate cash flow to payments for debt service, which would reduce the availability of our cash flow to fund working capital, capital expenditures and other investment;
 
●
the risk that we may be unable to maintain compliance with continued listing requirements of The Nasdaq Capital Market®, including without limitation those relating to maintaining a minimum bid price, market capitalization and stockholders’ equity, which could increase the probability that our stock will be delisted, which could cause our stock price to decline;
risks that unfavorable credit and financial markets may adversely affect our ability to fund our activities, through our ATM Program or otherwise, and that our ATM Program may expire unutilized or be exhausted; and that additional equity financings could result in substantial equity dilution or result in a downward adjustment to the exercise price of five-year warrants that we issued in February 2011 (which contain price-based anti-dilution adjustments);
iii
risks that reimbursement and health care reform may adversely affect us or that our products will not be accepted by physicians and others in the medical community;
 
●
risks that the unfavorable credit and economic environment will adversely affect our ability to fund our activities, that our Committed Equity Financing Facility (CEFF) and the ATM Program may be unavailable or may expire or be exhausted, and that additional equity financings could result in substantial equity dilution or result in a downward adjustment to the exercise price of five-year warrants that we issued in February 2011 (which contain price-based anti-dilution revisions);
the risk that changes in the national or international political and regulatory environment may make it more difficult to gain FDA or other regulatory approval of our drug products and medical device candidates;
 
●
the risks that we may be unable to maintain and protect the patents and licenses related to our products and that other companies may develop competing therapies and/or technologies;
the risk that if we fail to maintain compliance with continued listing requirements of The Nasdaq Capital Market, our common stock may be delisted and the value of our common stock decrease;
 
●
the risks that we may become involved in securities, product liability and other litigation and that our insurance may be insufficient to cover costs of damages and defense;
the risks that we may be unable to maintain and protect the patents and licenses related to our products and that other companies may develop competing therapies and/or technologies;
 
●
the risks that we will be unable to attract and retain key employees in a competitive market for skilled personnel, which could affect our ability to develop and market our products; and
the risks that we may become involved in securities, product liability and other litigation and that our insurance may be insufficient to cover costs of damages and defense;
 
●
the risk that we, our strategic partners or collaborators will be unable to attract and retain key employees, including qualified scientific, professional and other personnel, in a competitive market for skilled personnel, which could have a material adverse effect on our commercial and development activities and our operations; and
other risks and uncertainties detailed in “Risk Factors” and elsewhere in this Annual Report on Form 10-K, and in the documents incorporated by reference in this report.
 
Pharmaceutical, biotechnology and medical technology companies have suffered significant setbacks in advancedconducting clinical trials, even after obtaining promising earlier trial results.  Datapreclinical and clinical data.  Moreover, data obtained from such clinical trials are susceptible to varying interpretations, which could delay, limit or prevent regulatory approval.  After gaining approval of a drug product, pharmaceutical and biotechnology companies face considerable challenges in marketing and distributing their products, and may never become profitable.

The forward-looking statements contained in this report or the documents incorporated by reference herein speak only as of their respective dates.  Factors or events that could cause our actual results to differ may emerge from time to time and it is not possible for us to predict them all.  Except to the extent required by applicable laws, rules or regulations, we do not undertake any obligation to publicly update any forward-looking statements or to publicly announce revisions to any of the forward-looking statements, whether as a result of new information, future events or otherwise.

Trademark Notice
AEROSURF®, AFECTAIR®, DISCOVERYLABS®, INSPIRED INNOVATION®, SURFAXIN®, and WARMING CRADLE® are registered trademarks of Discovery Laboratories, Inc. (Warrington, PA).

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DISCOVERY LABORATORIES, INC.INC

Table of Contents to Annual Report on Form 10-K
For the Fiscal Year Ended December 31, 20112013
 
PART I
ITEM 1.
BUSINESS
1
ITEM 1A.
RISK FACTORS
3225
ITEM 1B.
UNRESOLVED STAFF COMMENTS
56
ITEM 2.
PROPERTIES
56
ITEM 3.
LEGAL PROCEEDINGS
57
ITEM 4.2.
MINE SAFETY DISCLOSUREPROPERTIES
57
ITEM 3.
LEGAL PROCEEDINGS
58
PART II
ITEM 5.
MARKET FOR REGISTRANT'S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
57
ITEM 6.
SELECTED FINANCIAL DATA
58
ITEM 6.
SELECTED FINANCIAL DATA
59
ITEM 7.
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
5860
ITEM 7A.
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
7780
ITEM 8.
FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
7780
ITEM 9.
CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
7781
ITEM 9A.
CONTROLS AND PROCEDURES
7781
ITEM 9B.
OTHER INFORMATION
83
78
PART III
ITEM 10.
DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE
7883
ITEM 11.EXECUTIVE COMPENSATION78
ITEM 12.SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS78
ITEM 13.CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE78
ITEM 14.PRINCIPAL ACCOUNTING FEES AND SERVICES78
PART IV
ITEM 15.
EXHIBITS AND FINANCIAL STATEMENT SCHEDULES
7983
 
SIGNATURES
8084
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PART I

ITEM 1.
BUSINESS.

COMPANY OVERVIEW

Discovery Laboratories, Inc. (referred to as “we,” “us,” or the “Company”) is a Delaware corporation, with our principal offices located at 2600 Kelly Road, Suite 100, Warrington, Pennsylvania.  We were incorporated as a Delaware corporation in 1992.  Our telephone number is 215-488-9300 and our corporate website address is www.discoverylabs.com.  Our common stock is listed on The Nasdaq Capital Market®, where our symbol is DSCO.

We are a specialty biotechnology company focused on creating life-saving products for critical carecritical-care patients with respiratory disease and improving the standard of care in pulmonary medicine.  Our proprietary drug technology produces a synthetic, peptide-containing surfactant (KL4 surfactant) that is structurally similar to pulmonary surfactant, a substance produced naturally in the lung and essential for normal respiratory function and survival.  We are developing our KL4 surfactant in liquid, lyophilized and aerosolized dosage forms.  We are also developing novel drug delivery technologies potentially to enable efficient delivery of inhaled therapies, including our aerosolized KL4 surfactant.  We believe that our proprietary technologies may make it possible, for the first time, to develop a significant pipeline of products to address a variety of respiratory diseases for which there frequently are few or no approved therapies.

On March 6, 2012,Initial Focus – Respiratory Distress Syndrome (RDS) in Premature Infants

We are initially focused on improving the U.S. Food and Drug Administration (FDA) granted us marketing approval for SURFAXIN® (lucinactant) for the preventionmanagement of respiratory distress syndrome (RDS) in premature infants at high risk for RDS.  SURFAXIN is the first synthetic, peptide-containing surfactant approved for use in neonatal medicine and provides healthcare practitioners with an alternative to the animal-derived surfactants that today are the standard of care to manage RDS in premature infants.  We are implementing a plan that, if successful, is intended to result in the commercial introduction of SURFAXIN in the United States in the fourth quarter of 2012.  See, “About SURFAXIN”,  “– Surfactant Replacement Therapy for Respiratory Medicine – Respiratory Distress Syndrome in Premature Infants (RDS) – SURFAXIN for the Prevention of RDS in Premature Infants at High Risk for RDS.”  See also, “– Proprietary Platform – Surfactant and Aerosol Technologies – Our KL4 Surfactant Technology.”

Our strategy is initially to focus on the development of our KL4 surfactant and aerosol technologies to improve the management of RDS in premature infants.  RDS is a serious respiratory condition caused by insufficient surfactant production in underdeveloped lungs of premature infants, andinfants.  RDS is the most prevalent respiratory disease in the neonatal intensive care unitNeonatal Intensive Care Unit (NICU).  RDS and can result in long-term respiratory problems, developmental delay and death.  Mortality

Our first KL4 surfactant drug product, SURFAXIN® (lucinactant) Intratracheal Suspension for the prevention of RDS in premature infants at high risk for RDS, was approved by the United States Food and morbidity rates associatedDrug Administration (FDA) in 2012.  SURFAXIN is our KL4 surfactant in liquid form and is the first synthetic, peptide-containing surfactant approved by the FDA and the only alternative to animal-derived surfactants currently used in the United States (U.S.).  Since November 2013, SURFAXIN has been commercially available in the U.S.

Premature infants with severe RDS havecurrently are treated with surfactants that can only be administered by endotracheal intubation supported with mechanical ventilation, both invasive procedures that may each result in serious respiratory conditions and other complications.  To avoid such complications, many neonatologists treat infants with less severe RDS by less invasive means, typically nasal continuous positive airway pressure (nCPAP).  Unfortunately, a significant number of premature infants on nCPAP will not meaningfully improved over respond well (an outcome referred to as nCPAP failure) and thereafter may require delayed surfactant therapy.  Since neonatologists currently cannot predict which infants will experience nCPAP failure, neonatologists are faced with difficult choices in treating infants with less severe RDS.  This is because the last decade.  Wemedical outcomes for those infants who experience nCPAP failure and receive delayed surfactant therapy may be less favorable than the outcomes for infants who receive surfactant therapy in the first hours of life.

AEROSURF® is an investigational combination drug/device product that combines our KL4 surfactant with our proprietary capillary aerosol generator (CAG).  With AEROSURF, neonatologists potentially will be able to administer aerosolized KL4 surfactant to premature infants supported with nCPAP, without having to use invasive intubation and mechanical ventilation.  By enabling delivery of our KL4 surfactant using less invasive procedures, we believe that AEROSURF will address a serious unmet medical need and potentially enable the RDS market is presently underserved, and that our RDS programs, beginning with SURFAXIN and, if approved, SURFAXIN LS™ and AEROSURF®, have the potential to greatly improve the managementtreatment of RDS and, collectively over time, to become the global standarda significantly greater number of care for premature infants with RDS.RDS who could benefit from surfactant therapy but are currently not treated.

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SURFAXIN LS is ourWe are also developing a lyophilized (freeze-dried) dosage form of SURFAXINour KL4 surfactant that is stored as a powder and resuspendedreconstituted to liquid form prior to use.  We are developing SURFAXIN LSuse with the objective of improving ease of use for healthcare practitioners, as well as potentially to prolong shelf life and eliminate the need for cold-chain storage.  We are implementing ainitially developing this dosage form for use in our AEROSURF development program.  We are also planning to seek regulatory plan intendedadvice to determine if we could gain marketing authorization for a lyophilized dosage form of SURFAXIN LSunder a development plan that would be both capital efficient and capable of implementation within a reasonable time.  If feasible, we would likely implement such a development plan and would plan to introduce it commercially as a life-cycle extension of SURFAXIN under the name SURFAXIN LS™, in the United States, the European UnionU.S. and potentially in other major markets worldwide.  See, “– Surfactant Replacement Therapy for Respiratory Medicine – Respiratory Distress Syndrome in Premature Infants (RDS) – SURFAXIN LS – Lyophilized SURFAXIN for RDS in Premature Infants.”markets.

AEROSURFThe current RDS market for surfactants is a drug/device combination productestimated to be approximately $75 million annually in the U.S. and $250 to $300 million annually worldwide; however, we believe that combinesthis market has been constrained, in part, by the risks associated with surfactant administration.  We believe that our RDS programs, including our aerosolized KL4 surfactant with our proprietary capillary aerosol generator (CAG)that potentially may be administered using less invasive means, collectively and over time, have the potential to greatly improve the management of RDS and to expand the current RDS estimated worldwide annual market to more than a $1 billion per year market opportunity.

To support the commercial introduction of SURFAXIN in the U.S. and our novel AFECTAIRother KL®4 surfactant pipeline products, if approved, we have established our own specialty respiratory critical care commercial and medical affairs team.  This team includes medical professionals with experience in neonatal/pediatric respiratory critical care, and has focused on products that address neonatal indications, beginning with SURFAXIN.  We believe that this team will be positioned to efficiently introduce our other KL4 ventilator circuit / patient interface connectors.  We are developingsurfactant products under development, if approved, including AEROSURF and potentially SURFAXIN LS and future applications of our aerosolized KL4 surfactant.

In addition, we recognize that our commercial and medical affairs team could potentially support introductions of other synergistic pipeline products, including products owned or developed by third parties for premature infantsthe NICU/PICU.  To that end, we would consider potential transactions focused on securing commercial rights to such synergistic products, including in the form of product acquisitions, in-licensing agreements or distribution, marketing or co-marketing arrangements.

Beyond RDS

In the future, we expect that we may be able to leverage the information, data and know-how that we gain from our development efforts with or at riskSURFAXIN and AEROSURF to support development of RDS.  Premature infants with RDS currently are treated with surfactants that can only be administered by endotracheal intubation supported with mechanical ventilation, both invasive procedures that frequently result ina potential product pipeline to address serious critical care respiratory conditions in larger children and complications.  Asadults in pediatric and adult intensive care units (PICUS and ICUs), including acute lung injury (ALI), chronic obstructive pulmonary disease (COPD) and cystic fibrosis (CF).  At the present time, however, we are focusing our resources primarily on the commercial introduction of SURFAXIN and development of AEROSURF through phase 2 clinical trials.  Once we have achieved these objectives, we believe we would be in a consequence, neonatologists will not treat infants who could benefit from surfactant therapy unlessbetter position to assess the potential benefits of surfactant therapy outweighother development programs to address the risks associated with such invasive administration procedures.  AEROSURF potentially will provide practitioners withcritical care needs of patients in the ability to deliver surfactant therapy using a less-invasive method.  For this reason, we believe that AEROSURF, if approved, potentially may enable the treatment of a significantly greater number of premature infants at risk for RDS who could benefit from surfactant therapy but are currently not treated.  See, “– Surfactant Replacement Therapy for Respiratory Medicine – Respiratory Distress Syndrome in Premature Infants (RDS) – AEROSURF for RDS in Premature Infants.”
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PICU and ICU.

AFECTAIR,We also have developed a series of disposable ventilator circuit / patient interface connectors, was initially developedaerosol-conducting airway connector for use in the NICU as part of our AEROSURF development program.  AFECTAIR devicesinfants that is intended to simplify the delivery of inhaled therapiesaerosolized medications (including our aerosolized KL4 surfactant) and other inhaled therapies to critical-care patients requiring ventilatory support by introducing the inhaled therapysupport.  This device introduces aerosolized medications directly at the patient interface and minimizingminimizes the number of connections in the ventilator circuit.  We initially developed a ventilator circuit / patient interface connector to be used with our CAG in the NICU.  To benefit all critical care patients who require inhaled therapies and who are receiving ventilatory support, we are developing AFECTAIR devices in different sizes for use in NICUs, pediatric intensive care units (PICUs) and adult intensive care units (ICUs), and to be compatible with a variety of aerosol generating devices.  In February 2012, we successfullyhave registered our initial AFECTAIRthis device which is intended for use with jet nebulizers and other aerosol generators, in the United States as a Class I, exempt medical device.  We believe that AFECTAIR has the potential to become a new standard of care for the delivery of inhaled therapies to critical care patients.  We are implementing a regulatory and manufacturing plan that, if successful, is intended to result in the commercial introduction of the initial AFECTAIR device in the United StatesU.S. under the name AFECTAIR® and the European Unionit is currently commercially available in the fourth quarter of 2012, and a second AFECTAIR device, AFECTAIR DUO, in mid-2013.U.S.

We are preparing for the commercial introductions, beginning in late 2012, of SURFAXIN in the United States, and AFECTAIR in the United States and the European Union and other markets worldwide thereafter.  To accomplish our objectives, in the United States, we plan to build our own, in-house, specialty respiratory critical care commercial and medical affairs organization that will specialize in neonatal indications, beginning with SURFAXIN.  We also expect that our commercial and medical affairs organization will be able to leverage the experience and relationships that we gain with the introduction of SURFAXIN to efficiently support the introductions of SURFAXIN LS and AEROSURF, if approved.  We also expect that our in-house organization will also work in a coordinated manner with a network of third-party distributors to execute the commercial introduction of the AFECTAIR devices.

In major markets outside the United States, an important priority is to secure the strategic resources to support the continued development and commercial introduction of our RDS products.  A key goal for us in 2012 is to secure one or more strategic alliances and/or collaboration arrangements potentially to share research and development expenses for our SURFAXIN LS and AEROSURF development programs, and, if approved, to support the commercial introduction of these products in Europe and elsewhere.  We may also seek strategic alliances and/or collaboration arrangements to support the potential commercial introduction of SURFAXIN in countries where regulatory marketing authorization is facilitated by the recent approval of SURFAXIN by the FDA.  We are engaged in discussions with potential strategic partners who could provide development and commercial expertise as well as financial resources (potentially in the form of upfront payments, milestone payments, commercialization royalties and a sharing of research and development expenses).  There can be no assurance, however, that we will be successful in concluding any strategic alliance, collaboration or other similar transaction.

BUSINESS STRATEGY

We continue to focus our drug research and development activities on the management of RDS in premature infants.  We believe that the RDS market represents a significant opportunity from both a medical and a business perspective.  See, “– Surfactant Replacement Therapy for Respiratory Medicine – Respiratory Distress Syndrome in Premature Infants (RDS).”  Our immediate goal is to successfully introduce SURFAXIN® in the United StatesU.S. and AFECTAIR® in the United States and the European Union.  In addition, we plan to advance development of our other KL4 surfactant product candidates, SURFAXIN LS™ and AEROSURF®. program.  Key elements of our strategy for achieving this goalto achieve these goals include:

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·		In 2012,With the introduction of SURFAXIN, the first synthetic, peptide-containing surfactant approved by the FDA, we plan to focus onbelieve that hospitals in the U.S., over time, will replace animal-derived surfactants, which are derived from pig and cow lungs using a chemical extraction process, with SURFAXIN and our other clinically differentiated synthetic KL4 surfactant products.
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oTo support the commercial introduction of SURFAXIN, in the United States and the initial AFECTAIR device in the United States and potentially in the European Union.  If successful, we also believe that we will be in a position to introduce the second AFECTAIR device, AFECTAIR DUO in both the United States and European Union in mid-2013.
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For the launch  of SURFAXIN in the United States, we plan to buildhave established our own in-house, specialty respiratory critical care commercial and medical affairs organization that will specializehas experience in respiratory critical care and is focused on neonatal / pediatric indications, beginning with SURFAXIN and, if approved,in the future, AEROSURF and our other KL4 surfactant products for RDS, SURFAXIN LS and AEROSURF.  Our strategyunder development, if approved.
oWe also will focus primarily on hospitals with NICUsseek to identify other synergistic products that we believe currently represent a significant portionmay be of the surfactant marketbenefit in the United States.NICU/PICU and could be marketed through our team.  To execute this strategy,gain access to synergistic products, we expect to incur annual expenses of approximately $12 - 13 million forwould consider potential transactions focused on securing commercial and medical affairs capabilities.rights in the U.S., including through product acquisitions or in-licensing, distribution, marketing or co-marketing arrangements.  We believe that this strategy will provideprovides us direct control over our U.S. sales and marketing activities, permitpermits us to establish a strong presence in NICUs and PICUs nationwide, and potentially optimizeoptimizes the economics of our business.
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o·We expect thatTo advance our commercial and medical affairs organization will also support the planned commercial introduction of AFECTAIRAEROSURF development program in the United States.  Many hospitals, including those that have adult ICUs, PICUs and critical care centers, as well as NICUs, will use AFECTAIR devices to benefit critical care patients.  Accordingly,U.S., we plan to further supportare conducting a phase 2 clinical program, having opened an investigational new drug (IND) application with the launch of AFECTAIR in the United States and the European Union through arrangements with third-party distributors experienced in introducing respiratory medical products into hospitals.  We expect that our commercial organization will work in a coordinated manner with our third-party distributors to assure that all hospitals with critical care facilities are aware of, and have access to, our AFECTAIR devices.  We believe that AFECTAIR has the potential to become the standard of care for delivery of inhaled therapies and, after an up-take period following introduction, revenues in the U.S. and the five largest countries in the European Union (EU5) could potentially be between $50 million and $75 millionFDA in the fourth full yearquarter of sales, which could occur as early as 2016.2013.
 
oThe first part of our clinical program, phase 2a, is designed to evaluate the safety and tolerability of a single exposure of AEROSURF in an escalating dose study evaluating three doses of increasing amounts of AEROSURF.  The comparator is nCPAP only.  We anticipate results in the second half of 2014.
oThe next phase of our clinical program, phase 2b, will have a primary objective to determine the optimal dose and define the expected efficacy margin.  The results of this phase will inform the design of a potential phase 3 clinical trial focused on safety and efficacy.  We currently plan to initiate phase 2b in the second half of 2014 and expect to complete it in the second half of 2015.
oSince June 2012, we have been working with Battelle Memorial Institute (Battelle), which supported us in a multi-phase development program that culminated in the manufacture of clinic-ready CAG devices and disposable AEROSURF Delivery Packs (ADPs) for our phase 2a clinical trial.  Battelle has agreed to manufacture a sufficient number of CAG devices and ADPs to support our planned phase 2b clinical trial and other development activities.
oWe plan to use our lyophilized KL4 surfactant in our AEROSURF program.  Our contract manufacturing organization (CMO), DSM Pharmaceuticals, Inc. (DSM) has manufactured sufficient lyophilized KL4 surfactant drug product to support our network of AFECTAIR distributors with an in-house medical affairs staff thatphase 2a clinical trial and we expect DSM will be focused on medical education activities, publicationsmanufacture additional product supply to support our planned phase 2b and, congresses.  We havepotentially, phase 3 clinical trials.
oTo advance our AEROSURF program in the European Union (EU) and will continuepotentially other markets outside the U.S., we plan to conduct and sponsor studies evaluating theretain regulatory consultants to assist us in engaging international regulatory authorities regarding a potential utility of AFECTAIR, including a series of studies with several inhaled therapies that have been or will be presented at medical congresses and medical meetings.  We are pleased with the results of our early studies, and believe that AFECTAIR has the potential to address a considerable unmet medical need and become a new standard of care for the delivery of inhaled therapies to patients requiring ventilatory support.AEROSURF development plan.

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·		We planWhile we currently intend to continue to focusretain all rights and commercialize our drug research and development activities on the management of RDS in premature infants.  We believe that the RDS market represents a significant opportunity from both a medical and a business perspective.  We further believe that our neonatal programs, SURFAXIN, SURFAXIN LS and AEROSURF, have the potential to greatly improve the management of RDS and, collectively, represent the opportunity, over time, to expand the current RDS estimated worldwide annual market of $200 million to a $1 billion market opportunity.
oSURFAXIN LS is our lyophilized (freeze-dried) dosage form of SURFAXIN that is stored as a powder and resuspended to liquid form prior to use.  We are developing SURFAXIN LS with the objective of improving ease of use for healthcare practitioners, as well as potentially to prolong shelf life and eliminate the need for cold-chain storage.  In recent years, we slowed the pace of this program as we focused our efforts on securing regulatory approval for SURFAXINapproved products in the United States and until we are able to secure the required capital to advance our program.  In 2012, we plan to continue our preclinical work and expect to advance the ongoing technology transfer of our SURFAXIN LS manufacturing process  to a contract manufacturer that manufactures in accordance with current good manufacturing practices (cGMP) established by the FDA and other international regulatory authorities, and that has expertise in lyophilized dosage forms.  We plan to implement a regulatory plan intended to gain marketing authorization for SURFAXIN LS in the United States, European Union and other major markets worldwide.  We have discussed with the FDA a proposed development program and expect to engage in further discussions with the FDA after we have received regulatory guidance with respect to our planned development program in Europe.  We believe, but need to confirm with the European Medicines Agency (EMA) and other relevant regulatory bodies, that we will have to conduct a Phase 3 clinical trial in Europe and will work with the FDA and EMA potentially to develop a single trial design that will support approval for SURFAXIN LS in the United States and the European Union.  We believe that, over time, SURFAXIN and SURFAXIN LS, if approved, collectively have the potential to displace the use of animal-derived surfactants in all major markets throughout the world.
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o
AEROSURF, our lead aerosolized KL4 surfactant program, is a drug-device combination product that produces our KL4 surfactant in aerosolized form using our CAG device and AFECTAIR ventilator circuit / patient interface connectors.  In recent years, we also slowed the pace of this program as we focused our efforts on securing regulatory approval for SURFAXIN in the United States and until we are able to secure the required capital to advance our program.  AEROSURF holds the promise to significantly expand the use of surfactant therapy in premature infants by providing neonatologists with a means of administering aerosolized KL4 surfactant without the risks associated with the current method of administering surfactant by invasive endotracheal intubation and mechanical ventilation.  In 2012, we plan to continue advancing our preclinical development activities for AEROSURF and, with the assistance of our own and third-party medical device engineers, we plan to optimize the design of the CAG device for use in our anticipated clinical program and, if approved, commercially.  We also plan to seek regulatory guidance to inform our regulatory plan for the AEROSURF development and clinical programs.
We believe that the pipeline of SURFAXIN, SURFAXIN LS and particularly AEROSURF could significantly advance the treatment of RDS and make it possible for many more infants with or at risk for RDS to be treated with surfactant therapy.
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AnU.S., an important priority for us is to manage and strengthen our long-termsecure strategic and financial positionresources to support the continued development and commercial introduction of our approvedRDS products advance our research and development programs, and maximize stockholder value.in markets outside the U.S.

oWe have managed,To advance and plan to continue closely managingsupport our expenditures in 2012, while focusing our resources on the initiatives outlined above.  We are engaged in discussions with potentialAEROSURF development activities, we seek a significant strategic partners whoalliance that potentially could provide development, regulatory and commercial market expertise as well as financial resources (potentiallyfor our AEROSURF development program, and, if approved, support the commercial introduction of AEROSURF in the EU and other selected markets outside the U.S.  Financial resources provided by such alliances typically could take the form of upfront payments, milestone payments, commercialization royalties and a sharing of research and development expenses)expenses.
oTo potentially advance the introduction of SURFAXIN in markets outside the U.S. where regulatory marketing authorization is facilitated by the information contained in our new drug application (NDA) approved by the FDA, we would consider various financing or collaboration arrangements that could provide regulatory expertise and support the commercial introduction of SURFAXIN, and potentially our other FDA-approved KL4 surfactant products, in other countries.  Such countries could potentially include those in Latin America, North Africa and the Middle East.
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·An important priority for us is to strengthen our long-term financial position.  We will require significant additional capital over time to advance our development programs, support development andthe introduction of our approved products, support our operations and maximize stockholder value.  See, “Item 7 – Management’s Discussion and Analysis of Financial Condition and Results of Operations – Liquidity and Capital Resources.”
oWe will require additional capital to fund our operations and development activities until such time as revenues from the sale of SURFAXIN and AEROSURF are sufficient, if ever, to fund our development activities and operations.  In February 2013, we entered into a loan agreement (Deerfield Loan) with affiliates of Deerfield Management Company, L.P. (Deerfield) and have received advances totaling $30 million, secured by a security interest in various markets.  There can be no assurance, however,substantially all of our assets.  The proceeds of these loans are being used to meet our working capital requirements.  We also entered into an At-the-Market Equity Offering Sales Agreement with Stifel, Nicolaus & Company, Incorporated (Stifel), under which Stifel, as our exclusive agent, may sell through an “at-the-market” program (ATM Program), at such times that we may elect in our sole discretion, during a three-year term, up to a maximum of $25,000,000 of shares of our common stock.  At December 31, 2013, $23.0 million was available under the ATM Program.  We plan to use any proceeds from the ATM Program to meet our working capital requirements.  During 2013, we raised aggregate gross proceeds of $75.8 million through public offerings of our common stock, including under our ATM Program.  We plan to continue to carefully managing our cash resources and will be successfulseek additional capital, including potentially through future debt and equity financings, as we deem necessary to maintain and strengthen our financial position.
oIn addition, as noted above, we expect that strategic alliances will play an important role in concluding any strategic alliance, collaboration or other financing transaction.strengthening our financial position as well as our capabilities as we advance our KL4 surfactant development programs.

o·We recently completed a public offering of 16,071,429 shares of our common stock, at a price to the public of $2.80 per share for gross proceeds of $45.0 million, and net proceeds to us of $42.1 million, after transaction-related fees and expenses, and before taking into account a 30-day option granted to the underwriters to purchase up to an additional 2,410,714 shares of common stock to cover over-allotments, if any.

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We have invested, and will continue to invest, in maintaining and enforcingimproving our potential competitive position by protecting our exclusive rights in and to our KL4surfactant technology, pipeline products and our drug delivery technologies, including our CAG and ventilator circuit / patient interface connectors,aerosol-conducting airway connector, through patents, patent extensions,term restoration, trademarks and trade secrets and regulatory exclusivity designations, including potential orphan drug and new drug product and supplemental exclusivities.secrets.  We believe that our development programs may alsowill provide opportunities for new patent filings, which potentially mayto extend our exclusivity rightsexclusivities into the future.future through new patents and other intellectual property.  We also hold, and will continue to seek, regulatory designations that provide post-approval market exclusivity for our pipeline products that would allow us to build our market share.  See,
“– Licensing, Patents and Other Proprietary Rights and Regulatory Designations.”

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We have, and will continue to evaluate, and invest in our quality systems and manufacturing capabilities, including atcapabilities.   We are planning for long-term continuity of supply and continued integrity and reliability of our drug manufacturing operations in Totowa, New Jersey, and our analytical and medical device development laboratories in Warrington, Pennsylvania.quality assurance processes.  We planseek to manufacture sufficient amounts of SURFAXIN drug productbuild a foundation to meetsupport our anticipated commercial requirementslong-term needs, and intend to support SURFAXIN-related preclinical, clinical and formulation development activities for our other KL4 surfactant product candidates.  For AFECTAIR, we have entered into a Manufacturing and Supply Agreement with Lacey Manufacturing, a unit of Precision Engineered Products, LLC to manufacture and supply AFECTAIR devices for commercial sale.  With respect to SURFAXIN LS, we are conducting a technology transfermake appropriate capital investments in the near-term, balancing the use of our lyophilizedavailable resources while maintaining flexibility in planning our long-term manufacturing process to a cGMP-compliant, third-party contract manufacturer with expertise in such dosage forms.  For AEROSURF, we plan to collaborate with engineering device expertsactivities and use contract manufacturers to produce CAG devices and related components to meet our manufacturing requirements.
goals.
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While we are currently focused on advancing our lead KL4 surfactant and drug delivery technologies to treat critical care patients with respiratory disease, beginning with RDS, we also believe that our KL4 surfactant technology has the potential tocould be developed into a broad product pipeline to address a variety of debilitating respiratory conditions and diseases.  As our resources permit,diseases, including pediatric and adult indications that could represent potentially significant market opportunities.  From time to time, we are conductinghave participated in investigator-initiated research programs and government funded research and preclinical development activities potentially to address acute lung injury (ALI),initiatives that explore the use of our KL4 surfactant in the treatment of a range of respiratory diseases, including CF and ALI.  Although there can be no assurance, we may in the future support development activities to establish a proof-of-concept and, if successful, thereafter determine whether to seek strategic alliances or collaboration arrangements or pursue other financial alternatives to address other diseases associated with inflammationfund further development and/or worldwide commercialization of the lung, such as asthma and chronic obstructive pulmonary disease (COPD).  In 2010, an investigator-initiated Phase 2a clinical trial assessing the safety, tolerability and short-term effectiveness (via improvement in mucociliary clearance) of our aerosolized KL4 surfactant in patients with cystic fibrosis (CF) concluded.  We will consider supporting such independent initiatives that explore the utility of applying our KL4 surfactant to address CF and other respiratory diseases.  See, “– Surfactant Replacement Therapy for Respiratory Medicine – Cystic Fibrosis.”
additional indications, if approved.

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Our estimates of market size and business opportunities included in this Business Section and elsewhere in this Annual Report on Form 10-K are based in part on our analysis of data derived from the following sources, among others:  Annual Summary of Vital Statistics: 2006,2010, Pediatrics, Martin et. al.; CDC National Vital Statistics, 2005; IMS Midas Data MAT, December 2010;2011; HCUP Hospital Discharge data, 2008; Hospital Insurance Claim Database, 2009; Management and Outcomes of Very Low Birth Weight, New England Journal of Medicine (NEJM), 2008, Eichenwald, Stark; Market Intelligence Report on Number of ICU Beds in EU5 Countries;
The Cystic Fibrosis Foundation website; Vermont Oxford Network Data, 2006; estimates from other companies with information on surfactant sales in countries where IMS data reporting is often incomplete or non-existent; and Discovery Labs Primary Market Research, December 2010 and May 2011; as well as our analysis of the SELECT and STAR trials described below.  In addition, our analysis and assumptions take into account estimated patient populations, expected adoption rates of our products, current pricing, and economics and anticipated potential pharmaco-economicpharmacoeconomic benefits of our drug products, if approved.  We provide estimates and projections to give the reader an understanding of our strategic priorities, but we caution that the reader should not rely on our estimates and projections.  These estimates and projections are forward-looking statements, which we intend to be subject to the safe-harbor provisions of the Private Securities Litigation Reform Act of 1995.  For a discussion of forward-looking statements, see, “Forward-Looking Statements” on page iii of this Annual Report on Form 10-K, and “Item 1A – Risk Factors.”

PROPRIETARY PLATFORM – KL4 SURFACTANT AND AEROSOL TECHNOLOGIES

Our KL4 Surfactant Technology

Pulmonary surfactants are protein and phospholipid compositions that form naturally in the human lung and are critical to survival and normal respiratory function.  They spread in a thin mono-layer to cover the entire alveolar surface, or air sacs, of the lungs and the terminal conducting airways that lead to the air sacs andsacs.  They facilitate breathing by continually modifying the surface tension of the fluid that lines the inside of the lungs.  If the lungs have a surfactant deficiency, as frequently occurs in premature infants, or experience surfactant degradation, generally due to disease, lung insult or trauma, the air sacs in the lungs will tend to collapse and will not absorb sufficientenough oxygen, resulting in severe respiratory diseases and disorders.  In addition to lowering alveolar surface tension, surfactants contribute in other important ways to respiration including, but not limited to,for example, by lowering the surface tension of the conducting airways and maintaining airflow and airway patency (keeping the airways open and expanded).  Human surfactants include four known surfactant proteins: A, B, C and D.  Numerous studies have established that, of the four known surfactant proteins, surfactant protein B (SP-B) is essential for respiratory function.  In our KL4 surfactant, KL4 is a synthetic peptide that is designed to closely mimic the essential attributes of surfactant protein B (SP-B).

Many respiratory disorders are associated with surfactant deficiency or surfactant degradation.  However, the use of surfactant therapy presently has limited application and is FDA-approvedapproved by the FDA only for managingto manage RDS in premature infants.  Currently available surfactants are derived from pig and cow lungs using a chemical extraction process.  Although clinically effective, these surfactants have several potential drawbacks and have not been developed to treat broader populations and other respiratory diseases.
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We believe our KL4 surfactant and our CAG technology may expand the therapeutic options to treat previously unaddressed respiratory problems in a range of patient populations, from premature infants to adults.  We plan to develop our aerosolized KL4 surfactant initially for RDS in premature infants and thereafter for a range of indications in neonatal, pediatric and adult critical care patient populations.

Our KL4 Surfactant Technology

Our proprietary KL4 surfactant technology produces a synthetic surfactant that is structurally similar to human pulmonary surfactant and contains a proprietary synthetic peptide, KL4 (sinapultide).  KL4 is, a 21 amino21-amino acid peptide that closely mimics the essential attributes of the human surfactant protein B (SP-B), which isone of four known surfactant proteins and the surfactant protein that is most important for the proper functioning of the respiratory system.  Our synthetic surfactant may beis manufactured to preciseapproved specifications, with minimal lot-to-lot variability, and formulated as ais being developed in liquid instillate, lyophilized (freeze-dried) and aerosolized dosage form (freeze-dried), or aerosolized liquid.  In October 1996, weforms.  We have licensed exclusive worldwide rights to this technology, which was invented at The Scripps Research Institute and exclusively licensed to and further developed by an affiliate of Johnson & Johnson, Inc. (J&J).

OurWe have demonstrated in preclinical studies that our KL4 surfactant is a synthetic surfactant that can be manufactured consistently and with minimal lot-to-lot variability.  We also believe that our synthetic surfactant mightmay possess pharmaceutical benefits not currently exhibited by the animal-derived surfactants.  Our synthetic KL4 surfactant has also demonstrated in preclinical studies unique characteristics,certain beneficial properties, including modulation of the inflammatory process, antimicrobial properties and is non-immunogenic.non-immunogenicity.  We believe these characteristics willproperties may be important attributes as we develop our KL4 surfactant technology pipeline potentially to address a broad range of respiratory conditions beyond RDS that represent significant unmet medical needs.  Several preclinical studies assessingHowever, the potential advantages of our KL4 surfactant technology have been presented at major medical congresses and are summarized below:

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In October 2011, an AEROSURF® study was presented at the 2011 European Society for Paediatric Research Annual Meeting (ESPR).  These data were initially presented at the 2011 Pediatric Academic Societies Annual Congress (PAS) in May 2011.  This preclinical study was conducted to determine which dose of AEROSURF would produce the optimal physiologic response and demonstrated that AEROSURF significantly improved gas exchange (p < 0.05), pulmonary mechanics (p < 0.05) and lung structure integrity (p < 0.05), and reduced levels of inflammatory mediators in the lung (p < 0.05), in a dose-dependent manner, in the well-recognized preterm lamb model of RDS.  The data also suggest that of the doses tested, AEROSURF delivered during a 20 to 30 minute dosing interval results in the most desirable overall dosing strategy.

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Also at the 2011 ESPR, data were presented from a study demonstrating that treatment with either bolus or aerosolized KL4 surfactant resulted in a significant improvement in lung function and survival when treating ALI in a preclinical model of ALI.  These data were initially presented at the 2011 PAS.  The objective of this study was to evaluate aerosolized KL4 surfactant in a piglet model with lung injury and subsequent reduced pulmonary function consistent with what is observed in humans with ALI.  Piglets were randomized to receive either endotracheal bolus KL4 surfactant with extubation to continuous positive airway pressure (CPAP), aerosolized KL4 surfactant while on CPAP, or CPAP alone (control).  Relative to control piglets on CPAP alone, treatment with either bolus or aerosolized KL4 surfactant resulted in a significant improvement in both oxygenation response  (p < 0.001) and overall survival (p < 0.05) throughout the evaluation period, with the most robust response observed in the aerosolized KL4 surfactant treatment group.  Piglets treated with aerosolized KL4 surfactant had reduced tissue levels of interleukin–8 (IL-8), a key marker of lung inflammation, compared with control piglets (p < 0.03).

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In December 2010, data were presented at the 2010 Annual Hot Topics in Neonatology Congress (Hot Topics) in Washington, DC demonstrating that AEROSURF meaningfully improved lung function and lung structural integrity and reduced lung tissue inflammatory marker levels in a preclinical study using the well-established preterm lamb model of RDS.  In this preclinical study, preterm lambs were randomized to receive CPAP alone or CPAP plus either 10, 20, 30, or 90 minutes of AEROSURF exposure.  The results demonstrated that treatment with AEROSURF resulted in a dose-dependent improvement in lung function and a decrease in IL-8, with marked differences following 20 minutes of AEROSURF exposure and no further improvement following 30 and 90 minutes of exposure.  Additionally, improvement in oxygenation was observed to a greater degree in the 10, 20, and 30-minute dosing groups compared with CPAP alone or the 90-minute dosing group and AEROSURF preserved lung structural integrity in all exposure groups.
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In May 2010, data were presented at the 2010 American Thoracic Society International Conference from a preclinical study using KL4 surfactant in an established porcine model of lung transplantation.  The objective of this study was to assess the potential protective role of KL4 surfactant in reducing ischemia-reperfusion injury by administering KL4 surfactant to donor lungs prior to harvest and transplantation in an experimental pig lung transplant model.  In transplanted donor lungs that were treated with KL4 surfactant prior to lung harvest and transplantation, a significant improvement in oxygenation (p < 0.05) was observed, as well as preservation of lung surfactant composition (p < 0.05) and a significant reduction in oxidative damage (p < 0.05) compared with animals receiving untreated transplanted lungs.  The study demonstrated a potentially important protective role in a newly transplanted lung, reducing ischemia-reperfusion injury often seen after lung transplantation, and suggesting that KL4 surfactant may play an important protective role in minimizing lung damage triggered by ischemia-reperfusion injury following lung transplantation.

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In May 2010, preclinical data were presented at PAS that demonstrate that our initial lyophilized KL4 surfactant, SURFAXIN LS™, improves lung function and oxygenation while attenuating lung inflammation in the preterm lamb model of RDS.  In one study, lyophilized KL4 surfactant was compared to commercially available animal-derived surfactants to assess improvements in pulmonary function (lung compliance, functional residual capacity and ventilator support requirements), integrity of lung tissue structure, and the potential impact on inflammatory mediators in preterm lambs with RDS.  This study demonstrated that treatment with lyophilized KL4 surfactant,  compared with untreated controls, resulted in significant improvements in pulmonary function (p < 0.05), significantly better microscopic lung tissue structure (p < 0.05), and a significant reduction in two potent inflammatory mediators: IL-8 and myeloperoxidase (p < 0.05).  Significant improvements in pulmonary function were observed in lambs treated with the animal-derived surfactants, Survanta® (beractant, a surfactant derived from cow lung and the most prescribed surfactant in the United States) and Curosurf® (poractant alfa, a surfactant derived from pig lung and the most prescribed surfactant in Europe), compared with controls (p < 0.05); however, oxygenation was significantly improved in lambs treated with lyophilized KL4 surfactant compared with those treated with comparator animal-derived surfactants (p < 0.05).

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In another preclinical study presented at the 2010 PAS, the effects of lyophilized KL4 surfactant on pulmonary function and peri-dosing associated effects of surfactant administration in preterm lambs with RDS were compared to those of Curosurf.  Both surfactants significantly improved pulmonary function (p < 0.05).  However, lambs treated with lyophilized KL4 surfactant required significantly lower mechanical ventilator pressures to maintain pulmonary function compared with Curosurf-treated lambs (p < 0.05).  Additionally, lambs treated with Curosurf experienced significant reductions in heart rate and rapidly increased brain oxygenation during the peri-dosing period (p < 0.05), in contrast to lambs treated with lyophilized KL4 surfactant.  The study investigators concluded that lyophilized KL4 surfactant may enable ventilation at lower mean airway pressures which may reduce the incidence of chronic lung disease.

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In December 2009, research was published in the Proceedings of the National Academy of Sciences indicating that a naturally occurring phospholipid in pulmonary surfactant, palmitoyl-oleoyl-phosphatidylglycerol (POPG), suppresses respiratory syncytial virus (RSV) infection and associated inflammation in both in vitro and in vivo models (Numata et al, Proc Nat Acad of Sci, Dec 09).  The research demonstrates that POPG inhibits the spreading of RSV infection in mice exposed to RSV.  We believe that our KL4 surfactant, which contains POPG, is the only exogenous surfactant in which POPG is a specified active pharmaceutical ingredient.  This study further supports our belief that our KL4 surfactant may play a unique role in addressing several debilitating respiratory disorders.

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In May 2009, data from a preclinical study was presented at the PAS 2009 Annual Meeting, that compared SURFAXIN®, at a dose of 5.8 mL/kg (the dose used in the SURFAXIN Phase 3 clinical trials for RDS), with Curosurf at a dose of 2.5 mL/kg (the dose prescribed in its label), in the well-established preterm lamb model.  The purpose of the study was to test the hypothesis that a larger dose volume of surfactant could potentially result in more homogeneous distribution of surfactant throughout the lungs and may ultimately result in improved pulmonary and clinical outcomes.  The data showed that both surfactants significantly increased pulmonary compliance and tidal volume in this preterm lamb model of RDS without adversely affecting heart rate, blood pressure, or cerebral blood flow, irrespective of the dose volume employed.  However, significantly more homogeneous lung distribution of SURFAXIN (p < 0.001) was observed compared with Curosurf, as measured by pulmonary distribution of a mix of gold-labeled microspheres and surfactant.
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Also at the 2009 PAS, data from a preclinical study was presented that demonstrated a favorable physiologic benefit and subsequent survival impact on treating ALI in an animal model for this severe respiratory condition.  The objective of the study was to examine the effectiveness of KL4 surfactant in treating newborn piglets with severe ALI.  The results demonstrated that piglets treated with KL4 surfactant experienced a statistically significant improvement in oxygenation (p < 0.001), as well as better structural integrity of the lung tissue (p < 0.05) and improved survival (p < 0.05).

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A preclinical study that assessed the impact of exogenous surfactants, including SURFAXIN, on hyperoxic-induced lung injury in an in-vitro cell-culture model was published in Pediatric Research, a prominent peer-reviewed journal in July 2008 and concluded that our KL4 surfactant reduced inflammation and cell injury in this model, resulting in improved cell survival and function compared with both a saline control and Survanta.

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In May 2008 at PAS, data were presented from animal preclinical study that assessed the effect of SURFAXIN on biomarkers of lung inflammation and lung structure as compared to those treated with Survanta, Curosurf, or no surfactant replacement therapy.  The chosen animal model, the preterm lamb, was selected because it closely resembles RDS in human lungs and is regarded as the most relevant system to study the pathophysiology and treatment of RDS.  The results of the study showed that animals treated with SURFAXIN had better lung function compared with those treated with Survanta, Curosurf, or no surfactant replacement.  In addition, animals treated with SURFAXIN had better structural integrity, as assessed by evaluation of lung tissue, and lower levels of lung tissue and blood inflammatory mediators, compared with animals treated with Survanta or no surfactant replacement therapy.

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An in vitro study presented at the PAS in May 2008 investigated the antimicrobial properties of SURFAXIN.  In that study, gram-positive and gram-negative bacteria-containing broth was mixed with SURFAXIN and Survanta, as well as with saline, a negative control, and ciprofloxacin, an antibiotic that served as a positive control.  While both SURFAXIN and Survanta suppressed gram-positive bacterial growth, only SURFAXIN suppressed gram-negative bacterial growth.

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Also at PAS in May 2008, a preclinical study was presented that assessed the potential for KL4 to induce an immune response known as anaphylaxis in a well-established animal model.  Anaphylaxis, a potentially life-threatening allergic reaction, can occur in humans after exposure to medications that contain a foreign protein.  In this study, a well-established animal model was used to test whether KL4 would trigger anaphylaxis.  Supporting our belief that our KL4 surfactant has nonimmunogenic properties, this study concluded that KL4 did not induce active or passive anaphylaxis in this animal model, even when the immune system was potentiated and sensitized.

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In May 2007, a preclinical study was presented at PAS, the objective of which was to determine the impact of SURFAXIN on cytokine-driven lung inflammation and focused specifically on the transforming growth factor-beta (TGF-beta) superfamily.  In this study, SURFAXIN suppressed two central members of the TGF-beta superfamily (BMP10 and BMP15), which could have implications in reducing inflammation and fibrosis (scarring) of the lung in a variety of pulmonary diseases.  Members of the TGF-beta superfamily are known to induce fibrosis (scar tissue formation) in the lung.  These results support our developing our KL4 surfactant technology to potentially treat diseases in which respiratory inflammation plays an integral part, such as acute lung injury.

We believe that the foregoing preclinical studies demonstrate promising novel properties and attributes of our KL4 surfactant that potentially may be of benefit in addressing various respiratory diseases and disorders in broad patient populations.  The clinical relevance of such attributes has not been adequately established and, accordingly, warrants further study.
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Dosage Form Flexibility

In the clinical environment,SURFAXIN is our synthetic, peptide-containingfirst KL4 surfactant has demonstrated attributes that we believe are uniquely beneficialapproved for sale in the treatment of premature infants at risk for RDSU.S. and warrant further scientific assessment to address a variety of debilitating respiratory conditions for which there currently are no or few approved therapies.

RDS in Premature Infants

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In 2011, the Journal of Neonatal-Perinatal Medicine (Volume 4, Number 2, 2011) published a post-hoc analysis of data from our pivotal SELECT and STAR Phase 3 clinical trials for SURFAXIN titled “Reintubation and risk of morbidity and mortality in preterm infants after surfactant replacement therapy.”  The article evaluated the consequences of reintubation and the potential effect of the choice of surfactant on reintubation rates and subsequent clinical outcomes in premature infants.  The analysis indicates that, for preterm infants at risk for RDS who received prophylactic surfactant therapy and were extubated, infants who were reintubated had significantly higher rates of six major complications of prematurity, including bronchopulmonary dysplasia (BPD, a chronic lung condition), necrotizing enterocolitis (a severe intestinal condition often requiring surgery and loss of bowel), sepsis, and intraventricular hemorrhage (bleeding into the brain)  is a highly predictive risk factor for mortality and major complications of prematurity.  The analysis also indicates that infants treated with SURFAXIN had a significantly lower incidence of reintubation and a significantly higher incidence of survival without reintubation, compared with infants who received animal-derived surfactants Survanta and Curosurf, the current standard of care.

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In May 2010, results from a Phase 2a feasibility study that we previously conducted as part of our AEROSURF development program for the prevention of RDS in premature infants were published in the Journal of Aerosol Medicine and Pulmonary Drug Delivery.  In this feasibility study, aerosolized KL4 surfactant was administered to seventeen infants within 30 minutes of birth using a commercially available aerosolization device via nasal CPAP (nCPAP) over a three-hour duration.  Aerosolized KL4 surfactant was generally safe and well tolerated with twelve (71%) of the infants requiring a single dose or aerosolized KL4 surfactant.  In addition, all infants survived through the assessment period (day 28 of life), fifteen  (88%) infants survived with no evidence of BPD at day 28 of life, and five (29%) infants required intubation and mechanical ventilation (commonly known as CPAP failure).  The study investigators concluded that our aerosolized KL4 surfactant can be safely administered via nCPAP to preterm infants at risk for RDS and may provide an alternative to surfactant administration via an endotracheal tube.

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In April 2009, we presented a pharmacoeconomic analysis of data from our pivotal SELECT and STAR Phase 3 clinical trials for SURFAXIN at the 2009 International Congress on Clinical Pharmacy (ICCP).  The analysis shows that in-hospital costs are higher for infants who require reintubation after surfactant administration and successful extubation, when compared with infants who do not require reintubation.  The presentation also included previously-reported data demonstrating that infants treated with SURFAXIN in the SELECT and STAR trials required less reintubation compared with infants treated with currently available animal-derived surfactants.

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Our Phase 3 pivotal clinical study, SELECT, has demonstrated that SURFAXIN is safe and efficacious when used for the prevention of RDS in premature infants.  Data taken together from our SELECT and STAR (a supportive Phase 3 trial) studies demonstrate that SURFAXIN improved survival (continuing through at least one year of life) and other outcomes versus the animal-derived comparator surfactants.  The SELECT and STAR trials, including follow-on neonatal patient assessment through the first year of life, have been presented at several international medical meetings and trial results were published in Pediatrics, the Official Journal of the American Academy of Pediatrics and a premier medical journal for pediatric healthcare practitioners.
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Acute Respiratory Failure / Acute Lung Injury

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In 2010, we concluded and reported results from a Phase 2 clinical trial evaluating the safety and tolerability of intratracheal administration of SURFAXIN (as a liquid bolus) and assessing whether SURFAXIN treatment could decrease the duration of mechanical ventilation in children with acute respiratory failure (ARF).  Data from the trial demonstrate that, based on patient stratification by severity of lung injury, SURFAXIN treatment significantly reduced time on mechanical ventilation in the least severe patient segment (p < 0.01).  Additionally, SURFAXIN intervention reduced the need for a second dose (p < 0.05), suggesting a decrease in disease severity following surfactant treatment.  ARF is a critical pediatric respiratory condition with a similar presentation to ALI that is often caused by severe respiratory infections.  We believe the results from the ARF trial suggest the rationale for an early-intervention strategy, prior to disease progression to a severe state requiring intubation, for our aerosolized KL4 surfactant as a potentially effective preventive measure for patients at risk for ALI.

Bronchopulmonary Dysplasia (BPD)

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In 2009, results of our Phase 2 clinical trial for SURFAXIN for the prevention of BPD, which was designed as an estimation study to evaluate the safety and potential efficacy of SURFAXIN in infants at risk for BPD, were published in Pediatrics.  In the clinical trial, infants were randomized to receive, in addition to standard of care, either a SURFAXIN standard or low dose or sham air as a control.  Observations from this pilot estimation study included that infants treated with the SURFAXIN standard dose, as compared to those in the control group experienced a lower incidence of death or BPD (58% vs. 66%), a higher survival rate through 36 weeks post-menstrual age (89% vs. 84%), and fewer days on mechanical ventilation.  BPD, also known as chronic lung disease, affects premature infants and is associated with surfactant deficiency and the prolonged use of mechanical ventilation and oxygen supplementation.  We believe that the results of our estimation trial suggest that our KL4 surfactant may potentially represent a novel therapeutic option for infants at risk for BPD.

Cystic Fibrosis

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In October 2010, results from an investigator-initiated Phase 2a clinical trial of aerosolized KL4 surfactant in patients with CF was presented at the North American Cystic Fibrosis Conference.  The trial demonstrated that aerosolized KL4 surfactant delivery to CF patients was feasible, generally safe and well tolerated and was not associated with serious adverse events.  Both aerosolized KL4 surfactant and the active comparator, aerosolized saline control, produced a marked, significant (p < 0.01) increase from patient baseline in mucociliary clearance measured one hour after the last dose in both whole lung and peripheral lung compartments.  We believe these results support further scientific assessment of a potential complementary therapeutic role for aerosolized KL4 surfactant specifically targeting airway mucus adhesions.

KL4 Surfactant Drug Product – Dosage Form Flexibility

SURFAXIN is a liquid instillate that is administered using endotracheal intubation and mechanical ventilation, which is the same method of administration required for currently-approved animal-derived surfactants.  Oursurfactants, endotracheal intubation and mechanical ventilation.  As with the animal-derived surfactants currently marketed in the U.S., it must be stored in refrigerated conditions and warmed prior to use.

In addition to liquid instillate, our KL4 surfactant technology also can be produced in a lyophilized (freeze-dried) dosage form (SURFAXIN LS) that is resuspendedreconstituted to liquid form prior to administration.  We have conductedIn several experiments, that demonstratewe have demonstrated that our lyophilized KL4 surfactant retains the key characteristics of our liquid KL4 surfactant (SURFAXIN).  Relative to liquid instillate surfactants, we believe that our lyophilized dosage formand may provide additional benefits in a clinical setting, including:including potentially:

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·		improved ease of use for healthcare practitioners, including

oshortened preparation time due to potential elimination of the drug product warming process prior to use;allowing for shortened preparation time; and

opotential elimination or reduction of continuous cold chain storage and refrigeration requirements;
 
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·		potential improved product stability and extended shelf life; and

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relatively lower viscosity, which may aid and/or improve the distribution of KL4 surfactant throughout the lung and potentially may reduce the frequency of transient peri-dosing events typically observed during administration of surfactants;
surfactants.

We have also demonstrated that we can aerosolize both liquid instillate and lyophilized dosage forms of our KL4 surfactant and that our aerosolized KL4 surfactant and have achievedhas the following important development objectives through research and feasibility studies:characteristics:
 
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·		full retention of the surface-tension lowering properties of a functioning surfactant necessary to restore lung function and maintain patency of the conducting airways;
 
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·		full retention of the surfactant composition upon aerosolization; and
 
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·		drug particle size believed to be suitable for deposition into the lung.

We initially plan to develop our aerosolized KL4 surfactant to treat RDS in premature infants and thereafter potentially to address a range of indications in neonatal, pediatric and adult critical care patient populations.  We believe our KL4 surfactant in liquid, lyophilized and aerosolized dosage forms, may be developed to expand the therapeutic options available to treat previously unaddressed respiratory problems in patients of all ages.

Our Aerosolization DeviceDelivery Technologies

Ventilator Circuit /Patient Interface Connectors and Related ComponentryCapillary Aerosol Generator (CAG) Technology

In connection with our AEROSURF development program, we developed a novel ventilator circuit / patient interface connector for potential use with our CAG to treat premature infants with or at risk for RDS.  Our ventilator circuit / patient interface connector simplifies the delivery any inhaled therapy to critical-care patients requiring ventilatory support by introducing the inhaled therapy directly at the patient interface and minimizing the number of connections in the ventilator circuit.  To benefit all critical care patients who require inhaled therapies and are receiving ventilatory support, we are developing a series of ventilator circuit / patient interface connectors, which are sized for use in NICUs, PICUs and ICUs and can be used with a variety of aerosol generating devices

The initial AFECTAIR® device has been designed for use with jet nebulizer aerosol generators and is currently registered in the United States as a Class I, exempt medical device.  In the European Union, we believe that this device will be classified as a Class IIa device, which must be cleared for marketing in the European Union through a European conformity (CE) marking process.  We are currently working with a regulatory services firm to obtain CE marking and believe that we will be cleared to market our initial AFECTAIR device in the European Union in fourth quarter of 2012.

We are developing a second AFECTAIR Device, AFECTAIR DUO, which is being designed for use with vibrating mesh nebulizers (VMN), metered dose inhalers (MDI) and other aerosol generator technologies.  We believe that we will be in a position to register AFECTAIR DUO in the United States in fourth quarter of 2012 and in the European Union in mid-2013.

Several in vitro studies have suggested that AFECTAIR improves the delivery of inhaled therapies to patients on ventilatory support:

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In December 2011, data from an in vitro study were presented at the 2011 Hot Topics.  The study was designed to compare the performance of the neonatal AFECTAIR device with a current SoC ventilator system in the delivery of nitric oxide under simulated neonatal ventilator conditions.  The simulated breathing pattern was maintained within narrow ranges and the delivery of oxygen was not different between the study conditions.  The investigators observed a 50 to 70 percent decrease in nitric oxide utilization requirements to achieve desired inhaled nitric oxide dose with the AFECTAIR device, compared with SoC (p < 0.001).  The study investigators concluded that AFECTAIR significantly decreased the nitric oxide utilization requirements to achieve the desired inhaled nitric oxide concentration and that results of the study support further investigation of AFECTAIR in the delivery of other medical gases and with other ventilation methods.

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In November 2011, data from an in vitro study were presented at the American Association for Respiratory Care (AARC) Congress 2011.  The objective of this study was to compare the dose of aerosolized albuterol sulfate delivered to lung simulator under various neonatal ventilator settings using the neonatal AFECTAIR device versus the current standard of care (SoC) delivery system.  The investigators observed that use of AFECTAIR resulted in a statistically significant 6-to-14 fold increase (p < 0.05) in the delivery of aerosolized albuterol when compared with SoC, and concluded that potential clinical use of AFECTAIR may result in increased delivery of aerosolized medication to neonates receiving positive pressure ventilatory support.
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Also in November 2011, data were presented at AARC from a second in vitro study, the objective of which was to determine the particle size distribution (PSD) using the neonatal AFECTAIR device versus SoC delivery system to deliver aerosolized albuterol in a neonatal ventilatory circuit.  PSD is an important determination for effective aerosolized medication delivery, where the ‘optimal PSD’ spans the human respirable range of 2-5 microns.  The investigators observed PSD at or below the lower end of the respirable range when using the SoC delivery system.  In contrast, the PSD observed using the AFECTAIR connector spanned the entire respirable range.  These observations suggest that the potential clinical use of AFECTAIR may result in increased delivery and retention of aerosolized medication in the lung.

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Also in November 2011, data were presented at AARC from a third in vitro study, the objective of which was to determine if the neonatal AFECTAIR device impacts respiratory system resistance in a ventilator circuit, compared with SoC connectors currently used in ventilator circuits.  The investigators observed that resistance measurements were similar between AFECTAIR and the SoC delivery system and concluded that AFECTAIR may be a comparably safe alternative to SoC in ventilator circuits.

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In May 2011, data from a study were presented at the 2011 PAS.  This data was also presented in June 2011 at the 2011 International Society for Aerosols in Medicine (ISAM) Annual Meeting.  The objective of this study was to assess our novel ventilator circuit / patient interface connectors.  The data from this study suggests that the neonatal AFECTAIR device reduces gas dilution when administered during CPAP respiratory support without increasing flow resistance, potentially improving efficiency of aerosolized medications delivery to preterm neonates receiving positive pressure ventilator support.

We plan to continue to sponsor and support studies that explore the benefits of AFECTAIR devices.  We believe that AFECTAIR has the potential to become a new standard of care for the delivery of inhaled therapies to critical care patients.

We are implementing a regulatory and manufacturing plan that, if successful, could position us to initiate the commercial introduction of the initial AFECTAIR device in the United States and the European Union in the fourth quarter of 2012, and a second AFECTAIR device, AFECTAIR DUO, in mid-2013.  We believe that AFECTAIR has the potential to become a new standard of care for the delivery of inhaled therapies to critical care patients.

Capillary Aerosolization Technology

We have worldwide exclusive rights to our CAG technology through exclusive license agreements with Philip Morris USA Inc. (PMUSA) in the United States, and Philip Morris Products S.A. (PMPSA) in all territories outside of the United States.  Each of these license agreements provides us with exclusive rights to the CAG technology for use with pulmonary surfactants (alone or in combination with any other pharmaceutical compound(s)) for all respiratory diseases and conditions.  In addition, we hold in the United StatesU.S. exclusive rights to the CAG technology for use with certain non-surfactant drugs to treat a wide range of pediatric and adult respiratory indications in hospitals and other health care institutions.See, “– Licensing, Patents and Other Proprietary Rights and Regulatory Designations – Patents and Proprietary Rights – Philip Morris USA Inc. and Philip Morris Products S.A.”

Our proprietary CAG technology has the potential to enable targeted, upper respiratory, airway or alveolar delivery of therapies, and has been initiallyis designed to produce a high-quality aerosols for deliveryaerosol capable of delivering our KL4 surfactant to the lung.  An aerosol is created by pumping our KL4 surfactant through a heated capillary, which converts the drug product to a vapor state.capillary.  Upon exiting the capillary, the vapor streamaerosol cools and slows in velocity, yielding a dense aerosol with a defined particle size.  With this technology, we believe that we may control and adjust the particle size through device modifications and potentially changes in drug formulation.  In addition, because our KL4 surfactant technology produces a surfactant that is designed to spread throughout the surface of the distal respiratory tree, we believe that our aerosolized KL4 surfactant may be used in combination with other drugs (small or large molecule) to enhance a desired therapeutic effect by delivering the combined drug products into the lung more effectively than would be possible without our KL4 surfactant.  With the assistance of our own and third-party medical device engineers, we are currently optimizing the design of the CAG device for anticipated clinical development in our AEROSURF development program and, if approved, potential commercial use.
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In studies conducted with our initial CAG device and our KL4 surfactant, we have generated an aerosolized KL4 surfactant at consistent and reproducible volumes suitable to deliver therapeutic dosages in a reasonable period of time.  Preclinical studies presented in 2007 at the Pediatric Academic Societies Annual Congress (PAS) comparing our CAG technology to commercially available aerosol that:devices indicated that our CAG device generated as much as a 10-fold higher aerosol output rate compared with the other devices studied.  We believe that our CAG technology is capable of effectively delivering our KL4 surfactant to the lung of premature infants with RDS without having to resort to invasive procedures that are currently required to administer surfactants.
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AFECTAIR Aerosol-Conducting Airway Connector

●We have also developed a novel, disposable aerosol-conducting airway connector that is intended to simplify the delivery of aerosolized medications, including our aerosolized KL4 surfactant, and inhaled therapies to infants requiring ventilatory support in the NICU and PICU.  This device introduces the aerosolized medication directly at the patient interface and minimizes the number of connections in the ventilator circuit, simplifying the delivery of aerosolized medications and other inhaled therapies.
retains the surface-tension lowering properties of a functioning surfactant;

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retains the surfactant composition of our liquid KL4 surfactant;
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has a drug particle size believed to be suitable for deposition into the lung;
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is produced at rates that can deliver therapeutic dosages in a reasonable period of time, with consistent reproducible output.  Preclinical studies presented at the 2007 PAS comparing our CAG technology to commercially-available aerosol devices indicated that our CAG device generated as much as a 10-fold higher aerosol output rate compared with the other devices studied; and
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produces in vivo evidence of uniform lung distribution and superior physiologic outcomes versus nCPAP alone in an animal model of RDS.
We registered this device in the U.S. under the name AFECTAIR as a Class I, exempt medical device and we have completed the European conformity (CE) marking process in the EU.  Based on in vitro studies demonstrating that AFECTAIR improves the delivery of inhaled therapies to infants requiring ventilatory support, we believe that it has the potential to greatly improve the delivery of aerosolized medications and inhaled therapies to critical-care patients. We currently are focused on gaining information and learning from the introduction of AFECTAIR in the U.S.  Thereafter, we may consider introducing AFECTAIR in markets outside the U.S.
 
SURFACTANT REPLACEMENT THERAPY FOR RESPIRATORY MEDICINE

ThePrior to the FDA’s approval of SURFAXIN, the only pulmonary surfactants commercially available todayin the U.S. were introduced in the United States in the 1990’s.  All areof the available pulmonary surfactants were animal-derived and are approved only for RDS in premature infants.  These products have not been approved for other respiratory indications.  SURFAXIN® is the first synthetic, peptide-containing surfactant approved for use in neonatal medicine and provides healthcare practitioners in the U.S. with an alternative to the animal-derived surfactants that today are the standard of care to manage RDS in premature infants.  We believe that our proprietary KL4 surfactant technology makes it possible, for the first time, to develop a significant pipeline of surfactant products targeted to treat a wide range of respiratory problems, including those for which there are currently few or no approved therapies.  Our potential programs include:

Respiratory Distress Syndrome in Premature Infants (RDS)

We are currently focused primarily on addressing RDS in premature infants, one of the most common serious respiratory problems facing premature infants in the NICU.  RDS is a condition in which premature infants are born with a lack of natural lung surfactant and are unable to absorb sufficient oxygen.  Premature infants born prior to 37 weeks gestation have not fully developed their own natural lung surfactant and therefore may need surfactant treatment to sustain life.  RDS is experienced in approximately half of the babies born between 26 and 32 weeks gestational age.  The incidence of RDS approaches 100% in babies born less than 26 weeks gestational age.  RDS can result in long-term respiratory problems and death.

Premature infants with severe RDS often require endotracheal intubation and mechanical ventilation to administer one of the currently available animal-derivedare treated with surfactants (usually(usually within the first hours of birth) and to provide respiratory support.  Unfortunately, many infants relapse following initial surfactant therapy and require reintubation and prolongedthat can only be administered by endotracheal intubation supported with mechanical ventilation, as well as supplemental oxygen, increasing their risk of developing furtherboth invasive procedures that may each result in serious respiratory conditions and other complications.  Neonatologists generally try to avoid mechanically ventilating infants due to the perceived risks associated with intubation, such as the risk of trauma and the need for paralytic agents and sedation.  As a result,To avoid these complications, many neonatologists will administer surfactants as an initial therapy only intubate in cases ofto premature infants with severe respiratory disease,RDS, where the potential benefits of invasive surfactant administrationtherapy more clearly outweigh the associated risks.  For all but the very low birth weight  Unfortunately, many infants with severeserver RDS awill relapse following initial surfactant therapy and require reintubation and prolonged mechanical ventilation as well as supplemental oxygen, increasing their risk of developing further serious respiratory complications.

A common ventilatory support treatment alternative to intubation and mechanical ventilation is nCPAP.nCPAP, which is generally used to support all but the very low birth weight infants with severe RDS.  Unfortunately, a significant number of infants do not respond adequately to nCPAP, an outcome referred to as nCPAP failure, and thereafter may require subsequentdelayed surfactant administration viatherapy administered by intubation and mechanical ventilation.  Several recent published studies point toward a high rate of nCPAP failure in the neonatal population (Finer et al, “Early CPAP versus surfactant in extremely preterm infants,” N Engl J Med 2010;362(21):1970-9 (Finer, et al, NEJM 2010); Morely et al, “Nasal CPAP or Intubation at Birth for Very Preterm Infants,” N Engl J Med 2008;358:700-8 (Morely et al, NEJM 2008)).  AsSince it currently is not possible to ascertain in advancepredict which patients will experience nCPAP failure, neonatologists are faced with a dilemma,difficult choices in deciding how best to treat premature infants with less severe RDS. This is because the outcomethe medical outcomes for those infants who experience nCPAP failure and receive delayed surfactant therapy may not be asless favorable asthan the outcomeoutcomes for those infants who receive surfactant therapy in the first hours of life.
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We estimate that approximately 360,000 low birth weight premature infants are born annually in the United StatesU.S. and at risk for RDS (approximately 600,000 children inclusive ofin the United States,U.S., major European medical markets, and Japan).  OfIn the United States total,U.S., we estimate that approximately 130,000 are diagnosed160,000 premature infants could benefit from surfactant therapy.  However, due to the risks associated with RDSintubation and mechanical ventilation, only approximately 86,00045,000 of these infants currently are treated with surfactant replacementsurfactants as the initial therapy for either the prevention or treatmentsevere RDS.  The remainder primarily receive nCPAP for less severe RDS.  As discussed above, a large percentage of RDS.  We also estimate that approximately 240,000 infants receive earlythese patients will fail nCPAP (as an initial RDS management strategy in lieu of initialtherapy and require delayed surfactant therapy administered via intubation and mechanical ventilation).  Recent peer-reviewed, published studies report ratesventilation.  We estimate this delayed surfactant therapy (post-nCPAP failure) population to be another approximately 45,000 infants, bringing the total number of nCPAP failure ranging between 60-80% of children receiving early nCPAP, depending on gestational age evaluated (Finer et al, NEJM 2010; Morely et al, NEJM 2008).premature infants in the U.S who are treated with surfactants for RDS to approximately 90,000.

Neonatologists’ treatment options have not improved significantly, nor have mortality and morbidity rates for RDS meaningfully improved over the last decade.  We believe that the neonatal medical community increasingly recognizeswould respond favorably to the potential benefitsintroduction of (i) a synthetic, peptide-containing surfactant such as SURFAXIN and SURFAXIN LS™, and more importantly, (ii) a less-invasive method of delivering surfactant, such as AEROSURF®, to treat premature infants at risk of suffering from respiratory disorders.  While the current RDS market for surfactants is estimated to be approximately $75 million annually in the United States and $200 million annually worldwide, we believe that this market has been constrained by the lack of further development of animal-derived surfactants coupled with the risks associated with surfactant administration.  We believe that SURFAXIN, SURFAXIN LS and AEROSURF have the potential, over time, to displace animal-derived products, expand the surfactant-eligible patient population, and support a greatly expanded RDS market.

SURFAXIN® for the Prevention of RDS in Premature Infants at High Risk for RDS

SURFAXIN is the first synthetic, peptide-containing surfactant that is structurally similar to pulmonary surfactant and mimics the surface-active properties of human surfactant.  SURFAXIN is a liquid instillate and is administered (usually within the first hours of birth) via endotracheal tube supported by mechanical ventilation for respiratory support.ventilation.  SURFAXIN represents the first synthetic, peptide-containing surfactant approved for usethe prevention of RDS in neonatal medicine.premature infants at high risk for RDS.

Our NDA for SURFAXIN was filed with the FDA in April 2004 and is supported by a Phasephase 3 pivotal trial (SELECT) to evaluate the safety and efficacy of SURFAXIN for the prevention of RDS in premature infants.  Co-primary endpoints were the incidence of RDS at 24 hours and RDS-related mortality at 14 days.  The SELECT trial enrolled 1,294 patients andprimary comparator was designed as a multinational, multicenter, randomized, masked, controlled, prophylaxis, event-driven, superiority trial to demonstrate the safety and efficacy of SURFAXIN over Exosurf®, an approved, non-protein containing synthetic surfactant.  Survanta, (colfosceril palmitate) with the intent of demonstrating superiority.  SURFAXIN demonstrated a surfactant derived from cow lungstatistically significant improvement in both RDS at 24 hours and a leading surfactant used in the United States,RDS-related mortality through day 14.  Survanta® (beractant) served as an additional active comparator.  SURFAXIN demonstrated a reference armstatistically significant reduction in the trial.  Key trial results were assessed by an independent, blinded, adjudication committee comprised of leading neonatologists and pediatric radiologists.  This committee provided a consistent and standardized method for assessing critical efficacy data in the trial.  An independent Data Safety Monitoring Board was responsible for monitoring the overall safety of the trial and no major safety issues were identified.

Data from the SELECT study demonstrate that SURFAXIN is significantly more effective in the prevention of RDS, death due to RDS, and the development of certain severe respiratory problemsRDS-related mortality through day 14 versus the primary comparator, Exosurf.  Although the Survanta reference arm was not the primary focus of comparison, significantly fewer infants treated with SURFAXIN died due to RDS compared with infants treated with Survanta.

We also conducted a supportive, multinational, multicenter, prophylaxis, randomized, controlled, masked, Phasedouble-blind, active-controlled, phase 3 clinical trial (STAR) which enrolled 252 patients and was designed as a non-inferiority trial comparing SURFAXIN to Curosurf,Curosurf® (poractant alfa), a surfactant derived from pig lung and the leading surfactant used throughout the developed world.  The STAR trial demonstrated the overall safety and non-inferiority of SURFAXIN compared with Curosurf.lung.

The SELECT and STAR trials, as well as a pooled Phasephase 3 analysis, have been presented at several international medical meetings and the results from the two studies were published in Pediatrics, the Official Journal of the American Academy of Pediatrics and a premier medical journal for pediatric healthcare practitioners.

Post-hoc analysis of data from our SELECT and STAR Phasephase 3 clinical trials reveals indicates that premature infants with RDS who were extubated after treatment with surfactant and who later required reintubation had a significantly higher rate of mortality than those infants who did not require reintubation.  The data also indicate that premature infants treated with SURFAXIN required less reintubation compared to those treated with Survanta and Curosurf.  Although the data indicated that the infants treated with SURFAXIN were observed to have a statistically significant lower incidence of reintubation than those infants treated with comparator surfactants, theThe clinical relevance of this finding has not been adequately established and, accordingly, warrants further study.

In April 2009, we received a Complete Response Letter (2009 Complete Response Letter)  However, pharmacoeconomic analysis suggests that focused primarilylower reintubation rates may result in significant hospital cost savings associated with reduction in time spent on the Chemistry, Manufacturingmechanical ventilation and Controls (CMC) sectionreduced rates of our NDA, and in particular, on certain aspects of our fetal rabbit biological activity test (BAT, an important quality control release and stability test for SURFAXIN).  The FDA did not question the quality of our clinical trial databronchopulmonary dysplasia (BPD), air leak, sepsis, necrotizing enterocolitis (NEC), or call for additional clinical trials demonstrating safety or efficacy.  The FDA indicated that, in addition to certain items that were easily addressed, we needed to satisfy the FDA as to the final validation of the BAT and demonstrate whether the BAT can adequately reflect the biological activity of SURFAXIN throughout its shelf life and discriminate biologically active from inactive SURFAXIN drug product.

At an end-of-review meeting in June 2009, we presented additional data from studies using the preterm lamb model and the BAT.  The FDA did not accept our analytical approach and indicated that the studies must demonstrate, in a point-to-point analysis, the same relative changes in respiratory compliance between the BAT and the preterm lamb model over time.  We believed that establishing the degree of consistency that the FDA required through preclinical experimentation using the animal models would represent a significant challenge.  In September 2009, we discussed with the FDA our detailed plans to optimize the precision of, and thereafter to revalidate, the BAT.  Following a successful revalidation of the BAT, we initiated our comprehensive preclinical program using the optimized BAT that involved performing a series of prospectively-designed, side-by-side preclinical studies (i.e., concordance studies) using multiple batches of SURFAXIN to demonstrate comparability between data generated from the BAT and from the preterm lamb model of RDS.  See, “– Background for the Comprehensive Preclinical Program,” below.  The concordance studies were intended to support final validation of the BAT and to demonstrate comparability of SURFAXIN drug product used in the Phase 3 clinical program with SURFAXIN drug product to-be-manufactured for commercial use.  The comprehensive preclinical program was also intended to provide support for final acceptance criteria, with respect to biological activity as assessed by the BAT, for release and ongoing stability of SURFAXIN drug product.intraventricular hemorrhage (IVH).

In December 2010, we received a communication from the FDA that directed us to increase the sample size of specified data sets by testing additional SURFAXIN batches.  In December 2010, we began manufacturing additional SURFAXIN batches for use in the comprehensive preclinical program.  See also, “– Business Operations – Manufacturing and Distribution – Precision Engineered Surfactant.”  We completed the comprehensive preclinical program and filed the Complete Response to the 2009 Complete Response Letter, on September 2, 2011.  On March 6, 2012, theThe FDA granted marketing approval for SURFAXIN.SURFAXIN on March 6, 2012.  In the third quarter of 2012, following a routine review, we determined that one of our analytical chemistry methods used to assess SURFAXIN drug product conformance to specifications required improvement and that an update to product specifications was needed.  We are now preparing forsubsequently improved and validated the analytical chemistry method and submitted updated product specifications to the FDA.  In November 2013, the FDA approved our submission and we initiated the commercial introduction of SURFAXIN in the United States, potentially in late 2012.SURFAXIN.

8
WARMING CRADLE®
Table of Contents
To facilitate proper administration of SURFAXIN, we plan to makeare making available to hospitals a dry block-warming device called a WARMING CRADLE® dry-block heating device that is designed to warm drug vials at the same temperature that is designated in the SURFAXIN prescribing information.  The WARMING CRADLE dry-block heater is registered with the FDA as a Class I, exempt laboratory medical device.  Our commercial organization will work with hospitals medical device control units to gain the appropriate clearances to make WARMING CRADLEs available to NICUs for use with SURFAXIN.

Background RegardingAEROSURF for the Comprehensive Preclinical Program
During our Phase 3 clinical trials, we did not employ a BAT to evaluate biological activity in SURFAXIN clinical drug product.  To demonstrate comparability between the SURFAXIN clinical drug product and the to-be-manufactured SURFAXIN drug product, we replicated studies in the well-established preterm lamb model using the to-be-manufactured SURFAXIN drug product that previously had been conducted using the SURFAXIN clinical drug product.  These studies demonstrated to the FDA’s satisfaction comparability between the SURFAXIN clinical drug product and the to-be-manufactured drug product.  Since we sought to use the BAT to demonstrate biological activity in our SURFAXIN drug product, rather than the preterm lamb model, we needed to correlate data generated using the preterm lamb model to data generated using the BAT.  Accordingly, we included data intended to satisfy the FDA on this point in the Complete Response that we submitted in response to an earlier Approvable Letter in October 2008.

SURFAXIN LS™ – Lyophilized SURFAXIN® for RDS in Premature Infants

SURFAXIN LS is our lyophilized (freeze-dried) dosage form of SURFAXIN that is stored as a powder and resuspended to liquid form prior to use.  We are developing SURFAXIN LS with the objective of improving ease of use for healthcare practitioners, as well as potentially to prolong shelf life and eliminate the need for cold-chain storage.  We are implementing a regulatory plan intended to gain marketing authorization for SURFAXIN LS in the United States, the European Union and other major markets worldwide.

In 2012, we plan to continue the technology transfer of our SURFAXIN LS lyophilized manufacturing process to a cGMP-compliant, third-party contract manufacturer with expertise in lyophilized drug products.  This initiative was slowed in 2011 to conserve resources while we focused our efforts on the potential approval of SURFAXIN.  We also plan to seek further regulatory and scientific guidance with respect to the planned SURFAXIN LS development program.  Our objective is to develop SURFAXIN LS for the United States and other major markets worldwide.  If we are successful in harmonizing the requirements of the FDA and the EMA, we expect to conduct a single Phase 3 clinical trial to gain regulatory approval for SURFAXIN LS in the United States and the European Union.  We anticipate initiating the clinical program, potentially in late 2013, but only after we have secured appropriate strategic alliances and/or necessary capital.

AEROSURF® for RDS in Premature Infants

AEROSURF is aan investigational drug-device combination product that produces our KL4 surfactant in aerosolized form using our CAG and drug delivery technologies.  Premature infantslyophilized KL4 surfactant with RDS currentlyour CAG.  We are treated with surfactants that can only be administered by endotracheal intubation supported with mechanical ventilation, both invasive procedures that frequently result in serious respiratory conditions and complications.  In many cases today, neonatologists will not treat infants who could benefit from surfactant therapy if the perceived potential benefits of surfactant therapy are outweighed by the risks associated with such invasive administration procedures.

developing AEROSURF if approved, may be administered through less-invasive nCPAP, and is being developed to potentially reduce or eliminate the need for intubation and mechanical ventilation.  We believe that ventilation in the treatment of RDS.  With AEROSURF, holds the promise to significantly expand the use ofneonatologists may potentially administer our KL4 surfactant in neonatal respiratory medicine by potentially providing neonatologists with a means to administeraerosolized KL4 surfactant to premature infants supported by nCPAP, without subjecting them to invasive intubation and mechanical ventilation, which are currently required to administer surfactant therapy to premature infants.  With the invasive procedures associatedrisk of intubation reduced or eliminated, we believe that AEROSURF could enable the treatment of a significantly greater number of premature infants with administration ofRDS who could benefit from surfactant therapy but who are currently approved surfactants.not treated.

In 2005, prior to the initiation of our AEROSURF program, we completed and announced the results of our first pilot Phase 2 clinical studyBy enabling delivery of our aerosolized KL4 surfactant forusing less invasive procedures, we believe that AEROSURF will address a serious unmet medical need, provide potentially transformative clinical and pharmacoeconomic benefits, and potentially enable the preventiontreatment of RDS ina significantly greater number of premature infants which was designedwith RDS who could benefit from surfactant therapy but are currently not treated.  As noted above, of the 160,000 infants that could likely benefit from surfactant therapy, approximately 115,000 currently receive nCPAP therapy as an open label, multicenter studythe initial therapy for RDS.  We believe, and market research with clinicians suggests, that, if AEROSURF is approved, a large majority of infants who currently receive nCPAP only will instead receive aerosolized KL4 surfactant as the initial treatment for RDS.  In addition, if AEROSURF is approved, of the 45,000 remaining premature infants who currently receive liquid surfactant administered using intubation and mechanical ventilation as the initial treatment, a significant number of these infants could potentially also receive aerosolized KL4 surfactant therapy as the initial treatment.

In addition to evaluate the feasibility, safetypotential clinical benefits of aerosolized KL4 surfactant, this therapy has the potential to provide significant pharmacoeconomic benefits for hospitals, payers and tolerabilityhealthcare systems.  The  cost to support a mechanically ventilated RDS patient (an estimated $55,000 per patient),  is much greater than the cost to manage a patient on nCPAP (an estimated $8,000 per patient).  These costs increase even more when treating complications associated with intubation and mechanical ventilation such as bronchopulmonary dysplasia.  By providing clinical and pharmacoeconomic benefits and enabling the treatment of a significantly greater number of premature infants with RDS who could benefit from surfactant therapy but are currently not treated, we estimate that AEROSURF delivered usingmay, over time, expand the size of the U.S. surfactant market from a commercially-available aerosolization device (Aeroneb Pro®) via nCPAP within 30 minutescurrent estimated $250-$300 million per year to a range of birth$600 million to over a three hour duration.  The study showed that it is feasible$1 billion per year.

We are developing AEROSURF to deliver our aerosolized KL4 surfactant via nCPAPusing the CAG.  To develop our CAG technology, in June 2012, we entered into a Research and thatDevelopment Services Agreement with Battelle, which has a particular expertise in developing and integrating aerosol devices using innovative and advanced technologies.  Battelle assisted us with technical support and expertise and, together with our medical device engineering team, conducted a multi-phased program to finalize the treatment was generally safedesign, test, and well tolerated.  We have since conducted or sponsoredmanufacture clinic-ready CAGs for our AEROSURF phase 2a clinical trial.  In addition, Battelle has agreed to manufacture a sufficient number of studies evaluating AEROSURFadditional CAG devices and our aerosolized KL4 surfactant drug product.  See, “Business – Proprietary Platform – Surfactant and Aerosol Technologies – Our KL4 Surfactant Technology.”

We are currently developing AEROSURF using our CAG technology.  See, “– Proprietary Platform – Surfactant and Aerosol Technologies – Our Aerosolization Device Technology – Capillary Aerosolization Technology.”  With our own in-house and third-party medical device engineers, we are optimizing the design of the CAG for anticipated clinical development and potential commercial use.  We have continued to conduct certain developmental and preclinical activitiesADPs to support our regulatory package, and we have met with and received guidance from the FDA with respect to the design of our planned Phase 2 clinical program.  We plan in 2012 to focus on finalizing the clinical / potential commercial device design of our CAG, and seeking further regulatory guidance with respect to our AEROSURF development program.  If successful, we plan to initiate a Phase 2phase 2b clinical trial, for AEROSURF in premature infants with or at risk for RDSwhich we anticipate could initiate in the second half of 2014.  In addition to the CAG, we are developing a lyophilized KL4 surfactant dosage form that we intend to use initially for AEROSURF.  See, “– Lyophilized KL4 Surfactant for RDS in Premature Infants.”  We plan to develop AEROSURF using the lyophilized dosage form of our KL4 surfactant.

To prepare for our AEROSURF development activities, we previously conducted preliminary meetings with the FDA to discuss the AEROSURF development plan.  We also engaged regulatory consultants to assist us in refining and submitting our IND to implement our phase 2a clinical program.  We filed with the FDA in October 2013 but only after we have secured appropriate strategic alliances and/or necessary capital.
and opened our IND in November 2013.  We currently plan to retain regulatory consultants to assist us in engaging international regulatory authorities regarding an AEROSURF development plan outside the U.S.
Our phase 2a program is currently ongoing.  This initial phase of our phase 2 clinical program is designed to evaluate the safety and tolerability of a single exposure of AEROSURF in an escalating dose study evaluating three doses of increasing amounts of AEROSURF.  The comparator is nCPAP only.  We plan to conduct this trial in up to four medical centers in the U.S., and anticipate results in the second half of 2014.

The next phase, phase 2b, of our clinical program is expected to begin in the second half of 2014 and conclude in the second half of 2015.  The primary objective of this phase will be to determine the optimal dose and define the expected efficacy margin.  The design of this phase will be informed by the results of the phase 2a trial.  This phase is expected to be a multicenter trial conducted in the U.S., with results to be available in the second half of 2015.  The potential phase 3 efficacy clinical will be defined based in part on the results of the phase 2 trial.

We believe that AEROSURF is a highly promising program.  In December 2010, the National Institutes of Health (NIH) awarded us Phase I of a Fast Track Small Business InnovationResearch(SBIR) Grant to support up to $580,000 of AEROSURF development activities.  Following conclusion of the Phase I grant activities, we anticipate that the NIH may potentially award usWe also have filed for a Phase II grant, whichSBIR Grant that could provide up to an additional $1.8$1.88 million to support our AEROSURF clinical activities.  See, “–Surfactant Replacement Therapy for Respiratory Medicine - Serious Respiratory Indications Associated with Inflammation of the Lungs.”

Lyophilized KL4 Surfactant for RDS in Premature Infants

We are developing a lyophilized (freeze-dried) dosage form of our KL4 surfactant that can be stored as a powder and reconstituted to liquid form prior to use, with the objective of improving ease of use for healthcare practitioners, as well as potentially prolonging shelf life and eliminating the need for cold-chain storage.  This lyophilized dosage form is intended initially to be used in our AEROSURF development program.  We have completed a technology transfer of our lyophilized surfactant manufacturing process to DSM, which has expertise in lyophilized products.  DSM has manufactured a supply of clinical drug product needed for the initial phase of our phase 2 program and will manufacture the clinical drug supply needed to complete our phase 2 clinical program.  We also have entered into a development agreement with DSM for the further development.  With the knowledgedevelopment of this lyophilized KL4 surfactant, potentially for our AEROSURF phase 3 program and, if approved, commercial supply.

We are focused initially on developing this dosage form for use in our AEROSURF development program.  We are also planning to seek regulatory advice to determine if we could gain marketing authorization for a lyophilized dosage form of SURFAXIN under a development plan that would be both capital efficient and capable of implementation within a reasonable time.  If feasible, we gain from ourwould likely implement such a development activities to treat premature infants with RDS, weplan and would plan to leverage our technology platform tointroduce it commercially as a life-cycle extension of SURFAXIN under the name SURFAXIN LS, in the U.S. and potentially address several respiratory conditions affecting pediatric and adult patient populations.  See, “– Licensing, Patents and Other Proprietary Rights and Regulatory Designations – Patents and Proprietary Rights – Philip Morris USA Inc. and Philip Morris Products S.A.”in other markets.

Serious Respiratory Indications Associated with Inflammation of the Lungs

Many respiratory diseases are associated with an inflammatory event that causes surfactant dysfunction and a loss of patency of the conducting airways.  Scientific data support the premise that the therapeutic use of surfactants in aerosol form has the ability to reestablish airway patency, improve pulmonary mechanics and act as an anti-inflammatory.

  For this reason, we believe that AEROSURF is a highly promising program and that, with the knowledge that we gain from our efforts to develop AEROSURF for the treatment of RDS in premature infants with RDS, we may be able to leverage our technology platform to potentially address serious respiratory conditions affecting pediatric and adult patient populations.  We believe that our proprietary aerosolized KL4 surfactant technology potentially may be usedeffective as a preventive measure to address debilitating respiratory disorders such astreat patients at risk for ALI and, possibly in the future CFCOPD and COPD.  As resources permit, we may invest in or support third-party studies of these indications.  If a proof-of-concept should be established, we will then determine whether to seek strategic alliances or collaboration arrangements or utilize other financial alternatives to fund their further development and/or worldwide commercialization, if approved.  There can be no assurance that we will invest or support studiesinvestment in these indications that any such efforts will be successful, or that we will be able to conclude any such strategic alliance, collaboration arrangement or secure any financial alternative.  We believe that these investments could potentially address significant unmet medical needs and redefine respiratory medicine.needs.

Acute Lung Injurylung injury (ALI)

:  ALI is associated with conditions that either directly or indirectly injure the air sacs of the lung.  ALI is a syndrome of inflammation and increased permeability of the lungs with an associated breakdown of the lungs’ surfactant layer.  Among the causes of ALI are complications typically associated with certain major surgeries, mechanical ventilator-induced lung injury (often referred to as VILI), smoke inhalation, pneumonia and sepsis.  There are a significant number of patients at risk in the United StatesU.S. for ALI annually and there are no currently approved therapies other than supportive respiratory care.
We believe that our aerosolized KL4 surfactant may potentially be effective as a preventive measure to treat patients at risk for ALI.  We are engaged in research and preclinical studies in collaboration with a prominent academic investigator to assess the use of our KL4 surfactant to potentially address ALI in an animal model.  This prophylactic approach may reduce the number of patients requiring costly intensive care therapy, eliminate long periods of therapy and generate cost savings in the hospital setting.

For a discussion of our Phase 2 clinical trial assessing whether SURFAXIN treatment could decrease the duration of mechanical ventilation in children with acute respiratory failure (ARF), see, “– Proprietary Platform – Surfactant and Aerosol Technologies – Our KL4 Surfactant Technology – Acute Respiratory Failure / Acute Lung Injury.”  For a discussion of preclinical proof of concept studies, see, “– Proprietary Platform – Surfactant and Aerosol Technologies – Our KL4 Surfactant Technology.”

Chronic Obstructive Pulmonary Diseaseobstructive pulmonary disease (COPD)

:  COPD is an incurable, chronic respiratory disorder that includes both emphysema and chronic bronchitis and is characterized by obstruction to airflow that interferes with normal breathing, inflammation, mucus plugs formation, infection, and disruption of the normal lung architecture.

We believe that our KL4 surfactant has unique attributes, including potential modulation of the inflammatory process and anti-microbial properties, that, when combined with a potential ability to enhance mucus clearance may be an effective treatment for COPD, potentially improving outcomes for these very ill patients.

We have collaborated in research and preclinical studies to assess the use of our KL4 surfactant to potentially address ALI in an animal model.  In September 2012, we announced four collaborations in a series of preclinical studies funded through various U.S. government-sponsored, biodefense-related initiatives, including collaborations with: (i) University of Pennsylvania, funded by the NIH’s National Institute of Allergy and Infectious Diseases (NIAID) to assess the ability of KL4 surfactant to mitigate effects of acute radiation exposure to the lung; (ii) University of Rochester, to evaluate the use of KL4 surfactant to protect the lung in a radiation-induced multi-organ dysfunction animal model; (iii) a facility of the U.S. Department of Defense through the NIH Office of the Director and the Countermeasures Against Chemical Threats (CounterACT) program, to assess the utility of KL4 surfactant for the treatment of chemical-induced ALI; and  (iv) a program funded by NIAID, to investigate the use of KL4 surfactant as a treatment for influenza-induced ALI.

We may in the future invest in or support third-party studies of these indications.  If a proof-of-concept should be established, we will then determine whether to seek strategic alliances or collaboration arrangements or utilize other financial alternatives to fund their further development.  There can be no assurance that we will invest or support studies in these indications, that any such efforts will be successful, or that we will be able to conclude any such strategic alliance, collaboration arrangement or secure any financial alternative.

Cystic Fibrosis (CF)

CF is a life-threatening genetic disease affecting the respiratory and other body systems.  CF is characterized by a genetic mutation that results in the production of thick, viscous mucus that is difficult to clear from the airways of the lung and typically leads to life-threatening respiratory infections.  Preclinical and exploratory clinical studies suggest that therapeutic surfactants may improve lung function by loosening mucus plugs and enhancing mucociliary clearance.

CF is the most common, life-threatening genetic disorder in the United States, occurringU.S.  CF occurs in approximately one in every 3,500 Caucasian live births.  CFbirths and affects approximately 30,000 patients in the United StatesU.S. and nearly 70,000 worldwide.  To date, treatment of pulmonary conditions in CF primarily includes antibiotics to address lung infection and airway clearance therapies to break down and remove mucus.  Life expectancy for CF has more than doubled in the past 25 years to age 37,the mid-forties, due to significant advances in research and care.

Our aerosolized KL4 surfactant was evaluated in an investigator-initiated Phase 2a clinical trial in CF patients conducted at The University of North Carolina with the support of the Cystic Fibrosis Foundation.  The trial concluded in 2010 and was designed as a double-blind, randomized study to evaluate whether  aerosolized KL4 surfactant is safe and well tolerated in patients with mild to moderate CF lung disease, and to assess the short-term effectiveness (via improvement in mucociliary clearance) of our aerosolized KL4 surfactant.  The trial demonstrated that aerosolized KL4 surfactant delivery to CF patients was feasible, generally safe and well tolerated and was not associated with serious adverse events.  Both aerosolized KL4  surfactant and the active comparator, aerosolized saline control, produced a marked, significant (p < 0.01) increase from patient baseline in mucociliary clearance measured one hour after the last dose in both whole lung and peripheral lung compartments.  We believe these results support further scientific assessment of a potential complementary therapeutic role for aerosolized KL4 surfactant specifically targeting airway mucus adhesion.  Additionally, in 2010 the FDA granted us orphan drug designation for the treatment of CF with KL4 surfactant.

We believe that our novel synthetic, peptide-containingKL4 surfactant has unique attributes, potentially including anti-microbial properties, modulation of the inflammatory process, and lack of immunogenicity, that when combined with a potential ability to enhance mucociliary clearance, in CF lung disease, may serve as a complementary therapy to advance the treatment of CF and improve treatment outcomes for these very ill patients.  WhileIn 2009, our near-term plans are focused on treating RDS in a critical care setting, we will continue to support investigator-initiated studies that explore the utility of using ouraerosolized KL4 surfactant to treatwas evaluated in an investigator-initiated phase 2a clinical trial in CF patients conducted at The University of North Carolina with the support of the Cystic Fibrosis Foundation.  In addition, we have received an orphan drug designation for CF from the FDA and other diseases.the European Medicines Agency (EMA).

BUSINESS OPERATIONS

Research and Development

Our research and development activities are initially focused on developing our proprietary KL4 surfactant, CAG, and aerosol delivery technologies into a series of pipeline programs that wouldpotentially could support a significant respiratory critical care franchise,franchise.  We are initially focused on the management of RDS in premature infants, and complimented by our aerosol delivery technologies.infants.  We continually evaluate our research and development priorities in light of a number of factors, including the results obtained in our preclinical research and related activities, advances in technology, and relationship of a project to our near-term objectives; our cash flow requirements, and financial liquidity, and our ability to secure the availability of third-party funding, advances in technology, the results of ongoing development projectsnecessary capital; and the potential for development partnerships and collaborations.collaboration agreements.  In connection with our evaluations, we modify and adapt our research and development plans from time to time and anticipate that we will continue to do so.
We plan to closely manage our expenditures in 2012 and focus our research and development resources in the near term on our RDS pipeline drug programs, primarily AEROSURF.  We are presently engaged in a phase 2a clinical trial for AEROSURF and are preparing to advance our SURFAXIN LS™ and AEROSURF® programs towardsinitiate a phase 2b trial, potentially in the initiation of clinical programs in second half of 2013; on finalizing the design of our AFECTAIR® and AFECTAIR DUO devices; and preclinical studies examining the utility and potential benefits of the AFECTAIR devices.  For our RDS programs, we are considering potential strategic alliances that could provide financial support (potentially2014.  Battelle has assisted us in the formdevelopment and manufactured for us a supply of upfront payments, milestone payments, commercialization royaltiesclinic-ready CAG devices to support preclinical activities and a sharing ofour phase 2a clinical trial.  We are working with Battelle to manufacture additional CAG devices to support additional research and development expenses)activities and development and commercial capabilitiesour phase 2b clinical trial.  We are also working with DSM to advance ourmanufacture a supply of lyophilized KL4 surfactant technology.  To accomplishin mid-2014 to support the phase 2b trial and conduct further manufacturing development work for the planned phase 3 trial.

In addition to developing our objectives,lyophilized KL4 surfactant for AEROSURF, we plan to seek regulatory advice to determine if we could gain marketing authorization for a lyophilized dosage form of SURFAXIN under a development plan that would be both capital efficient and capable of implementation within a reasonable time.  If feasible, we would likely implement such a development plan and would plan to introduce it commercially as a life-cycle extension of SURFAXIN under the name SURFAXIN LS, in the U.S. and potentially in other markets.

In markets outside the U.S., for AEROSURF, we plan to engage international regulatory authorities regarding a potential AEROSURF development plan to advance AEROSURF in the EU and potentially other markets.  We also would invest in research and development activities to support a significant strategic alliance focused on the EU and/or other selected markets outside the U.S. for the development and, if approved, commercial introduction of AEROSURF.  For SURFAXIN, we would consider various financial alternatives andfinancing or collaboration arrangements that wouldcould provide infusions of capitalregulatory expertise and other needed resources.  Although we are considering several potential opportunities, there can be no assurance that any strategic alliance or other financing alternatives or collaboration arrangement will be successfully concluded.  Until we secure sufficient strategic and financial resources to support the continuing developmentcommercial introduction of SURFAXIN, and potentially our pipeline programs and support our operations, we will continue to focus our resources on RDS programs and pace investments in potential non-RDS pipeline programs accordingly.

We will continue to consider supporting investigator-initiated studies, and may invest opportunistically in studies of other potentialFDA-approved KL4 surfactant pipeline programs that would target adult andproducts, in other indications, such as ALI and CF.  We believe that these programs could represent significant market opportunities.  If we were able to demonstrate proof-of-concept for any of these indications, we would consider whether to develop these products through potential strategic alliances or collaboration arrangements, or utilize other financial alternatives to fund their further development and commercialization, if approved.  There can be no assurance that we will pursue such investments or, if we do, that we will succeed in demonstrating proof of concept or entering into any such alliance.countries.

To support our research and development activities, we have:

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·		physicians and scientists with expertise in pediatric and pulmonary medicine and extensive contacts in the neonatal medical community;
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·		expertise in the design and implementationexecution of preclinical experiments and studies to support drug development.  We conduct certain development-related experiments and bench studies in-house and also engage professional research laboratories as well as academic and education centers to conduct animal studies and experiments requiring specialized equipment and expertise;
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·		expertise in the design, development and management of clinical trials.  OurWe have our own expertise includes scientific, medical, biostatistics, and trial and data management capabilities.  WeFor the initial phase of the AEROSURF program, we plan to analyze and report on our clinical trial data, supported by third-party technology systems and independent consultants.consultants, and will monitor all activities using our clinical operations capabilities.  We rely on scientific advisory committees and other medical and consulting experts to assist in the design and monitoring of clinical trials that we may conduct.trials.  We also plan to rely on contract research organizations (CROs)CROs to support operations of our planned multi-center AEROSURF trials, in certain countries;including potentially for locations outside the U.S.;
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·		regulatory personnel with expertise in FDA regulatory matters.  We also consult extensively with independent FDA and international regulatory experts, including former senior scientific staff of the FDA;
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·		engineering expertise to support development of our CAG and aerosol delivery technologies.  In addition to our own design engineering team, we planare engaged in a development program with Battelle to work with consulting design engineers, medicalbring its significant expertise in developing and integrating aerosol device experts and other third-party collaboratorstechnologies to advance the development ofoptimize our CAG device and manufacture clinic-ready CAG devices for use in our phase 2 AEROSURF clinical trials and, if approved, commercial application;trials;
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·		quality operations capabilities to assure compliance with applicable regulations;
 
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manufacturing capabilities to manufacture SURFAXIN® and our liquid KL4 surfactant for use in preclinical studies.  We also plan to rely on contract manufacturing organizations (CMOs)CMOs to produce our lyophilized dosage form of our KL4 surfactant and to manufacture and assemble our AFECTAIR devices.  We plan to rely on third-party manufacturers to manufacture and assemble our CAG systems and related components; and
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our own analytical and testing laboratories, research and medical device development laboratory, and KL4 surfactant manufacturing facilities and related capabilities.laboratory.  We also rely on a number of third-party analytical and testing laboratories to support our research activities and provide certain laboratory services.
Research and development costs are charged to operations as incurred.  During the yearsyear ended December 31, 2011, and 2010, our2013, we invested approximately $27.7 million for research and development expenses were $17.2 million,expense, which includes (i) product development and $17.1 million, respectively.manufacturing, (ii) medical and regulatory operations, and (iii) direct preclinical and clinical programs.

Manufacturing and Distribution

In 2005, we acquired manufacturing operations located in a leased facility in Totowa NJ (Totowa Facility) to manufacture SURFAXIN, our liquid instillate KL4 surfactant.  To support our manufacturing operations, in 2007, we established our own analytical and technical support laboratory at our headquarters in Warrington, Pennsylvania (Warrington Laboratory).  We use third parties for the manufacture of our lyophilized KL4 Surfactant surfactant and medical devices and related components, certain analytical and laboratory services in support of our manufacturing activities, packaging and labeling, warehousing, third-party logistics services and distribution.

KL4 Surfactant

Our KL4 surfactant products, including SURFAXIN, must be manufactured in compliance with current good manufacturing practices (cGMP) established by the FDA and other international regulatory authorities.  SURFAXINauthorities, as applicable.  Our KL4 surfactant is a complex drug product comprised of four active ingredients.pharmaceutical ingredients (APIs).  It must be aseptically manufactured at our facility as a sterile, liquid suspension and requires ongoing monitoring of drug product stability and conformance to specifications.

Our drug products are manufactured by combining raw materials, such as  Like some other surfactants, it is stored and shipped in a refrigerated, cold-chain environment.  We currently rely on single source suppliers under separate product supply agreements for KL4, which is provided by Bachem California, Inc., and POPG, two of our APIs, and source our other active ingredients, including certain lipidsAPIs from single source suppliers under purchase orders that are provided by suppliers such as Corden Pharma (from a facility that was owned previously by Genzyme Pharmaceuticals) and Avanti Polar Lipids, Inc.  We currently obtainwe issue from time to time.  To mitigate our active ingredients from single-source providers, althoughrisk, we plan to qualify secondary suppliers for our APIs over the next 1218 to 36 months.  Our risk of losing a source of supply is currently somewhat mitigated by our decision to enlarge our safety stock of all APIs when we began the fact thatcommercial introduction of SURFAXIN.  While we generally maintain a minimum six-month supply of all critical active ingredients.  Suppliers ofpurchase our containers, closuresprimary packaging components and excipients used in our manufacturing process include West Pharmaceutical Services, Inc., Gerresheimer Glass Inc. and Spectrum Chemical Mfg. Corp.  Our inactive raw materials and critical componentsfrom single-sources, these items are generally readily available from multiple sources.  As we preparemanufacturers.

We conduct our manufacturing activities for the commercial introduction of SURFAXIN we will need to identify service providers toin our Totowa Facility and our analytical and technical support labeling,laboratory in our Warrington Laboratory.  We have a third-party agreement for packaging warehousing and othervial labeling services for our SURFAXIN drug product.

Our manufacturingTotowa facility in Totowa, New Jersey, consists of pharmaceutical manufacturing and development space that is designed for the manufacture and filling of sterile liquid pharmaceuticals in compliance with cGMP.  See, “Item 2 – Properties.”  These operations are configured and approved to produce SURFAXIN which is manufactured ascommercial drug product.  In addition, we also operate a liquid instillate to be administered intratracheally via an endotracheal tube to neonates.  These operations also play an integral part of our long-term manufacturing strategy for the continued development of our KL4 surfactant technology, including life-cycle management of SURFAXIN, new formulations development and formulation enhancements.  Owning our own manufacturing operations has provided us with direct operational control and, we believe, potentially improved economics for the production of preclinical, clinical and commercial supply of SURFAXIN and possibly other KL4 surfactant liquid drug product candidates.  We also are conducting a technology transfer of the SURFAXIN LS dosage form manufacturing process to a cGMP-compliant contract manufacturer with expertise in lyophilized formulations.

In connection with our efforts to respond to the 2009 Complete Response Letter that we received from the FDA, in December 2010, we began manufacturing additional SURFAXIN batches for use in the comprehensive preclinical program.  In January 2011, quality control testing performed by us indicated that two newly manufactured SURFAXIN batches did not meet one of the pre-specified release specifications.  In accordance with our quality assurance procedures and manufacturing practices, we conducted an investigation to determine why the SURFAXIN batches did not meet specification and, if appropriate, to implement a corrective action and preventative action plan.  While we identified certain differences in the batches, we did not confirm a definitive root cause of the failures.  See, “Item 1A – Risk Factors – Manufacturing problems potentially could cause us to delay preclinical or clinical programs, or, if our products are approved, product launch, or cause us to experience shortages of products inventories, which could have a material adverse effect on our business.”  Following the investigation, we implemented a process improvement and continued to manufacture SURFAXIN batches for use in the comprehensive preclinical program, which batches successfully met all specifications, including the specifications that the two unacceptable batches did not meet.  In January 2012, the FDA completed a pre-approval inspection (PAI) of our manufacturing facility and issued an Establishment Inspection Report indicating an approval recommendation for our SURFAXIN NDA.

Our manufacturing operation also includes our analytical and quality systems.  We have consolidated all of our in-house analytical, quality and development activities in our analytical and developmentmicrobiology laboratory at our headquarters inTotowa Facility that supports our manufacturing activities.  In our Warrington Pennsylvania.  Activities conducted there includeLaboratory, we conduct certain analytical development and quality control activities, including release testing of all APIs as well as release and stability testing of raw materials as well asSURFAXIN clinical and commercial drug product supply of SURFAXINsupply.  Our Warrington Laboratory also provides analytical testing and quality system support for our other drug product candidates, if approved.  We also perform development work with respectefforts to identify and protect our intellectual property, and for our lyophilized and aerosolized KL4 surfactant dosage forms as well as other potential formulations of our KL4 surfactant technology.  In addition, we have a microbiology laboratory atin support of AEROSURF and our Totowa facility to support the manufacture of our drugother KL4 surfactant product candidates.  In February 2010, we completed construction of a new medical device development laboratory which we believe greatly enhances our ability to leverage our internal development engineering resources and manage ongoing preclinical development activities for AEROSURF, while at the same time controlling the related expense and conserving our financial resources.

In addition, to further support our development activities and quality programs, weWe work with a number of third-party institutions and laboratories that perform various studies as well as quality control release and stability testing and other activities related to our KL4 surfactant development and manufacturing activities.  Among these,activities, including  our BATbiological activity test (BAT) release and stability testing is conducted at a laboratory owned by the University of California, San Diego, School of Medicine, Department of Pediatrics.testing.  At the present time, several of these laboratories are single sourcesingle-source providers.  We are implementing a plan to identify and potentially qualify over the next 12- 24 months additional sources to meet our key release testing and stability requirements.

Importantly, as we undertake the commercial introduction of SURFAXIN and the development of AEROSURF, we are planning for long-term continuity of supply and continued integrity and reliability of our manufacturing and quality assurance processes.  We seek to build a foundation to support our anticipated long-term needs, and intend to make appropriate capital investments in the near-term, balancing the use of our available resources while maintaining flexibility in planning our manufacturing goals.

·The lease for our Totowa Facility currently expires on June 30, 2015.  We continue to explore possible alternatives that could enable longer-term utilization of that facility for the manufacture of SURFAXIN and potentially lyophilized KL4 surfactant.
·We completed the technology transfer of our lyophilized KL4 surfactant manufacturing process to DSM in 2013 and have manufactured a sufficient clinical supply of KL4 surfactant to support the phase 2a AEROSURF clinical trial.  We plan to manufacture additional clinical supply in mid-2014 to support our phase 2b clinical trial.  We also have entered into a development agreement with DSM for the potential further development and  manufacture of lyophilized KL4 surfactant for our AEROSURF phase 3 clinical program, as well as other potential pipeline development programs.
·To secure an additional source of SURFAXIN commercial drug product, in 2012 we initiated a technology transfer of our liquid KL4 surfactant manufacturing process to DSM and in August 2013 entered into a supply agreement with DSM that provides for the manufacture of commercial supply of SURFAXIN drug product through December 31, 2015, with such further extensions at that time as the parties may agree.
·We also have initiated a project to identify a second CMO that would manufacture clinical and commercial supply and assure a continuous and back up supply of SURFAXIN drug product.  We currently are working through potential development plans with a few CMOs and thereafter plan to initiate a technology transfer of our liquid KL4 manufacturing process.

We also believe that our in-house manufacturing capabilities, including our executive management, in-house manufacturing and quality operations managers and employees, are important to our long-term success.  Our management team includes executives experienced in pharmaceutical and biopharmaceutical drug product manufacturing, with extensive experience in manufacturing both small and large molecules, biological and sterile drug/device combination products in both domestic and overseas operations, and supply chain; as well as in worldwide quality operations to assure consistent and continued quality and cGMP compliance for our products, whether manufactured on our own or with a CMO.  Our manufacturing operations are lead by seasoned professionals with broad technical and managerial skills in all facets of our KL4 surfactant manufacturing process, expertise built on many years of accumulated knowledge in biopharmaceutical manufacturing, facility management, process and cleaning validation, sterility assurance and microbiological analyses, clean room operation and direction of formulation and aseptic filling of our drug product.  Although there can be no assurance, we believe that we can leverage the extensive experience that we have gained from having managed our own manufacturing operations since 2005 to flexibly respond over time and provide for the continued manufacture of our KL4 surfactant drug product, on our own or with our CMOs.

CAG Device and Related Componentry and Aerosol Delivery Devices

AEROSURF our initialis a combination drug-device product that producing aerosolized KL4 surfactant combinesby combining our lyophilized KL4 surfactant technology with our CAG technology.device and aerosol delivery technologies.  We are developing and, if approved, will commercialize AEROSURF in the U.S. for RDS inthe treatment of premature infants.  See, “– Licensing, Patents and Other Proprietary Rights and Regulatory Designations – Patents and Proprietary Rights – Philip Morris USA Inc. and Philip Morris Products S.A.”infants with RDS.  We also plan to developbelieve that our aerosolized KL4 surfactant may be used to address a broad range of serious respiratory conditions.conditions in the NICU as well as in children and adults in the PICU and ICU.

To develop our CAG technology, we have worked in the past with selected component manufacturers and an integrator to manufacture and integrate our initial prototype CAG system.  We are currently focused on developing an optimized, clinic-readyThe CAG device to meet regulatoryincludes an aerosol control unit and ease-of-use design requirements and prepare for planned Phase 2 and later Phase 3 clinical trials.  We expect to rely on third-party contract manufacturers to manufacture and assemble the CAG device and related components to support our preclinical experiments, planned clinical studies and potential commercialization ofa disposable AEROSURF if approved.  Certain of these components must be manufactured in an environmentally-controlled area and, when assembled,delivery pack (ADP). The ADP includes the critical drug product-contact components that are either cleaned or manufactured in an environmentally-controlled, clean area. The control unit and patient interface systems must beADPs are assembled and packaged and sterilized.in a clean area.  Each of the CAGADP devices is tested for conformance to designated product specifications during assembly and disposable componentseach of the assembled control units must be quality control tested prior to release and monitored for conformance to designated product specification.  See, “Item 1A – Risk Factors – Manufacturing problems potentially could cause us to delay preclinical or clinical programs, or, if our products are approved, product launch, or cause us to experience shortages of products inventories, which could have a material adverse effect on our business.”specifications.

AFECTAIRIn June 2012, we entered into an agreement with Battelle under which Battelle assisted in a multi-phase development program focused on design and testing of clinic-ready CAG devices for our AEROSURF phase 2a clinical trials, and then manufactured CAG devices for the phase2a clinical trial that is currently underway.  In addition, we recently entered into an agreement with Battelle for the ®manufacture and assembly of a sufficient number of control units, ADPs Devicesand related components to support our planned phase 2b clinical trial and development activities.  In the future, we expect to rely on CMOs to manufacture and assemble the CAG device and related components needed to support our development activities, planned phase 3 clinical studies and, if approved, potential commercialization of AEROSURF.
AFECTAIR Aerosol-Conducting Airway Connector

For the manufacture of AFECTAIR devices, in FebruaryIn 2012 we entered into a supply agreement (Agreement) with Lacey Manufacturing Company, a division of Precision Products, LLC (“Lacey”)(Lacey), to manufacture our initial AFECTAIR devices.devices through October 2015.  Lacey operates a cGMP-compliant manufacturing facility and has significant experience with the mold injection process required to manufacture AFECTAIR devices.  Pursuant to the Agreement, Lacey will manufacture AFECTAIR and AFECTAIR DUO medical devices.  In addition to providing manufacturing support, Lacey willhas agreed to label, package, and prepare AFECTAIR devices for shipment.  We currently plan to direct ship ordered goods to distributors from Lacey and expect to warehouse an inventory of AFECTAIR devices at one of our facilities.

The initial term of our Agreement with Lacey is the shorter of three years from the date of the first order for commercial product or four years from the effective date.  The term may be extended by written agreement of the parties.  Among other rights to terminate the Agreement, either party may terminate the Agreement upon 30 days written notice to the other party if we, after a good faith effort, are unable to agree on (i) go-forward planning steps to complete development of one or both AFECTAIR Devices, or (ii) key terms, including, without limitation, pricing or order volume requirements.  We will retain ownership of all equipment, molds and tooling and other capital assets purchased by Lacey to manufacture AFECTAIR Devices on our behalf.  In connection with any termination of the Agreement, Lacey is obligated to cooperate and provide us reasonable assistance to transfer all equipment, inventory and materials to any successor manufacturing site or to such other location that the Company may designate in writing.Distribution

Distribution

We are currently manufacturingTo support the commercial introduction of SURFAXIN, as a liquid instillate that requires cold-chain storage and distribution.  We arranged forwe have established arrangements with ASD Specialty Healthcare Inc. (ASD) and Integrated Commercialization Solutions, Inc. (ICS), affiliates of AmerisourceBergen Specialty Group, for warehousing, distribution and related services.  ICS is our third-party logistics provider and assists us with inventory tracking, customer service, order management, distribution, returned goods, contract and accounts receivable management, certain financial management services and other similar services.

In 2012, we amended and updated our agreement with ASD, which agreed to act as our sole wholesalerexclusive specialty distributor for SURFAXIN, and the WARMING CRADLE dry-block heaters and AFECTAIR devices in the United States.  This arrangement was originally put in place in 2006U.S. and continuesprovide related services.  Lacey will ship the finished product to be availableICS who has agreed to warehouse and provide third-party logistic services for us.  Under our agreement with ASD we expect that ASD will provide certain promotional and marketing activities, maintain inventory, shipping and certain compliance and regulatory activities.
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has agreed to act as distributor for AFECTAIR devices.

Our collaboration with Esteve provides that Esteve has responsibility for distribution of specified KL4 surfactant products in Andorra, Greece, Italy, Portugal and Spain.  See, “– Business Operations – Strategic Alliances and Collaboration Arrangements – Laboratorios del Dr. Esteve, S.A.”  In other parts of the world, we plan to evaluate third-party distribution capabilities prior to commercializing in those regions.

To distribute AFECTAIR, we plan to complement the activities of our own commercial team with a network of distributors in the United States, and also plan to have a network of distributors in the European Union and elsewhere.  We expect that our distributors will be regional and will have a focus and expertise in distributing hospital-based medical device products.

General and Administrative

We have made significant investments in our sales and marketing capabilities and intend to continue investing in general and administrative resources primarily to support our intellectual property portfolios (including building and enforcing our patent and trademark positions), our business development initiatives, financial systems and controls, legal and corporate and healthcare compliance requirements, management information technologies, and general management capabilities.

Strategic Alliances and Collaboration Arrangements

Laboratorios del Dr. Esteve, S.A.

We have a strategic alliance with Laboratorios del Dr. Esteve, S.A. (Esteve) for the development, marketing and sales of a broad portfolio of potential KL4 surfactant products in Andorra, Greece, Italy, Portugal, and Spain.Spain (collectively, the territory).  Antonio Esteve, Ph.D., a principal of Esteve, served as a member of our Board of Directors from May 2002 until January 2013.  Under the alliance, Esteve will pay us a transfer price on sales of our KL4 surfactant products.  We will be responsible for the manufacture and supply of all of the covered products and Esteve will be responsible for all sales and marketing in the territory.  Esteve is obligated to make stipulated cash payments to us upon our achievement of certain milestones, primarily upon receipt of marketing regulatory approvals for the covered products.  In addition, Esteve has agreed to contribute to Phasephase 3 clinical trials for the covered products by conducting and funding development performed in the territory.  As part of a 2004 restructuring of this alliance in December 2004,which Esteve returned certain rights to us in consideration of Esteve returning commercialization rights in portions of the territory originally licensed to Esteve, including key European markets and Latin Americacertain territories (Former Esteve Territories), we agreed to pay to Esteve 10% of any cash up front and milestone fees (up to a maximum aggregate of $20 million in the aggregate)million) that we may receive in connection with any strategic collaborations for the development and/or commercialization of certain of our KL4 surfactant products in the Former Esteve Territories.  The alliance will terminate as to each covered product, on a country-by-country basis, upon the latest to occur of: the expiration of the last patent claim related to a covered product in such country; the first commercial sale in such country of the first-to-appear generic formulation of the covered product, and the tenth anniversary of the first sale of the covered product in such country.  In addition to customary termination provisions for breach of the agreement by a party, the alliance agreement may be terminated by Esteve on 60 days’ prior written notice, up to the date of receipt of the first marketing regulatory approval, or, on up to six months’ written notice, if the first marketing regulatory approval has issued.  We may terminate the alliance agreement in the event that Esteve acquires a competitive product (as defined in the agreement).
Potential Alliances and Collaboration Arrangements

We continueWhile we currently intend to retain all rights and commercialize our approved products in the U.S.,  we seek strategic alliances and other collaborativecollaboration arrangements for the development and/or commercialization of our KL4 surfactant product candidates with a current focus on the development and, if approved, commercialization of SURFAXIN LS and AEROSURF in the European Union and other markets outside the United States.  We seek alliances that would provide financial support (potentially in the form of upfront payments, milestone payments, commercialization royalties and a sharing of research and development expenses) and development and commercial capabilities to help us maximize the potential of these KL4 surfactant programs.  We also would consider various financial alternatives or collaboration arrangements that would provide infusions of capital and other resources needed to advance our KL4 respiratory pipeline programs.  Although we are considering several potential opportunities, there can be no assurance that any strategic alliance or other financing alternatives or collaboration arrangement will be successfully concluded.  See, “– Business Strategy,” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Liquidity and Capital Resources – Financings Pursuant to Common Stock Offerings.”U.S.
 

LICENSING, PATENTS AND OTHER PROPRIETARY RIGHTS AND
REGULATORY DESIGNATIONS

We continue to invest in maintaining and enforcing our potential competitive position through a number of means: (i) by protecting our exclusive rights in our KL4 surfactant, CAG and ventilator circuit / patient interfaceaerosol-conducting airway connector technologies through patents and patent extensions, (ii) by seeking regulatory exclusivities, including potential orphan drug and new drug product exclusivities, and (iii) through protecting our trade secrets and proprietary methodologies that support our manufacturing and analytical processes.

Patents and Proprietary Rights

Johnson & Johnson, Ortho Pharmaceutical Corporation and The Scripps Research Institute

Our precision-engineered KL4 surfactant technology, including SURFAXIN,®, is based on the proprietary synthetic peptide KL4 (sinapultide), a 21 amino acid protein-like substance that closely mimics the essential human lung protein SP-B.  This technology was invented at The Scripps Research Institute (Scripps) and was exclusively licensed to and further developed by Johnson & Johnson.J&J.  We have received an exclusive, worldwide license and sublicense from J&J and its wholly-owned subsidiary, Ortho Pharmaceutical Corporation, for, with rights to, a series of over 30 patents and patent filings (worldwide) which are important, either individually or collectively, to our strategy for commercializing our KL4 surfactant product candidates.  The license and sublicense give us the exclusive rights to such patents for the life of the patents.  Under the license agreement, we are obligated to pay the licensors fees of up to $2.5 million in the aggregate upon our achievement of certain milestones, primarily upon receipt of marketing regulatory approvals for certain designated products.  In addition, we have paid $450,000$950,000 to date for milestones that have been achieved.  In addition, we are required to make royalty payments at different rates, depending upon type of revenue and country, in amounts in the range of a high single-digit percent of net sales (as defined in the agreement) of licensed products sold by us or sublicensees, or, if greater, a percentage of royalty income from sublicensees in the low double digits.  The license agreement provides that the license will expire, on a country-by-country basis, upon the payment of royalties for all licensed products for the longest of (i) ten years beginning on the date of the first commercial sale of  the first commerciallicensed product  in such country or (ii)and thereafter until the expiration of the last licensed patent containing a valid claim covering athe licensed product in such country; or for countries in the European UnionEU in which royalties are paid only by virtue of licensed know-how, upon the payment of royalties ending on the earlier of (i) the date on which the licensed know-how becomes public or (ii) the tenth anniversary of the first commercial sale of the first licensed product in any such country.  In addition to customary termination provisions for breach of the agreement by a party, we may terminate the agreement, as to countries other than the United StatesU.S. and Western Europe territories (as defined in the agreement), on a country-by-country basis, on six months’ prior written notice; and as to the entire agreement, on 60 days’ prior written notice.

Patents covering our proprietary precision-engineered surfactant technology that have been issued or are pending worldwide include composition of matter, formulation, manufacturing and uses and include the following issued United States patents: U.S. Patent No. 5,164,369; U.S. Patent No. 5,260,273; U.S. Patent No. 5,407,914; U.S. Patent No. 5,789,381; U.S. Patent No. 5,952,303; U.S. Patent No. 6,013,619; and U.S. Patent No. 6, 613,734613,764 (along with certain corresponding issued and pending foreign counterparts).  These patents relate to precision-engineered pulmonary surfactants (including SURFAXIN), certain related peptides (amino acid protein-like substances) and compositions, methods of treating respiratory distress syndromes with these surfactants and compositions, and a pulmonary lavage method of treating RDS with these surfactants.  Our licensed patent estate also includes United Statesthe U.S. and foreign patents and applications that relate to methods of manufacturing SURFAXIN and certain peptides that may be used in the manufacture of SURFAXIN, and other aspects of our precision-engineered surfactant technology.  These patents include U.S. Patent No. 5,741,891; U.S. Patent No. 5,952,303,5,952,303; U.S. Patent No. 6,013,764; U.S. Patent No. 6,120,795; U.S. Patent No. 6,492,490; and U.S. Patent No. 6,492,4908,217,142 (along with certain corresponding issued and pending foreign counterparts).
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The patent term of U.S. Patent No. 5,407,914 has been extended until November 17, 2012 with further extensions potentially available until November 17, 2014.  European counterparts of these patents will expire in June 2012.  U.S. Patent No. 5,952,303 will expire on March 29, 2017.  U.S. Patent No. 5,741,891 will expire on October 22, 2016.  U.S. Patent No. 6,013,764 will expire on June 25, 2017.  U.S. Patent No. 6,120,795 will expire on March 4, 2017.  U.S. Patent No. 6,492,490 and U.S. Patent No. 8,217,142 will expire on June 25, 2017.  U.S. Patent No. 6,013,619 will expire on April 28, 2017.

We also have licensed or optioned for license certain patents and pending patent applications from Scripps that relate to combination therapies of pulmonary surfactant and other drugs, and methods of use.  TheseSome of these patent applications have issued and some are still pending in the United StatesU.S. and a number of foreign jurisdictions, including Canada, Europe and Japan.  For example, selected compositions of pulmonary surfactants and protease inhibitors and methods of administering these compositions are claimed in the U.S. Patent No. 7,863,241 titled “Compositions for treatment and prevention of pulmonary conditions” which issued on January 4, 2011 and will expire on February 17, 2025.

Our KL44-Related Patents and Patent Rights

We have been active in seeking patent protection for our innovations relating to new dosage forms, formulations and methods of manufacturing and delivering synthetic peptide containing pulmonary surfactants.  Our patent activities have focused particularly on improved dosage forms and delivery of aerosolized pulmonary surfactant.

In November 2005, we filed U.S. and International patent applications (US 11/274,701 which is now U.S. Patent No. 7,582,312 issued on September 1, 2009 and PCT US/2005/041281, now entered national phase), directed to lyophilized formulations of sinapultidesynthetic peptide containing pulmonary surfactants and methods of manufacture.

In December 2005, we filed U.S. and International patent applications (US 11/316,308 which is now U.S. Patent No. 8,337,815 issued on December 25, 2012 and PCT US/2005/046862, now entered national phase), directed to sinapultidesynthetic peptide containing pulmonary surfactant formulations having improved viscosity characteristics, aerosolization capacity and storage stability.

In January 2006, we filed U.S. and International patent applications (US 11/326,885 which is now U.S. Patent No 7,541,331 issued on June 2, 2009 and PCT/US06/000308, now entered national phase), directed to a surfactant treatment regimen for BPD.

In September 2007, we filed U.S. and International patent applications (US 11/901,866 which is now U.S. Patent No. 8,221,772 and PCT US/2007/020260, now entered national phase) directed to surfactant compositions and methods of promoting mucus clearance and treating pulmonary disorders such as cystic fibrosis.

EachIn March 2013, we filed International patent applications (PCT/US13/34364 and PCT/US13/34464 and commenced expedited examination in US and EU) directed to lyophilized pulmonary surfactant and methods of the above-listed PCT applications has entered national phase in Europe and Japan, among other countries.manufacture.

Philip Morris USA Inc. and Philip Morris Products S.A.

In 2008, we restructured ourto restructure a December 2005 strategic alliance, with PMUSA andwe entered into an Amended and Restated License Agreement with PMUSAPhilip Morris USA, Inc. (PMUSA) with respect to the United StatesU.S. (U.S. License Agreement), and, as PMUSA had assigned to Philip Morris Products S.A. (PMPSA) all rights in and to the CAG technology outside of the United StatesU.S. (International Rights), effective on the same date, we entered into a License Agreement with PMPSA with respect to the International Rights (International License Agreement) on substantially the same terms and conditions as the U.S. License Agreement.  In addition to customary termination provisions for breach of the agreements, we may terminate the License Agreements, in whole or in part, upon advance written notice to the licensor.  In addition, either party to each License Agreement may terminate upon a material breach by the other party (subject to a specified cure period).  Our license under each License Agreement, unless terminated earlier, will expire as to each licensed product, on a country-by-country basis, upon the latest to occur of: the date on which the sale of such licensed product ceases to be covered by a valid patent claim in such country; the date a generic form of the product is introduced in such country; or the tenth anniversary of the first commercial sale of such licensed product.
Under the license agreements,License Agreements, we are obligated to pay royalties at a rate equal to a low single-digit percent of sales of products sold in the Exclusive Field (as defined below) in the territories.  In connection with exclusive undertakings of PMUSA and PMPSA not to exploit the CAG technology for all licensed uses, we are obligated to pay royalties on all product sales, including sales of certain aerosol devices and related components that are not based on the CAG technology; provided, however, that no royalties are payable to the extent that we exercise our right to terminate the license with respect to a specific indication.  We also agreed in the futureare required to pay minimum royalties quarterly beginning  in 2014, but are entitled to a reduction of future royalties in the amount of any minimum royalties paid.  Our license rights extend to innovations to the CAG technology that are made under the license agreements.  With these proprietary rights, weLicense Agreements.  We believe that our AEROSURF aerosolized KL4 surfactant can be developed to potentially address a broad range of serious respiratory conditions.  We are developing AEROSURF® to treat premature infants with or at risk for RDS using the CAG technology.

Capillary Aerosolization Technology Patents and Patent Rights

We currently hold exclusive licenses to the CAG technology both in and outside of the United StatesU.S. for use with pulmonary surfactants (alone or in combination with any other pharmaceutical compound(s)) for all respiratory diseases and conditions.  In addition, under the U.S. License Agreement, our license to use the CAG technology includes certain non-surfactant drugs to treat a wide range of pediatric and adult respiratory indications in hospitals and other health care institutions.  The aerosolization technology patents expire on various dates beginning in May 2016 and ending in 2023,2031, or, in some cases, possibly later.  Our license under each License Agreement, unless terminated earlier, will expire as to each licensed product, on a country-by-country basis, upon the latest to occur of: the date on which the sale of such licensed product ceases to be covered by a patent claim of an issued and unexpired patent in such country; the date a generic form of the product is introduced in such country; and the tenth anniversary of the first commercial sale of such licensed product.

Other Aerosolization DeviceAerosol-Conducting Airway Connector Technology Patents and Patent Rights

In March 2009, we filed International patent application (PCT US/2009/037409) directed to improvements of an aerosol delivery system and ventilation circuit adaptoraerosol-conducting airway connectors that we plan to market under the trademark AFECTAIR®. and improvements of an aerosol delivery system using AFECTAIR. The International patent application is an interim phase in the prosecution of patents and is now expired.concluded.  Beginning on September 16, 2010, this application entered national phase in US, Europe and Japan, among other countries and is currently pending.  The claims of this application are directed to a novel ventilation circuit adaptor (an aerosol-conducting airway connector)  and related aerosol circuitry that are intended to increase the efficiency of aerosol delivery to the patient by allowing more efficient delivery of aerosols to the patient, reduce drug compound dilution and wastage and result in more precise aerosol dosing.See, “Proprietary Platform – Surfactant and Aerosol Technologies – Our Aerosolization Device Technologies.”

See, “Item 1A – Risk Factors – If we cannot protect our intellectual property, other companies could use our technology in competitive products.  Even if we obtain patents to protect our products, those patents may not be sufficiently broad or they may expire and others could then compete with us”;us;” “– Intellectual property rights of third parties could limit our ability to develop and market our products”;products;” and “– If we cannot meet requirements under our license agreements, we could lose the rights to our products.”

Trademarks

AEROSURF®, AFECTAIR®, AFECTAIR® DUO, DISCOVERYLABS®, SURFAXIN®, SURFAXIN LS™, and WARMING CRADLE® are our registered and common law trademarks.

Trade Secrets

In addition to our patent exclusivities, we rely on trade secrets to protect and maintain our competitive position.  We take measures to protect and maintain our trade secrets and know-how licensed to us or developed by us by entering in confidentiality agreements with third parties.  Our trade secrets and know-how include information related to manufacturing processes for our drug products and devices, analytical methods and procedures, research and development activities, provisional patent applications, as well as certain information provided to FDA that was not made public which relates to our regulatory activities and clinical trials.
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Other Regulatory Designations

New Drug Product Exclusivity

SURFAXIN is expected to receive  at least three years of marketing exclusivity as a new drug product based on the new data from the SELECT and STAR clinical trials.  In addition, the FDA has indicated that our SURFAXIN drug product also qualifies as a “new molecular entity,” which we expect willmay provide extended marketing exclusivity from three toof five years.  However, we will have to await the FDA has not made its final determination byas to the FDA.length of the exclusivity period for SURFAXIN.

Orphan Drug and Orphan Medicinal Product Designations

“Orphan Drugs” are pharmaceutical products that are intended to address diseases affecting fewer than 200,000 patients in the United States.U.S.  The Office of Orphan Product Development of the FDA grants certain advantages to the sponsors of Orphan Drugs including, but not limited to, seven years of market exclusivity upon approval of the drug, certain tax incentives for clinical research and grants to fund testing of the drug.  The FDA has granted Orphan Drug designation for SURFAXINour KL4 surfactant for the treatment of RDS in premature infants.  However, as our indication foris SURFAXIN is for the prevention, rather than treatment, of RDS, we filed a request with the FDA to allow for application ofsuch that this designation does not apply to SURFAXIN.  We recently were advised by the FDA that our request has been denied.  If we develop AEROSURF or SURFAXIN LS for the treatment of RDS, this orphan drug designation willmay apply for that indication.those indications.  We are currently seeking the confirmation from the FDA.  The FDA has also granted Orphan Drug designation to (i) SURFAXINKL4 surfactant for the prevention and treatment of BPD in premature infants, (ii) our KL4 surfactant for the treatment of ARDS in adults, and (iii) our KL4 surfactant for the treatment of CF.

The European Commission grants “Orphan Medicinal Product” designation for pharmaceutical products for the diagnosis, prevention or treatment of a life-threatening or chronically debilitating condition affecting no more than 5 in 10,000 people which provides for exclusive marketing rights for indications in Europe for 10 years (subject to revision after six years) following marketing approval by the EMA.  In addition, the designation would enable us to receive regulatory assistance in the further development process, and to access reduced regulatory fees throughout its marketing life.  We have received Orphan Medicinal Product designation for (i) SURFAXINKL4 surfactant for the prevention andof RDS in premature infants, (ii) KL4 surfactant for the treatment of RDS in premature infants, (ii)(iii) our KL4 surfactant for the treatment of ALI in adults (which in this circumstance encompasses ARDS), and (iii)(iv) our KL4 surfactant for the treatment of CF.

Fast Track Designations

Designation as a “Fast Track” product means that the FDA has determined that the drug is intended for the treatment of a serious or life-threatening condition and demonstrates the potential to address unmet medical needs, and that the FDA will facilitate and expedite the development and review of the application for the approval of the product.  The FDA generally will review an NDA for a drug granted Fast Track designation within six months.

The FDA has granted “Fast Track” designation for (i) SURFAXIN for the prevention and treatment of BPD in premature infants, and (ii) our KL4 surfactant for the treatment of ARDS.

COMPETITION

We are engaged in the highly competitive fields of pharmaceutical research and development.  Competition from numerous existing companies and others entering the fields in which we operate is intense and expected to increase.  We expect to compete with among others, conventional pharmaceutical companies.companies, among others.  Most of these companies have substantially greater research and development, manufacturing, marketing, financial, technological personnel and managerial resources than we do.  Acquisitions of competing companies by large pharmaceutical or health care companies could further enhance such competitors’ financial, marketing and other resources.  Moreover, competitors that are able to complete clinical trials, obtain required regulatory approvals and commence commercial sales of their products before we do may enjoy a significant competitive advantage over us.  There are also existing therapies that may compete with the products we are developing.  See, “Item 1A – Risk Factors – Our industry is highly competitive and we have less capital and resources than many of our competitors, which may give them an advantage in developing and marketing products similar to ours or make our products obsolete.”

Currently, the FDA has approved surfactants as replacement therapy only for the prevention andand/or treatment of RDS in premature infants.  Administration of these surfactants requires invasive intubation and mechanical ventilation.  The most commonly used of these approved surfactants are Curosurf® (poractant (poractant alfa), which is derived from a chemical extraction process of porcine (pig) lung, and Survanta® (beractant), which is derived from a chemical extraction process of bovine (cow) lung.  Curosurf is marketed in Europe by Chiesi Farmaceutici S.p.A. and in the United StatesU.S. by its wholly-owned subsidiary, Cornerstone Therapeutics Inc.  In addition, Chiesi has published the results of a preclinical study in an early-stage effort to develop a synthetic surfactant (Sato A, Ikegami M (2012) SP-B and SP-C Containing New Synthetic Surfactant for Treatment of Extremely Immature Lamb Lung. PLoS ONE 7(7): e39392.doi:10.1371/journal.pone.0039392).  Chiesi has also initiated a first-in-human phase 2 clinical trial to study the safety and tolerability of intratracheal administration of two different single doses of its investigational synthetic surfactant in preterm neonates with RDS (clinicaltrials.gov). Survanta ishistorically has been marketed by the Abbott Nutritionals, Inc. (Abbott).  However, in December 2012, Abbott distributed to its shareholder a wholly-owned subsidiary, AbbVie Inc. (AbbVie), which separated Abbott’s research-based pharmaceuticals business, including Survanta, from the remainder of its businesses.  ONY, Inc. markets Infasurf®Infasurf®, a surfactant derived from calf lung surfactant extractlavage in the United States.U.S.

With respect to our drug delivery technologies, efforts to aerosolize animal-derived surfactants have not been very successful.  Recent studies suggest that to aerosolize a surfactant for delivery to premature infants, it is necessary to optimize the aerosol to a particular particle size range, use an aerosol generator with characteristics that are compatible with the patient’s breathing, and employ a delivery system that delivers sufficient drug product to the patient (Mazela, et. al., Aerosolized Surfactants, Current Opinion in Pediatrics 2007, 19:155–162; Finer, et. al., An Open Label, Pilot Study of AEROSURF Combined with nCPAP to Prevent RDS in Preterm Neonate, Journal of Aerosol, Medicine and Pulmonary Drug Delivery, Volume 23, Number 5, 2010).   There are a number of device manufacturers with aerosolization expertise, including Pari and Aerogen.  These companies manufacture aerosol devices such as nebulizers, aerosol masks, and compressors.  Pari, for example, has provided nebulizers for use in clinical research and in commercial product for several companies. Chiesi has recently investigated the use of nebulized Curosurf using a Pari eFlow Neonatal Nebulizer System (CureNeb study; PAS 2013 abstract  - http://www.abstracts2view.com/pas/view.php?nu=PAS13L1_3500.7).   Aerogen manufactures a number of aerosolization devices, including a disposable, single patient nebulizer and a reusable, multi-patient nebulizer. Our AFECTAIR device is an aerosol-conducting airway connector that is intended to replace standard connectors in the ventilatory circuit.  AFECTAIR has been shown in various studies to potentially increase the delivery of aerosolized medications.  Although we are not aware of any efforts by a competitor to develop an alternative to AFECTAIR, it may be viewed as competing with companies that are developing aerosol generators with the intent of improving the delivery of aerosols to infants.

GOVERNMENT REGULATION

The development, manufacture, distribution, marketing and advertising of drug, device, and combination drug-device products are subject to extensive regulation by federal, state and local governmental authorities in the United States,U.S., including the FDA, and by similar agencies in other countries.  Any product that we develop must receive all relevant regulatory approvals or clearances before it may be marketed in a particular country.  Gaining regulatory approval of a drug, device, or combination product candidate requires the expenditure of substantial resources over an extended period.  As a result, larger companies with greater financial resources will likely have a competitive advantage over us.

Drug Product Regulations

Development Activities:  To gain regulatory approval of our KL4 surfactant technology pipeline products, we must demonstrate, through experiments, preclinical studies and clinical trials that each of our drug product candidates meets the safety and efficacy standards established by the FDA and other international regulatory authorities.  In addition, we and our suppliers and contract manufacturersCMOs must demonstrate that all development-related laboratory, clinical and manufacturing practices comply with regulations of the FDA, other international regulators and local regulators.  Regulations establish standards for such things as drug substances, materials and excipients; medical device components, subassemblies and device manufacture; drug manufacturing operations and facilities, and analytical laboratories and medical device development laboratories processes and environments; in each instance, in connection with research, development, testing, manufacture, quality control, labeling, storage, record keeping, approval, advertising and promotion, and distribution of product candidates, on a product-by-product basis.  See, “Item 1A – Risk Factors – The regulatory approval process for our products is expensive and time-consuming and the outcome is uncertain.  We may not obtain required regulatory approvals for the commercialization ofto commercialize our products.”
Preclinical Studies and Clinical Trials:  Development testing generally begins with laboratory testing and experiments, as well as research studies using animal models to obtain preliminary information on a product’s efficacy and to identify any safety issues.  The results of these studies are compiled along with other information in an investigational new drug (IND) application, which is filed with the FDA.  After resolving any questions raised by the FDA, which may involve additional testing and animal studies, clinical trials may begin.  Regulatory agencies in other countries generally require a Clinical Trial Application (CTA) to be submitted and approved before each trial can commence in each country.

Clinical trials normally are conducted in three sequential phases and may take a number of years to complete.  Phasephase 1 consists of testing the drug product in a small number of humans, normally healthy volunteers, to determine preliminary safety and tolerable dose range.  Phase 2 usually involves studies in a limited patient population to evaluate the effectiveness of the drug product in humans having the disease or medical condition for which the product is indicated, determine dosage tolerance and optimal dosage and identify possible common adverse effects and safety risks.  Phase 3 consists of additional controlled testing at multiple clinical sites to establish clinical safety and effectiveness in an expanded patient population of geographically dispersed testclinical sites to evaluate the overall benefit-risk relationship for administering the product and to provide an adequate basis for product labeling.  Phase 4 clinical trials may be conducted after approval to gain additional experience from the treatment of patients in the intended therapeutic indication.

The conduct of clinical trials is subject to stringent medical and regulatory requirements.  The time and expense required to establish clinical sites, provide training and materials, establish communications channels and monitor a trial over a long period isare substantial.  The conduct of clinical trials at institutions located around the world is subject to foreign regulatory requirements governing human clinical trials, which vary widely from country to country.  Delays or terminations of clinical trials could result from a number of factors, including stringent enrollment criteria, slow rate of enrollment, size of patient population, having to compete with other clinical trials for eligible patients, geographical considerations and others.  Clinical trials are monitored by the regulatory agencies as well as medical advisory and standards boards, which could determine at any time to reevaluate, alter, suspend, or terminate a trial based upon accumulated data, including data concerning the occurrence of adverse health events during or related to the treatment of patients enrolled in the trial, and the regulator’s or monitor’s risk/benefit assessment with respect to patients enrolled in the trial.  If they occur, such delays or suspensions could have a material impact on our KL4 surfactant technology development programs.  See, “Item 1A–Risk Factors – Our research and development activitiesprograms, including for AEROSURF involve significant risks and uncertainties that are inherent in the clinical development and regulatory approval processes,processes.” and “– Our clinical trials may be delayed, or fail, which will harm our business.”

Regulatory Review:  The results of preclinical and clinical trials for drug products are submitted to the FDA in an NDA, with comparable filings submitted to other international regulators.  After the initial submission, the FDA has a period of time in which it must determine if the NDA is complete.  If an NDA is accepted for filing, following the FDA’s review, the FDA may grant marketing approval, request additional information, or deny the application if it determines that the application does not provide an adequate basis for approval.  If the FDA grants approval, the approval may be conditioned upon the conduct of post-marketing clinical trials or other studies to confirm the product’s safety and efficacy for its intended use.  Until the FDA has issued its approval, no marketing activities can be conducted in the United States.U.S.  Similar regulations apply in other countries.
After an NDA is submitted, although the statutory period provided for the FDA’s standard review is less thanapproximately one year, dealing with questions or concerns of the agency and, taking into account the statutory timelines governing such communications, may result in review periods that can take several years.  For example, theThe FDA has issuedmay decline to us three Approvable Lettersaccept an NDA and may deliver what is referred to as a Complete Response Letter indicating that our SURFAXIN® drug product may be approved if we satisfy certain conditions.  Although in many cases applicants are required todescribes the shortcomings of the application, including whether the applicant should consider additional clinical trials, which maycould have the effect of terminating a development program, the approvable letters and the Complete Response Letter that we have received did not require additional clinical trials demonstrating safety and efficacy.  Our development programs have, however, been substantially delayed as the FDA has required us to develop additional data to respond to the issues it has raised.  See, “Item 1A–Risk Factors – The 2009 Complete Response Letter and the resulting delay in our gaining approval of SURFAXIN has caused us to make fundamental changes in our business strategy and to take steps to conserve our financial resources, which may expose us to unanticipated risks and uncertainties.  We plan to continue assessing our regulatory position and available resources and may implement at any time additional and potentially significant changes to our business strategy, development programs and our operations, which, if adopted, could prove to be disruptive and detrimental to our development programs.program.

Manufacturing Standards:  The FDA and other international regulators establish standards and routinely inspect facilities and equipment, analytical and quality laboratories and processes used in the manufacturing and monitoring of products.  Prior to granting approval of a drug product, the agency will conduct a pre-approval inspection of the manufacturing facilities, and the facilities of suppliers, to determine that the drug product is manufactured in accordance with cGMP regulations and product specifications.  Following approval, the FDA will conduct periodic inspections.  If, in connection with a facility inspection, the FDA determines that a manufacturer does not comply with cGMP, the FDA will issue an inspection report citing the potential violations and may seek a range of remedies, from administrative sanctions, including the suspension of our manufacturing operations, to seeking civil or criminal penalties.  In connection with our efforts to gain FDA marketing approval for SURFAXIN, in January 2012, the FDA conducted a Pre-approval Inspection of our Totowa, NJ manufacturing operations and our analytical and testing laboratory in Warrington, PA, and other of the quality assurance/quality control facilities for SURFAXIN including those of our third-party raw material suppliers and testing laboratories.  On February 24, 2012, the FDA issued an EIR recommending approval of our Totowa, NJ manufacturing operations for the manufacture of SURFAXIN.  The FDA may determine to conduct such inspections at any time.  See, “Item 1A – Risk Factors – Manufacturing problems potentially could cause us to delay preclinical or clinical programs, or, if our products are approved, product launch, or cause us to experience shortages of products inventories, which could have a material adverse effect on our business.”

International Approvals:  In addition to seeking regulatory approval to market our products in the United States, we also will need to apply for approval with other international regulators.  Regulatory requirements and approval processes are similar in approach to that of the United States.  With certain exceptions, although the approval of the FDA carries considerable weight, international regulators are not bound by the findings of the FDA and there is a risk that foreign regulators will not accept a clinical trial design or may require additional data or other information not requested by the FDA.  In Europe, there is a centralized procedure available under which the EMA will conduct the application review and recommend marketing approval to the European Commission, or not, for the sale of drug products in the EU countries.

Post-approval Regulation:  Following the grant of marketing approval, the FDA regulates the marketing and promotion of drug products.  Promotional claims are generally limited to the information provided in the product package insert for each drug product, which is negotiated with the FDA during the NDA review process.  In addition, the FDA enforces regulations designed to guard against conflicts of interest, misleading advertising and improper compensation of prescribing physicians.  The FDA will review, among other things, direct-to-consumer advertising, prescriber-directed advertising and promotional materials, sales representative communications to healthcare professionals, promotional programming and promotional activities on the Internet.  The FDA will also monitor scientific and educational activities.  If the FDA determines that a company has promoted a product for an unapproved (off-label) use, (“off-label”), or engaged in other violations, it may issue a regulatory letter and may require corrective advertising or other corrective communications to healthcare professionals.  Enforcement actions may also potentially include product seizures, injunctions and civil or criminal penalties.  The consequences of such an action and the related adverse publicity could have a material adverse effect on a developer’s ability to market its drug and its business as a whole.  Regulation and enforcement of advertising and promotion by institutions other than FDA are discussed below.

Following approval, the FDA and other international regulators will continue to monitor data to assess the safety and efficacy of an approved drug.  A post-approval discovery of previously unknown problems or failure to comply with the applicable regulatory requirements may result in restrictions on the marketing of a product or a recall or withdrawal of the product from the market, as well as possible civil or criminal sanctions.  Similar oversight is provided by international regulators.

Medical Device Products

To varying degrees, each of the regulatory agencies having oversight over medical devices, including the FDA and comparable foreign regulators, has laws and regulations governing the development, testing, manufacturing, labeling, marketing, and distribution of medical devices.  In the U.S., medical device products are subject to regulation that is intended to calibrate regulatory requirements to the issues of safety and efficacy presented by specific devices.  Medical devices are classified into one of three classes based on the level of control necessary to assure the safety and effectiveness of the device.  The three classes and the requirements that apply to them are: (i) Class I General Controls, with exemptions and without exemptions, (ii) Class II General Controls and Special Controls, with exemptions and without exemptions, and (iii) Class III General Controls and Premarket Marketing authorization.  The class to which a device is assigned determines the process that applies for gaining marketing authorization.  Most Class I devices are exempt from Premarket Notification 510(k); most Class II devices require Premarket Notification 510(k); and most Class III devices require Premarket Marketing authorization.

Combination Drug-Device Products

Combination drug products such as AEROSURF® and potentially other of our aerosolized KL4 surfactant drug product candidatesproducts are similarly subject to extensive regulation by federal, state and local governmental authorities in the United StatesU.S. and in other countries.  Combination products involve review of two or more regulated components that might normally be reviewed by regulatory authorities having different expertise and may involve more complicated and time-consuming regulatory coordination, approvals and clearances than a drug product alone.  In the United States,The FDA has determined that our aerosolized KL4 surfactant combination drug-device product will be evaluated as a drug and, therefore, will be reviewed by the Center for Drug Evaluation and Research (CDER) of the FDA, with input from the division that approves medical devices.Center for Devices and Radiological Health (CDRH).  Among other things, we will have to demonstrate compliance with both cGMP, to ensure that the drug possesses adequate strength, quality, identity and purity, and applicable Quality System Regulations (QSR), to ensure that the device is in compliance with applicable performance standards.  Although cGMP and QSR overlap in many respects, each is tailored to the particular characteristics of the types of products to which they apply, such that compliance with both cGMP and QSR may present unique problems and manufacturing challenges.

Medical Device Products

To varying degrees, each of the regulatory agencies having oversight over medical devices, including the FDA and comparable foreign regulators, has laws and regulations governing the development, testing, manufacturing, labeling, marketing, and distribution of medical devices.  In the United States, medical device products are subject to regulation that is intended to calibrate regulatory requirements to the issues of safety and efficacy presented by specific devices.  Medical devices are classified into one of three classes based on the level of control necessary to assure the safety and effectiveness of the device.  The three classes and the requirements that apply to them are: (i) Class I General Controls, with exemptions and without exemptions, (ii) Class II General Controls and Special Controls, with exemptions and without exemptions, and (iii) Class III General Controls and Premarket Marketing authorization.  The class to which a device is assigned determines the process that applies for gaining marketing authorization.  Most Class I devices are exempt from Premarket Notification 510(k); most Class II devices require Premarket Notification 510(k); and most Class III devices require Premarket Marketing authorization.
Manufacturing Standards

Exempt Class I Medical Device:The FDA and other international regulators establish requirements and standards and routinely inspect the quality system, facilities,  equipment, processes, and analytical  laboratories  used in the manufacturing and monitoring of products.  Prior to marketing an exempt Class I medical device,granting approval of a drug product, the manufacturer must register its establishment, list the generic category or classification nameFDA will conduct a pre-approval inspection of the medical device being marketedmanufacturing facilities and paythe facilities of suppliers to determine that the drug product is manufactured in accordance with cGMP regulations and product specifications.  Following approval, the FDA will conduct periodic inspections.  If, in connection with a registration fee.  We have consulted with our regulatory experts and believe that AFECTAIR® qualifies as an exempt Class I medical device.  We therefore plan to comply with the registration requirements applicable to Class I medical devices.  Once registered, we would be required to update and renew our registration annually.

510(k) Clearance Process:  If for any reason,facility inspection, the FDA determines that a manufacturer does not comply with cGMP, the FDA will issue an inspection report citing the potential violations and may seek a range of remedies, from administrative sanctions, including the suspension of our manufacturing operations, to seeking civil or criminal penalties.  The FDA may determine to conduct such inspections at any time and for any reason.  See, “Item 1A – Risk Factors – Manufacturing problems potentially could cause us to experience shortages of SURFAXIN and AFECTAIR isproduct inventories, or delay our preclinical or clinical programs, which could have a Class II medical device, we would havematerial adverse effect on our business.”

International Approvals

In addition to obtain FDA clearance, before marketing AFECTAIRseeking regulatory approval to market our products in the U.S., throughwe also expect to apply for such approval with other international regulators.  Regulatory requirements and approval processes are similar in approach to that of the 510(k) clearance process.  We believe that if weU.S. but are required to seek marketing authorization usingnot harmonized.  International regulators are independent and not bound by the 510(k) clearance process, we will be able to complete the process and launch AFECTAIR within the time frames set forth above.  The 510(k) clearance process is available if we can demonstrate that AFECTAIR is substantially equivalent to a legally marketed medical device.  In this process, we would be required to submit data that supports our equivalence claim.  We must receive an order fromfindings of the FDA finding substantial equivalence to another legally marketed medical device before we can commercially distribute AFECTAIR.  Modifications to cleared medical devices can be made without using the 510(k) process if the changes do not significantly affect safety or effectiveness.

Pre-market Marketing Authorization: A more rigorous and time-consuming process applicable to Class III medical devices, known as pre-market marketing authorization (PMA), would require us to independently demonstrate that AFECTAIR is safe and effective.  We would do this by collecting data regarding design, materials, bench and animal testing, and human clinical data for the medical device.  The FDA will authorize commercial release of a Class III medical device if it determines there is reasonable assurancea risk that foreign regulators will not accept clinical trial design/results or may require additional data or other information not requested by the medical device is safe and effective.  This determination is based on benefit outweighing risk for the population intended to be treated with the device.  This process is much more detailed, time-consuming and expensive than the 510(k) clearance process.  We do not believe that we will be required to file an application for PMA.

CE Marking Process:  The European Union has comparable regulations to the FDA for the registration or marketing authorization of medical devices.  We believe that in the European Union AFECTAIR will be classified as a Class IIa device, which will require us to obtain a “CE mark” by filing a statement of registration.  We must first seek a review of a third-party “Notified Body” that will conduct an audit to ensure that our manufacturers and we are in compliance with applicable quality regulations, and, if the audit is successful, will certify the product for a CE mark.  We are working with a regulatory services firm to obtain CE marking.  The regulatory services firm will assist us with compiling the required technical file, labeling review, a clinical evaluation report to support CE marking, design control and quality system implementation, subcontractor audit and general regulatory consulting.  In addition, in the European UnionFDA.  Therefore, we will have to designate a single Authorized Representative located in the European Union to interactcomply with the local authoritiesboth cGMP and respond to technical document requests.  The Authorized Representative will be responsible for preparing supplemental submissions to member states that have additional requirements for marketing authorization.International Conference on Harmonization (ICH) guidelines.
Anti-Kickback, False Claims Act, and Other Laws Regarding Advertising and Promotion

Other Regulatory Requirements: Pervasive and Continuing Regulation
After a device is placed on the market, numerous regulatory requirements may apply.  These include:

●product listing and establishment registration, which helps facilitate FDA inspections and other regulatory action;
●  Quality System Regulation (“QSR”), which is the medical device term for good manufacturing practices, requires manufacturers, including third-party manufacturers, to follow stringent design, testing, control, documentation and other quality assurance procedures during all aspects of the manufacturing process;
●  labeling regulations and FDA prohibitions against the promotion of products for uncleared, unapproved or off-label use or indication;
●  clearance of product modifications that could significantly affect safety or efficacy or that would constitute a significant change in the safety or efficacy of our cleared devices;
●  medical device reporting regulations, which require that manufacturers comply with FDA requirements to report if their device may have caused or contributed to a death or serious injury, or has malfunctioned in a way that would likely cause or contribute to a death or serious injury if the malfunction of the device or a similar device were to recur;
●  post-approval or post-clearance restrictions or conditions, including post-approval or post-clearance study commitments;
●  post-market surveillance regulations, which apply when necessary to protect the public health or to provide additional safety and effectiveness data for the device; and
●the FDA’s recall authority, whereby it can ask, or under certain conditions order, device manufacturers to recall from the market a product that is in violation of governing laws and regulations.
Advertising and promotionIn addition to FDA’s ongoing post-approval regulation of drugs, devices, and medical devices, in additioncombination products discussed above, several other types of laws and regulations, subject to being regulated by the FDA, are also regulated by the Federal Trade Commissiondiffering enforcement regimes, govern advertising and by state regulatory and enforcement authorities.  Recently,promotion.   In recent years promotional activities forof FDA-regulated products of certain companieshave come under intense scrutiny and have been the subject of enforcement action brought by the Department of Justice (DOJ), state authorities, and even private individuals.

The federal Anti-Kickback statute prohibits, among other things, knowingly and willfully offering, paying, soliciting or receiving remuneration to induce or in return for purchasing, leasing, ordering or arranging for the purchase, lease or order of any healthcare item or service reimbursable under health care reimbursementMedicare, Medicaid or other federally financed healthcare programs. This statute has been interpreted to apply to arrangements between pharmaceutical or device manufacturers, on the one hand, and prescribers, purchasers, and formulary managers on the other. Violations are punishable by imprisonment, criminal fines, civil monetary penalties and exclusion from participation in federal healthcare programs.   Any sales or marketing practices that involve remuneration intended to induce prescribing, purchases, or recommendations may be subject to scrutiny under the Anti-Kickback statute.  Many states have likewise adopted state anti-kickback statutes, and enforcement has been significant.
Another development affecting the healthcare industry is the increased use of the federal civil False Claims Act to impose liability on any person or entity who, among other things, knowingly presents, or causes to be presented, a false or fraudulent claim for payment by a federal healthcare program.  If certain conditions are met, the False Claims Act allows a private individual called a “whistleblower” to bring a civil action on behalf of the federal government and to share in any monetary recovery.  In recent years, the number or suits brought by private individuals has increased dramatically.  In addition, many states have enacted false claim laws similar to the federal False Claims Act.
A host of other laws and consumer protection statutes.  In addition, underregulations govern the advertising and promotion of drugs and devices.  The federal “Open Payments” law (previously referred to as “Sunshine Law”), which is part of the Patient Protection and Affordable Care Act, as amended by the Health Care and Education Reconciliation Act, each enacted in March 2010, imposes federal transparency provisions, requiring annual reporting of various types of payments to physicians and teaching hospitals.   Implementation of the Open Payments provisions has been subject to delay by the U.S. Centers for Medicare and Medicaid Services (CMS).  Under the current regime, applicable manufacturers were to begin tracking relevant transfer-of-value data in August 2013, and must report data collected between August 1 and the end of 2013 to CMS in a two-phased approach by March 31, and May 31, 2014, respectively.  CMS will publish the data on a public website later in the year.  Inaccurate or incomplete reports may be subject to enforcement.   Like the federal Open Payments law, several states have existing laws that require manufacturers to report transfers of value to select healthcare providers licensed within the state.   Additionally, other laws such as the federal Lanham Act and similar state laws allow competitors and others canto initiate litigation relating to advertising claims.  In addition, we are required to meet regulatory requirements inAdditionally, the U.S. Foreign Corrupt Practices Act and local laws of other countries outsidepotentially implicate the U.S., whichsale and marketing of drugs and devices internationally.  This complex patchwork of laws can change rapidly with relatively short notice.  If the FDA determines that our promotional materials or training constitutes promotion of an unapproved or uncleared use, it could request that we modify our training or promotional materials or subject us to regulatory or enforcement actions, including the issuance of an untitled letter, a warning letter, injunction, seizure, civil fine or criminal penalties.  It is also possible that other federal, state or foreign enforcement authorities will take action if they consider our promotional or training materials to constitute promotion of an unapproved use, which could result in significant fines or penalties under other statutory authorities, such as laws prohibiting false claims for reimbursement.  In that event, our reputation could be damaged and adoption of the products would be impaired.  In addition to this domestic US regulatory scheme, there are numerous additional regulatory considerations pertaining to medical devices in foreign jurisdictions.

SURFAXIN is our first approved drug product in the United StatesU.S. and AFECTAIR is our first approvedregistered medical device in the United States.U.S.  None of our other products under development has been approved for marketing in the United StatesU.S. or elsewhere.  We may not be able to obtain regulatory approval for any of these products.  If we do not obtain the requisite governmental approvals or if we fail to obtain approvals of the scope we request, we or our licensees or strategic alliance or marketing partners may be delayed or precluded entirely from marketing our products, or the commercial use of our products may be limited.  Such events would have a material adverse effect on our business, financial condition and results of operations.  See, “Item 1A – Risk Factors – Our technology platform is based solely on our proprietary KL4 surfactant technology, our novel CAG technology, and our novel patient interface and related componentry”;aerosol-conducting airway connector;” “– Our research and development activitiesprograms, including for AEROSURF involve significant risks and uncertainties that are inherent in the clinical development and regulatory approval processes”,  “– Our ongoing clinical trials may be delayed, or fail, which will harm our business”, “– We may not successfully develop and market our products, and even if we do, we may not become profitable,processes,” “– The regulatory approval process for our products is expensive and time-consuming and the outcome is uncertain.  We may not obtain required regulatory approvals for the commercialization ofto commercialize our products,” and “– Even assuming thatif we gainsucceed in gaining regulatory approval to market our drugs, if the FDA and foreign regulators later withdraw their approval or otherwise restrict marketing, our business would be materially harmed.”

Certain of our product candidates may qualify for Fast Track and/or Orphan Drug designation.  Fast Track designation, means that the FDA has determined that the drug is intended to treat a serious or life-threatening condition and demonstrates the potential to address unmet medical needs.  An important feature is that it provides for accelerated approval and the possibility of rolling submissions and emphasizes the critical nature of close, early communication between the FDA and sponsor to improve the efficiency of product development.  The FDA generally will review an NDA for a drug granted Fast Track designation within six months instead of the typical review cycle that can extend a year or more. Orphan Drug designation, is granted to pharmaceutical products that are intended to address diseases affecting fewer than 200,000 patients in the United States and provides certain advantages to the Orphan Drugs sponsors, including, but not limited to, seven years ofor other potential expedited regulatory pathway options.  Each potential expedited regulatory pathway could provide for expedited FDA communication or approval, as well as additional potential benefits, such as additional market exclusivity upon approval of the drug, certainor tax incentives for clinical research and grants to fund testing of the drugs.incentives.  See, “Item– Licensing, Patents and Other Proprietary Rights and Regulatory Designations – Patents and Proprietary Rights – Other Regulatory Designations,” and “Item 1A – Risk Factors – Even though some of our product candidates have qualified for expedited review, the FDA may not approve them at all or any sooner than other product candidates that do not qualify for expedited review,review.” and  “– Licensing, Patents and Other Proprietary Rights and Regulatory Designations – Patents and Proprietary Rights – Other Regulatory Designations.”
 

EMPLOYEES

As of March 21, 2012,7, 2014, we have 73 employees, 70126 employees.  Of this total, 14 (approximately 11% of which are full-time, three are part-time and 14our total labor force) are employed in connection withat our manufacturing operations in Totowa New Jersey,Facility, and are subject to a collective bargaining agreement that expires on December 3, 2012.2015.  All are employed in the United States.U.S.  See, “Item 1A – Risk Factors – We depend upon key employees and consultants in a competitive market for skilled personnel.  If we or our partners or collaborators are unable to attract and retain key personnel, it could adversely affect our ability to develop and market our products.”See also, “Part III – Item 10 – Directors, Executive Officers and Corporate Governance,” and “– Item 11 – Executive Compensation.”

AVAILABLE INFORMATION

We file annual, quarterly and current reports, proxy statements and other information with the Securities and Exchange Commission.Commission (SEC).  You may read and copy any materials that we file with the SEC at the SEC’s Public Reference Room at 100 F Street, N.E., Washington, D.C. 20549.  You may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330.  Many of our SEC filings are also available to the public from the SEC’s website at “http://www.sec.gov.”  We make available for download free of charge through our website our Annual Report on Form 10-K, our quarterly reports on Form 10-Q and current reports on Form 8-K, and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Exchange Act as soon as reasonably practicable after we have filed it electronically with, or furnished it to, the SEC.
We maintain a websitewebsites at http://www.DiscoveryLabs.com.www.DiscoveryLabs.com, www.SURFAXIN.com, and www.AFECTAIR.com.  Our websitewebsites and the information contained therein or connected thereto are not incorporated into this Annual Report on Form 10-K.

ITEM 1A.
RISK FACTORS.

You should carefully consider the following risks and any of the other information set forth in this Annual Report on Form 10-K and in the documents incorporated herein by reference, before deciding to invest in shares of our common stock.  The risks described below are not the only ones that we face.  Additional risks that are not presently known to us or that we currently deem immaterial may also impair our business operations.  The following risks, among others, could cause our actual results, performance, achievements or industry results to differ materially from those expressed in our forward-looking statements contained herein and presented elsewhere by management from time to time.  If any of the following risks actually occurs, our business prospects, financial condition or results of operations could be materially harmed.  In such case, the market price of our common stock would likely decline due to the occurrence of any of these risks, and you could lose all or part of your investment.

We may failwill require in the development and commercialization of our products.

Although we have regulatory clearance to market SURFAXIN® and AFECTAIR®, they are not currently available for sale and we have no other products approved for marketing.  We are implementing a plan intended to result in the commercial introduction of SURFAXIN and AFECTAIR in late 2012.  We are conducting research and development on our other product candidates.  As a result, we have not begun to market or generate revenues from the commercialization of any of our products.

Wenear term, but may experience a delay in, or be unable to achieve, the commercial introduction of, SURFAXIN and AFECTAIR in the United States and other markets as planned, or we may not successfully develop and marketsecure when needed, significant additional capital to support our other KL4 surfactant and aerosol delivery pipeline products.  Our long-term viability will be impaired if we experience a significant delay  or failure to successfullyoperations, pay our debt service, commercialize our approved products or obtain regulatory approval for and successfully market, our product candidates.  Even if we successfully develop and gain regulatory approval for our products we still may not generate sufficient or sustainable revenues or we may not become profitable, which could have a material adverse effect on our ability to continue our marketing and distribution efforts, research andunder development, programs and operations.

We will require significant additional capital to continue our planned research and development activities and continue our operations.  Moreover, such additional financing could result in equity dilution.

Until we are able to generate sufficient revenues from the sale of SURFAXIN and AFECTAIR, we will need substantial additional funding to support our commercial operations and our ongoing research and development activities and our operations.  Our current plans are to focus our resources on our lead drug product and device development programs, SURFAXIN LS™ andincluding AEROSURF®, and on beingto continue our other research and development programs.  Moreover, any financings could result in a positionsubstantial dilution to initiate key clinical programs after we have secured the necessary capital.  We would preferour stockholders, cause our stock price to accomplishfall and adversely affect our objectives through strategic alliances and collaboration arrangements.  If we are unableability to raise substantial additional funds through strategic alliances or other alternatives, including potentially future debt and equity financings, we may be forced to further limit investments in our development programs, which could have a material adverse effect on our business.  In the meantime, as we continue to conserve our financial resources, we will likely experience additional delays in our development programs.capital.

Our operations have consumed substantial amounts of cash since inception.  As of December 31, 2011,2013, we have an accumulated deficit of approximately $397.4$480 million and we expect to continue to incur significant, increasing operating losses over the next several years.  To date, we have generated capital to support our activities primarily from equity financings, research grants, collaboration agreements, and investments.  As of December 31, 2011,2013, we had cash and cash equivalents of $10.2 million.  In the first quarter 2012,approximately $86.3 million and $30 million ($18.4 million net of discount) of long-term debt under a secured loan (Deerfield Loan) with affiliates of Deerfield Management, L.P.(Deerfield).  During 2013, we receivedraised aggregate gross proceeds of $75.8 million through public offerings of our common stock, including net proceeds of approximately $50.3$1.8 million from that we raised under our ATM Program.  On November 8, 2013, we announced the commercial launch of SURFAXIN®. Before any additional financings, including under our ATM Program, we anticipate that we will have sufficient cash available to support our operations and debt service obligations through the exercisethird quarter of warrants to purchase shares of our common stock.  2015.

We expect to continue to require significant additional infusions of capital to execute our business strategy until such time as the net revenues from SURFAXIN and, potentially, AEROSURF, and from potential strategic alliance and collaboration arrangements and other sources, are sufficient to offset our cash outflows in 2012 to increase asflow requirements.  Even if we invest in our commercial and medical affairs organization and prepare forsucceed with the commercial introduction of SURFAXIN, we expect our approved products.


Our ability to fund our research and development activitiesrevenues from SURFAXIN will be modest in the future is dependent uponfirst 12-24 months and then increase slowly over time.  For the next several years, we expect that our ability tocash outflows for development programs, operations and debt service will far outpace the rate at which we may generate revenues from the saleproduct sales.  See, “Item 7 – Management’s Discussion and Analysis of approved productsFinancial Condition and raiseResults of Operations – Liquidity and Capital Resources.”

We cannot be certain that additional capital to fund our research and development and commercial programs and meet our obligationsfunding will be available on a timely basis.  We are seeking strategic alliances to support the development of SURFAXIN LS and AEROSURF and, if approved, to commercialize these product candidates in the European Union and other markets outside the United States.  Even if  we are successful in generating revenues from the sale of approved products, we will likely not have sufficient cash flow and liquidity to fund our research and development programs, and will require additional capital through strategic alliances and other financing alternatives.acceptable terms, or at all.  If we are unable to successfully raise the necessary additional capital in sufficient amounts or on terms acceptable to us, we will likely notmay have sufficient cash flow and liquidity to fundsignificantly delay, scale back or discontinue the development or commercialization of our products or our research and development programs.  We also could be required to:

seek collaborators for one or more of our development programs which will force usfor territories that we had planned to curtailretain or on terms that are less favorable than might otherwise be available; and/or
relinquish or license on unfavorable terms our activities and, ultimately, potentially cease operations.  Even ifrights to technologies or product candidates that we otherwise would seek to develop or commercialize ourselves.

If we are ableunable to raisesecure capital from strategic alliances and collaboration arrangements and other similar transactions, we may seek additional capital such financings may only be availablefrom the public markets, which could have a dilutive impact on unattractive terms,our stockholders and the issuance, or even potential issuance, of shares could result in significant dilution of stockholders’ interests and, in such event,have a negative effect on the market price of our common stock may decline.

In addition, dependingstock.  Depending on conditions in the global financial markets, we may face significant challenges accessing the capital markets at a time when we would like or require, and at an increased cost of capital.  Except for our CEFF and our at-the-market equity program with Stifel, Nicolaus & Company, Incorporated (ATM Program (which are subject to certain limitations)), which can be cancelled at any time, we currently do not have in place arrangements to obtain additional financing.capital.  Any such financing could be difficult to obtain or only available on unattractive terms and could result in significant dilution of stockholders’ interests.  In any such event, the market price of our common stock may decline.  In addition, failure to secure any necessary financing in a timely manner and on favorable terms could have a material adverse effect on our business plan, financial performance and stock price and could delay new product development and clinical trial plans.
The financial and operational projections that we may make from time to time are subject to inherent risks.

The projections that our management may provide from time to time (including, but not limited to, those relating to product approval, production and supply dates, commercial launch dates, and other financial or operational matters) reflect numerous assumptions made by management, including assumptions with respect to our specific as well as general business, economic, market and financial conditions and other matters, all of which are difficult to predict and many of which are beyond our control. Accordingly, there is a risk that the assumptions made in preparing the projections, or the projections themselves, will prove inaccurate. There will be differences between actual and projected results, and actual results may be materially different from those contained in the projections. The inclusion of the projections in (or incorporated by reference in) this Annual Report on Form 10-K should not be regarded as an indication that we or our management or representatives considered or consider the projections to be a reliable prediction of future events, and the projections should not be relied upon as such.

Our clinical development program for AEROSURF involves significant risks and uncertainties that are inherent in the clinical development and regulatory approval processes.  Our clinical trials may be delayed, or fail, which will harm our business prospects.

ToWe are currently conducting a phase 2a clinical trial, which is an open label, single-dose study with the primary goal of evaluating the safety and tolerability of aerosolized KL4 surfactant drug product administered in escalating inhaled doses in premature infants 29 to 32 weeks gestational age who are receiving nasal continuous positive airway pressure (nCPAP) for respiratory distress syndrome (RDS), compared to infants receiving nCPAP alone.  This initial clinical trial is the first in a series of clinical trials that will be needed to gain marketing authorization for AEROSURF.  Such programs generally take two to five years or more to complete and may be delayed by a number of factors.  We may not reach agreement with the U.S. Food and Drug Administration (FDA) or a foreign regulator on the design of any one or more of the clinical trials necessary for approval, or we may be unable to reach agreement on a single design that would permit us to conduct a single clinical program.  Conditions imposed by the FDA and foreign regulators on our clinical program could significantly increase the time required to complete and the costs of conducting clinical trials.  For example, we may not be successful in achieving a study design that is acceptable to both the FDA and regulators in other countries, which would cause us to limit the scope of our activities or greatly increase our investment.  Like many biotechnology companies, even after obtaining promising preliminary findings or results in earlier preclinical studies and clinical trials, we may suffer significant setbacks in any stage of our clinical trials.  Clinical data is susceptible to varying interpretations that may delay, limit or prevent regulatory approval.  In addition, we may be unable to enroll patients quickly enough to meet our expectations for completing any or all of these trials.

The timing and completion of current and planned clinical trials of our product candidates depend on many factors, including the rate at which patients are enrolled.  Delays in patient enrollment in clinical trials may occur, which would be likely to result in increased costs, program delays, or both.  Patient enrollment is a function of many factors, including:

the number of clinical sites;
the size of the patient population;
the eligibility and enrollment criteria for the study;
the willingness of patients’ parents or guardians to participate in the clinical trial;
the existence of competing clinical trials;
the existence of alternative available products; and
geographical and geopolitical considerations.

If in our clinical trials, we succeed in achieving our patient enrollment targets, our patients could suffer adverse medical events or side effects that are known to be associated with surfactant administration, such as a decrease in the oxygen level of the blood, or currently unknown to us.  It is also possible that we, our AEROSURF Clinical Trial (ACT) Steering Committee, the Safety Review Committee (SRC), or the FDA could interrupt, delay or halt any one or more of our clinical trials for AEROSURF or any of our product candidates.  If our ACT Steering Committee, the SRC, any regulator or we believe that study participants face unacceptable health risks, any one or more of our clinical trials could be suspended or terminated.  In addition, clinical trials may be interrupted, delayed or halted, in whole or in part, for reasons other than health and safety concerns, including, among other things, matters related to the design of the study, drug availability, ACT Steering Committee and/or SRC recommendation, or business reasons.

In addition to our planned clinical program to support AEROSURF, in the commercializationfuture, we also may initiate or support clinical trials evaluating other KL4 surfactant pipeline products.  All of these clinical trials will be time-consuming and potentially costly.  Should we fail to complete our clinical development programs or should such programs yield unacceptable results, such failures would have a material adverse effect on our business.

If we fail to successfully commercialize SURFAXIN, or if our efforts to commercialize SURFAXIN are significantly delayed or impaired, our ability to grow our revenues and continue our development programs  will be impaired, and we may be unable to secure the additional capital that we require, which would have a material adverse effect on our business, financial condition and results of operations and the price of our common stock would likely decline.

We initiated the commercial introduction of SURFAXIN in late 2013.  SURFAXIN product sales are expected to constitute most, if not all, of our total revenue from product sales over the next several years.  Our efforts to successfully execute the commercial introduction of SURFAXIN are subject to a variety of risks and uncertainties that could cause actual results to be materially different.  The commercial success of SURFAXIN and our ability to generate and increase revenues will depend on a number of factors, including the following:

the number of hospitals and critical-care centers that agree to place SURFAXIN drug product on their formulary lists and the length of time required to achieve broad formulary acceptance;
the willingness of hospitals to accept and employ WARMING CRADLE® dry-block heater, a device that warms drug vials at the same temperature and for the time period designated in the SURFAXIN prescribing information;
the effectiveness of our marketing, sales and medical affairs organizations and their ability to (a) accurately describe SURFAXIN consistent with its approved labeling, and (b) educate and provide critical care providers and hospitals with medical and scientific education and information;
our ability to gain access to the entire market with our commercial organization;
our ability to provide hospitals acceptable evidence of the safety and efficacy of SURFAXIN and the perceived advantages of SURFAXIN, a synthetic peptide-containing surfactant, over alternative animal-derived surfactants;
the pharmacoeconomic benefits (which are determined by comparing, among other things, the cost and effects of a product when compared to different treatment options) and cost-effectiveness of our products;
the impact of adding SURFAXIN and WARMING CRADLE heater to formulary and medical device hospital lists and the availability, cost and potential advantages of alternative treatments, including less expensive generic drugs and other competitive products;
the availability of different size drug vials and medical devices to meet the specific needs of healthcare practitioners;
the claims, limitations, warnings and other information that appear in the package insert and labeling of SURFAXIN drug product;
the willingness of third-party payers, including government payers, to provide coverage and reimbursements to patients, physicians and other providers who wish to prescribe and use our products;
our ability to secure and maintain regulatory marketing approvals from the U.S. and foreign regulatory authorities;
the rate of preterm births;
the number of infants who are diagnosed with RDS and the number treated with SURFAXIN;
the growth of commercial sales;
our ability to meet commercial demand for SURFAXIN, including through maintenance of commercial supplies of our active drug substances and other excipients, and manufacturing capabilities, by ourselves and through contract manufacturing organizations (CMOs); and commercial inventory supplies of our medical device products; and
the sufficiency of coverage or reimbursement by third parties.

Generally, before we can attempt to sell products in a hospital, drug products must be approved for addition to that hospital’s list of approved drugs, or formulary list, by the hospital’s Pharmacy and Therapeutics (P&T) committee.  A hospital’s P&T committee typically governs all matters pertaining to the use of medications within the institution, including the review of medication formulary data and recommendations for the appropriate use of drugs within the institution to the medical staff.  The frequency of P&T committee meetings at hospitals varies considerably, and P&T committees often require additional information to aid in their decision-making process.  Therefore, we may experience substantial delays in obtaining formulary approvals.  In addition, our AFECTAIR®, device must be approved for use by hospitals’ materials management, and we planwill need to establisharrange with each hospital to include WARMING CRADLE on the hospital’s list of approved laboratory equipment.  There can be no assurance that we will successfully gain the required hospital approvals for our products.  Additionally, hospitals may be concerned that the cost of acquiring our products for use in their institutions will adversely impact their overall budgets, which could cause resistance to efforts to add our drugs to the formulary and products to the materials list, or cause hospitals to implement restrictions on the usage of our drugs and products in order to control costs.  We cannot guarantee that we will be successful in obtaining the approvals we need from enough hospitals quickly enough to optimize hospital sales of SURFAXIN, AFECTAIR or our other products.

Our efforts to achieve formulary acceptance of SURFAXIN, and to educate the medical community and third-party payers regarding the benefits of SURFAXIN will require significant, focused and competent resources and we may not be successful in achieving our objectives.  If we are unable to achieve formulary acceptance in our target hospitals, the revenues we generate from sales will be limited and we may never achieve profitability.
The commercial success of our product candidates, including SURFAXIN, AFECTAIR, and, if  approved, AEROSURF, will depend in large part upon the degree of market acceptance by physicians, patients, healthcare payers and others in the medical community.

Even if we are successful in achieving formulary acceptance of SURFAXIN and, if approved, AEROSURF, and adoption of AFECTAIR device, in our target hospitals, if we do not achieve broad market acceptance of our products by physicians, respiratory therapists, nurses and other personnel in neonatal and pediatric intensive care units (NICUs and PICUS) and elsewhere in the hospital, as well as patients, healthcare payers and others in the medical community in general, we may not generate sufficient revenues to support continued commercialization of these and our other products, if approved for commercial sale.  The degree of market acceptance of our approved products will depend on a number of factors, including:

the willingness of physicians and hospitals to utilize our products and the willingness of hospitals’ P&T Committees to place our products on formulary or on the list of medical devices the hospital will purchase;
the safety and efficacy of our products, both in fact and as perceived by the medical community, regulatory agencies and insurers and other payers, on both a short and long-term basis;
the potential advantages of our products over alternative treatments;
the relative convenience and ease of use;
the prevalence and severity of any adverse events, including any unexpected adverse events of which we become aware; and
the degree to which the market believes that we are able to manufacture our products and produce supply sufficient to meet market demand.

As a company, we have limited experience in the field of marketing or selling pharmaceutical and medical device products and limited marketing capabilities, which may restrict our success in commercializing our products.  We have established our own commercial and medical affairs organization enter into distribution arrangementsto launch our products in the U.S.  While we believe that this strategy greatly improves our ability to introduce our products in the U.S., it may also increase the cost to commercialize our products.

We have limited experience in marketing or selling pharmaceutical and medical device products, although we have endeavored to hire individuals that have significant experience in markets outside the United States, seek one neonatal indications and/or more strategic allianceshospital-based products.  We plan to rely solely on our own specialty respiratory critical care commercial and medical affairs organization to market and support the developmentSURFAXIN, and, if approved, commercialization of our KL4 surfactant productsAEROSURF and AFECTAIR devices.  If we enter into distributor arrangements or strategic alliances, we may be required to transfer rights to our products and will be exposed to risks associated with the transfer of control to third parties.

To support the commercial introduction ofpotentially SURFAXIN and AFECTAIRLS™, if approved, in the United States, we U.S.  We also plan to establishrely on our own commercial and medical affairs organization.  In addition,organization to introduce AFECTAIR device in the U.S.  We believe that AFECTAIR device will be of interest to many of the same hospitals, neonatologists and neonatal intensive care units that purchase SURFAXIN.  Commercializing our products in the U.S. on our own may cause our commercialization costs to increase, but will potentially avoid the transfer of rights to our products or drug product candidates and thereby potentially increase the revenue opportunity.  Building our own commercial and medical affairs capabilities is potentially expensive and time-consuming and requires a substantial capital investment.  Recruiting, training and retaining qualified personnel will be critical to our success.  Competition for such personnel can be intense, and we expectmay be unable to enter intoattract and retain a sufficient number of qualified individuals to successfully support the launch and continued distribution of our products.  We also may be unable to provide competitive incentives to retain our sales force.  If we are unable to successfully retain, motivate and / or co-marketing arrangementsattract experienced individuals for our commercial and medical affairs organization to support the introduction, marketing and sale of AFECTAIR inour products, we will have difficulty selling, maintaining and increasing the sales of our products, which could have a broad rangematerial adverse effect on our business.
We may also seek strategic alliances and/or collaboration arrangements to support the potential commercial introduction of SURFAXIN and, if approved, SURFAXIN LS in countries where regulatory marketing authorization is facilitated by the recent approval ofinformation contained in the SURFAXIN new drug application (NDA) approved by the FDA.  We also may consider strategic alliances and/or collaboration arrangements, including third-party distributors or marketing alliances, to sell our AFECTAIR device in international markets.  We may not be successful in entering into any such arrangements, and the terms of any such arrangements may not be favorable to us.  In addition, if we enter into co-marketing arrangements to market and sell additional products directly, we may need to further expand our commercial staff and incur additional expense.

If we enter into alliances, distribution and collaboration arrangements to commercialize our products, such arrangements will subject us to a number of risks, including:

our distributors or collaborators may require that we transfer to them important rights to our products and/or product candidates;
we may not be able to control the amount and timing of resources that our distributors or collaborators devote to the commercialization of our products;
if our distributors or collaborators fail to perform their obligations under our arrangements to our satisfaction, we may not achieve our projected sales and our revenues would suffer.  We also may incur additional expense to terminate such arrangements and to identify and enter into arrangements with replacement distributors or collaborators;
our distributors or collaborators may experience financial difficulties; and
business combinations or significant changes in a collaborator’s business strategy may adversely affect a collaborator’s willingness or ability to perform its obligations under any arrangement, which would adversely affect our business.

If we fail to enter into arrangements with third parties in a timely manner or if such parties fail to perform, it could adversely affect sales of our products.  We and our third-party distributors and collaborators must also market our products in compliance with federal, state and local laws related to providing incentives and inducements.  Violation of these laws can result in substantial penalties.

If we fail to maintain our commercial and medical affairs capabilities or if we are unable to enter into arrangements with third parties in a timely manner when needed, or if such third parties fail to perform, it could adversely affect sales of our products.  In addition, even if we establish or secure such capabilities, our third-party collaborators and we must also market our products in compliance with federal, state and local laws relating to the restrictions on incentives and inducements.  Violation of these laws can result in substantial penalties.  If we are unable to successfully motivate our sales force, or if our distributors fail to promote our products, we will have difficulty maintaining and increasing the sales of our products.

If we do not adequately forecast customer demand for our approved products, including SURFAXIN and, if approved, AEROSURF, our business could suffer.  If we are successful, we also potentially are subject to risks associated with doing business globally.

Our business planning requires us to forecast demand and revenues despite numerous uncertainties.  Actual results of operations may deviate materially from projected results. The timing and amount of customer demand and the commercial requirements to meet changing customer demand are difficult to predict.  We may not be able to accurately forecast customer demand for our products and product candidates, starting with SURFAXIN, or to respond effectively to unanticipated increases in demand.  This could have an adverse effect on our business.  If we overestimate customer demand, or attempt to commercialize products for which the market is smaller than we anticipate, we could incur significant unrecoverable costs from creating excess capacity.
In addition, the current economic conditions may result in reduced demand for our products, increased pricing pressure, longer sales cycles, and slower adoption rates for our products.  Conditions in the healthcare industry, including lower healthcare utilization, cost containment efforts by governments and other payers for healthcare services and other factors may result in weaker overall customer demand and increased pricing pressure for our products.  The current economic conditions may also adversely affect our suppliers, which could affect our ability to manufacture and sell our products.

We expect to offer certain of our products in the EU and elsewhere, which would subject us to risks associated with doing business globally and under the laws, regulations and customs of various jurisdictions and geographies.  These risks include fluctuations in currency exchange rates, changes in exchange controls, increasingly complex labor environments, expropriation and other governmental actions, availability of raw materials, changes in taxation, importation limitations, export control restrictions, changes in or violations of U.S. or local laws, including the FCPA, pricing restrictions, economic and political instability, diminished or insufficient protection of intellectual property, and disruption in a significant geographic region regardless of cause, including war, terrorism, riot, civil insurrection or social unrest. Failure to comply with, or material changes to, the laws and regulations that affect our business could have an adverse effect on our business, financial condition or results of operations.

Our manufacturing strategy includes relying, at least in part in the future, on third parties to manufacture our current approved products as well as certain of our drug product candidates and medical devices, which exposes us to risks that may affect our ability to maintain supplies of our commercial products and/or delay our research and development activities, regulatory approval and commercialization of our drug product candidates.

We currently manufacture SURFAXIN at our Totowa Facility.  Our strategy includes potentially manufacturing SURFAXIN in the future and our lyophilized dosage form of our KL4 surfactant, as well as our capillary aerosol generator (CAG) for AEROSURF and AFECTAIR devices, using third-party contract manufacturing organizations (CMOs).  Our efforts to conduct a technology transfer of our manufacturing process and our planned future reliance on CMOs exposes us, among other things, to the following risks:

we may be unable to identify manufacturers with whom we might establish appropriate arrangements on acceptable terms, if at all, because the number of potential CMOs is limited and the FDA must approve any replacement CMO.  This approval could require one or more pre-approval inspections as well as a potentially lengthy qualification process.  In addition, a new manufacturer would have to be educated in, or develop substantially equivalent processes for, production of our approved products after receipt of FDA approval. This could take as long as 2 years to qualify and receive regulatory approval;
we may implement a plan to execute a technology transfer of our manufacturing process to a CMO and, after investing significant time and resources, learn that the CMO we chose is unable to successfully complete the technology transfer and thereafter manufacture our products in accordance with our plan;
CMOs might be unable to manufacture our products in the volume and to our specifications to meet our commercial and clinical needs, or we may have difficulty scheduling the production of drug product and devices in a timely manner to meet our timing requirements;
CMOs may not perform as agreed, or may not remain in the CMO business for a lengthy time, or may refuse to renew an expiring agreement as expected, or may fail to produce a sufficient supply to meet our commercial and/or clinical needs;
CMOs are subject to ongoing periodic unannounced inspection by the FDA, international health authorities, registered Notified Body(ies), the Drug Enforcement Administration, and corresponding state agencies to ensure strict compliance with cGMP and/or quality system regulations (QSR) and other government regulations and corresponding foreign standards.  We do not have control over a CMO’s compliance with these regulations and standards;
if we desire to make our drug products and/or devices available outside the U.S. for commercial or clinical purposes, our CMOs would become subject to, and may not be able to comply with, corresponding manufacturing and quality system regulations of the various foreign regulators having jurisdiction over our activities abroad.  Such failures could restrict our ability to execute our business strategies; and
if any third-party manufacturer makes improvements in the manufacturing process for our products, we may not have rights to, or may have to share, the intellectual property rights to any such innovation.  We may be required to pay fees or other costs for access to such improvements.
Each of the foregoing risks and others could delay our commercial manufacturing plans and our development programs, the approval, if any, of our product candidates by the FDA or result in higher costs or deprive us of potential product revenues.

We may enter into strategic alliances, distributor, co-marketing or other collaboration arrangements, which could expose us to risks associated with the transfer of control to third parties and may require that we transfer rights to our products to our partners and collaborators.

To support our AEROSURF development program and potentially the commercial introduction of AEROSURF in markets outside the U.S., we seek a significant strategic alliance that potentially could provide development, regulatory and commercial market expertise as well as financial resources for our AEROSURF development program, and, if approved, support for the commercial introduction of AEROSURF in the EU and other selected markets outside the U.S.  While we are engaged in discussions with potential strategic partners who could provide development and commercial expertise as well as financial resources (potentially in the form of upfront payments, milestone payments, commercialization royalties and a sharing of research and development expenses).  We have also considered various other financial alternatives that could potentially provide infusions of capital and other resources needed to advance our KL, there4 surfactant pipeline programs meet our capital requirements and continue our operations.  Although we continue to consider potential opportunities, there can be no assurance that any strategicwe will ultimately secure such an alliance, or other financing alternatives will be successfully concluded.  We plan to continue assessing available opportunities with a view to maintaining and strengthening our financial and operational position.  Moreover, consideration and planning of such strategic alliances diverts management’s attention and other resources from day-to-day operations, which may subject us to further risks and uncertainties.if at all, on acceptable terms.

To support the commercial introduction of SURFAXIN and our other KL4 surfactant products, including potentially SURFAXIN LS, in markets outside the U.S., we may enter into distributor arrangements or seek strategic alliances and/or collaboration arrangements to support the potential commercial introduction of SURFAXIN and, if approved, SURFAXIN LS, in countries where regulatory marketing authorization is facilitated by the recent approval of SURFAXIN by the FDA.  If we determine to distribute AFECTAIR devices in markets outside the U.S., we may enter into distributor arrangements in various countries.

If we succeed in entering into one or more strategic alliances, or distributor, co-marketing or other collaboration arrangements,our ability to execute our current operating plan will depend upon numerous factors, including the performance of the strategic partners and collaborators with whom we may contract.engage.  Under these arrangements, our partners may control key decisions relating to the development and, assuming approval,if approved, commercialization of our products.  Such rights of our partners would limit our flexibility in considering development strategies and in commercializing our products.  In addition, if we breach or terminate our strategic alliance agreements or if our strategic partners or collaborators  otherwise fail to conduct their activities in a timely manner, or if there is a dispute about our respective obligations, we may need to seek other partners or collaborators or, in the alternative and after a potentially unacceptable delay, develop our own internal sales and marketing capabilities to commercialize our products in markets outside the United States.U.S.  If we fail to successfully develop these relationships, or if we or our partners or collaborators fail to successfully develop or commercialize any of our products, it may delay or prevent us from developing or commercializing our products in a competitive and timely manner and would have a material adverse effect on the commercialization of our products.
For example, our collaboration arrangement with Esteve for SURFAXIN and certain other of our drug product candidates is focused on Andorra, Greece, Italy, Portugal and Spain.  We have limited influence over the decisions made by Esteve or its sublicensees or the resources that they may devote to the marketing and distribution of our KL4 surfactant products in their licensed territory, and Esteve or its sublicensees may not meet their obligations in this regard.  Our marketing and distribution arrangement with Esteve may not be successful, and, as a result, we may not receive any revenues from it.  In addition, we may not be able to enter into marketing and sales agreements for our KL4 surfactant pipeline products on acceptable terms, if at all, in territories not covered by the Esteve agreement, or for any of our other drug product candidates.  If Esteve or we should fail to conduct our respective collaboration-related activities in a timely manner, or otherwise breach or terminate the agreements that make up our collaboration arrangements, or if a dispute should arise under our collaboration arrangements, such events could impair our ability to commercialize or develop our products for the Esteve territory in Europe.  In that event, we may need to seek other partners and collaboration arrangement, or we may have to develop our own internal capabilities to market the covered products in the Esteve territory without a collaboration arrangement.arrangements.

We currently have limited expertise in marketing or selling pharmaceutical products and limited marketing capabilities, which may restrict our success in commercializing our product candidates.  To launch our drug product candidates in the United States, weOur plan to developuse strategic alliances and collaboration arrangements to leverage our own commercial and medical affairs capabilities which could increase the cost to commercialize our products.  We also plan to seek third-party distribution arrangements and marketing alliances, particularly to support the commercialization of AFECTAIR® in the United States and in markets outside the United States, which could require us to give up rights to our drug product candidates.

We have limited experience in marketing or selling pharmaceutical products and have limited marketing capabilities.  We plan to establish and primarily rely on own, in-house, specialty respiratory critical care commercial organization to market SURFAXIN, and,may not be successful if approved, SURFAXIN LS and AEROSURF, in the United States.  We expect that our commercial organization will also support the commercial introduction of AFECTAIR.  Commercializing our drug product candidates in the United States on our own will likely cause our commercialization costs to increase, but will potentially avoid the transfer of rights to our products or drug product candidates.  Developing an internal commercial and medical affairs capabilities is potentially a difficult, expensive and time-consuming process and requires a substantial capital investment.  Recruiting, training and retaining qualified personnel will be critical to our success.  Competition for such personnel can be intense, and we may be unable to attract and retain a sufficient number of qualified individuals to successfully support the launch and continued distribution of our products.  We also may be unable to provide competitive incentives to retain our sales force.  If we are unable to successfully attractintegrate our partners’ capabilities with our own or if our partners’ capabilities do not meet our expectations.

As part of our strategy, we intend to continue to evaluate strategic partnership opportunities and motivatecollaboration arrangements.  In order for these efforts to be successful, we must first identify partners whose capabilities complement and integrate well with ours.  Technologies to which we gain access may prove ineffective or unsafe.  Ownership of these technologies may be disputed.  The agreements that grant us access to such technologies may expire and may not be renewable or could be terminated if our partners or we do not meet our respective obligations.  In addition, our partners may provide certain services for us, such as product development support or distribution services.  These agreements may be subject to differing interpretations and we and our partners may not agree on the appropriate interpretation or specific requirements.  Among other things, our partners may prove difficult to work with, less effective than we originally expected or unable to satisfy their financial and other commitments to us.  Failure of our partners to perform as needed could place us at a commercial teamcompetitive disadvantage.

If one of our strategic partners or collaborators pursues a product that competes with our products, there could be a conflict of interest and we may not receive expected revenues or milestone or royalty payments.

Certain of our potential strategic partners and collaborators may be developing or marketing a variety of products, some with other partners.  Partners or collaborators with whom we enter into distribution agreements may sell and market products that compete with ours, or they may seek to supportdevelop, market or sell existing or alternative products or technologies or products targeted at the introductionsame diseases or conditions as the products that are the subject of an arrangement with us.  Our strategic partners and salecollaborators may also develop products that are similar to or compete with products they are developing in collaboration with us.  If these entities pursue other products instead of our products, we will have difficulty selling, maintaining and increasingmay not receive the sales ofanticipated revenues or milestone or royalty payments, or our efforts to distribute our products which could have a material adverse effect on our business.

Even with our own commercial organization to support the launch of SURFAXIN in the United States, we may also need to enter into co-marketing arrangements with third parties where our own personnel are neither well situated nor large enough to achieve maximum penetration in the market.  In addition, we may seek strategic alliances and/or collaboration arrangements to support the potential commercial introduction of SURFAXIN in countries where regulatory marketing authorization is facilitated by the recent approval of SURFAXIN by the FDA.  We may not be successful in entering into any co-marketing arrangements, and the terms of any co-marketing arrangements may not be favorable to us.  In addition, if we enter into co-marketing arrangements or market and sell additional products directly, we may need to further expand our commercial staff and incur additional expense.

We also plan to rely on third-party distributors to distribute, or enter into marketing alliances to sell, our AFECTAIR devices in the United States and internationally.  We may not be successful in identifying such third parties or finalizing such arrangements on terms and conditions that are favorable to us and, as a result, we may not be able to commercialize our drug product candidates on a timely basis.  If we are not successful in finalizing such arrangements, we may not have sufficient funds to successfully commercialize SURFAXIN or any other potential product in the United States or elsewhere.  If we enter into distribution arrangements and marketing alliances to commercialize our drug product candidates, such arrangements will subject us to a number of risks, including:

●
our distributors or collaborators may require that we transfer to them important rights to our products and/or drug product candidates;
●
we may not be able to control the amount and timing of resources that our distributors or collaborators devote to the commercialization of our products;
●
if our distributors or collaborators fail to perform their obligations under our arrangements to our satisfaction, we may not achieve our projected sales and our revenues would suffer.  We also may incur additional expense to terminate such arrangements and to identify and enter into arrangements with replacement distributors or collaborators;
●
our distributors or collaborators may experience financial difficulties; and
●
business combinations or significant changes in a collaborator’s business strategy may adversely affect a collaborator’s willingness or ability to perform its obligations under any arrangement, which would adversely affect our business.

If we fail to enter into arrangements with third parties in a timely manner or if such parties fail to perform, it could adversely affect sales of our products.  We and our third-party distributors and collaborators must also market our products in compliance with federal, state and local laws related to providing incentives and inducements.  Violation of these laws can result in substantial penalties.

If we fail to establish or secure commercial and medical affairs capabilities or fail to enter into arrangements with third parties in a timely manner or if such third parties fail to perform, it could adversely affect sales of our products.  In addition, even if we establish or secure such capabilities, our third-party distributors and we must also market our products in compliance with federal, state and local laws relating to the restrictions on incentives and inducements.  Violation of these laws can result in substantial penalties.  If we are unable to successfully motivate our sales force, or if our distributors fail to promote our products, we will have difficulty maintaining and increasing the sales of our products.
affected.

The commercial success of our product candidates will depend upon the degree of market acceptance by physicians, patients, healthcare payers and others in the medical community.

Any products that we bring to market, including SURFAXIN and AFECTAIR, may not gain or maintain market acceptance by governmental purchasers, group purchasing organizations, physicians, patients, healthcare payers and others in the medical community. If any products that we develop do not achieve an adequate level of acceptance, we may not generate sufficient revenues to support continued commercialization of these products. The degree of market acceptance of SURFAXIN and AFECTAIR and our product candidates, if approved for commercial sale, will depend on a number of factors, including:

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the perceived safety and efficacy of our products;
●
the potential advantages over alternative treatments;
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the prevalence and severity of any side effects;
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the relative convenience and ease of administration;
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cost effectiveness;
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our ability to gain access to the entire market through our distributor arrangements;
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the rate of preterm births;
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the willingness of the target patient population to try new products and of physicians to prescribe our products;
●
the willingness of the target hospitals to accept and employ the WARMING CRADLE
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the effectiveness of our marketing strategy and distribution support; and
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the sufficiency of coverage or reimbursement by third parties.

If our business development activities are unsuccessful, our business could suffer and our financial performance could be adversely affected.

As part of our long-term growth strategy, we are engagedengage in business development activities intended to develop strategic opportunities, including potential strategic alliances, joint development opportunities, acquisitions, technology licensing arrangements and other similar opportunities.  Such opportunities may result in substantial investments.  Our success in developing products or expanding into new markets from such activities will depend on a number of factors, including our ability to find suitable opportunities for investment, alliance or acquisition; whether we are able to complete an investment, alliance or acquisition on terms that are satisfactory to us; the strength of our underlying technology, products and our ability to execute our business strategies; any intellectual property and litigation related to these products or technology; and our ability to successfully execute the investment, alliance or acquisition into our existing operations, including to fund our share of any in-process research and development projects.  If we are unsuccessful in our business development activities, we may be unable to meet our financial targets and our financial performance could be adversely affected.

We may have difficulty managing our growth.

We have experienced significant growth in the scope of our operations as we have prepared for the anticipated launch of our products in the U.S., and thereafter, through strategic partnerships or distributorships, in the EU and in selected markets outside the U.S.  As this potential growth occurs, it has and will continue to place additional significant demands on our management and our financial and operational resources, and will require that we continue to develop and improve our operational, financial and other internal controls.  We also are engaged in discussions with potential strategic partners, which, if successful, will require additional management resources and controls to implement and potentially add a layer of complexity to our operations.  We plan at various stages of development to distribute our products in the U.S. and potentially the EU and potentially other major markets, through potential strategic alliances and collaboration arrangements.  This expansion could further increase the challenges involved in implementing appropriate operational and financial systems, expanding manufacturing and production capacity, expanding our marketing and sales infrastructure and capabilities, and providing adequate training and supervision to maintain high quality standards.  We believe that the significant challenges associated with our potential growth will include our ability to recruit, train and integrate skilled marketing, sales, medical affairs, supply chain, administrative and management personnel; to establish and effectively manage strategic partnerships and collaboration arrangements to support our development and commercialization activities; and to provide for manufacturing, including analytical testing and distribution capabilities, for our products, and clinical capabilities for our products under development.  Our inability to grow our business effectively and appropriately or otherwise adapt to growth would cause our business, financial condition and results of operations to suffer.

We are continually evaluating our business strategy and may modify this strategy in light of developments in our business and other factors.

As we proceed with our plans to commercialize SURFAXIN in markets both inside and potentially outside the U.S., we will continually evaluate our commercial strategy and will modify our plans as necessary to achieve our objectives.  The activities associated with introduction of a new product are complex, involve many persons and entities, including third parties that we may not be able to control, and require the coordination of a number of elements, any one of which could involve unforeseen events or circumstances that require adjustment or the development of alternative strategies.  If we encounter such events or circumstances, we will change our strategy and plans if we believe that such a change will be in our best interest.  For example, if we experience any significant delay in our efforts to commercialize our products, we may adjust our approach to take into account any potential impact such a delay may have on our cash resources and our ability to fund our activities, or, if we were to determine that an alternative approach or structure would allow us to maintain control of our products or improve the profitability of our products in one or more markets, we will consider adopting such other approaches, including increasing our investment in internal capabilities.  Similarly, if a potential partner or collaborator were to make observations or recommendations concerning the focus, sequence or approach of any or all of our research and development programs, we may consider taking such observations or recommendations into account in our planning process and activities.  There can be no assurance, whether or not we alter our strategy or plans for any reason, that we will be successful, or that our product launches will be effectively executed on time, if at all, in all markets that we may identify.
Our ability to discover and develop new products depends on our internal research capabilities and our ability to acquire products.  Although we continue to conduct research and development activities on products, our limited resources may not be sufficient to discover and develop new product candidates.  To assist us with the development of our products and, if approved, commercialization of our products in markets outside the U.S., we continue to evaluate potential strategic partnership and collaboration arrangements.  However, there can be no assurance that our efforts will be successful or that, even if we identify and enter into any such strategic partnership or collaboration arrangement, that such transactions will be successfully implemented, if at all, within our expected time frames.

We continue to evaluate our business strategy and, as a result, may modify our strategy in the future.  With respect to our research and development activities, to respond to changing circumstances, we may, from time to time, refocus our product development efforts on different products or may pace, delay or halt the development of various products.  As a result of changes in our strategy, we may also change or refocus our existing drug discovery, development, commercialization and manufacturing activities.  This could require changes in our facilities and personnel and restructuring various financial arrangements.  There can be no assurances that any product development or other changes that we implement will be successful or that, after implementation of any such changes, that we will not refocus our efforts on new or different objectives.

Our existing and future debt obligations could impair our liquidity and financial condition, and in the event we are unable to meet our debt obligations, the lenders could foreclose on our assets.

In connection with a facility agreement entered into on February 13, 2013, Deerfield advanced the Deerfield Loan to us, consisting of $30 million principal amount.  Our debt obligations:

could impair our liquidity;
could make it more difficult for us to satisfy our other obligations;
require us to dedicate cash flow to payments on our debt obligations, which would reduce the availability of our cash flow to fund working capital, capital expenditures and other corporate requirements;
impose restrictions on our ability to incur other indebtedness, grant liens on our assets, other than permitted indebtedness and permitted liens, and could impede us from obtaining additional financing in the future for working capital, capital expenditures, acquisitions and general corporate purposes;
impose restrictions on us with respect to the use of our available cash, including in connection with future acquisitions;
could adversely affect our ability to enter into strategic transactions and similar agreements, or require us to obtain the consent of our lenders;
make us more vulnerable in the event of a downturn in our business prospects and could limit our flexibility to plan for, or react to, changes in our licensing markets; and
could place us at a competitive disadvantage when compared to our competitors who are not similarly restricted.

We have pledged substantially all of our assets to secure our obligations under the Deerfield Loan. In the event that we were to fail in the future to make any required payment under the Deerfield Loan or fail to comply with the covenants contained in the facility agreement and other related agreements, we would be in default regarding that indebtedness. A debt default would enable the lenders to foreclose on the assets securing such debt and could significantly diminish the market value and marketability of our common stock and could result in the acceleration of the payment obligations under all or a portion of our consolidated indebtedness.
Our activities are subject to various and complex laws and regulations, and we are susceptible to a changing regulatory environment.  Any failure to comply could adversely affect our business, financial condition and results of operations.

Our products and our operations are regulated by numerous government agencies, both inside and outside the United States.U.S.  Our drug product candidates and medical devices must undergo lengthy and rigorous testing and other extensive, costly and time-consuming procedures mandated by the FDA and foreign regulatory authorities.  Our facilities and those of our third-party providers must be approved and licensed prior to production and remain subject to inspection at any time thereafter.  Failure to comply with the requirements of the FDA or other regulatory authorities, including a failed inspection or a failure in our adverse eventpost-marketing reporting, system, could result in warning letters, product recalls or seizures, monetary sanctions, injunctions to halt the manufacture and distribution of our products, civil or criminal sanctions, refusal of a government to grant approvals or licenses, restrictions on operations or withdrawal of existing approvals and licenses.  Any of these actions could damage our reputation and have a material adverse effect on our sales.  In addition, requirements of the FDA and other regulatory authorities may change;change and implementing any additional compliance requirements may increase our costs, or force us or our third-party providers to suspend production, which could result in a shortage of our approved product or delays in the commercial introduction of our new product candidates, if approved.

With the commercial launch of SURFAXIN, AFECTAIR and, if approved, AEROSURF, we are and will be required to comply with not only the requirements of the FDA and potentially international regulators, but will also become subject to various federal, state and international laws regulating the sales, marketing, and distribution of healthcare-related products.  These laws govern such activities as our relationships with healthcare providers, the promotion of our products, and pricing of prescription drug products and medical devices.  The sales and marketing of products and relationships that pharmaceutical and medical device companies have with healthcare providers are under increasing scrutiny by federal, state and foreign government agencies.  The FDA and other federal regulators have increased their enforcement activities with respect to the Anti-Kickback Statute, False Claims Act, off-label promotion of products, and other healthcare related laws, antitrust and other competition laws.  The Department of Justice (DOJ) also has increased its focus on the enforcement of the U.S. Foreign Corrupt Practices Act (FCPA), particularly as it relates to the conduct of pharmaceutical companies.  Foreign governments have also increased their scrutiny of pharmaceutical companies’ sales and marketing activities and relationships with healthcare providers.  The

Of particular importance, federal and state anti-kickback laws and standards governingmake it illegal for a prescription drug manufacturer to solicit, offer, receive, or pay any remuneration in exchange for, or to induce, the promotion, sale and reimbursementreferral of our products and those governing our relationships with healthcare providers and governmentsbusiness, including the purchase or prescription of a particular drug. These laws can be complicated, are subject to frequent change and may be violated unknowingly.  In addition, the absence of guidance for some of these laws and the very few court decisions addressing industry practices increase the likelihood that our practices could be challenged under anti-kickback or similar laws.  False claims laws prohibit anyone from knowingly and willingly presenting, or causing to be presented, for payment to the government (including Medicare and Medicaid) claims for reimbursed drugs or services that are false or fraudulent, claims for items or services not provided as claimed, or claims for medically unnecessary items or services.  In addition, a number of states require that companies implement compliance programs or comply with industry ethics codes, adopt spending limits, and report to state governments any gifts, compensation, and other remuneration provided to physicians.  Many pharmaceutical, device, and other health care companies have been investigated and prosecuted for alleged violations of these laws.  Sanctions under these laws may include civil monetary penalties, exclusion of a manufacturer's products from reimbursement under government programs (including Medicare and Medicaid), criminal fines, and imprisonment.  Companies that have chosen to settle these alleged violations have typically paid multi-million dollar fines to the government and agreed to abide by corporate integrity agreements, which often include significant and costly burdens.  Under the federal False Claims Act and related state laws, private individuals may bring similar actions.  In addition, an increasing number of state laws require manufacturers to report to the state certain pricing and marketing information. Many of these laws contain ambiguities as to what is required to comply with the laws.  Given the lack of clarity in laws and their implementation, our reporting actions could be subject to the penalty provisions of the state authorities.
We are developingcontinually evaluating our comprehensive compliance programs,program, including policies, training and various forms of monitoring, designed to address these risks.the sales-and-marketing-related risks set forth above.  However, these programs and policies may not always protect us from conduct by individual employees, well meaning or otherwise, that violate these laws.no compliance program can mitigate risk in its entirety.  Violations or allegations of violations of these laws may result in large civil and criminal penalties, debarment from participating in government programs, diversion of management time, attention and resources and may otherwise have a material adverse effect on our business, financial condition and results of operations.

The regulatory approval process for our products is expensive and time-consuming and the outcome is uncertain.  We may not obtain required regulatory approvals to commercialize our products.

To test, make and sell our products under development, we must receive regulatory approvals for each product.  The FDA and foreign regulators, such as the EMA,European Medicines Agency (EMA), extensively and rigorously regulate the testing, manufacture, distribution, advertising, pricing and marketing of drug products.  This approval process includes (i) preclinical studies and clinical trials of each drug product candidate and active pharmaceutical ingredient to establish its safety and effectiveness, and (ii) confirmation by the FDA and foreign regulators that we maintain good laboratory and manufacturing practices during testing and manufacturing.  Even if favorable data are generated by clinical trials, the FDA or foreign regulator may not accept or approve an NDA or MAAMarket Authorization Application (MAA) filed for a drug product on a timely basis or at all.  See, “Item 1 – Business – Government Regulation.”

In particular, we filed with the FDA an NDA for SURFAXIN for the prevention of RDS in premature infants.  We received the 2009 Complete Response Letter for this NDA.  Followingare currently conducting a number of exchanges with the FDA, we conducted a comprehensive preclinical program that consisted of a series of prospectively-designed, side-by-side preclinical studies employing our optimized BAT and the well-established preterm lamb model of RDS.  These time-consuming studies were intended to demonstrate comparability of drug product used in the Phase 3phase 2a clinical program with SURFAXIN drug product to be manufactured for commercial use, and to gain the FDA’s agreement on final acceptance criteria, with respect to biological activity as assessed by the BAT, for release and ongoing stability of SURFAXIN drug product.  See, “Item 1 – Business – Surfactant Replacement Therapy for Respiratory Medicine – Respiratory Distress Syndrome in Premature Infants (RDS) – SURFAXIN for the Prevention of RDS in Premature Infants at High Risk for RDS.”

To gain approval of SURFAXIN LS and AEROSURF, we expect to conduct a clinical program and are working to be in a position to initiate a Phase 2 clinical trial for AEROSURF and a Phase 3 clinical trial for SURFAXIN LS in late 2013.  We believe that our success in gaining approval for SURFAXIN in the United States may facilitate our efforts to gain regulatory approval for SURFAXIN LS and AEROSURF.  However, thereThere can be no assurance that issues requiring protracted and time-consuming preclinical studies will not arise.arise or that our clinical program trials will be concluded successfully.  There can be no assurance that we will be successful in gaining regulatory approval for AEROSURF or, if we determine that there is a feasible development plan that can be accomplished with an acceptable investment and within an acceptable time, SURFAXIN LS, and / or AEROSURF, if at all, within our expected time frame.all.

If we chooseWe plan to pursue clinical development and commercialization in the European Union or otherwiseU.S. and potentially in the EU and other markets, and, if approved, market and sell our products outside ofin the United States,U.S. and potentially in the EU and other major markets.  To accomplish this objective, we must obtain and maintain regulatory approvals and comply with regulatory requirements in such jurisdictions.  each jurisdiction.  To avoid the significant expense and lengthy time required to complete multiple clinical programs, we expect to meet with relevant regulatory authorities with the goal of designing a single, global clinical program.  There can be no assurance that our efforts will be successful.  If we are unable to reach agreement with the various regulatory authorities, we may not be able to pursue regulatory approval of our products in all of our selected markets.
The approval procedures vary among countries in complexity and timing.  We may not obtain approvals from regulatory authorities outside the United StatesU.S. on a timely basis, if at all, which would preclude us from commercializing products in those markets.  In addition, some countries, particularly the countries of the European Union,EU, regulate the pricing of prescription pharmaceuticals.  In these countries, pricing discussions with governmental authorities can take considerable time after the receipt of marketing approval for a product.  To obtain reimbursement or pricing approval in some countries, we may be required to conduct a clinical trial that compares the cost-effectiveness of their product candidate to other available therapies.  Such trials may be time-consuming and expensive, and may not show an advantage in efficacy for our products.  If reimbursement of our products is unavailable or limited in scope or amount, or if pricing is set at unsatisfactory levels, in either the United StatesU.S. or the European Union,EU, we could be adversely affected.

Even though some of our product candidates have qualified for expedited review, the FDA may not approve them at all or any sooner than other product candidates that do not qualify for expedited review.
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surfactant technology pipeline, BPD in premature infants and ARDS in adults, have been granted designation as “Fast Track” products under provisions of the Food and Drug Administration Modernization Act of 1997.  We believe that other potential products in our KL4 surfactant technology pipeline may also qualify for Fast Track designation.  Fast Track designation does not accelerate clinical trials nor does it mean that the regulatory requirements are less stringent.  Our products may cease to qualify for expedited review and our other product candidates may fail to qualify for Fast Track designation or expedited review.  Moreover, even if we are successful in gaining Fast Track designation, other factors could result in significant delays in our development activities with respect to our Fast Track products.

Even assuming thatif we have gainedsucceed in gaining regulatory approval to market our drugs, if the FDA and foreign regulators later withdraw their approval or otherwise restrict marketing, our business would be materially harmed.

The FDA has approved SURFAXIN for marketing in the United States.U.S.  Our development programsprogram for AEROSURF is in phase 2 clinical trials.  We currently are planning to seek regulatory advice from the FDA to determine if we could gain marketing authorization for SURFAXIN LS, a lyophilized dosage form of SURFAXIN, under a development plan that would be both capital efficient and AEROSURF are in the preclinical stage, with clinical trials potentially anticipated in late 2013.  capable of implementation within a reasonable time.  If feasible, we would likely seek to implement such a development plan.  Foreign regulators have not yet approved SURFAXIN or any of our KL4 surfactant products under development for marketing.development.  Without regulatory approval, we will not be able to market these products.  Even if we were to succeed in gaining regulatory approvals for any of our products, the FDA or a foreign regulator could at any time withdraw any approvals granted if there is a later discovery of previously unidentified problems or if we fail to comply with other applicable regulatory requirements at any stage in the regulatory process, or the FDA or a foreign regulator may restrict or delay our marketing of a product, including by requiring us to include warnings and other restrictions in the package inserts for our products, or force us to make product recalls.  In addition, the FDA could impose other sanctions such as fines, injunctions, civil penalties or criminal prosecutions.  Any withdrawal of our regulatory approval or significant restriction on our ability to market our products after approval would have a material adverse effect on our business.

Even though some of our product candidates have qualified for expedited review, the FDA may not approve them at all or any sooner than other product candidates that do not qualify for expedited review.

The FDA has notified us that two indications of our KL4 surfactant technology pipeline, BPD in premature infants and ARDS in adults, have been granted designation as “Fast Track” products under provisions of the Food and Drug Administration Modernization Act of 1997.  We believe that other potential products in our KL4 surfactant technology pipeline may also qualify for Fast Track designation.  Fast Track designation does not accelerate clinical trials nor does it mean that the regulatory requirements are less stringent.  Our products may cease to qualify for expedited review and our other product candidates may fail to qualify for Fast Track designation or expedited review.  Moreover, even if we are successful in gaining Fast Track designation, other factors could result in significant delays in our development activities with respect to our Fast Track products.
Our continuing research and development KL4 surfactant programs, including for SURFAXIN LS™ and AEROSURF,® involve significant risks and uncertainties that are inherent in the clinical development and regulatory approval processes.

Development risk factors include, but are not limited to, whether we, or our third-party collaborators, contract research organizations (CROs), drug substances and materials suppliers and third-party contract manufacturers,CMOs, will be able to:

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complete our preclinical and clinical trials of our KL4 surfactant product candidates with scientific results that are sufficient to support further development and regulatory approval;
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receive the necessary regulatory approvals;
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obtain adequate supplies of surfactant active drug substances, manufactured to our specifications and on commercially reasonable terms;
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perform under agreements to supply drug substances, medical devices and related components and related services necessary to manufacture our KL4 surfactant product candidates;
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provide for sufficient manufacturing capabilities, at our manufacturing operations in Totowa and with third-party contract manufacturers, to produce sufficient drug product, including for SURFAXIN-related studies, SURFAXIN LS and AEROSURF, and CAG devices and related materials to meet our preclinical and clinical development requirements;
●
obtain the capital necessary to fund our research and development efforts, including our business administration, preclinical and clinical organizations, and our quality and manufacturing operations.

competently execute and complete our preclinical and clinical trials of our KL4 surfactant product candidates with scientific results that are sufficient to support further development and regulatory approval;
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receive the necessary regulatory approvals;
Tableobtain adequate supplies of Contents
the active pharmaceutical ingredients, manufactured to our specifications and on commercially reasonable terms;
perform under agreements to supply drug substances, medical devices and related components and related services necessary to manufacture our KL4 surfactant product candidates;
provide for sufficient manufacturing capabilities, at our manufacturing operations in Totowa and with CMOs, to produce sufficient drug product, including for KL4 surfactant-related studies, AEROSURF and SURFAXIN LS development activities, and CAG devices and related materials to meet our preclinical and clinical development requirements; and
obtain the capital necessary to fund our research and development efforts, including our business administration, preclinical and clinical organizations, and our quality and manufacturing operations.

Because these factors, many of which are outside our control, could have a potentially significant impact on our development activities, the success, timing of completion and ultimate cost of development of any of our product candidates is highly uncertain and cannot be estimated with any degree of certainty.  The timing and cost to complete drug trials alone may be impacted by, among other things:

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slow patient enrollment;
slow patient enrollment;
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long treatment time required to demonstrate effectiveness;
long treatment time required to demonstrate effectiveness;
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lack of sufficient clinical supplies and material;
lack of sufficient clinical supplies and material;
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adverse medical events or side effects in treated patients;
adverse medical events or side effects in treated patients;
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lack of compatibility with complementary technologies;
lack of compatibility with complementary technologies;
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failure of a drug product candidate to demonstrate effectiveness; and
failure of a drug product candidate to demonstrate effectiveness; and
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lack of sufficient funds.
lack of sufficient funds.

If we do not successfully complete clinical trials, we will not receive regulatory approval to market our KL4 surfactant pipeline products.  Failure to obtain and maintain regulatory approval and generate revenues from the sale of our products would have a material adverse effect on our financial condition and results of operations and likely reduce the market value of our common stock.

Our clinical trials may be delayed, or fail, which will harm our business.

We have completed our Phase 3 clinical trials for SURFAXIN for the prevention of RDS in premature infants and certain Phase 2 trials for other drug product candidates for other indications.  If we successfully advance our other KL4 surfactant development programs, SURFAXIN LS and AEROSURF, through the initial preclinical phase of development, we plan to conduct Phase 2 and/or Phase 3 clinical trials, potentially beginning in late 2013.  However, before we will initiate a clinical program, we will have to secure adequate capital to support that activity.  Such clinical trials generally take two to five years or more to complete and may be delayed by a number of factors.  We may not reach agreement with the FDA or a foreign regulator on the design of any one or more of the clinical studies necessary for approval.  Conditions imposed by the FDA and foreign regulators on our clinical trials could significantly increase the time required for completion of such clinical trials and the costs of conducting the clinical trials.  Like many biotechnology companies, even after obtaining promising results in earlier trials or in preliminary findings for such clinical trials, we may suffer significant setbacks in late-stage clinical trials.  Data obtained from clinical trials are susceptible to varying interpretations that may delay, limit or prevent regulatory approval.  In addition, we may be unable to enroll patients quickly enough to meet our expectations for completing any or all of these trials.  The timing and completion of current and planned clinical trials of our product candidates depend on many factors, including the rate at which patients are enrolled.  Delays in patient enrollment in clinical trials may occur, which would be likely to result in increased costs, program delays, or both.

Patient enrollment is a function of many factors, including:

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the number of clinical sites;
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the size of the patient population;
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the proximity of patients to the clinical sites;
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the eligibility and enrollment criteria for the study;
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the willingness of patients or their parents or guardians to participate in the clinical trial;
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the existence of competing clinical trials;
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the existence of alternative available products; and
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geographical and geopolitical considerations.

If we succeed in achieving our patient enrollment targets, patients that enroll in our clinical trials could suffer adverse medical events or side effects that are known, such as a decrease in the oxygen level of the blood upon administration, or currently unknown to us.  It is also possible that we, our Scientific Advisory Board (SAB), the Data and Safety Monitoring Committee (DSMC), the FDA or foreign regulators could interrupt, delay or halt any one or more of our clinical trials for any of our product candidates.  If our SAB, the DSMC, any regulator or we believe that trial participants face unacceptable health risks, any one or more of our trials could be suspended or terminated.  In addition, clinical trials may be interrupted, delayed or halted, in whole or in part, for reasons other than health and safety concerns, including, among other things, matters related to the design of the study, drug availability, SAB and/or DSMC recommendation, or business reasons.

In addition to our planned clinical programs to support SURFAXIN LS and AEROSURF, we also may initiate or support clinical studies evaluating other KL4 surfactant pipeline products.  All of these clinical trials will be time-consuming and potentially costly.  Should we fail to complete our clinical development programs or should such programs yield unacceptable results, such failures would have a material adverse effect on our business.

Marketing authorization to promote, manufacture and/or sell AFECTAIR® will be limited and subject to continuing review.

We have successfully registered our initial AFECTAIR in the United States.  We expect to register this device in the European Union in 2012.  Even if regulatory clearance of this product is granted in the European Union, or if regulatory clearance of any subsequent AFECTAIR device is granted, such clearance will be subject to limitations on the intended uses for which the product may be marketed and reduce our potential to successfully commercialize the product and generate revenue from the product.  The FDA and other regulatory agencies actively enforce regulations prohibiting promotion of off-label uses and the promotion of products for which marketing clearance has not been obtained.  If the FDA determines that our promotional materials, labeling, training or other marketing or educational activities constitute promotion of an unapproved use, it could request that we cease or modify our training or promotional materials or subject us to serious regulatory enforcement actions, including some of those listed above.  It is also possible that other federal, state or foreign enforcement authorities will take action if they consider our training or other promotional materials to constitute promotion of an unapproved use, which could result in significant fines or penalties under other statutory authorities, such as laws prohibiting false claims for reimbursement.  A company that is found to have improperly promoted off-label uses may be subject to significant liability, including civil and administrative remedies as well as criminal sanctions.  Due to these legal constraints, our distributors’ sales and marketing efforts will focus only on the general technical attributes and benefits of AFECTAIR and the FDA cleared indications for use.  We plan to conduct a series of studies evaluating the utility of AFECTAIR in delivering specific inhaled therapies, but there can be no assurance that our efforts will be successful, or even if successful, that we will be able to expand our label to include the additional indications.
In addition, we may be required to conduct costly post-market testing and surveillance to monitor the safety or effectiveness of AFECTAIR, and we must comply with medical device reporting requirements, including the reporting of adverse events and malfunctions related to our products.  Later discovery of previously unknown problems with AFECTAIR, including unanticipated adverse events or adverse events of unanticipated severity or frequency, manufacturing problems or failure to comply with regulatory requirements may result in changes to labeling, restrictions on such products or manufacturing processes, withdrawal of the products from the market or regulatory enforcement actions.

Failure to complete the development of our CAG device and related componentry in a timely manner, if at all, would have a material adverse effect on our efforts to develop AEROSURF®, or our other aerosolized KL4 surfactant products, and our business strategy.

Since early 2008, weWe have been responsible forrecently completed development of our proprietary CAG technology, including finalizing the design of an optimizeda clinic-ready CAG device that is suitable for use in our ongoing phase 2 clinical trial and currently are working to further develop our CAG device for use in our planned Phase 2 and Phasephase 3 clinical trials.trial and potentially for commercial use.  Our development activities are subject to certain risks and uncertainties, including, without limitation:

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We may not successfully develop a CAG device that is suitable for use in a clinical environment, if at all, on a timely basis and such inability may delay or prevent initiation of our planned clinical trials.
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We will require access to sophisticated engineering capabilities.  We have medical device engineering staff with industry experience in developing medical devices, and plan to work with leading medical device development engineers and medical device design experts that have a successful track record of developing innovative devices for the medical and pharmaceutical industries.  If we are unable to identify design engineers and medical device experts to support our development efforts, including for a clinic-ready CAG system for use in our planned clinical trials and, potentially, for later versions of the CAG systems, it would impair our ability to commercialize or develop AEROSURF or other aerosolized KL4 surfactant products.
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We may not successfully develop a CAG device that is acceptable for use in a phase 3 program and commercial environment, if at all, on a timely basis and such inability may delay or prevent initiation of our phase 3 clinical trial.
TableWe will require access to sophisticated engineering capabilities.  We have medical device engineering staff and we are currently working with Battelle Memorial Institute (Battelle), which has expertise in medical device development and medical device design and a successful track record in developing aerosolization systems for the medical and pharmaceutical industries.  If for any reason we are unable to retain our own engineering capabilities, the agreement with Battelle is terminated, and we are unable to identify design engineers and medical device experts to support our development efforts, including for a clinic-ready CAG system for use in our planned clinical trials and, potentially, for commercial use and later versions of Contentsthe CAG systems, it would have a material adverse effect on our business strategy and impair our ability to commercialize or develop AEROSURF or other aerosolized KL4 surfactant products.
We will also require additional capital to advance our development activities and plan to seek a potential strategic partner or third-party collaborator to provide financial support and potentially medical device development and commercialization expertise.  There can be no assurance, however, that we will successfully identify or be able to enter into agreements with such potential partners or collaborators on terms and conditions that are favorable to us.  If we are unable to secure the necessary medical device development expertise to support our development program, this could impair our ability to commercialize or develop AEROSURF or other aerosolized KL4 surfactant products.
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We will also require additional capital to advance our development activities and plan to seek a potential strategic partner or third-party collaborator to provide financial support and potentially medical device development expertise.  There can be no assurance, however, that we will successfully identify or be able to enter into agreements with such potential partners or collaborators on terms and conditions that are favorable to us.  If we are unable to secure the necessary medical device development expertise to support our development program, this could impair our ability to commercialize or develop AEROSURF or other aerosolized KL4 surfactant products.

The realization of any of the foregoing risks would have a material adverse effect on our business.

Manufacturing problems potentially could cause us to experience shortages of SURFAXIN and AFECTAIR product inventories, or delay our preclinical or clinical programs, or, if our products are approved, product launch, or cause us to experience shortages of product inventories, which could have a material adverse effect on our business.

The manufacture of pharmaceutical and medical device products requires significant expertise and compliance with strictly enforced federal, state and foreign regulations.  We, our contract manufacturersCMOs or our materials and drug substances suppliers may experience manufacturing or quality control and assurance problems that could result in a failure to maintain compliance with the FDA’s current good manufacturing practices (cGMP) and Quality requirements,System Requirements (QSR), or those of foreign regulators or notified bodies, which is necessary to continue manufacturing of our drug products, materials or drug substances.  Other problems that may be encountered include:

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the need to make necessary modifications to maintain a qualified and facility;
the need to make necessary modifications to qualify and validate a facility;
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difficulties with production and yields, including manufacturing and completing all required release testing on a timely basis to meet demand;
difficulties with production and yields, including manufacturing and completing all required release testing on a timely basis to meet demand;
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quality control and assurance problems related to, among other things, in-process monitoring and controls, and release and stability testing of our drug product, or materials and drug substances;
availability of raw materials and supplies;
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casualty damage to a facility; and
quality control and assurance;
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shortages of qualified personnel.
casualty damage to a facility; and
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shortages of qualified personnel.

Such a failure could result in product production and shipment delays or an inability to obtain materials or drug substance supplies.

For example, we40
We currently manufacture our SURFAXIN drug product at our facilitymanufacturing  operations in Totowa, New Jersey.NJ (Totowa Facility).  We manufacture our lyophilized KL4 surfactant, WARMING CRADLE dry-block heaters and AFECTAIR aerosol-conducting airway connectors with CMOs.  In December 2010,the past, we beganhave experienced manufacturing additional SURFAXIN batches for use in the comprehensive preclinical program.  In January 2011,or quality control testing performed by us indicated that two newly manufactured SURFAXIN batches did not meet one of the pre-specified release specifications.  In accordance with our quality assurance proceduresproblems and manufacturing practices, we conducted an investigation to determine why the SURFAXIN batches did not meet specification and, if appropriate, to implement a corrective action and preventative action plan.  While we identified certain differences in the batches, we did not confirm a definitive root cause of the failures.  Following the investigation, we implemented a process improvement and continued to manufacture SURFAXIN batches for use in the comprehensive preclinical program, which batches successfully met all specifications, including the specifications that the two unacceptable batches did not meet.  In this instance, our efforts appear to have been successful.  In January 2012, the FDA completed a pre-approval inspection (PAI) of our manufacturing facility and issued an Establishment Inspection Report indicating an approval recommendation for the commercial manufacture of SURFAXIN.

Manufacturing or quality controlsuch problems may again occur, at our facility in Totowa New Jersey,Facility or may occur at the facilities of a contractCMO or a manufacturer of our drug substances and materials suppliers.  Such problems may in the particular circumstance require potentially complex, time-consuming and costly comprehensive investigations to determine the root causes of such problems and may require detailed and time-consuming remediation efforts, which can further delay a return to normal manufacturing and production activities.  Any failure by our own manufacturing operations or by the manufacturing operations of any of our CMOs or suppliers to comply with cGMP or, for devices, QSR, requirements or other FDA or similar foreign regulatory requirements could adversely affect our ability to manufacture our drug products, which could have a material adverse effect on our ability to commercializemanufacture a supply of commercial SURFAXIN drug product, or our products under development, and potentially adversely affect our clinical research activities.

We currently do not have a back-up facility.activities and our business and financial condition.  Any interruption of our manufacturing operations at the Totowa NJ,Facility could result in a shortage of our commercial drug supply of SURFAXINSURFAXIN.  We currently do not have a back-up facility for the Totowa Facility or our CMOs, or back-up suppliers of APIs or excipients and could affect our preclinical and clinical development activities.  other materials.

A number of factors could cause interruptions, including:

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equipment malfunctions or failures;
equipment malfunctions or failures;
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technology malfunctions;
technology malfunctions;
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interruption of material availability;
work stoppages or slowdowns;
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work stoppages or slowdowns;
damage to or destruction of the facility;
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damage to or destruction of the facility;
regional power shortages; and
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regional power shortages; and
product tampering.
product tampering.

In connection with our drug product manufacturing activities, we own certain specialized manufacturing equipment, employ experienced manufacturing senior executive and managerial personnel, and continue to invest in enhanced quality systems and manufacturing capabilities.  However, we do not have fully-redundant systems and equipment to respond promptly in the event of a significant loss at our or a CMO’s manufacturing operations.  Under certain conditions, we may be unable to produce SURFAXIN at the required volumes or to appropriate standards, if at all.  If we are unable to successfully maintain our manufacturing capabilities and at all times comply with cGMP, it will adversely affect our efforts to commercializemarket and sell SURFAXIN and have an adverse effect on our sales.

If the parties we depend on for supplying our active drug substances, materials and excipients as well as manufacturing-related services do not timely supply these products and services, it may delay or impair our ability to develop, manufacture and market our approved products and execute our development plans for our pipeline products.  Such delays could adversely impact our operations and financial performance.

We rely on suppliers for our active drug substances, materials and excipients, and third parties for certain manufacturing-related services to manufacture drug product that meets appropriate content, quality and stability standards for commercial drug product use in preclinical programs and clinical trials and, iffor our approved forproducts, commercial distribution.sales.  Our ability to manufacture depends upon receiving adequate supplies and related services, which may be difficult or uneconomical to procure.  Supply chain or manufacturing interruptions could negatively impact our operations and financial performance.  The supply of any of our manufacturing materials may be interrupted because of supply shortages, poor vendor performance or other events outside our control, which may require us, among other things, to identify alternate vendors, which could involve a lengthy process, for AEROSURF, a combination drug-device product, includes the assemblyand result in lost sales and increased expenses.
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In some cases, we are dependent upon a single supplier to provide all of our requirements for one or more of our drug substances, materials and excipients or one or more of our drug product device subcomponents, components and subassemblies.  To assure compliance with cGMP requirements, we have entered into Quality Agreements with all of our suppliers of active drug substances and related materials.  However, we have a requirements contract relating to continued access to active drug substances with only one of three providersprovider of our drug substances.  If we do not maintain manufacturing and service relationships that are important to us and are not able to identify a replacement supplier or vendor or develop our own manufacturing capabilities, our ability to obtain regulatory approval for our products could be impaired or delayed and our costs could substantially increase.  Even if we are able to find replacement manufacturers, suppliers and vendors when needed, we may not be able to enter into agreements with them on terms and conditions favorable to us or there could be a substantial delay before such manufacturer, vendor or supplier, or a related new facility is properly qualified and registered with the FDA or other foreign regulatory authorities.  The process of changing a supplier could have an adverse impact on future growth opportunities during the transition period if supplies of drug substances, materials or excipients on hand are insufficient to satisfy demand.  Such delays could have a material adverse effect on our development activities and our business.

Relying exclusively onA catastrophic event at our Warrington, Pennsylvania facility or at our Totowa Facility or any of the facilities used by our third parties to manufacture certainparty-manufacturers would prevent us from producing many of our drug productproducts candidates andand/or medical devices exposes us to risks that may delay our research and development activities, regulatory approval and commercializationdevices.

Our facilities consist of our headquarters in Warrington, Pennsylvania and our Totowa Facility.  We maintain our analytical testing and device development laboratories in Warrington, Pennsylvania.  Our Totowa Facility is specifically designed for the aseptic manufacture and filling of sterile pharmaceuticals in compliance with cGMP and is our only drug product candidates.

manufacturing facility.  While we manufacture our SURFAXIN liquid instillate at our facilities in Totowa NJ,Facility, we plan to depend upon third-party manufacturers to manufacture SURFAXIN LS,WARMING CRADLE dry-block heaters, our lyophilized dosage form of SURFAXIN,KL4 surfactant, our AFECTAIR devicesdevice and our CAG.  Our anticipated future reliance onAll of these products are or will be manufactured at a single facility.  If a catastrophic event occurred at any our facilities or the facilities of any of our third-party manufacturers, exposes ussuch as a fire, flood or tornado, many of those products could not be produced until the manufacturing portion of such facility was restored and cleared by the FDA. With respect to our Totowa Facility, we maintain a disaster plan to minimize the following risks:

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We may be unable to identify manufacturers with whom we might establish appropriate arrangements on acceptable terms, if at all, because the number of potential manufacturers is limited and the FDA must approve any replacement contractor.  This approval would require new testing and compliance inspections.  In addition, a new manufacturer would have to be educated in, or develop substantially equivalent processes for, production of our products after receipt of FDA approval, if any;
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Third-party manufacturers might be unable to manufacture our products in the volume and to our specifications to meet our clinical needs and, if approved, commercial needs;
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Contract manufacturers may not perform as agreed or may not remain in the contract manufacturing business for the time required to supply our clinical trials or to successfully produce, store and distribute our products;
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Product manufacturers are subject to ongoing periodic unannounced inspection by the FDA, the Drug Enforcement Administration, and corresponding state agencies to ensure strict compliance with cGMP and / or quality system regulations (QSR) and other government regulations and corresponding foreign standards.  We do not have control over third-party manufacturers’ compliance with these regulations and standards;
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If any third-party manufacturer makes improvements in the manufacturing process for our products, we may not own, or may have to share, the intellectual property rights to any such innovation.  We may be required to pay fees or other costs for access to such improvements;
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Each of these risks could delay our development programs, the approval, if any, of our product candidates by the FDA or the commercialization of our product candidates or result in higher costs or deprive us of potential product revenues;
such a catastrophe, and we have obtained insurance to protect against certain business interruption losses.  However, there can be no assurance that any such coverage will be adequate or that such coverage will continue to remain available on acceptable terms, if at all.

IfFor the development and, if approved, commercialization of AEROSURF, we fail to identify or maintain relationships withwill depend in large measure upon the manufacturers and assemblers of our CAG devices,devices.  If we are unable to identify qualified manufacturers and assemblers, the timeline of our plans for the development and, if approved, commercialization of AEROSURF and any other aerosolized ® and our other aerosolized KL4 surfactant products, could suffer.  We are exposed to similar risks with respect to the manufacture of our AFECTAIR® devices.

In connection with the development of AEROSURF, which is a combination drug/device product that produces our  aerosolized KL4 surfactant, including AEROSURF, which is a drug/device combination product, we currently plan to rely on third-party contract manufacturersCMOs to manufacture and assemble the CAG and all subcomponents of ourthe CAG technology and to assemble the component parts to support our preclinical experiments, planned clinical studiestrials and, potential commercialization of AEROSURF.  Certain of these components must be manufactured inif approved, commercial device.  The CAG device includes an environmentally-controlled areaaerosol control unit and when assembled,a disposable ADP. The ADP includes the critical drug product-contact components that are either cleaned or manufactured in an environmentally-controlled, clean area. The control unit and ventilator circuit / patient interface connectors must be packaged.ADPs are assembled and packaged in a clean area.  Each of the aerosolization systemADP devices is tested for conformance to designated product specifications during assembly and each of the assembled control units must be quality control tested prior to release and monitored for conformance to designated product specification.specifications.
We have worked with selected component manufacturersBattelle to develop our initial prototype CAG device.  We are currently focused on developing an optimized CAG device to meet regulatory and ease-of-use design requirements for AEROSURF and prepare for potential Phasesupport our phase 2 clinical trials.  However, asprogram.  As with many device development initiatives, there is a risk that, even if we will not be successfulare able to finalize specifications for a  CAG system that is suitable for use in our development effortsa phase 3 trial and, that theif approved, commercial applications, we may have difficulty identifying manufacturers that we identify may not beare able to consistently manufacture and assemble if at all, the subcomponents of our CAG systems to our specified standards.  In addition, we may not be able to identify qualified additional or replacement manufacturers and assemblers to manufacture subcomponents and assemble our optimized CAG system and, if developed, later versions of our CAG systems, or we may not be able to enter into agreements with them on terms and conditions favorable and acceptable to us.  In addition, the manufacturers and assemblers that we identify may be unable to timely comply with FDA, or other foreign regulatory agency, regulatory manufacturing requirements.  If we do not successfully identify and enter into contractual agreements with manufacturers and assemblers that have the required expertise to produce our CAG devices as and when needed, it will adversely affect our timeline for the development and, if approved, commercialization of our aerosolized KL4 surfactant, including AEROSURF.

Our relationship with Lacey exposes usWe are exposed to similar risks.risks in the manufacture of our AFECTAIR device.  We are reliant upon Laceyon our CMO for, among other things, the manufacture, packaging and labeling of our AFECTAIR devices.device.  These activities must be performed to specifications and in compliance with the QSRregulations of the FDA and foreign regulators.  Lacey is obligated to cooperate with us inIn the event of any release of defective product, our CMO is obligated to cooperate with us, including for those defects that resultsresult in product recalls or other similar events.  If Laceyour CMO is unable to manufacture to our specifications, or if Laceyour CMO fails to comply with the QSRsregulations of the FDA or foreign regulators, it could have a material adverse effect on our development and commercial activities and our financial condition and prospects.

The cost of materials required for the manufacture of AFECTAIR® may increase or be higher than anticipated.

The components of AFECTAIR are manufactured from high-quality medical grade materials that are generally recognized as safe.  Suppliers of these materials, due to a change in their pricing policies or an increase in raw materials costs, might charge us increasingly higher than anticipated prices.  In turn, we might experience diminishing profit margins or remain unprofitable indefinitely.

Issues with product quality could have an adverse effect uponon our business, subject us to regulatory actions and costly litigation and cause a loss of customer confidence in our products or us.

Our success depends upon the quality of our products.  Our future revenues will depend upon our ability to develop, maintain, and continuously improve our quality management program,system, including an objective and systematic process for monitoring and the evaluation of key effectivenessprocess indicators.  Quality and safety issues may occur with respect to any of our products.  We are dependent upon third-party suppliers, manufacturers and service providers to support our development and commercialization activities.  Third-party suppliers are required to comply with our quality standards.  Failure of a third-party supplier to provide compliant raw materials or supplies could result in delays or other quality-related issues.  A quality or safety issue could have an adverse effect on our business, financial condition and results of operations and may result in warning letters, product recalls or seizures, monetary sanctions, injunctions to halt manufacture and distribution of products, civil or criminal sanctions, refusal of a government to grant approvals and licenses, restrictions on operations or withdrawal of existing approvals and licenses.  An inability to address a quality or safety issue in an effective and timely manner may also cause negative publicity, a loss of customer confidence in our current or future products or us, which may result in the loss of sales and difficulty in commercializing our products.

AFECTAIR®Medical device product inadequacies could lead to recalls and harm our reputation, business and financial results.

The design, manufacture and marketing of our medical device products involve certain inherent risks.  Our products must be designed, manufactured and marketed to specific product specifications.  Manufacturing or design defects, unanticipated use of our products, or inadequate disclosure of risks relating to the use of our products can lead to injury or other adverse events.  Personal injuries relating to the use of our products can also result in product liability claims being brought against us.  In some circumstances, such adverse events could also cause delays in new product approvals.
We also may be restricted or prohibited from marketing or manufacturing a product, even after obtaining marketing authorization, if previously unknown problems with the product or its manufacture are subsequently discovered and we cannot provide assurance that newly discovered or developed safety issues will not arise following any regulatory clearance.  The FDA and similar foreign governmental authorities have the authority to require the recall of commercialized products in the event of material deficiencies or defects in design or manufacture.  In the case of the FDA, the authority to require a mandatory recall must be based on an FDA finding that there is a reasonable probability that the device would cause serious adverse health consequences or death.  In addition, foreign governmental bodies have the authority to require the recall of our products in the event of material deficiencies or defects in design or manufacture.  Manufacturers may, under their own initiative, initiate a field alert or action, known as a recall, for a product if any material deficiency in a device is found.  A government mandated or voluntary recall by us or our third-party manufacturers or suppliers could occur as a result of component failures, manufacturing errors, design  or labeling defects or other deficiencies and issues.  Recalls of any of our products would divert managerial and financial resources and have an adverse effect on our financial condition and results of operations.  The FDA requires that certain classifications of recalls be reported to the FDA within 10 working days after the recall is initiated.  We are required to maintain certain records of recalls, even if they are not reportable to the FDA.  We may initiate voluntary recalls involving our products in the future that we determine do not require notification to the FDA.  If the FDA disagrees with our determinations, they could require us to report those actions as recalls.  A future recall announcement could harm our reputation with customers and negatively affect our sales.  In addition, the FDA could take enforcement action for failing to report the recalls when they were conducted.

Under the FDA medical device reporting regulation, medical device manufacturers are required to report to the FDA information that a device has or may have caused or contributed to a death or serious injury or has malfunctioned in a way that would likelymay cause or contribute to death or serious injury if the malfunction of the device or one of our similar devices were to recur.  If we fail to report these events to the FDA within the required timeframes, or at all, the FDA could take enforcement action against us.  Any such adverse event involving our products also could result in future voluntary corrective actions, such as recalls or customer notifications, or agency action, such as inspection or enforcement action.  Any corrective action, whether voluntary or involuntary, as well as defending ourselves in a lawsuit, will require the dedication of our time and capital, distract management from operating our business, and may harm our reputation and financial results.

Marketing authorization to promote, manufacture and/or sell our products will be limited and subject to continuing review.

We have successfully registered our AFECTAIR device in the U.S.  This registration does not include substantial claims with respect to potential use or efficacy.  If we register this product  in the European Union (EU), such clearance will be subject to limitations on the uses for which the product may be marketed and reduce our potential to successfully commercialize the product and generate revenue from the product.  Similarly, although our label for SURFAXIN contains more information, including data from our pivotal phase 3 clinical trial, there are limitations that affect the manner in which we may market and sell our SURFAXIN drug product.  The FDA and other regulatory agencies actively enforce regulations prohibiting promotion of off-label uses and the promotion of products for which marketing clearance has not been obtained.  If the FDA were to determine that our promotional materials, labeling, training or other marketing or educational activities constitute promotion of an unapproved use, it could direct us to cease or modify our training or promotional materials or subject us to serious regulatory enforcement actions.  It is also possible that other federal, state or foreign enforcement authorities could take action if they consider our training or other promotional materials to constitute promotion of an unapproved use, which could result in significant fines or penalties under other statutory authorities, such as laws prohibiting false claims for reimbursement.  A company that is found to have improperly promoted off-label uses may be subject to significant liability, including civil and administrative remedies as well as criminal sanctions.  Due to these legal constraints, our marketing and sales efforts will have to focus on the general technical attributes and benefits of AFECTAIR and any FDA-cleared indications for use.  We have conducted a series of studies, and plan to conduct further studies, evaluating the utility of AFECTAIR in delivering specific inhaled therapies, but there can be no assurance that our efforts will be successful, or even if successful, that we will be able to expand our label to include the additional indications.  For SURFAXIN, our marketing and sales efforts will have to be based on our label, although there is other data and information available that speaks to the benefits of our KL4 surfactants.

In addition, for both our AFECTAIR device and SURFAXIN, we will have to comply with reporting requirements applicable to medical devices and drug products, including the reporting of adverse events and device malfunctions related to our products.  Later discovery of previously unknown problems, including unanticipated adverse events or adverse events of unanticipated severity or frequency, manufacturing problems or failure to comply with regulatory requirements may result in changes to labeling, restrictions on such products or manufacturing processes, withdrawal of the products from the market or regulatory enforcement actions.

Failure in our information technology systems could disrupt our operations and cause the loss of confidential information, customers and business opportunities.

As we prepare for the commercialization of our first approved products, we will need extensive information technology (IT) systems in virtually all aspects of our business, including billing, customer service, logistics and management of clinical trial and medical data management.  OurIn selecting the appropriate software packages and systems to manage and support our activities, we will consider both in-house development and specialty software and system packages offered by third party vendors, service providers and consultants.  The systems we select may not be adequate to meet our needs or may fail to perform to the specified requirements.  We may be required to seek other sources of system support, which would increase our costs and potentially delay our implementation of necessary activities.  There can be no assurance that the systems that we select or choose to develop will be adequate to our needs, that they will perform to our requirements or that we will be successful in integrating them into our operations.

In addition, our technology systems are potentially vulnerable to breakdown or other interruption by fire, power loss, system malfunction, unauthorized access and other events.  Our success will depend, in part, on the continued and uninterrupted performance of our IT systems.  IT systems may be vulnerable to damage, disruptions and shutdown from a variety of sources, including telecommunications or network failures, human acts and natural disasters.  They also may be subject to physical or electronic intrusions, computer viruses, unauthorized tampering and similar disruptive problems.  Likewise, data privacy breaches by employees and others with permitted access to our systems may pose a risk that sensitive data may be exposed to unauthorized persons or to the public.  Along with our new systems, we plan to take precautionary measures to prevent unanticipated problems.  Nevertheless, we may experience damages to our systems, system failures and interruptions and unauthorized disclosure of confidential information, and our data could be compromised.

There can be no assurance that our efforts will prevent significant breakdowns, breaches in our systems or other cyber incidents that could have a material adverse effect upon our reputation, business, operations or financial condition of the company.  In addition, there can be no assurances that a significant implementation issue may not arise as we continue to implement new systems and consolidate or replace existing (legacy) systems.

If we experience systems problems, or if the systems we implement do not meet our expectations, they may interrupt our ability to operate.  If we experience systems problems, or if we experience unauthorized disclosure of confidential information, it could adversely affect our reputation, result in a loss of customers and revenues and cause us to suffer financial damage, including significant costs to alleviate or eliminate the problem.

If we do not adequately forecast customer demand for our approved products, including SURFAXIN® and AFECTAIR®, our business could suffer.  We are also subject to risks associated with doing business globally.

The timing and amount of customer demand and the commercial requirements to meet changing customer demand are difficult to predict.  We may not be able to accurately forecast customer demand for our products and product candidates, starting with SURFAXIN and AFECTAIR, or to respond effectively to unanticipated increases in demand.  This could have an adverse effect on our business.  If we overestimate customer demand, or attempt to commercialize products for which the market is smaller than we anticipate, we could incur significant unrecoverable costs from creating excess capacity.

In addition, the current economic conditions may result in reduced demand for our products, increased pricing pressure, longer sales cycles, and slower adoption rates for our products.  Conditions in the healthcare industry, including lower healthcare utilization, cost containment efforts by governments and other payers for healthcare services and other factors may result in weaker overall customer demand and increased pricing pressure for our products.  The current economic conditions may also adversely affect our suppliers, which could affect our ability to manufacture and sell our products.

We expect to offer certain of our products in the European Union and elsewhere, which subjects us to risks associated with doing business globally and under the laws, regulations and customs of various jurisdictions and geographies.  These risks include fluctuations in currency exchange rates, changes in exchange controls, increasingly complex labor environments, expropriation and other governmental actions, availability of raw materials, changes in taxation, importation limitations, export control restrictions, changes in or violations of U.S. or local laws, including the FCPA, pricing restrictions, economic and political instability, diminished or insufficient protection of intellectual property, and disruption in a significant geographic region regardless of cause, including war, terrorism, riot, civil insurrection or social unrest. Failure to comply with, or material changes to, the laws and regulations that affect our business could have an adverse effect on our business, financial condition or results of operations.

Our CEFF and ATM Program may become unavailable to us if we do not comply with their conditions.

Except for our CEFF and ATM Program (which are subject to certain limitations), we currently do not have arrangements to obtain additional financing.  If we are unable to meet the conditions provided under the CEFF and ATM Program, we will not be able to issue any portion of the shares potentially available for issuance thereunder and these programs may expire unutilized.  In addition, our ability to utilize the ATM Program or any new CEFF in the future may be impaired.  In February 2011, we issued five-year warrants that contain anti-dilution provisions that potentially adjust the exercise price of these warrants upon the issuance of securities at prices lower than the warrant exercise price.  The warrant anti-dilution provisions are not triggered by draw downs under our existing CEFF but are triggered by financings under the ATM Program or any new CEFF.  In that event, the potential dilutive effect of a financing could be increased if the applicable purchase price of such financing is less than the exercise price of the warrants, which could result in a decline in the market price of our stock.

Future sales and issuances of our common stock or rights to purchase our common stock, including pursuant to our CEFF and ATM Program, stock incentive plans and upon the exercise of outstanding securities exercisable for shares of our common stock, could result in substantial additional dilution of our stockholders, cause our stock price to fall and adversely affect our ability to raise capital.

We will require additional capital to continue to execute our business plan and advance our research and development efforts.  To the extent that we raise additional capital through the issuance of additional equity securities and through the exercise of outstanding warrants, our stockholders may experience substantial dilution.  We may sell shares of our common stock in one or more transactions at prices that may be at a discount to the then-current market value of our common stock and on such other terms and conditions as we may determine from time to time.  Any such transaction could result in substantial dilution of our existing stockholders.  If we sell shares of our common stock in more than one transaction, stockholders who purchase our common stock may be materially diluted by subsequent sales.  Such sales could also cause a drop in the market price of our common stock.  The issuance of shares of our common stock under the CEFF and the ATM Program, has, and the issuance of shares upon exercise of theoutstanding warrants, weincluding those issued to KingsbridgeDeerfield in connection with our CEFFsthe Deerfield Loan, will have a dilutive impact on our other stockholders and the issuance, or even potential issuance, of such shares could have a negative effect on the market price of our common stock.

In addition, if we access the ATM Program, we will pay Lazard a commission equal to three percent of the aggregate purchase price.  If we access the CEFF, we will issue shares of our common stock to Kingsbridge at a discount (from 4.38% to 17.5%, depending upon the market price) to the daily volume-weighted average price of our common stock on each trading day, which will further dilute the interests of other stockholders.  See, “Item 7 –  Management’s Discussion and Analysis of Financial Condition and Results of Operations – Liquidity and Capital Resources – Committed Equity Financing Facility (CEFF).”  Furthermore, to the extent that Kingsbridge sells to third parties the shares of our common stock that we sell to Kingsbridge under the CEFF, our stock price may decrease due to the additional selling pressure in the market.  The perceived risk of dilution from sales of stock to or by Kingsbridge may cause holders of our common stock to sell their shares, or it may encourage short sales of our common stock or other similar transactions.  This could contribute to a decline in the stock price of our common stock.

We also filed a universal shelf registration statement with the SEC on Form S-3 (File No. 333-174786) on June 8, 2011 (which was declared effective shortly thereafter) for the proposed offering from time to time of up to $200 million of our securities, including common stock, preferred stock, varying forms of debt and warrant securities, or any combination of the foregoing.  We have issued securities pursuant to this shelf registration statement on several occasions, and may do so again in the future in response to market conditions or other circumstances on terms and conditions that will be determined at such time.

As of March 21, 2012, we had 43,307,867 shares of common stock issued and outstanding.  In addition, as of December 31, 2011, approximately (i) 13.0 million shares of our common stock were reserved for potential issuance upon the exercise of outstanding warrants, (ii) 2.4 million shares of our common stock were reserved for issuance pursuant to our equity incentive plans, and (iii) 342,833 shares of our common stock were reserved for issuance pursuant to our 401(k) Plan.  The exercise of stock options and other securities could cause our stockholders to experience substantial dilution.  Moreover, holders of our stock options and warrants are likely to exercise them, if ever, at a time when we otherwise could obtain a price for the sale of our securities that is higher than the exercise price per security of the options or warrants.  Such exercises, or the possibility of such exercises, may impede our efforts to obtain additional financing through the sale of additional securities or make such financing more costly.  It may also reduce the price of our common stock.

If, during the term of certain of our warrants, we declare or make any dividend or other distribution of our assets to holders of shares of our common stock, by way of return of capital or otherwise (including any distribution of cash, stock or other securities, property or options by way of a dividend, spin off, reclassification, corporate rearrangement or other similar transaction), then the exercise price of such warrants may adjust downward and the number of shares of common stock issuable upon exercise of such warrants would increase.  In addition, in February 2011, we issued five-year warrants that contain an anti-dilution provision that, subject to certain exclusions, potentially adjusts the exercise price of these warrants upon the issuance of securities at prices lower than the warrant exercise price.  For the purpose of valuing securities that we may issue in the future in unit offerings, this anti-dilution provision values the warrant portion of a unit offering based on a Black Scholes pricing model.  When such Black Scholes value is subtracted from the actual per-unit price of the offering, per-share value of the shares issued in such unit offering is decreased for the purposes of the anti-dilution provision.  If we issue shares, units, or warrants in a financing that triggers the anti-dilution provision of our February 2011 five-yearthese warrants, the exercise price of the February 2011 five-year warrants will be lowered thereby, increasing the likelihood that such warrants would be exercised.  As a result of such warrant adjustments, we may be required to issue more shares of common stock, or shares at lower prices, than previously anticipated, which could result in further dilution of our existing stockholders.

We filed a universal shelf registration statement with the SEC on Form S-3 (File No. 333-174786) on June 8, 2011 (which was declared effective shortly thereafter) for the proposed offering from time to time of up to $200 million of our securities, including common stock, preferred stock, varying forms of debt and warrant securities, or any combination of the foregoing.  We have issued securities pursuant to this shelf registration statement on several occasions, and may do so again in the future in response to market conditions or other circumstances on terms and conditions that will be determined at such time.  To provide flexibility and support any future transactions we may undertake, in 2014, we plan to replace this registration statement, which expires in June 2014, with a new universal shelf registration statement.
As of March 7, 2014, we had 84,696,919 shares of common stock issued and outstanding.  In addition, as of December 31, 2013, approximately (i) 14.8 million shares of our common stock were reserved for potential issuance upon the exercise of outstanding warrants, (ii) 5.4 million shares of our common stock were reserved for issuance pursuant to our equity incentive plans, and (iii) 166,243 shares of our common stock were reserved for issuance pursuant to our 401(k) Plan.  The exercise of stock options and other securities could cause our stockholders to experience substantial dilution.  Moreover, holders of our stock options and warrants are likely to exercise them, if ever, at a time when we otherwise could obtain a price for the sale of our securities that is higher than the exercise price per security of the options or warrants.  Such exercises, or the possibility of such exercises, may impede our efforts to obtain additional financing through the sale of additional securities or make such financing more costly.  It may also reduce the price of our common stock.

The market price of our stock may be adversely affected by market volatility.

The market price of our common stock, like that of many other development stage pharmaceutical or biotechnology companies, has been and is likely to be volatile.  In addition to general economic, political and market conditions, the price and trading volume of our stock could fluctuate widely in response to many factors, including:

●
announcements of the results of clinical trials by us or our competitors;
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patient adverse reactions to drug products;
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governmental approvals, delays in expected governmental approvals or withdrawals of any prior governmental approvals or public or regulatory agency concerns regarding the safety or effectiveness of our products;
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changes in the United States or foreign regulatory policy during the period of product development;
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changes in the United States or foreign political environment and the passage of laws, including tax, environmental or other laws, affecting the product development business;
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developments in patent or other proprietary rights, including any third-party challenges of our intellectual property rights;
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announcements of technological innovations by us or our competitors;
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announcements of new products or new contracts by us or our competitors;
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actual or anticipated variations in our operating results due to the level of development expenses and other factors;
●
changes in financial estimates by securities analysts and whether our earnings meet or exceed the estimates;
47
patient adverse reactions to our products;
Tablegovernmental approvals, delays in expected governmental approvals or withdrawals of Contents
any prior governmental approvals or public or regulatory agency concerns regarding the safety or effectiveness of our products;
changes in the U.S. or foreign regulatory policy during the period of product development;
●
changes in the U.S. or foreign political environment and the passage of laws, including tax, environmental or other laws, affecting the product development business;
conditions and trends in the pharmaceutical and other industries;
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developments in patent or other proprietary rights, including any third-party challenges of our intellectual property rights;
new accounting standards; and
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announcements of technological innovations by us or our competitors;
announcements of new products or new contracts by us or our competitors;
actual or anticipated variations in our operating results due to the level of development expenses and other factors;
changes in financial estimates by securities analysts and whether our earnings meet or exceed the estimates;
conditions and trends in the pharmaceutical and other industries;
new accounting standards; and
the occurrence of any of the risks described in these “Risk Factors” or elsewhere in this Annual Report on Form 10-K or our other public filings.
the occurrence of any of the risks described in these “Risk Factors” or elsewhere in this Annual Report on Form 10-K or our other public filings.

Our common stock is listed for quotation on The Nasdaq Capital Market.Market®.  During the 12-month period ended December 31, 2011,2013, the price of our common stock ranged between $1.44$1.50 and $4.18.$3.05.  We expect the price of our common stock to remain volatile.  The average daily trading volume in our common stock varies significantly.  For the twelve month period ended December 31, 2011,2013, the average daily trading volume in our common stock was approximately 389,347549,650 shares, and the average number of transactions per day was approximately 796.1,502.  The instability observed in our daily volume and number of transactions per day may affect the ability of our stockholders to sell their shares in the public market at prevailing prices.
In the past, following periods of volatility in the market price of the securities of companies in our industry, securities class action litigation has often been instituted against companies in our industry.  Even if securities class actions that may be filed against us in the future were ultimately determined to be meritless or unsuccessful, they would involve substantial costs and a diversion of management attention and resources, which could negatively affect our business.

If we fail to adhere to the strict listing requirements of The Nasdaq Capital Market,®, we may be subject to delisting.  As a result, our stock price may decline and following a hearing, our common stock may be delisted.  If our stock were no longer listed on theThe Nasdaq Capital Market, the liquidity of our securities likely would be impaired.

Our common stock currently trades on theThe Nasdaq Capital Market under the symbol DSCO.  If we fail to adhere to the market’s strict listing criteria, our stock may be delisted.  This could potentially impair the liquidity of our securities not only in the number of shares that could be bought and sold at a given price, which might be depressed by the relative illiquidity, but also through delays in the timing of transactions and the potential reduction in media coverage.  As a result, an investor might find it more difficult to dispose of our common stock.  We believe that current and prospective investors would view an investment in our common stock more favorably if it continues to be listed on theThe Nasdaq Capital Market.

In December 2009, we received a letter from  Any failure at any time to meet the continuing The Nasdaq Global Market® (Global Market) indicating that we had failed to comply with Nasdaq Listing Rule 5450(a)(1) (Minimum Bid Price Rule), which requires that we maintain a minimum closing bid price of $1.00 per share.  Anticipating that we would not regain compliance with the Minimum Bid Price Rule on or before June 1, 2010, in May 2010, we applied to transfer our common stock to the Nasdaq Capital Market which was effective on June 4, 2010.  Based on our ability to comply with all listing requirements could have an adverse impact on the value of the Nasdaq Capital Market other than the Minimum Bid Price Rule, Nasdaq also granted us an additional 180 days, or until November 29, 2010, to regain compliance with the Minimum Bid Price Rule.

On November 30, 2010, we received written notification from Nasdaq that our common stock was subject to delisting because we had not regained compliance with the Minimum Bid Price Rule within the 180-day period previously granted.  We requested a hearing with a Nasdaq Hearing Panel, which stayed the delisting of our stock pending the Panel’s review.  On December 28, 2010, we implemented a 1-for-15 reverse stock split, after which the closing market price of our stock was above $1.00.  On January 11, 2011, following our hearing, the Nasdaq Hearing Panel determined that we had regained compliance with the Minimum Bid Price Rule because our common stock had maintained a minimum closing bid price of $1.00 per share over a period of 10 consecutive business days.  Currently, our common stock continues to comply with all Nasdaq Listing Requirements for the Nasdaq Capital Market.

Although we have regained compliance with the Minimum Bid Price Rule, there can be no assurance that we will be able to maintain continued compliance with the Minimum Bid Price Rule or the other listing requirements of Nasdaq.  There can be no assurance that the closing bid price of our common stock will continue to trade above $1.00.  Moreover, ifand trading activity in our common stock were to reduce the total market capitalization of our company, we may find it difficult to fund our activities, which would result in reductions in our stockholders’ equity.  In addition to the Minimum Bid Price Rule, certain other Nasdaq continued listing requirements require that we maintain a market capitalization of at least $35 million or stockholders’ equity of at least $2.5 million.  If we were unable to meet these requirements, we would receive another delisting notice from the Nasdaq Capital Market for failure to comply with one or more of the continued listing requirements.

We expect to face uncertainty over reimbursement and healthcare reform.

In both the United StatesU.S. and other countries, sales of our products will depend in part upon the availability of reimbursement from third-party payers, which include governmental health administration authorities, managed care providers and private health insurers.  Government and other healthcare payers increasingly challenge the price and examine the cost effectiveness of medical products and services.  Moreover, the current political environment in the United StatesU.S. and abroad may result in the passage of significant legislation that could, among other things, restructure the markets in which we operate and restrict pricing strategies of drug development companies.  If, for example, price restrictions were placed on the distribution of our drugs, we may be forced to curtail development of our pipeline products and this could have a material adverse effect on our business, results of operations and financial condition.  Even if we succeed in commercializing our drug products, uncertainties regarding health care policy, legislation and regulation, as well as private market practices, could affect our ability to sell our products in quantities or at prices that will enable us to achieve profitability.

To obtain reimbursement from a third-party payer, it must determine that our drug product is a covered benefit under its health plan, which is likely to require a determination that our product is:

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safe, effective and medically necessary;
safe, effective and medically necessary;
●
appropriate for the specific patient;
appropriate for the specific patient;
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cost-effective; and
cost-effective; and
●
neither experimental nor investigational.
neither experimental nor investigational.

Obtaining a determination that a product is a covered benefit may be a time-consuming and costly process that could require us to provide supporting scientific, clinical and cost-effectiveness data about our products to each payer.  We may not be able to provide sufficient data to gain coverage.  Even when a payer determines that a product is covered, the payer may impose limitations that preclude payment for some uses that are approved by the FDA or other regulatory authorities.  Cost-containment measures, if implemented to affect the coverage or reimbursement of our products, could have a material adverse effect on our ability to market our products profitably.  Moreover, coverage does not imply that any product will be covered in all cases or that reimbursement will be available at a rate that would permit a health care provider to cover its costs of using our product.
Prices in many countries, including many in Europe, are subject to local regulation and certain pharmaceutical products may be subject to price controls in several of the world’s principal markets, including many countries within the European Union.EU.  In the United States,U.S., where pricing levels for our products are substantially established by third-party payers, if payers reduce the amount of reimbursement for a product, it may cause groups or individuals dispensing the product to discontinue administration of the product, to administer lower doses, to substitute lower cost products or to seek additional price-related concessions.  These actions could have a negative effect on our financial results, particularly in cases where our products command a premium price in the marketplace.  The existence of direct and indirect price controls and pressures over our products could materially adversely affect our financial prospects and performance.

The implementation of the 2010 Health Care Reform Law in the United StatesU.S. may adversely affect our business.

The Patient Protection and Affordable Care Act as amended by the Health Care and Education Reconciliation Act, each enacted in March 2010, generally known as the Health Care Reform Law, significantly expands health insurance coverage to uninsured Americans and changes the way health care is financed by both governmental and private payers.  We expect expansion of access to health insurance may increase the demand for our products, but other provisions of the Health Care Reform Law could affect us adversely.  We also expect that further federal and state proposals for healthcare reform are likely.  The changes contemplated by the health care reform law are subject to rule-making and implementation timelines that extend for several years, and this uncertainty limits our ability to forecast changes that may occur in the future.  However, any changes that lower reimbursements for our products could adversely affect our business and results of operations.

The Health Care Reform Law establishesincludes provisions, referred to as the federal “Open Payments” law (previously referred to as the “Sunshine Law”), that establish new reporting and disclosure requirements for pharmaceutical and medical device manufacturers.  Data collection obligations wereUnder the law, pharmaceutical and device manufacturers are required to commence in January 2012,annually report various types of payments and reporting requirements areother transfers of value to be implemented in 2013.  On December 14, 2011,physicians and teaching hospitals.  Implementation of the sunshine provisions has been subject to delay by the U.S. Centers for Medicare and Medicaid Services issued proposed regulations(CMS).  Under the current regime, applicable manufacturers were to implement these provisionsbegin tracking relevant transfer-of-value data in August 2013, and sought substantial comments, thereby apparently delayingmust report data collected between August 1 and the January 1, 2012 startend of information collection.  These proposed regulations are broadly drafted2013 to CMS in a two-phased approach by March 31, and still subject to change, and it is possible that when these regulations are finalized, our contract manufacturersMay 31, 2014, respectively.  CMS will publish the data on a public website later in the year.  Inaccurate or we willincomplete reports may be subject to these reporting requirements.  In addition,enforcement.   Like the federal Sunshine Law, several states have existing laws that require pharmaceutical and/or device companiesmanufacturers to report expenses relatingtransfers of value to select healthcare providers licensed within the marketing and promotion of productsstate, or even go so far as well as gifts and payments to individual practitioners in the states, or prohibit certain marketing related activities.  Other states, such as California, Nevada, Massachusetts and Connecticut, require pharmaceutical and/or device companies to implement compliance programs or marketing codes.  Wholesale distributors are covered by the laws in certain of these states.  In others, it is possible that we will be subject us to the state’s reporting requirements and prohibitions.  Compliance activities with respect to these measures could increase our costs and adversely affect business operations.

The Health Care Reform Law contains many provisions designed to generate the revenues necessary to fund the coverage expansions and to reduce costs of Medicare and Medicaid, including imposing a 2.3% excise tax on domestic sales of medical devices by manufacturers and importers beginning in 2013, and a fee on branded prescription drugs that was implemented in 2011, both of which may affect sales of our products.  As U.S. net sales are expected to be a significant portion of our worldwide net sales in the coming years, this additional tax burden may have a material, negative impact on our results of operations and our cash flows.  The Health Care Reform Law also mandates pharmacy benefit manager transparency regarding rebates, discounts and price concessions with respect to drug benefits under Medicare Part D, and in 2014 with respect to drug benefits offered through qualified health plans offered through state exchanges, which could affect pricing and competition.
Political, economic and regulatory influences are subjecting the healthcare industry to potential fundamental changes that could substantially affect our results of operations.  Government and private sector initiatives to limit the growth of healthcare costs, including price regulation, competitive pricing, coverage and payment policies, comparative effectiveness of therapies, technology assessments and managed-care arrangements, are continuing in many countries where we plan to do business, including the United States.U.S.

The Health Care Reform Law establishes the Independent Payment Advisory Board, which will be responsible, beginning in 2014, annually to submit proposals aimed at reducing Medicare cost growth while preserving quality.  These proposals automatically will be implemented unless Congress enacts alternative proposals that achieve the same savings targets.  Further, the legislation calls for a Center for Medicare and Medicaid Innovation that will examine alternative payment methodologies and conduct demonstration programs.  The legislation provides for extensive health insurance reforms, including the elimination of pre-existing condition exclusions and other limitations on coverage, fixed percentages on medical loss ratios, expansion in Medicaid and other programs, employer mandates, individual mandates, creation of state and regional health insurance exchanges, and tax subsidies for individuals to help cover the cost of individual insurance coverage.  The legislation also permits the establishment of accountable care organizations, a new healthcare delivery model.  While the ultimate impact of the legislation on the healthcare industry is unknown, it is likely to be extensive and may result in significant change.  Our failure to adapt to these changes could have a material adverse effect on our business.

If we fail to maintain an effective system of internal control over financial reporting, we may not be able to accurately report our financial results, which will likely result in significant legal and accounting expense and diversion of management resources, and current and potential stockholders may lose confidence in our financial reporting and the market price of our stock will likely decline.

We are required by the SEC to establish and maintain adequate internal control over financial reporting that provides reasonable assurance regarding the reliability of our financial reporting and the preparation of financial statements in accordance with generally accepted accounting principles.  We are likewise required, on a quarterly basis, to evaluate the effectiveness of our internal controls and to disclose any changes and material weaknesses in those internal controls.

In our internal control report for our Quarterly Report on Form 10-Q for the quarter ended September 30, 2010, management was unable to conclude that we had maintained effective internal control over financial reporting as of September 30, 2010, and identified a material weakness regarding our process and procedures related to the initial classification and subsequent accounting of registered warrants as liabilities or equity instruments.  Upon a reassessment of those financial instruments, in light of GAAP as currently interpreted, we determined that we should have accounted for registered warrants that we issued in May 2009 and February 2010 as derivative liabilities instead of equity.  As a result, to reclassify the affected warrants as derivative liabilities, in November 2010, we restated our consolidated financial statements for the periods ended June 30, 2009 through June 30, 2010.  The process to restate our financial statements was highly time-consuming, resource-intensive and involved substantial attention from management and significant legal and accounting expense.

To remediate the identified material weakness in our internal controls, we have enhanced our process to identify and correctly apply developments in accounting and to improve our understanding of the nuances of increasingly complex accounting standards.  We have improved access to the accounting literature, research materials and documents and increased communication among our legal and finance personnel and third-party professionals with whom we consult regarding complex accounting applications.

Any failure to maintain internal controls could adversely affect our ability to report our financial results on a timely and accurate basis.  If our financial statements are not accurate, investors may not have a complete understanding of our operations.  Likewise, ifIf we do not file our financial statements are not filed on a timely basis as required by the SEC and The Nasdaq Capital Market, we could face severe consequences from those authorities.  In either case, there could result a material adverse effect on our business.  Inferior internal controls could also cause investors to lose confidence in our reported financial information, which could have a negative effect on the trading price of our common stock.  We can give no assurance that additional material weaknesses or restatements of financial results will not arise in the future due to a failure to implement and maintain adequate internal control over financial reporting or circumvention of these controls.  In addition, although we believe that we have remediated the material weakness that we identified in November 2010, in the future our controls and procedures may no longer be adequate to prevent or identify irregularities or errors or to facilitate the fair presentation of our consolidated financial statements.  Responding to inquiries from the SEC or The Nasdaq in the future will,Capital Market, regardless of the outcome, are likely to consume a significant amount of our management resources and cause us to incur significant legal and accounting expense.  Further, many companies that have restated their historical financial statements have experienced a decline in stock price and related stockholder lawsuits.
We depend upon key employees and consultants in a competitive market for skilled personnel.  If we or our strategic partners or collaborators are unable to attract and retain key personnel, it could adversely affect our ability to develop and market our products.

We will needAs we prepared for the commercial introduction of SURFAXIN, we implemented a plan to hire additional qualified personnel to support (i) the commercializationcommercial introduction of SURFAXIN and AFECTAIR, and (ii) the advancement of our AEROSURF and, potentially, SURFAXIN LS and AEROSURF development programs.  In particular, over the next 12 months, we expect to hire approximately 50 new employees primarily in the areas of field basedestablished our field-based sales and marketing and medical affairs organizations, and continue to invest in our regulatory affairs, and quality control and assurance.  We expect that the hiring of such additional personnel will increase our annual expenditures by approximately $8.0 million.assurance and administrative capabilities.  We compete for qualified individuals with numerous biopharmaceutical companies, universities and other research institutions.  Competition for such individuals is significant and attracting and retaining qualified personnel will be critical to our success, and any failure to do so successfully may have a material adverse effect on us.

We are highly dependent upon the members of our executive management team and our directors, as well as our scientific advisory board members, consultants and collaborating scientists.  Many of these individuals have been involved with us for many years, have played integral roles in our progress and we believe that they continue to provide value to us.  A loss of any of our key personnel may have a material adverse effect on aspects of our business and clinical development and regulatory programs.

As of December 31, 2011,In March 2013, we hadentered into employment agreements with fourfive executive officers, including Chief Executive Officer;the President and Chief FinancialExecutive Officer and Treasurer;Chief Financial Officer; the Senior Vice President and Chief Operating Officer; the Senior Vice President, General Counsel and Corporate Secretary; the Senior Vice President, Human Resources.Resources; and the Senior Vice President, Research and Development.  These agreements provideexpire on March 31, 2015, subject to automatic renewal for automaticadditional one-year renewal at the end of each term,periods, unless otherwise terminated by eithera party and will expire in May 2012.  In February 2012, we providedprovides notice of non-renewal for these agreements.at least 90 days in advance.  In addition, in May 2010, we recently entered into retentionnew agreements with five other executive officers under which each officer is provided certain severance benefits, based on title.  These agreementsthat also expire in May 2012.  Prior to the May 2012 expiration date for the executive officer agreements, the Compensation Committee of our Board of Directors expects to review market and other compensation data, as well as other information that the Committee may request, with a view to entering into new agreements with our executive officers.on March 31, 2015.  The loss of services from any of our executives could significantly adversely affect our ability to develop and market our products and obtain necessary regulatory approvals.  Further, we do not maintain key man life insurance.

As we prepare forproceed with the commercializationcommercial introduction of our approved products and undertake our AEROSURF phase 2 clinical program, we will need to attract candidatesand retain highly-qualified personnel to join our management, commercial, medical affairs and development teams, although there can be no assurances that we will be successful in that endeavor.  We may be unable to attract and retain necessary executive talent.  Our industry generally seeks to attract and retain executive talent with compensation packages that include a significant equity component.  Moreover, the equity incentives, including options and restricted stock, that we have issued are, for the most part, significantly devalued or out of the money and less likely to be exercisable in the future.  We plan in the future to seek stockholder approval for additional authorizations to support the use of equity incentives.  However, there can be no assurance that our stockholders will approve such incentives and, even if our stockholders approve new equity incentives that we will be able to attract and retain key executive talent in the interim period.

Our future success also will depend in part on the continued service of our key scientific and management personnel and our ability to identify, hire and retain additional personnel.  While we attempt to provide competitive compensation packages to attract and retain key personnel at all levels in our organization, many of our competitors have greater resources and more experience than we do, making it difficult for us to compete successfully for key personnel.  We may experience intense competition for qualified personnel and the existence of non-competition agreements between prospective employees and their former employers may prevent us from hiring those individuals or subject us to lawsuits brought by their former employers.
Our industry is highly competitive and we have less capital and resources than many of our competitors, which may give them an advantage in developing and marketing products similar to ours or make our products obsolete.

Our industry is highly competitive and subject to rapid technological innovation and evolving industry standards.  We compete with numerous existing companies intensely in many ways.   We need to successfully introduce new products to achieve our strategic business objectives.  The development and acquisition of innovative products and technologies that improve efficacy, safety, patients’ and clinicians’ ease of use and cost-effectiveness involve significant technical and business risks.  The success of new product offerings will depend on many factors, including our ability to properly anticipate and satisfy customer needs, adapt to new technologies, obtain regulatory approvals on a timely basis, demonstrate satisfactory clinical results, manufacture products in an economic and timely manner, and differentiate our products from those of our competitors.  If we cannot successfully introduce new products, adapt to changing technologies or anticipate changes in our current and potential customers’ requirements, our products may become obsolete and our business could suffer.

We intend to market our products under development for the treatment of diseases for which other technologies and treatments are rapidly developing and, consequently, we expect new companies to enter our industry and that competition in the industry will increase.  Many of these companies have substantially greater research and development, manufacturing, marketing, financial, technological, personnel and managerial resources than we have.  In addition, many of these competitors, either alone or with their collaborative partners, have significantly greater experience than we do in:

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developing products;
developing products;
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undertaking preclinical testing and human clinical trials;
undertaking preclinical testing and human clinical trials;
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obtaining FDA and other regulatory approvals or products; and
obtaining FDA and other regulatory approvals or products; and
●
manufacturing and marketing products.
manufacturing and marketing products.

Accordingly, our competitors may succeed in obtaining patent protection, receiving FDA or foreign regulatory approval or commercializing products before us.  IfOur competitors may successfully secure regulatory exclusivities in various markets, which could have the effect of barring us or limiting our ability to market our products in such markets.  As we commence commercial product sales, we will compete against companies with greater marketing and manufacturing capabilities that may successfully develop and commercialize products that are more effective or less expensive than our products.  As none of our products are approved, we currently have limited or no experience in these areas.  In addition, developments by our competitors may render our drug product candidates obsolete or noncompetitive.

We also face, and will continue to face, competition from colleges, universities, governmental agencies and other public and private research organizations.  These competitors frequently aggressively seek patent protection and licensing arrangements to collect royalties for use of technology that they have developed.  Some of these technologies may compete directly with the technologies that we are developing.  These institutions will also compete with us in recruiting highly qualified scientific personnel.  We expect that therapeutic developments in the areas in which we are active may occur at a rapid rate and that competition will intensify as advances in this field are made.  As a result, we need to continue to devote substantial resources and efforts to research and development activities.

If we cannot protect our intellectual property, other companies could use our technology in competitive products.  Even if we obtain patents to protect our products, those patents may not be sufficiently broad or they may expire and others could then compete with us.

We seek patent protection for our drug and device products and product candidates to prevent others from commercializing equivalent products in substantially less time and at substantially lower expense.  The pharmaceutical industry places considerable importance on obtaining patent and trade secret protection for new technologies, products and processes.  Our success will depend in part on our ability and that of parties from whom we license technology to successfully obtain patents, defend our patents, protect our trade secrets, and otherwise prevent others from infringing our proprietary rights, including our trade secrets.rights.

The patent position of companies relying upon biotechnology is highly uncertain and involves complex legal and factual questions for which important legal principles are unresolved.  To date, the United States Patent and Trademark Office (USPTO) has not adopted a consistent policy regarding the breadth of claims that it will allow in biotechnology patents or the degree of protection that these types of patents afford.  As a result, there are risks that we may not secure rights to products or processes that appear to be patentable.

The parties licensing technologies to us and we have filed various United StatesU.S. and foreign patent applications with respect to the products and technologies under our development, and the USPTO and foreign patent offices have issued patents with respect to our products and technologies.  These patent applications include international applications filed under the Patent Cooperation Treaty.  Our pending patent applications, those we may file in the future or those we may license from third parties may not result in the USPTO or foreign patent office issuing patents.  In addition, if patent rights covering our products are not sufficiently broad, they may not provide us with sufficient proprietary protection or competitive advantages against competitors with similar products and technologies.  Furthermore, even if the USPTO or foreign patent offices were to issue patents to us or our licensors, others may challenge the patents or circumvent the patents, or the patent office or the courts may invalidate the patents.  Thus, any patents we own or license from or to third parties may not provide us any protection against competitors.

The patents that we hold also have a limited life.  We have licensed a series of patents for our KL4surfactant technology from J&J and its wholly-owned subsidiary Ortho Pharmaceutical Corporation (Ortho Pharmaceutical), which are important, both individually and collectively, to our strategy of commercializing our KL4 surfactant products.  These patents, which include important KL4 composition of matter claims and relevant European patents, began to expire in November 2009, and will expire on various dates ending in 2017 or, in some cases, possibly later.  Of the patents that have expired, we have extended the term of our most important patent until November 2012, with further extensions possible into 2014.  For our aerosolized KL4 surfactant, we hold worldwide exclusive licenses infrom PMUSA and PMPSA to the United States and outside the United States to PMUSA’s CAG technology for use with pulmonary surfactants together or in combination with other products for all respiratory diseases.  Our exclusive license in the United StatesU.S. also extends to other (non-surfactant) drugs to treat a wide range of pediatric and adult respiratory indications in hospitals and other health care institutions.  The CAG technology patents expire on various dates beginning in May 2016 and ending in 2023,2031, or, in some cases, possibly later.  We have filed, and when possible and appropriate, will file, other patent applications with respect to our products and processes in the United StatesU.S. and in foreign countries.  We may not be able to develop enhanced or additional products or processes that will be patentable under patent law and, if we do enhance or develop additional products that we believe are patentable, additional patents may not be issued to us.See also, “– If we cannot meet requirements under our license agreements, we could lose the rights to our products.”

Our technology platform is based solely on our proprietary KL4 surfactant technology, our novel CAG technology, and our novel ventilator circuit / patient interface connectors.aerosol-conducting airway connector.

Our technology platform is based on the scientific rationale of using our KL4 surfactant technology, our CAG technology and our novel patient interface and related componentry to treat life-threatening respiratory disorders and to serve as the foundation for the development of novel respiratory therapies and products.  Our business is dependent upon the successful development and approval of our drug product candidates and our combination drug-device combination products based on these technologies.  Any material problems with our technology platforms could have a material adverse effect on our business.

Intellectual property rights of third parties could limit our ability to develop and market our products.

Our commercial success also depends upon our ability to operate our business without infringing the patents or violating the proprietary rights of others.  In certain cases, the USPTO keeps United StatesU.S. patent applications confidential while the applications are pending.  As a result, we cannot determine in advance what inventions third parties may claim in their pending patent applications.  We may need to defend or enforce our patent and license rights or to determine the scope and validity of the proprietary rights of others through legal proceedings, which would be costly, unpredictable and time consuming.  Even in proceedings where the outcome is favorable to us, they would likely divert substantial resources, including management time, from our other activities.  Moreover, any adverse determination could subject us to significant liability or require us to seek licenses that third parties might not grant to us or might only grant at rates that diminish or deplete the profitability of our products.  An adverse determination could also require us to alter our products or processes or cease altogether any product sales or related research and development activities.

If we cannot meet requirements under our license agreements, we could lose the rights to our products.

We depend on licensing agreements with third parties to maintain the intellectual property rights to our products under development.  Presently, we have licensed rights from J&J, Ortho Pharmaceutical, PMUSA, PMPSA and PMPSA.The Scripps Institute.  These agreements require us to make payments and satisfy performance obligations to maintain our rights under these licensing agreements.  All of these agreements last either throughout the life of the related patents or for a number of years after the first commercial sale of the relevant product.

In addition, we are responsible for the cost of filing and prosecuting certain patent applications and maintaining certain issued patents licensed to us.  If we do not meet our obligations under our license agreements in a timely manner, we could lose the rights to our proprietary technology.

Finally, we may be required to obtain licenses to patents or other proprietary rights of third parties in connection with the development and use of our products and technologies.  Licenses required under any such patents or proprietary rights might not be made available on terms acceptable to us, if at all.

We rely on agreements containing obligations regarding intellectual property, confidentiality agreementsand noncompetition provisions that could be breached and may be difficult to enforce.

Although we take what we believe to be reasonable steps to protect our intellectual property, including the use of agreements relating to the non-disclosure of our confidential and proprietary information and trade secrets to third parties, as well as agreements that provide for disclosure and assignment to us of all rights to the ideas, developments, improvements, discoveries and inventions of our employees, consultants, advisors and consultantsresearch collaborators while we employ them, such agreements can be difficult and costly to enforce.  We generally seek to enter into these types of agreements with consultants, advisors and research collaborators; however, to the extent that such parties apply or independently develop intellectual property in connection with any of our projects, disputes may arise concerning allocation of the related proprietary rights.  Such disputes often involve significant expense and yield unpredictable results.  In addition, we also rely on trade secrets and proprietary know-how that we seek to protect, in part, through confidentiality agreements with our employees, consultants, advisors or others.

Despite the protective measures we employ, we still face the risk that:

●
agreements may be breached;
●
agreements may not provide adequate remedies for the applicable type of breach;
●
our trade secrets or proprietary know-how may otherwise become known;
●
our competitors may independently develop similar technology; or
●
our competitors may independently discover our proprietary information and trade secrets.

Moreover, although all employees enter into agreements with us that include non-compete covenants, and our fourfive senior executive officers have agreements that include broader non-competition covenants and provide for severance payments that are contingent upon the applicable employee’s refraining from competition with us, such noncompetenon-compete provisions can be difficult and costly to monitor and enforce, such that, if any should resign, we may not be successful in enforcing our noncompetition agreements with them.

Despite the protective measures we employ, we still face the risk that:

agreements may be breached;
agreements may not provide adequate remedies for the applicable type of breach;
our trade secrets or proprietary know-how may otherwise become known;
our competitors may independently develop similar technology; or
our competitors may independently discover our proprietary information and trade secrets.

The failure to prevail in litigation or the costs of litigation, including securities class action,actions, product liability claims and patent infringement claims, could harm our financial performance and business operations.

We are potentially susceptible to litigation.  For example, as a public company, we may be subject to claims asserting violations of securities laws.  Even if such actions are found to be without merit, the potential impact of such actions, which generally seek unquantifiedunquantifiable damages and attorneys’ fees and expenses, is uncertain.  There can be no assurance that an adverse result in any future proceeding would not have a potentially material adverse effect on our business, results of operations and financial condition.

Our business activities, including manufacturingthe design, manufacture and marketing of our drug products and medical devices also exposes us to liability risks.  Using our drug product candidates or medical devices in clinical trials may expose us to product liability claims.  For our products that are approved for commercial sale, the risk of product liability claims is increased.  Even if approved, our products may be subject to claims resulting from unintended effects that result in injury or death.   In addition, we may be subject to product liability claims involving our AFECTAIR and other medical devices and alleged design defects or other safety issues that result in an unsafe condition leading to injury or death.  Product liability claims alleging inadequate disclosure and warnings in our package inserts and medical device disclosures also may arise.

The design, manufacture and marketing of SURFAXIN and the AFECTAIR devices involve an inherent risk of product liability claims.  There are a number of factors that could result in an unsafe condition or injury to a patient, including manufacturing flaws, design defects or inadequate disclosure of product-related risks or product-related information.  Product liability claims may be brought by individuals or by groups seeking to represent a class.  The outcome of litigation, particularly class action lawsuits, is difficult to assess or quantify.  Plaintiffs in these types of lawsuits often seek recovery of very large or indeterminate amounts, and the magnitude of the potential loss relating to such lawsuits may remain unknown for substantial periods of time.

We presently carry general liability, excess liability, products liability and property insurance coverage in amounts that are customary for companies in our industry of comparable size and level of activity.  However, our insurance policies contain various deductibles, limitations and exclusions from coverage, and in any event might not fully cover any potential claims.  There can be no assurance that the insurance coverage we maintain is sufficient or will be available in adequate amounts or at a reasonable cost.  A successful claim brought against us in excess of available insurance or not covered by indemnification agreements, or any claim that results in significant adverse publicity against us, could have an adverse effect on our business and our reputation.
We may need to obtain additional product liability insurance coverage, including with locally-authorized insurers licensed in countries where we market our approved products or conduct our clinical trials, before initiating clinical trials; however, such insurance is expensive and may not be available when we need it.  In the future, we may not be able to obtain adequate insurance, with acceptable limits and retentions, at an acceptable cost.  Any product, general liability or product liability claim, even if such claim is within the limits of our insurance coverage or meritless and/or unsuccessful, could adversely affect the availability or cost of insurance generally and our cash available for other purposes, such as research and development.  In addition, such claims could result in:

●
uninsured expenses related to defense or payment of substantial monetary awards to claimants;
uninsured expenses related to defense or payment of substantial monetary awards to claimants;
●
a decrease in demand for our drug product candidates;
a decrease in demand for our drug product candidates;
●
damage to our reputation; and
damage to our reputation; and
●
an inability to complete clinical trial programs or to commercialize our drug product candidates, if approved.
an inability to complete clinical trial programs or to commercialize our drug product candidates, if approved.

Moreover, the existence of a product liability claim could affect the market price of our common stock.

In addition, as the USPTO keeps United StatesU.S. patent applications confidential in certain cases while the applications are pending, we cannot ensure that our products or methods do not infringe upon the patents or other intellectual property rights of third parties.  As the biotechnology and pharmaceutical industries expand and more patents are applied for and issued, the risk increases that our patents or patent applications for our KL4 surfactant product candidates or our medical device and combination drug/device products may give rise to a declaration of interference by the USPTO, or to administrative proceedings in foreign patent offices, or that our activities lead to claims of patent infringement by other companies, institutions or individuals.  These entities or persons could bring legal proceedings against us seeking to invalidate our patents, obtain substantial damages or enjoin us from conducting research and development activities.

Our corporate compliance program cannot ensure that we are in compliance with all applicable laws and regulations affecting our activities in the jurisdictions in which we may sell our products, if approved, and a failure to comply with such regulations or prevail in litigation related to noncompliance could harm our business.

Many of our activities, including the research, development, manufacture, sale and marketing of our products, are subject to extensive laws and regulation, including without limitation, health care "fraud and abuse" laws, such as the federal false claims act, the federal anti-kickback statute, and other state and federal laws and regulations.  We have developed and implemented a corporate compliance policy and oversight program based upon what we understand to be current industry best practices, but we cannot assure you that this program will protect us from governmental investigations or other actions or lawsuits stemming from a failure to be in compliance with such laws or regulations.  If any such investigations, actions or lawsuits are instituted against us, and if we are not successful in defending or disposing of them without liability, such investigations, actions or lawsuits could result in the imposition of significant fines or other sanctions and could otherwise have a significant impact on our business.

Provisions of our Amended and Restated Certificate of Incorporation, as amended, our Amended and Restated By-Laws, our Shareholder Rights Agreement and Delaware law could defer a change of our management and thereby discourage or delay offers to acquire us.

Provisions of our Amended and Restated Certificate of Incorporation, as amended, our Amended and Restated By-Laws, our Shareholder Rights Agreement and Delaware law may make it more difficult for someone to acquire control of us or for our stockholders to remove existing management, and might discourage a third-party from offering to acquire us, even if a change in control or in management would be beneficial to our stockholders.  For example, our Amended and Restated Certificate of Incorporation as amended, allows us to issue shares of preferred stock without any vote or further action by our stockholders.  Our Board of Directors has the authority to fix and determine the relative rights and preferences of preferred stock.  Our Board of Directors also has the authority to issue preferred stock without further stockholder approval.  As a result, our Board of Directors could authorize the issuance of a series of preferred stock that would grant to holders the preferred right to our assets upon liquidation, the right to receive dividend payments before dividends are distributed to the holders of common stock and the right to the redemption of the shares, together with a premium, before the redemption of our common stock.  In addition, our Board of Directors, without further stockholder approval, could issue large blocks of preferred stock.  We have adopted a Shareholder Rights Agreement, which under certain circumstances would significantly impair the ability of third parties to acquire control of us without prior approval of our Board of Directors, thereby discouraging unsolicited takeover proposals.  This agreement expired in February 2014. The rights issued under the Shareholder Rights Agreement would cause substantial dilution to a person or group that attempts to acquire us on terms not approved in advance by our Board of Directors.
None.
ITEM 2.
PROPERTIES.

Not applicable.

ITEM 2.
PROPERTIES.
We maintain our principal executive offices at 2600 Kelly Road, Suite 100, Warrington, Pennsylvania 18976-3622, which consistsconsist of 39,594 square feet of space that we lease at an annual rent of approximately $0.9 million.  In April 2007,lease.  On January 3, 2013, we entered into a Second Amendment to Lease Agreement (Amendment) to extend the lease which originally expiredfor an additional five years until February 2018.  In addition, the Amendment provides for a reduction to the base rent effective as of October 1, 2012; a reduction in the security deposit over a two year period beginning in 2013, from $400,000 to $225,000; the elimination of our obligation to remove certain improvements and restore the premises; and an adjustment of our option to extend the lease to an additional period of five years through February 2010 with2023.  The total aggregate base rental payments under the lease prior to the extension were approximately $7.2 million and the total aggregate base rental payments under the extended portion of $4.6 million, was extended through February 2013, with additional payments of $3.0 million over the three-year extension period.lease are approximately $4.9 million.  We do not own any real property.

We also maintain at our principal executive office anWarrington location our analytical and developmenttechnical support laboratory that is involved predominantly involved in release testing of all active pharmaceutical ingredients (APIs), release and stability testing of raw materials as well as commercial and clinicalSURFAXIN® drug product, supply.  We also perform at this locationand supporting our research and development work with respect tofor our lyophilized and aerosolized KL4 surfactant dosage forms as well as our efforts to identify and novel formulations ofprotect our product candidates.  In February 2010, we completed construction ofintellectual property.  We also maintain a new medical device development laboratory withinat this location that is used by our Warrington, Pennsylvania executive offices that supportdevelopment engineering team to conduct preclinical development activities for AEROSURF® and our aerosol delivery technologies.  Having our own device development laboratory allows us to conduct a range of research activities while at the further development ofsame time controlling the related expense and conserving our CAG systems.  The facilityfinancial resources.  Our laboratory space includes a controlled environment with two class 10,000 hoods (for activities requiring clean room procedures).  We also use this laboratory for component parts and finished assembly inspection and storage.

We lease approximately 21,000 square feet of space for our manufacturing operations in Totowa, New Jersey (Totowa Facility), at an annual rent of $150,000.  In early 2014, we extended the term of this lease such that it will now expire on June 30, 2015.  This space is specifically designed for the manufacture and filling of sterile liquid pharmaceuticals in compliance with cGMP and is our only manufacturing facility.  This lease expires in December 2014, subjectcurrently dedicated to the landlord’s right,manufacture of SURFAXIN drug product.  We currently are in certain circumstances and upon two years’ prior notice, to terminate the lease early.  In addition, depending upon the timing of the notice, if we satisfy certain financial conditions at the time,discussions with the landlord would be obligatedpotentially to make early termination payments to us.  We are assessing our alternatives upon early termination or expirationenable longer-term utilization of this leasethat facility for the manufacture of SURFAXIN and are developing a long-term manufacturing strategy that could include (i) subject to the landlord’s agreement, potentially renegotiating our current lease, (ii) building or acquiring additional manufacturing capabilities to support product development and commercial production of ourlyophilized KL4 surfactant product candidates,surfactant.  See, “Item 1 – Business – Business Operations – Manufacturing and (iii) potentially using contract manufacturers.Distribution – KL4 Surfactant.”

We are not aware of any pending or threatened legal actions to which we are a party or of which our property is the subject that would, if determined adversely to us, have a material adverse effect on our business and operations.

We have from time to time been involved in disputes and proceedings arising in the ordinary course of business, including in connection with the conduct of our clinical trials.  In addition, as a public company, we are also potentially susceptible to litigation, such as claims asserting violations of securities laws.  Any such claims, with or without merit, if not resolved, could be time-consuming and result in costly litigation.  There can be no assurance that an adverse result in any future proceeding would not have a potentially material adverse effect on our business, results of operations or financial condition.

ITEM 4. 
MINE SAFETY DISCLOSURE.

Not applicable.
 
PART II
 

Market Information

Our common stock is traded on The Nasdaq Capital Market® under the symbol “DSCO.”  As of March 21, 2012,7, 2014, we had 137124 stockholders of record of shares of our common stock.  We also have been advised by Broadridge Financial Solutions, Inc. that, as of March 26, 2012,December 13, 2013, there are approximately 23,42120,774 beneficial owners of our common stock whose positions are held in street name.  As of March 21, 2012,7, 2014, there were 43,307,86784,696,919 shares of our common stock issued and outstanding.

The following table sets forth the quarterly sales price ranges of our common stock for the periods indicated, as reported by The Nasdaq (adjusted for the 1-for-15 reverse stock split that was effective December 28, 2010).Capital Market.

  Low  High 
       
First Quarter 2010 $7.35  $12.58 
Second Quarter 2010 $2.70  $9.30 
Third Quarter 2010 $2.56  $5.10 
Fourth Quarter 2010 $2.52  $5.40 
First Quarter 2011 $1.71  $4.18 
Second Quarter 2011 $1.79  $2.95 
Third Quarter 2011 $1.93  $2.70 
Fourth Quarter 2011 $1.44  $2.01 
 
 2013  2012 
 
 High  Low  High  Low 
Period: 
  
  
  
 
First Quarter $2.91  $2.11  $5.39  $1.67 
Second Quarter $2.40  $1.50  $3.15  $2.12 
Third Quarter $2.23  $1.54  $3.51  $2.30 
Fourth Quarter $3.05  $1.90  $3.29  $1.71 

We have not paid dividends on our common stock and do not expect to declare and pay dividends on our common stock in the foreseeable future.

Sales of Unregistered Securities

Effective as of March 18, 2011, we entered into an exchange agreement with a former employee pursuant to whichDuring the quarter ended December 31, 2013, we issued a warrant to purchase 30,000 shares of our common stock (warrant shares) in exchange for the return of options to purchase 123,334 shares of our common stock (surrendered options) that had been issued pursuant to our 2007 Long-Term Incentive Plan (2007 Plan).  The warrant expires on March 18, 2016 and is exercisable at a price per share of $3.20.  The warrant is excisable for cash only, except that the warrant may be exercised as a cashless exercise (as defined in the warrant) (i) if we determine to permit cashless exercise in our sole discretion, or (ii) if an exemption from registration under the Securities Act of 1933, as amended (the Act) and applicable state laws is not available for resale of the warrant shares to be received by the warrant holder upon exercise of the warrant unless the warrant is exercised as a cashless exercise.  The exercise price, number of8,750 unregistered shares of common stock and/orto a consultant as compensation for management consulting services rendered during the amount and/or type of property issuable upon exercise of the warrant are subject to adjustment in the event we declare or enter into transactions affecting our capital stock, as provided in the warrant.   period from August 31, 2013 through November 30, 2013.  The warrant wasshares were issued in reliance upon the exemption from securities registration provided by Section 3(a)(9) and/or Section 4(2)4(a)(2) of the Act.  We received no cash proceeds in connection with this transaction.

During the 12-month period ended December 31, 2011, we did not conduct any stock repurchases.58


Consolidated Statement of Operations Data:
(in thousands, except per share data)
 
 For the year ended December 31, 
 2013  2012  2011  2010  2009 
Revenues from grants $388  $195  $582  $–  $– 
Operating expenses:                    
Cost of product sales  517                 
Research and development  27,661   21,570   17,230   17,136   19,077 
Selling, general and administrative  16,718   16,444   7,864   8,392   10,120 
Total expenses(1)
  44,896   38,014   25,094   25,528   29,197 
Operating loss  (44,508)  (37,819)  (24,512)  (25,528)  (29,197)
Change in fair value of common stock warrant liability  761   555   3,560   6,422   369 
Other (expense) / income  (1468)  (51)  (13)  (69)  (1,043)
Net loss $(45,215) $(37,315) $(20,965) $(19,175) $(29,871)
Net loss per common share – basic and diluted $(0.82) $(0.95) $(0.93) $(1.65) $(3.89)
Weighted average number of common shares outstanding – basic and diluted  55,258   39,396   22,660   11,602   7,680 

Not applicable.
(1)
Included in the net loss for 2013, 2012, 2011, 2010, and 2009  were non-cash charges for stock-based compensation and depreciation of $2.9 million, $3.3 million, $2.2 million, $2.8 million, and $4.3 million, respectively.

Consolidated Balance Sheet Data: 
 
(in thousands) December 31, 
 2013  2012  2011  2010  2009 
 
  
  
  
  
 
Cash and investments $86,283  $26,892  $10,189  $10,211  $15,741 
Working capital  75,384   16,107   (516)  2,920   176 
Total assets  89,317   29,943   13,324   14,537   21,403 
Long-term debt, net of discount of $11,646  18,354   –   –   –   – 
Other long-term obligations, less current portion  607   591   913   935   1,118 
Total stockholders’ equity $58,501  $17,653  $1,264  $6,026  $1,296 

 
INTRODUCTION

Some of the information contained in this discussion and analysis or set forth elsewhere in this Annual Report on Form 10-K, including information with respect to our plans and strategy for our business and related financing activities, includes forward-looking statements that involve risks and uncertainties.  You should review the “Forward Looking Statements” and “Risk Factors” sections of this Annual Report on Form 10-K for a discussion of important factors that could cause actual results to differ materially from the results described in or implied by the forward-looking statements contained in the following discussion and analysis or elsewhere in the Annual Report on Form 10-K.

Management’s discussion and analysis of financial condition and results of operations (MD&A) is provided as a supplement to the accompanying consolidated financial statements and footnotes to help provide an understanding of our financial condition, the changes in our financial condition and our results of operations.  This item should be read in connection with our Consolidated Financial Statements.  See, “Item 15 – Exhibits and Financial Statement Schedules.”  Our discussion is organized as follows:
 
●
·
Company Overview and Business StrategyStrategy::  this section provides a general description of our company and business plans.

●
·
Critical Accounting Policies:  this section contains a discussion of the accounting policies that we believe are important to our financial condition and results of operations and that require the exercise of judgment and use of estimates on the part of management in their application.  In addition, all of our significant accounting policies, including the critical accounting policies and estimates, are discussed in Note 3 to the accompanying consolidated financial statements.

●
·
Results of Operations:  this section provides an analysis of our results of operations presented in the accompanying consolidated statements of operations, including comparisons of the results for the years ended December 31, 20112013, 2012 and 2010.
2011.

●
·
Liquidity and Capital Resources:  this section provides a discussion of our capital resources, future capital requirements, cash flows, committed equity financing facilities, historical financing transactions, outstanding debt arrangements and commitments.

OVERVIEW

Discovery Laboratories, Inc. (referred to as “we,” “us,” or the “Company”) is a specialty biotechnology company focused on creating life-saving products for critical carecritical-care patients with respiratory disease and improving the standard of care in pulmonary medicine.  Our proprietary drug technology produces a synthetic, peptide-containing surfactant (KL4 surfactant) that is structurally similar to pulmonary surfactant, a substance produced naturally in the lung and essential for normal respiratory function and survival.  We are developing our KL4 surfactant in liquid, lyophilized and aerosolized dosage forms.  We are also developing novel drug delivery technologies potentially to enable efficient delivery of inhaled therapies, including our aerosolized KL4 surfactant.  We believe that our proprietary technologies may make it possible, for the first time, to develop a significant pipeline of products to address a variety of respiratory diseases for which there frequently are few or no approved therapies.

On March 6, 2012,We are initially focused on improving the U.S. Food and Drug Administration (FDA) granted us marketing approval for SURFAXIN® (lucinactant) for the preventionmanagement of respiratory distress syndrome (RDS) in premature infants at high risk for RDS.  SURFAXIN is the first synthetic, peptide-containing surfactant approved for use in neonatal medicine and provides healthcare practitioners with an alternative to the animal-derived surfactants that today are the standard of care to manage RDS in premature infants.  We are implementing a plan that, if successful, is intended to result in the commercial introduction of SURFAXIN in the United States in fourth quarter of 2012.
Our strategy is initially to focus the development of our KL4 surfactant and aerosol technologies to improve the management of RDS in premature infants.  RDS is a serious respiratory condition caused by insufficient surfactant production in underdeveloped lungs of premature infants, andinfants.  RDS is the most prevalent respiratory disease in the neonatal intensive care unitNeonatal Intensive Care Unit (NICU).  RDS and can result in long-term respiratory problems, developmental delay and death.  Mortality

Our first KL4 surfactant drug product, SURFAXIN® (lucinactant) Intratracheal Suspension for the prevention of RDS in premature infants at high risk for RDS, was approved by the United States Food and morbidity rates associatedDrug Administration (FDA) in 2012.  SURFAXIN is our KL4 surfactant in liquid form and is the first synthetic, peptide-containing surfactant approved by the FDA and the only alternative to animal-derived surfactants currently used in the United States (U.S.).  Since November 2013, SURFAXIN has been commercially available in the U.S.

Premature infants with severe RDS havecurrently are treated with surfactants that can only be administered by endotracheal intubation supported with mechanical ventilation, both invasive procedures that may each result in serious respiratory conditions and other complications.  To avoid such complications, many neonatologists treat infants with less severe RDS by less invasive means, typically nasal continuous positive airway pressure (nCPAP).  Unfortunately, a significant number of premature infants on nCPAP will not meaningfully improved overrespond well (an outcome referred to as nCPAP failure) and thereafter may require delayed surfactant therapy.  Since neonatologists currently cannot predict which infants will experience nCPAP failure, neonatologists are faced with difficult choices in treating infants with less severe RDS.  This is because the last decade.  Wemedical outcomes for those infants who experience nCPAP failure and receive delayed surfactant therapy may be less favorable than the outcomes for infants who receive surfactant therapy in the first hours of life.
AEROSURF® is an investigational combination drug/device product that combines our KL4 surfactant with our proprietary capillary aerosol generator (CAG).  With AEROSURF, neonatologists potentially will be able to administer aerosolized KL4 surfactant to premature infants supported with nCPAP, without having to use invasive intubation and mechanical ventilation.  By enabling delivery of our KL4 surfactant using less invasive procedures, we believe that AEROSURF will address a serious unmet medical need and potentially enable the RDS market is presently underserved, and that our RDS programs, beginning with SURFAXIN and, if approved, SURFAXIN LS™ and AEROSURF®, have the potential to greatly improve the managementtreatment of RDS and, collectively over time, to become the global standarda significantly greater number of care for premature infants with RDS.RDS who could benefit from surfactant therapy but are currently not treated.

SURFAXIN LS is ourWe are also developing a lyophilized (freeze-dried) dosage form of SURFAXINour KL4 surfactant that is stored as a powder and resuspendedreconstituted to liquid form prior to use.  We are developing SURFAXIN LSuse with the objective of improving ease of use for healthcare practitioners, as well as potentially to prolong shelf life and eliminate the need for cold-chain storage.  We are implementing ainitially developing this dosage form for use in our AEROSURF development program.  We are also planning to seek regulatory plan intendedadvice to determine if we could gain marketing authorization for a lyophilized dosage form of SURFAXIN LSunder a development plan that would be both capital efficient and capable of implementation within a reasonable time.  If feasible, we would likely implement such a development plan and would plan to introduce it commercially as a life-cycle extension of SURFAXIN under the name SURFAXIN LS™, in the United States,U.S. and potentially in other markets.

To support the European Unioncommercial introduction of SURFAXIN in the U.S. and our other major markets worldwide.
AEROSURF is a drug/device combination product that combines our KL4 surfactant pipeline products, if approved, we have established our own specialty respiratory critical care commercial and medical affairs team.  This team includes medical professionals with experience in neonatal/pediatric respiratory critical care, and has focused on products that address neonatal indications, beginning with SURFAXIN.  We believe that this team will be positioned to efficiently introduce our proprietary capillary aerosol generator (CAG)other KL4 surfactant products under development, if approved, including AEROSURF and potentially SURFAXIN LS and future applications of our novel AFECTAIRaerosolized KL®4 ventilator circuit / patient interface connectors.  We are developingsurfactant.

In addition we recognize that our commercial and medical affairs team could potentially support introductions of other synergistic pipeline products, including products  owned or developed by third parties for the NICU/PICU.  To that end, we would consider potential transactions focused on securing commercial rights to such synergistic products, including in the form of product acquisitions, in-licensing agreements or distribution, marketing or co-marketing arrangements.

In the future, we expect that we may be able to leverage the information, data and know-how that we gain from our development efforts with SURFAXIN and AEROSURF for premature infants with or at riskto support development of RDS.  Premature infants with RDS currently are treated with surfactants that can only be administered by endotracheal intubation supported with mechanical ventilation, both invasive procedures that frequently result ina potential product pipeline to address serious critical care respiratory conditions in larger children and complications.  Asadults in pediatric and adult intensive care units (PICUS and ICUs), including acute lung injury (ALI), chronic obstructive pulmonary disease (COPD) and cystic fibrosis (CF).  At the present time, however, we are focusing our resources primarily on the commercial introduction of SURFAXIN and development of AEROSURF through phase 2 clinical trials.  Once we have achieved these objectives, we believe we would be in a consequence, neonatologists will not treat infants who could benefit from surfactant therapy unlessbetter position to assess the potential benefits of surfactant therapy outweighother development programs to address the risks associated with such invasive administration procedures.  AEROSURF potentially will provide practitioners withcritical care needs of patients in the abilityPICU and ICU.

We also have developed a disposable aerosol-conducting airway connector for infants that is intended to deliver surfactant therapy using a less-invasive method.  For this reason, we believe that AEROSURF, if approved, potentially may enable the treatment of a significantly greater number of premature infants at risk for RDS who could benefit from surfactant therapy but are currently not treated.
AFECTAIR, a series of disposable ventilator circuit / patient interface connectors, was initially developed for use in NICUs as part of our AEROSURF development program.  AFECTAIR devices simplify the delivery of inhaled therapiesaerosolized medications (including our aerosolized KL4 surfactant) and other inhaled therapies to critical-care patients requiring ventilatory support by introducing the inhaled therapysupport.  This device introduces aerosolized medications directly at the patient interface and minimizingminimizes the number of connections in the ventilator circuit.  We initially developed a ventilator circuit / patient interface connector to be used with our CAG in the NICU.  To benefit all critical care patients who require inhaled therapies and who are receiving ventilatory support, we are developing AFECTAIR devices in different sizes for use in NICUs, pediatric intensive care units (PICUs) and adult intensive care units (ICUs), and to be compatible with a variety of aerosol generating devices.  In February 2012, we successfullyhave registered our initial AFECTAIRthis device which is intended for use with jet nebulizers and other aerosol generators, in the United States as a Class I, exempt medical device.  We believe that AFECTAIR has the potential to become a new standard of care for the delivery of inhaled therapies to critical care patients.  We are implementing a regulatory and manufacturing plan that, if successful, is intended to result in the commercial introduction of the initial AFECTAIR device in the United StatesU.S. under the name AFECTAIR and the European Unionit is currently commercially available in the fourth quarterU.S.

We are preparing for the commercial introductions, beginning in late 2012, of SURFAXIN in the United States, and AFECTAIR in the United States and the European Union and other markets worldwide thereafter.  To accomplish our objectives, in the United States, we plan to build our own, in-house, specialty respiratory critical care commercial and medical affairs organization that will specialize in neonatal indications, beginning with SURFAXIN.  We expect that our commercial and medical affairs organization will be able to leverage the experience and relationships that we gain with the introduction of SURFAXIN to efficiently support the introductions of SURFAXIN LS and AEROSURF, if approved.  We also expect that our in-house organization will also work in a coordinated manner with a network of third-party distributors to execute the commercial introduction of the AFECTAIR devices.
In major markets outside the United States, an important priority is to secure the strategic resources to support the continued development and commercial introduction of our RDS products.  A key goal for us in 2012 is to secure one or more strategic alliances and/or collaboration arrangements potentially to share research and development expenses for our SURFAXIN LS and AEROSURF development programs, and, if approved, to support the commercial introduction of these products in Europe and elsewhere.  We may also seek strategic alliances and/or collaboration arrangements to support the potential commercial introduction of SURFAXIN in countries where regulatory marketing authorization is facilitated by the recent approval of SURFAXIN by the FDA.  We are engaged in discussions with potential strategic partners who could provide development and commercial expertise as well as financial resources (potentially in the form of upfront payments, milestone payments, commercialization royalties and a sharing of research and development expenses).  There can be no assurance, however, that we will be successful in concluding any strategic alliance, collaboration or other similar transaction.
The reader is referred to, and encouraged to read in its entirety “Item 1 – Business” of this Annual Report on Form 10-K, which contains a discussion of our Business and Business Strategy, as well as information concerning our proprietary technologies and our current and planned KL4 pipeline programs.
 
CRITICAL ACCOUNTING POLICIES

The preparation of financial statements, in conformity with accounting principles generally accepted in the United States,U.S., requires management to make estimates, judgments and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period.  Actual results could differ from those estimates.

We believe the following accounting policies are the most critical for an understanding of our financial condition and results of operations.  For further discussion of our accounting policies, see, “Note“Item 8 – Note 3 – Summary of Significant Accounting Policies and Recent Accounting Pronouncements” in the Notes to Consolidated Financial Statements for the year ended December 31, 2011,2013, in Part IV to this Annual Report on Form 10-K.

Product Sales

Revenues from product sales are recognized when (1) persuasive evidence of an arrangement exists, (2) delivery has occurred or services have been rendered, (3) the price is fixed or determinable and (4) collectability is reasonably assured. 

Our products are distributed in the U.S. using a specialty distributor.  Under this model, the specialty distributor purchases and takes physical delivery and title of product, and then sells to hospitals.  We began the commercial introduction of SURFAXIN in the fourth quarter of 2013 and, for that reason, we currently cannot make a reasonable estimate of future product returns when product is delivered to the specialty distributor.  Therefore, we currently do not recognize revenue upon product shipment to the specialty distributor, even though the distributor is invoiced upon product shipment.  Instead, we recognize revenue once product has been sold through to the hospital and all revenue recognition criteria have been met.  Once product has been delivered to the hospital, the risk of material returns is significantly mitigated. As of December 31, 2013, we have deferred revenue recognition on all product sales since the inception of the commercial launch of SURFAXIN in November 2013.  We will recognize those revenues at the point in time when all revenue recognition criteria have been met.

We will begin to recognize revenue at the time of shipment of product to our specialty distributor when we can reasonably estimate expected distributor sales deductions and returns. In developing estimates for sales returns we consider the shelf life of the product, expected demand based on market data and return rates of other surfactant products. 

Product sales are recorded net of accruals for estimated chargebacks, discounts, specialty distributor deductions and returns.

·Chargebacks.  Chargebacks are discounts that occur when contracted customers purchase directly from our specialty distributor.  Contracted customers, which currently consist primarily of member hospitals of Group Purchasing Organizations, generally purchase the product at a discounted price.  Our specialty distributor, in turn, charges back the difference between the price initially paid by the specialty distributor and the discounted price paid to the specialty distributor by the customer.  The allowance for specialty distributor chargebacks is based on known sales to contracted customers.
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Research and development expenses
·Sales discounts:  Sales discounts are offered to certain contracted customers based upon a customer’s historical volume of surfactant product purchases.  Customers must enter into a Letter of Participation (LOP) with us to receive sales discounts.  Sales discounts are calculated on a quarterly basis based upon the customer’s quarterly purchases of SURFAXIN, as provided in the LOP.  The allowance for sales discounts is based on known sales to contracted customers.

·Specialty distributor deductions. Our specialty distributor is offered various forms of consideration including allowances, service fees and prompt payment discounts. Specialty distributor allowances and service fees are provided in our contractual agreement and are generally a percentage of the purchase price paid by the specialty distributor. The specialty distributor is offered a prompt pay discount for payment within a specified period.

·Returns.  Sales of our products are not subject to a general right of return; however, we will accept product that is damaged or defective when shipped or for expired product up to 6 months subsequent to its expiry date.  Product that has been administered to patients is no longer subject to any right of return.
Research and development costs consist primarily of expenses associated with our

We track research and development expense by activity, as follows: (a) product development and manufacturing, (b) medical and regulatory operations, and (c) direct preclinical and clinical programs.   Research and development expense includes personnel, facilities, manufacturing and quality operations, pharmaceutical and device development, research, clinical, regulatory, other preclinical and clinical activities and medical affairs.  Research and development costs are charged to operations as incurred.
Inventory
Inventories, which are recorded at the lower of cost or market, include materials, labor, and other direct and indirect costs and are valued at cost using the first-in, first-out method.  We capitalize inventories produced in preparation for commercial launch when it becomes probable that the related product candidate will receive regulatory approval and that the related costs will be recoverable through commercial sale of the product.  Costs incurred prior to FDA approval of SURFAXIN drug product and registration of AFECTAIR device have been recorded in our statement of operations as research and development expense.  Inventories are evaluated for impairment based on consideration of such factors as the net realizable value, lower of cost or market, obsolescence, and product expiry.  Inventories do not have carrying values that exceed either cost or net realizable value.

We establish expiry risk by evaluating current and future product demand relative to product shelf life.  We build demand forecasts based on consideration of such factors as overall market potential, market share, market acceptance and hospital ordering practices.
Deferred revenue
Deferred revenue reflects amounts related to sales of SURFAXIN to our specialty distributor, which are then deferred and recognized as revenue once product has been sold through to the hospital and all revenue recognition criteria have been met.  See, “– Product Sales.”

Warrant accounting

We account for common stock warrants in accordance with applicable accounting guidance provided in Accounting Standards CodificationASC Topic 815 “Derivatives and Hedging – Contracts in Entity’s Own Equity” (ASC Topic 815), as either derivative liabilities or as equity instruments depending on the specific terms of the warrant agreement.  We classify derivative warrant liabilities on the consolidated balance sheet as a current liability,liabilities, which isare revalued at each balance sheet date subsequent to the initial issuance.  We use the Black-Scholes or trinomial pricing models, depending on the applicable terms of the warrant agreement, to value the derivative warrant liabilities.  Changes in the fair value of the warrants are reflected in the consolidated statement of operations as “Change in the fair value of common stock warrant liability.”  See, “– Results of Operations“Item 8 –Note 8 – Change in Fair Value of Common Stock Warrant Liability.Liability,” for a detailed description of our accounting for derivative warrant liabilities.
RESULTS OF OPERATIONS

Net Loss and Operating Loss

The net loss for the years ended December 31, 2013, 2012, and 2011 was $45.2 million (or $0.82 per share), $37.3 million (or $0.95 per share), and 2010 was $21.0 million (or $0.93 per share) and $19.2 million (or $1.65 per share), respectively.  Included in the net loss is the change in fair value of certain common stock warrants classified as derivative liabilities, resulting in non-cash income of $0.8 million, $0.6 million, and $3.6 million for 2013, 2012, and $6.4 million for the years ended December 31, 2011, and 2010, respectively.

The operating loss for the years ended December 31, 2013, 2012, and 2011 and 2010 was $24.5$44.5 million, $37.8 million, and $25.5$24.5 million, respectively.  The operating loss includes $2.2$2.9 million, $3.3 million, and $2.8$2.2 million for non-cash items related to depreciation and stock-based compensation for the years ended December 31,2013, 2012, and 2011, and 2010, respectively.  Excluding non-cash items related to depreciation and stock-based compensation, the operating loss was $41.6 million, $34.5 million, and $22.4 million for 2013, 2012, and $22.72011, respectively.
The increase in operating loss from 2012 to 2013 was primarily due to (i) a $3.2 million respectively,increase in investment in AEROSURF development activities, primarily to develop and manufacture a clinic-ready CAG for use in our AEROSURF phase 2 clinical program and in the technology transfer and further development of our lyophilized KL4 surfactant manufacturing process at DSM Pharmaceuticals, Inc. (DSM), (ii) a $3.2 million increase in investment in our specialty commercial and medical affairs organization that is focused on neonatal/pediatric respiratory critical care in NICUs/PICUs across the U.S.; and (iii) a $1.7 million increase in purchases of raw materials to manufacture drug product for SURFAXIN and our AEROSURF development program, which were partially offset by a $2.0 million one-time charge in the fourth quarter of 2012 associated with certain contractual severance obligations and stock-based compensation charges related to the resignation of our former Chief Executive Officer.

The increase in operating loss from 2011 to 2012 was primarily due to (i) a $6.5 million investment to establish our commercial and medical affairs organization; (ii) a $1.6 million investment to advance the development of our CAG for potential use in our AEROSURF phase 2 clinical program; and (iii) a $2.0 million one-time charge in the fourth quarter of 2012 associated with certain contractual severance obligations and stock-based compensation charges related to the resignation of our former Chief Executive Officer.

Product Sales

As of December 31, 2013, we have deferred revenue recognition on all product sales since the initiation of the commercial launch of SURFAXIN in November 2013.  In accordance with our revenue recognition policy, we will recognize revenue once product has been sold through to the hospital and all revenue recognition criteria have been met.

Grant Revenue

We recognized grant revenue of $0.4 million, $0.2 million and $0.6 million for the years ended December 31, 2013,  2012 and 2011, respectively.  The grant revenue in 2012 and 2010.2013 represents funds received and expended under a Small Business Innovation Research (SBIR) Phase I award from National Institute of Health’s (NIH) National Institute of Allergy and Infectious Diseases (NIAID) Center for Medical Counter Measures Against Radiation and Nuclear Threats to assess the ability of KL4 surfactant to mitigate the effects of acute radiation exposure to the lung, including acute pneumonitis and delayed lung injury.  The total amount of the Phase I award was $0.6 million and we have received and expended the full amount as of December 31, 2013.

Grant RevenueIn the future, we expect that we may be able to leverage the information, data and know-how that we gain from our development efforts with SURFAXIN and AEROSURF to support development of a potential product pipeline to address serious critical care respiratory conditions in larger children and adults in pediatric and adult intensive care units (PICUS and ICUs), including acute lung injury (ALI), chronic obstructive pulmonary disease (COPD) and cystic fibrosis (CF).  While we are currently focused on RDS, we are currently, and will consider in the future, collaborating with leading research institutions to conduct preclinical studies, including those that may be funded through various U.S. government-sponsored, biodefense-related initiatives, including NIAID.

For the year ended December 31,64
The grant revenue in 2011 we recognized revenue of $0.6 million, forrepresents funds received and expended under a Fast Track Small Business Innovation Research Grant (SBIR)SBIR from the National Institutes of HealthNIH to support the development of aerosolized KL4surfactant for RDS.  We didRDS.

Cost of Product Sales
(in thousands) 
Years Ended
December 31,
 
 2013  2012  2011 
 
 
Cost of product sales $517  $–  $– 
Cost of product sales for 2013 primarily reflects inventory reserves for costs of SURFAXIN finished goods inventory that is not recognize any grant revenues in 2010.expected to be recoverable through commercial sale of the product during the initial launch period due to product expiration.

Research and Development Expenses

Our research and development expenses are charged to operations as incurred and we track such costs by category rather than by project.  As many of our research and development activities form athe foundation for the development of our KL4 surfactant and drug delivery technologies, they are expected to benefit more than a single project.  For that reason, we cannot reasonably estimate the costs orof our research and development activities on a project-by-project basis.  We believe that tracking our expenses by category is a more accurate method of accounting for these activities.  Our research and development costs consist primarily of expenses associated with (a) manufacturingproduct development and product development,manufacturing, (b) medical and regulatory operations, and (c) direct preclinical and clinical programs.  We also track research and development and report by major expense category as follows: (i) salaries and benefits, (ii) contracted services, (iii) rents and utilities, (iv) depreciation, (v) raw materials and supplies, (vi) contract manufacturing, (vii) stock-based compensation and (viii) other.


Research and development expenses by category for the years ended December 31, 2013, 2012 and 2011 and 2010 were $17.2 million, and $17.1 million, respectively.  These costs are charged to operations as incurred and are tracked by category, as follows:

(Dollars in thousands)
 Year Ended December 31, 
Years Ended
December 31,
 
Research and Development Expenses(1):
 2011  2010 
      2013  2012  
2011(1)
 
Manufacturing and product development $12,359  $11,739 
(in thousands) 
Product development and manufacturing $20,471  $15,788  $12,359 
Medical and regulatory operations  3,452   3,337   5,966   4,818   3,452 
Direct preclinical and clinical programs  1,419   2,060   1,224   964   1,419 
Total Research and Development Expenses $17,230  $17,136  $27,661  $21,570  $17,230 

(1) Certain 2010 expenses have been reclassified to conform to 2011(1)  Certain prior year expenses have been reclassified to conform to 2013 presentation.

Research and development expenses include non-cash charges associated with stock-based compensation and depreciation of $1.4 million, $1.3 million, and $1.7$1.4 million for the years months ended December 31,2013, 2012, and 2011, and 2010, respectively.

For a description of the clinical programs included in research and development expenses, see,See, “Item 1 – Business – Surfactant Replacement Therapy for Respiratory Medicine” in this Annual Report on Form 10-K.Medicine.”

Manufacturing
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Product Development and Product DevelopmentManufacturing

ManufacturingProduct development and product development includes:manufacturing includes (i) the cost of our manufacturing operations, both in-house and with our CMOs, validation activities and quality assurance and analytical chemistry capabilities to assure adequatesupport production of clinical and commercial drug supply for our KL4 surfactant products, in conformance with current good manufacturing practices (cGMP);, and medical devices, including AFECTAIR, the WARMING CRADLE®, and the CAG, in accordance with Quality System Regulations (QSR), (ii) design and development activities related to the development and manufacture of our CAG device for use in our preclinical programs, our anticipatedAEROSURF phase 2 clinical programs, and, if approved, commercial use,program;  (iii) design and development activities related to our novel ventilator circuit / patient interface connectors, including our AFECTAIR® and AFECTAIR DUO devices, and;aerosol-conducting airway connector; and (iv) pharmaceutical development activities, including development of a lyophilized dosage form of our KL4 surfactant.  These costs include employee expenses, facility-related costs, depreciation, costs of drug substances (including raw materials), supplies, quality control and assurance activities, analytical services, and expert consultants and outside services to support pharmaceutical and device development activities.

The $0.6Product development and manufacturing expenses increased $4.7 million increase in manufacturing and product development expenses in 2011 as comparedfrom 2012 to 2010 is2013 primarily due to increases in (i) investments in design and development activities related to our CAG for use in our AEROSURF phase 2 clinical trials,  including work with third-party device experts and work that we began in June 2012 with Battelle Memorial Institute (Battelle), which assisted in a multi-phase project to design, test, and manufacture clinic-ready CAG devices for the AEROSURF phase 2a clinical trial; (ii) costs associated with the technical transfer and further development of our KL4 surfactant manufacturing processes at DSM; and (iii) purchases of active pharmaceutical ingredients (APIs) used in the manufacture of SURFAXIN drug product and our lyophilized KL®4 batches neededsurfactant, for commercial use and preclinical development activities, including to executecomplete the comprehensive preclinical programtechnical transfer and further develop our KL4 surfactant manufacturing process at DSM, and activities to develop a clinic-ready CAG and prepare for our AEROSURF phase 2 clinicalprogram.

Product development and manufacturing expenses increased $3.4 million from 2011 to 2012 primarily due to (i) an increase in investments in manufacturing and quality activities as we prepared for commercial introduction of SURFAXIN and the AFECTAIR device for infants; (ii) costs associated with our efforts to optimize the design of our CAG with our engineering staff and third-party medical device experts, including work that we conducted to respond to the 2009 Complete Response Letter, partially offset bybegan in June 2012 with Battelle Memorial Institute (Battelle), which assisted us in a reductionmulti-phase development program focused on design, testing, and manufacturing of clinic-ready CAG devices for our AEROSURF phase 2 clinical trials, and (iii) an increase in costs associated with the technology transfer of our SURFAXIN LS™ lyophilized manufacturing process to a third-party contract manufacturer.employee incentive compensation plans.

ManufacturingProduct development and product developmentmanufacturing expenses include non-cash charges associated with stock-based compensation and depreciation of $1.2$0.9 million, $1.0 million, and $1.4$1.2 million, respectively, for the years ended December 31, 2013, 2013 and 2011, respectively.

Consistent with our long-term strategy, in 2014 and 2010.beyond, we plan to invest in and assure long-term manufacturing development capabilities.  We currently are in discussions with the landlord of our Totowa, NJ, manufacturing operations (Totowa Facility) potentially to enable longer-term utilization of that facility for the manufacture of SURFAXIN and potentially lyophilized KL4 surfactant.  The lease for that facility currently expires on June 30, 2015.  To assure continuity of supply, we are working with DSM to provide for the manufacture of both SURFAXIN and our lyophilized KL4 surfactant for use initially in our AEROSURF development program.  We are also working to identify a second contract manufacturing organization (CMO) to potentially supply SURFAXIN commercial drug product and lyophilized KL4 surfactant. We also will continue to invest in the development of our manufacturing process for our lyophilized KL4 surfactant with DSM, and plan to manufacture drug product for preclinical and clinical activities, including for our AEROSURF phase 2 clinical program and potentially our other KL4 surfactant development programs.  By manufacturing our drug products at our Totowa Facility and with CMOs, we believe that we will be able to bring our own manufacturing expertise to our CMOs, maintain an appropriate balance between capital investments and variable manufacturing expense, and remain flexible while potentially reducing the risk profile of meeting the long-term requirements for development and commercial supply of our drug products. For a discussion of our long-term business strategy to provide for the long-term continuity of supply and continued integrity and reliability of our manufacturing and quality capabilities, see, “Item 1 – Business – Business Operations – Manufacturing and Distribution.”

Medical and Regulatory Operations

Medical and Regulatory Operations

Medical and regulatory operations includes:includes (i) medical, scientific, clinical, regulatory, data management and biostatistics activities in support of our research and development programs; and (ii) medical affairs activities to provide scientific and medical education support in connection withrelated primarily to SURFAXIN, as well as our other KL4 surfactant and aerosol delivery technologies programs;products under development.  These costs include personnel, expert consultants, outside services to support regulatory and data management, symposiums at key neonatal medical meetings, facilities-related costs, and other costs for the management of clinical trials.
Medical and regulatory operations expenses increased $1.1 million from 2012 to 2013 primarily due to a full year investment in 2013 in our medical affairs organization to support the commercial introduction of SURFAXIN and the AFECTAIR device.

Medical and regulatory operations expenses inincreased $1.4 million from 2011 are comparable to 2010,2012 primarily due to (i) investment to establish our efforts to conserve financialmedical affairs organization in preparation for the commercial introduction of SURFAXIN and other resources while we focused our efforts on securing marketing authorizationthe AFECTAIR device for SURFAXIN.infants, and (ii) costs associated with employee incentive compensation plans.

Medical and regulatory operations expenses include non-cash charges associated with stock-based compensation and depreciation of $0.2$0.4 million, $0.3 million, and $0.3$0.2 million for the years months ended December 31, 20112013, 2012, and 2010,2011, respectively.

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Direct Preclinical and Clinical Programs

Direct preclinical and clinical programs include: (i) activities related to responding to the 2009 Complete Response Letter; (ii) preclinicaldevelopment activities, including preparatory activities for the anticipatedAEROSURF clinical trials for SURFAXIN LS and AEROSURF® for RDS in premature infants,program, toxicology studies and other preclinical studies to obtain data to support potential Investigationalour investigational new drug (IND) application and, potentially, our New Drug (IND) and NDAApplication (NDA) filings for AEROSURF, and potentially our other KL4 surfactant product candidates; and (iii)(ii) activities, if any, associated with conducting human clinical trials, (includingincluding patient enrollment costs, external site costs, clinical device and drug supply, and related external costs, such as contract research consultant fees and expenses), including, in 2010, activities related to the completion of the Phase 2 clinical trial evaluating the use of SURFAXIN in children up to two years of age suffering with Acute Respiratory Failure (ARF).expenses.

The $0.6 million decrease in directDirect preclinical and clinical programprograms expenses in 2011 as comparedincreased $0.3 million from 2012 to 2010 is2013 primarily due to expenses associated with the completion of the Phase 2 ARF clinical trial incurredinvestments in 2010.

In an effort to focus our financial resources, we plan to focus our drug research and development activities on the management of RDS in premature infants and specifically in our SURFAXIN LS and AEROSURF development programs to advance them towards initiation of our planned Phase 2 and Phase 3 clinical trials, respectively.  We also plan to meet with U.S. and European regulatory authorities to discuss the requirements for our regulatory packages, including potential trial design requirements, to prepare for our plannedAEROSURF phase 2 clinical trials.  If successful, we planprogram.  Such activities included manufacture of a sufficient number of clinic-ready CAG devices to initiate the planned AEROSURF Phase 2support our phase 2a clinical trial, implementation of clinical data management systems and selection of clinical site locations.  Costs in 2012 included a $0.5 million charge related to a milestone payment that became payable to Johnson and Johnson (J&J) upon FDA approval of SURFAXIN LS Phase 3in March 2012.

Direct preclinical and clinical programs expenses decreased $0.5 million from 2011 to 2012 primarily due to a decrease in late 2013, after we have secured one or more strategic alliances and/or necessary capital, ourcosts associated with activities completed in 2011 to respond to a Complete Response Letter received from the FDA in 2009 (2009 Complete Response Letter), offset by a $0.5 million charge related to a milestone payment that became payable to J&J upon FDA approval of SURFAXIN LS Phase 3in March 2012.

We anticipate that direct clinical program costs associated with conducting the AEROSURF phase 2 clinical program will be approximately $8 -10 million for 2014 through the anticipated completion of the AEROSURF phase 2 program in late 2013.  As resources permit, we may make limited investments in non-RDS programs, including potentially acute lung injury (ALI), chronic obstructive pulmonary disorder (COPD) and cystic fibrosis (CF).2015.
 
Research and Development Expense by Major Expense Category

We also track our research and development expense by major expense category as shown in the following table:

 2011  2010 
(in thousands) 
Years Ended
December 31,
 
       2013  2012  2011 
Salaries & Benefits $8,231  $6,858  $11,213  $9,986  $8,231 
Contracted Services  3,317   4,395   8,248   6,332   3,317 
Raw Materials & Supplies  1,871   1,009   3,633   1,652   1,871 
Rents & Utilities  1,531   1,442   1,186   1,366   1,531 
Depreciation  1,141   1,207   659   841   1,141 
Contract Manufacturing  143   990   1,441   15   143 
Travel  447   316   188 
Stock-Based Compensation  289   479   784   488   289 
All Other  707   756   50   574   519 
Total $17,230 17,280  $17,136  $27,661  $21,570  $17,230 

The increase in salaries and benefits infrom 2012 to 2013 and from 2011 as compared to 20102012 is primarily due to the establishment of our medical affairs organization primarily to support the commercial introduction of SURFAXIN and AFECTAIR, increased benefit costs and employee incentive payments and employee severance costs.payments.

Contracted services include the cost of preclinical studies, clinical trial activities, certain components of our manufacturing operations, quality control and analytical testing of our drug product, biological activity testing,including our BAT, consulting services, aerosol device design and engineering services, etc.  The decrease inincrease from 2012 to 2013 and from 2011 as compared to 20102012 is primarily due to costs associated with work that we began in 2010 relatedJune 2012 with Battelle to the completion of the Phase 2 ARFoptimize design, test, and manufacture clinic-ready CAG devices to be used in our AEROSURF phase 2a clinical trial, and a decreaseinvestments in outside laboratory testing related toour manufacturing and quality activities to addressas we prepare for the 2009 Complete Response Letter.commercial introduction of SURFAXIN.

Raw materials and supplies consist of purchases of our active pharmaceutical ingredients (APIs) for the manufacture of our KL4 surfactant product candidates and supplies to support our manufacturing and laboratoryanalytical testing and development laboratories operations.  In addition, raw materials and supplies include component parts used in the development of our CAG and raw materials and supplies used in manufacturing and product development activities for our novel ventilator circuit / patient interface connectors.AFECTAIR aerosol-conducting airway connector. The increase in raw materials and supplies in 2011 as comparedfrom 2012 to 20102013 is primarily due to thea $1.6 million increase in purchases of raw materials to manufacture drug product for SURFAXIN commercial supply and to support manufacturing development activities.  The decrease in raw materials and supplies from 2011 to 2012 is primarily due to a decrease in raw material purchases following submission in 2011 of SURFAXIN batches needed to execute the comprehensive preclinical program that we conducted to respondour response to the 2009 Complete Response Letter.Letter.


Rents and utilities are associated withcosts related to our leased manufacturing, laboratory, and relatedcorporate facilities. The decrease from 2012 to 2013 is primarily due to (i) decreased rent for our corporate and laboratory facility in Warrington, PA in connection with an amended lease agreement executed in January 2013, and (ii) decreased utility costs at our manufacturing facility.  The decrease from 2011 to 2012 is primarily due to decreased utility costs at our manufacturing facility due to decreased manufacturing activity for SURFAXIN.

Depreciation is primarily associated with leasehold improvements at our laboratories and headquarters in Warrington, Pennsylvania as well as manufacturing and laboratory equipment, and leasehold improvements at our manufacturing operations inthe Totowa New Jersey.Facility. The decrease from 2012 to 2013 and from 2011 to 2012 is primarily due to capitalized assets becoming fully depreciated.
Contract manufacturing represents costs related to the technology transfer of the SURFAXIN LSour liquid and lyophilized KL4 surfactant manufacturing processprocesses to a cGMP-compliant, third-party contract-management organization (CMO) with expertiseCMO.  The increase in contract manufacturing from 2012 to 2013 was due to an increase in activities to transfer our KL4 manufacturing processes for our lyophilized formulations.KL4 surfactant as well as SURFAXIN.  The decrease in contract manufacturing costs infrom 2011 as compared to 20102012 is due to a reduction inpacing of our technology transfer activities associated with SURFAXIN LS while we focused our efforts on responding to the 2009 Complete Response Letter and securing marketing authorization for SURFAXIN.

The category “All Other” consists primarily of ongoing research and development costs such as insurance, taxes, education and training and software licenses.

Research and Development Projects

A substantial portion of our cumulative losses to date including approximately $34.4 million in the two-year period ended December 31, 2011, relate to investments in our research and development projects.projects, for which we incurred $66.5 million in expenses for the three-year period ended December 31, 2013.  Due to the significant risks and uncertainties inherent in clinical development and the regulatory approval processes, the nature, timing and costs of the efforts necessary to complete individual projects in development are not reasonably estimable.  With every phase of a development project, there are significant unknowns that may significantly affect cost projections and timelines.  As a result of the number and nature of these factors, many of which are outside our control, the success, timing of completion and ultimate cost, of development of any of our product candidates is highly uncertain and cannot be estimated with any degree of certainty.

For a discussion of certainIn addition to the risks and uncertainties affecting our research and development projects discussed in this MD&A, including those affecting our ability to estimate projections and timelines,see, “Item 1 – Business – Government Regulation,” and “Item 1A – Risk Factors – The regulatory approval process for our products is expensive and time-consuming and the outcome is uncertain.  We may not obtain required regulatory approvals for the commercialization ofto commercialize our products;products;” “– Our research and development activities involve significant risks and uncertainties that are inherent in the clinical development and regulatory approval processes;” “– Our clinical trials may be delayed, or fail, which will harm our business,” “– Manufacturing problems potentially could cause us to delay preclinical or clinical programs, or, if our products are approved, product launch, or cause us to experience shortages of products inventories, which could have a material adverse effect on our business;” as well as elsewhere in this Annual Report on Form 10-K.

Our lead KL4 surfactant drug product, SURFAXIN, was recently approved for marketing in the United States.  In addition, we recently registered our initial AFECTAIR device in the United States and expect to complete the registration of that device in the European Union in 2012.  Although we have two approved products at this time, neither are available for commercial sale.  We currently plan to initiate the commercial introduction of SURFAXIN and AFECTAIR in late 2012, although there can be no assurance that we will be successful in commercializing these products or in realizing a profit in the foreseeable future.

Our other KL4 surfactant drug development projects initially are initially focused on the management of RDS in premature infants, and includeincluding (i) SURFAXIN LS and AEROSURF.  We believe that these neonatal programs haveliquid instillate, which has been approved by the potential to greatly improveFDA for the managementprevention of RDS and expand the currentat high risk for RDS, market worldwide.  We plan in 2012 to seek regulatory and scientific guidance with respect to(ii) our planned development programs for SURFAXIN LS and AEROSURF; however, our ability to move forward with our planned clinical trials for both SURFAXIN LS and AEROSURF will depend upon the success of our efforts to complete our development activities and secure strategic alliances and/or necessary capital to support these activities.  Iflyophilized KL4 surfactant, which we are successful withindeveloping initially for use in our target time frame,AEROSURF development program and, if we believedetermine that we could gain marketing authorization for a lyophilized dosage form of SURFAXIN under a development plan that would be both capital efficient and capable of implementation within a reasonable time, we would likely implement such a plan and would plan to introduce it commercially as a life-cycle extension of SURFAXIN under the name SURFAXIN LS; and (iii) our aerosol delivery technology, including preparation of a clinic-ready CAG device to support our AEROSURF phase 2 clinical program.

With respect to activities in a positionsupport of our AEROSURF development program, from 2012 through December 2013, we invested approximately $7 million to initiatedevelop the CAG and complete the technology transfer and further develop our lyophilized KL4 surfactant manufacturing process at DSM, in preparation for initiation of the AEROSURF phase 2 program.  In addition, as noted above, we anticipate that direct clinical programs for SURFAXIN LS andprogram costs associated with conducting the AEROSURF in late 2013.  However, there can be no assurance that wephase 2 clinical program will be successfulapproximately $8 - 10 million for 2014 through the anticipated completion of the AEROSURF phase 2 program in securing such an alliance or capital, that our development plans for these products will be successful, if at all, and within our anticipated time frames.  Accordingly, we are unable to reliably project when we might implement these programs, the pace of such implementation or the overall anticipated expense that we might incur.2015.


The status of our lead projects and our other pipeline candidates, including the potential timing and milestones for each, is discussed in “Item 1 – Business – Surfactant Replacement Therapy for Respiratory Medicine.”  See also, “Item 1 – Business – Business Strategy,” and “Item 1A – Risk Factors – We may not successfully develop and market our products, and even if we do, we may not become profitable,”  “– We will require significant additional capital to continue our planned research and development activities and continue to operate as a going concern.  Moreover, such additional financing could result in equity dilution.”

Our ability to generate sufficient capital to support our product development activities and, if approved, commercialization69
In the European Union and other markets outside the U.S., depends upon many factors, including the success of our efforts (i) to commercialize SURFAXIN and AFECTAIR, (ii) to secure one or more strategic alliances or other collaboration arrangements to support the further development and, if approved, commercialization of SURFAXIN LS and AEROSURF in markets outside the United States, and/or (iii) to enter into alternative financial arrangements that would provide the required capital.  We believe that our ability to successfully enter into meaningful strategic alliances has likely improved with receipt of marketing approval in the United States for SURFAXIN and our improved financial condition as a result of our March 2012 public offering (see, “– Liquidity and Capital Resources –Financings Pursuant to Common Stock Offerings – 2011 Universal Shelf”),  and will further improve iffuture, we are able to advance our SURFAXIN LS and AEROSURF programs towards initiation of planned Phase 2 and Phase 3 clinical trials, respectively.  There can be no assurance, however,expect that we will successfully commercialize SURFAXIN LS or AFECTAIR, that we willmay be able to secure strategic partners or collaboratorsleverage the information, data and know-how that we gain from our development efforts with SURFAXIN and AEROSURF to support and provide expert advice to guide our activities, that our research and development projects will be successful, or that we will be able to obtain additional capital to support our activities when needed on acceptable terms, if at all.  See, “– Liquidity and Capital Resources.”

We believe that our KL4 surfactant technology has theof a potential to be developed into a broad product pipeline that couldto address a variety of debilitatingserious critical care respiratory conditions in patient populations ranging from premature infants to adults.larger children and adults in pediatric and adult intensive care units (PICUS and ICUs), including Acute Lung Injury (ALI), Chronic Obstructive Pulmonary Disorder (COPD) and Cystic Fibrosis (CF).  At the present time, we plan to focusare focusing our resources primarily on RDS programsthe commercial introduction of SURFAXIN and pace investmentsdevelopment of AEROSURF through phase 2 clinical trials.  Once we have achieved these objectives, we believe we would be in potential non-RDS pipeline programs.  See, “Item 1 – Business – Surfactant Replacement Therapy for Respiratory Medicine.”  However, we plan to consider opportunistically sponsoring and supporting third-party investigator-initiated preclinical and clinical programs directed at establishing proof-of-concept through Phase 2 studies for each potential indication.  If successful, we plana better position to assess the potential markets for these productsof other development programs to address the critical care needs of patients in the PICU and determine whether to seek strategic alliances or collaboration arrangements, or utilize other financial alternatives to fund their further development.ICU.  See, “Item 1 – Business – Business Strategy,” and “– Surfactant Replacement Therapy For Respiratory Medicine.”

Ultimately, if we do not successfully develop and gain marketing approval for our drug product candidates, in the United StatesU.S. or elsewhere, we will not be able to commercialize, or generate any revenues from the sale of our products and the value of our company and our financial condition and results of operations will be substantially harmed.

Selling, General and Administrative Expenses

General
(in thousands) Years Ended December 31, 
 
 2013  2012  2011 
Selling, General and Administrative Expenses $16,718  $16,444  $7,864 
Selling, general and administrative expenses consist primarily of the costs ofsales and marketing activities, executive management, business and commercial development, intellectual property, finance and accounting, intellectual property and legal, human resources, information technology, facility and other administrative costs.

General and administrative expenses for the years ended December 31, 2011 and 2010 were $7.9 million and $8.4 million, respectively.  Included inSelling, general and administrative expenses wereincreased $0.3 million from 2012 to 2013 primarily due to an increase in investments in our marketing and field-based sales force to execute the commercial introduction of SURFAXIN and the AFECTAIR device for infants.  Selling, general and administrative expenses in 2012 include a $2.0 million one-time charge associated with certain contractual cash severance obligations and stock-based compensation charges related to the resignation of our former Chief Executive Officer.

 Selling, general and administrative expenses increased $8.6 million from 2011 to 2012 primarily due to (i) investments in our marketing and field-based sales force to support the anticipated commercial introduction of SURFAXIN; (ii) marketing-related activities primarily for SURFAXIN; (iii) a $2.0 million one-time charge associated with certain contractual cash severance obligations and stock-based compensation charges related to the resignation of our former Chief Executive Officer; and (iv) increased costs associated with employee incentive compensation plans.

Selling, general and administrative expenses include non-cash charges associated with stock-based compensation and depreciation of $0.7$1.5 million, $2.0 million, and $1.1 million, respectively, for the years ended December 31, 2011 and 2010.  In addition, general and administrative expenses include one-time charges of $0.4 million and $1.0$0.7 million, for the years ended December 31, 2013, 2012 and 2011, and 2010, respectively, associated with certain contractual cash severance obligations related to our former Executive Vice President and General Counsel in 2011 and for our former President and Chief Executive Officer in 2010.  Excluding therespectively.  The 2012 amount includes $0.8 million of stock-based compensation charges related to the resignation of our severance obligation and charges associated with stock-based compensation and depreciation, general and administrative expenses increased $0.5 million in 2011 as compared to 2010.  The increase is primarily related to employee incentive payments and AFECTAIR market research activities.former Chief Executive Officer.


We believe our existing general and administrative resources, including in legal, finance business development,and accounting, and information technologies, humanto support the commercial introduction of our products.  With these investments, we believe that our general and administrative resources and general management capabilities, arewill be sufficient to support our business operations for the foreseeable future.  operations.

We expectplan to may make additionalcontinue our investments in the future to enhance these capabilities asprosecuting and when required to meet the needs of our business.

With respect to our planned commercial introduction of SURFAXIN and AFECTAIR in late 2012, we expect to incur expenses at an annual rate of approximately $12-13 million, which primarily represents investment in marketing, field-based sales and medical affairs capabilities.  We anticipate that our medical affairs personnel will provide medical education support for both SURFAXIN and AFECTAIR, as both products may be of interest to many of the same medical practitioners and involve many of the same medical congresses, many of the same medical journals and publications, and many of the same hospitals.  We expect that this anticipated synergy will result in certain economies for each of these products.

We expect to invest in maintaining our existing patent portfolio and trademarks, and in protecting our trade secrets and regulatory exclusivity designations, including potential orphan drug and new drug product exclusivities, andexclusivities.  We also plan, when appropriate, to invest in potential patent extensions, new patents, new trademarks, and new regulatory exclusivity designations, when available.  See, “Item 1 – Business – Licensing, Patents and Other Proprietary Rights and Regulatory Designations.”
Change in Fair Value of Common Stock Warrant Liability

(in thousands) 
Years Ended
December 31,
 
  2013  2012  2011 
  
 
Change in fair value of common stock warrant liability $761  $555  $3,560 

We account for common stock warrants in accordance with applicable accounting guidance provided in ASC Topic 815,“Derivatives and Hedging Contracts in Entity’s Own Equity”, either as derivative liabilities or as equity instruments depending on the specific terms of the warrant agreement.  Derivative warrant liabilities are valued at the date of initial issuance and as of each subsequent balance sheet date using the Black-Scholes or trinomial pricing models, depending on the applicable terms of the applicable warrant agreement at the date of initial issuance and each subsequent balance sheet date.agreement.  Changes in the fair value of the warrants are reflected in the consolidated statement of operations as “Change in the fair value of common stock warrant liability.”

The form of warrant agreement for the registered warrants that we issued in our May 2009 and February 2010 public offerings generally provide that, in the event a related registration statement or an exemption from registration is not available for the issuance or resale of the warrant shares upon exercise of the warrant, the holder may exercise the warrant on a cashless basis.  Notwithstanding the availability of cashless exercise, under generally accepted accounting principles (GAAP) provide that these registered warrants are deemed to be subject to potential net cash settlement and must be classified as derivative liabilities because (i) under the federal securities laws, it may not be within our absolute control to provideproviding freely-tradable shares upon exercise of the warrants may not be within our control in all circumstances, and (ii) the warrant agreements do not expressly stateprovide that there is no circumstance in which we may be required to effect a net cash settlement of the warrants.  The applicable accounting principlesguidance expressly do not allow forprecludes an evaluation of the likelihood that an event would result in a cash settlement.settlement could occur.  Accordingly, the May 2009 and February 2010 warrants have been classified as derivative liabilities and reported, at each balance sheet date, at estimated fair value determined using the Black-Scholes option-pricing model.

The form of warrant agreement for the registered five-year warrants that we issued in the February 2011 public offering (February 2011 five-year warrants) expressly provide that under no circumstances will we be required to effect a net cash settlement of these warrants.  However, these warrants contain anti-dilutive provisions that adjust the exercise price if we issue any common stock, securities convertible into common stock, or other securities (subject to certain exceptions) at a value below the then-existing exercise price of the February 2011 five-year warrants.  DueAlthough by their express terms, these warrants are not subject to potential cash settlement, due to the nature of the anti-dilution provisions, these warrants have been classified as derivative liabilities and reported, at each balance sheet date, at estimated fair value determined using a trinomial pricing model.


The changeChanges in fair value ofour common stock warrant liability for the years ended December 31, 2011 and 2010 resulted in income of $3.6 million and $6.4 million, respectively, dueare primarily related to a decreasechanges in our common stock share price during the periods.

Other Income / (Expense)

Other income / (expense), net, for the years ended December 31, 2011 and 2010, respectively, is as follows:

(Dollars in thousands) Year Ended December 31, 
(in thousands)
Years Ended
December 31,
 
Other Income / (Expense):2013  2012  2011 
 2011  2010 
 
       
  
  
 
Interest income $13  $13  $3  $3  $13 
Interest expense  (20)  (357)  (1,471)  (13)  (20)
Other income / (expense)  (6)  275   –   (41)  (6)
Other income / (expense), net $(13)  $(69) $(1,468) $(51) $(13)

Interest income consists of interest earned on our cash and cash equivalents.  To ensure preservation of capital, we invest our cash in an interest-bearing operating cash account and a U.S. treasury-based money market fund.funds.

Interest expense for the year ended December 31, 2011in 2013 consists of interest onexpense associated with the Deerfield Loan (see, “– Liquidity and Capital Resources – Deerfield Loan”) and interest expense incurred under our equipment financing facilities.  Interest expense for the year ended December 31, 20102012 and 2011 consists of interest on our loan with PharmaBio, interest onexpense incurred under our equipment financing facilities andloan.

The following amounts comprise the Deerfield Loan interest expense for the periods presented:
(in thousands) 
Years Ended
December 31,
 
 
 2013  2012  2011 
Cash interest expense $911  $–  $– 
Non-cash amortization of debt discounts  534   –   – 
Amortization of debt costs  18   –   – 
Total Deerfield Loan interest expenses $1,463  $–  $– 

Cash interest expense represents interest at an annual rate of 8.75% calculated on the outstanding principal amount for the period, paid in cash on a quarterly basis.  Non-cash amortization of deferred financing costs for a warrant issued to PharmaBio in October 2006 as consideration for restructuring our loan in 2006.  The deferred financing costs were fully amortized asdebt discount represents the amortization of April 2010.  The decrease in interest expense in 2011 as compared to 2010 is primarily due totransaction fees and the maturing of our loan with PharmaBio in April 2010 and full repaymentfair value of the outstanding balance asDeerfield Warrants.  The amortization of September 30, 2010.

Other income / (expenses) for 2010 includes grant proceeds received under the Patient Protection and Affordable Care Act of 2010 to reimbursedebt costs represents professional fees incurred in 2009 to advance our aerosolized KL4 surfactant program forconnection with the prevention of neonatal RDS.Deerfield Loan.

LIQUIDITY AND CAPITAL RESOURCES

We have incurred substantial losses since inception, due to investments in research and development, manufacturing, and, potentialmore recently, commercialization and medical affairs activities, and we expect to continue to incur substantial losses over the next several years.  Historically, we have funded our business operations through various sources, including public and private securities offerings, draw downs under a seriesdebt facilities, strategic alliances, the use of Committed Equity Financing Facilitiescommitted equity financing facilities (CEFFs), and at-the-market equity programs, and capital equipment financings.

As of December 31, 2013, we had cash and cash equivalents of $86.3 million and $30 million ($18.4 million net of discount) of long-term debt facilities, and strategic alliances.  We expect to fundunder our business operations primarilyDeerfield Loan with affiliates of Deerfield Management  Company, L.P. (Deerfield).  See, “– Deerfield Loan.”  During 2013, we raised aggregate gross proceeds of $75.8 million through a combination, or all, of public offerings of our common stock, including under our CEFF and ATM Program (see, “– Committed Equity Financing Facility (CEFF),At-the-Market Program (ATM Program)”).  In February 2013, we entered into the Deerfield Loan and, “–upon execution of the agreement, Deerfield advanced to us $10 million ($9.85 million net of transaction fee).  In May 2013, we completed a public offering of 10.847 million shares of common stock, including 1.347 million shares under an option granted to and exercised by the underwriters, at an offering price of $1.50 per share, resulting in gross proceeds of $16.3 million ($15.1 million net of commissions, discounts and expenses).  In October 2013, we completed an offering under the ATM Program”); anticipated revenue fromProgram and issued 713,920 shares of our common stock resulting in net proceeds to us of approximately $1.8 million (net of  commissions).  In November 2013, we completed a public offering of 28.75 million shares of common stock, including 3.75 million shares under an option granted to and exercised by the underwriters for over-allotments, at an offering price of $2.00 per share resulting in gross proceeds of $57.5 million ($53.9 million net of commissions, discounts and expenses).  In December 2013, we received an additional $20 million under the Deerfield Loan ($19.7 million net of transaction fee), which became available under the Deerfield Loan upon the first commercial introductionsale of SURFAXIN® and AFECTAIR®; strategic alliances; the exercise of outstanding warrants;SURFAXIN.  Before any additional financings, including under our ATM Program, we anticipate that we will have sufficient cash available to fund our operations and debt facilities.service obligations through the third quarter of 2015.
Our future capital requirements depend upon many factors, primarily the success of our efforts to (i) to execute the commercial introduction of SURFAXIN and AFECTAIR in the United States and other markets,U.S.; (ii) advance the AEROSURF development program to completion of the phase 2 clinical program as planned (ii) toin the second half of 2015; and (iii) secure one or more strategic alliances or other collaboration arrangements to support the development and, if approved, commercial introduction of AEROSURF and potentially SURFAXIN LS™ and AEROSURF®in the European Union and markets outside the U.S., (iii)  We believe that, if we are able to complete the AEROSURF phase 2 clinical program on a timely basis and obtain encouraging results, and if we are able to successfully advance the commercial introduction of SURFAXIN, LS and AEROSURF development programsour ability to enter into a significant strategic alliance will be in a positionenhanced.  There can be no assurance, however, that our efforts will be successful, or that we will be able to initiate planned Phase 3 and Phase 2 clinical trials, respectively, and (iv) to procure theobtain additional capital necessary and desirable to support our activities when needed on acceptable terms, if at all.
Even if we succeed with the commercial introduction of SURFAXIN, given the time required to secure formulary acceptance at our target hospitals, we expect our revenues from SURFAXIN to be modest in the first 12-24 months and then increase slowly over time.  For the next several years, we expect that our cash outflows for marketing, commercial and medical activities, development programs, operations and debt service will far outpace the rate at which we may generate revenues.  Therefore, to execute our business strategy and fund our operations over the long term, we will require significant additional infusions of capital until such time as the net revenues from ourthe sale of approved products, from potential strategic alliance and other collaboration arrangementsalliances and from other sources such as future warrant exercises, are sufficient to offset our cash flow requirements.  To secure the necessary capital to fund our development programs, we would prefer to enter into strategic alliances or collaboration arrangements with partners having broad experience in markets outside the U.S., including regulatory and product-development expertise as well as an ability to commercialize our products, if approved.  Such alliances typically would also provide financial resources, in the form of upfront payments, milestone payments, commercialization royalties and a sharing of research and development expenses.  Collaboration, co-marketing and other similar arrangements would provide, in addition to an ability to introduce our products in markets outside the U.S., a sharing of revenues.  Under our ATM Program, subject to market conditions, we may sell up to approximately $23 million of common stock at such times and in such amounts that we deem appropriate, subject to a 3% commission.  However, use of the ATM Program is subject to market and other conditions and the ATM Program could be cancelled at any time by either party.  We also may consider public and private equity offerings or other financing transactions, including potentially secured equipment financing facilities or other similar transactions.  There can be no assurance, however, that our AEROSURF and other research and development projects will be successful, that our products under development will obtain necessary regulatory approval in the U.S. and other markets, that any approved product, including SURFAXIN, will be commercially viable, that the ATM Program will be available when needed, if at all, or that we will be able to obtain additional capital when needed on acceptable terms, if at all.  Even if we succeed in raising additional capital and developing and subsequently commercializing product candidates, we may never achieve sufficient sales revenue to achieve or maintain profitability.

The accompanying financial statements have been prepared assuming that we will continue as a going concern, which contemplates the realization of assets and satisfaction of liabilities in the normal course of business.  For the next several years, our ability to continue as a going concern will be dependent on our ability to raise additional capital, to fund our research and development and commercial programs and meet our obligations, including debt service, on a timely basis.  If we are unable to successfully raise sufficient additional capital when needed, we will likely not have sufficient cash flows and liquidity to fund our business operations, which could significantly limit our ability to continue as a going concern.  In that event, we may be forced to further limit our programs and consider other means of creating value for our stockholders, such as licensing the development and commercialization of products that we consider valuable and would otherwise likely develop ourselves.  If we are unable to raise the necessary capital, we may be forced to curtail all of our activities and, ultimately, potentially cease operations.  Even if we are able to raise additional capital, such financings may only be available on unattractive terms, or could result in significant dilution of stockholders’ interests and, in such event, the market price of our common stock may decline.  The balance sheets do not include any adjustments relating to recoverability and classification of recorded asset amounts or the amounts and classification of liabilities that might be necessary should we be unable to continue in existence.

As of December 31, 2011, we had cash and cash equivalents of $10.2 million.  From January 1, 2012 through March 21, 2012, (i) holders of 15-month warrants we issued in February 2011 have exercised warrants to purchase 2,233,000 shares of our common stock at an exercise price of $2.94 per share, resulting in proceeds to us of $6.6 million; and (ii) holders of the five-year warrants we issued in February 2011 have exercised warrants to purchase 46,250 shares of our common stock at an exercise price of $3.20 per share, resulting in proceeds to us of $148,000.  In addition, on March 7, 2012, we delivered a sales notice under our ATM Program to sell shares of common stock.  We terminated the offering on March 8, 2012.  As a result of that offering, we issued an aggregate 350,3742013, 150 million shares of common stock at an aggregate purchase price of approximately $1.56 million, resulting in net proceeds to us of approximately $1.52 million, after deducting commissions due to the sales agent.  On March 21, 2012, we completed a public offering of 16,071,429 shares of common stock for net proceeds to us (after underwriter fees and anticipated expenses) of approximately $42.1 million.  In addition, we granted the underwriters a 30-day option to purchase up to an additional 2,410,714 shares of common stock at a public offering price of $2.80 per share, with respect to which we potentially could realize additional net proceeds of $6.3 million.


As of December 31, 2011 and March 21, 2012, of the 100 million shares of common stockwere authorized under our Amended and Restated Certificate of Incorporation, we hadand approximately 42.1 million shares of common stock were available for issuance and not otherwise reservedreserved.

In addition, as of December 31, 2013, we had outstanding warrants to purchase approximately 14.8 million shares of our common stock at various prices, exercisable on different dates into 2019.  Of these warrants, 7 million warrants were issued to Deerfield in connection with the Deerfield Loan at an exercise price of $2.81 per share.  The Deerfield Warrants may be exercised for future issuance,cash or on a cashless basis.  In lieu of paying cash upon exercise, the holders also may elect to reduce the principal amount of the Deerfield loan in an amount sufficient to satisfy the exercise price of the Deerfield Warrants.  In addition to the Deerfield Warrants, we have outstanding warrants to purchase approximately 56.5 million and 40.04.8 million shares of common stock respectively.

To execute our business strategy over time,that were issued in February 2011, are exercisable for five-years, and contain anti-dilution provisions that adjust the exercise price if we anticipate potentially securing additional infusions of capital fromissue any common stock, securities convertible into common stock, or other securities (subject to certain exceptions) at a combination of some or allvalue below the then-existing exercise price of the warrants.  These warrants were originally issued with an exercise price of $3.20 per share and thereafter adjusted downward, first to $2.80 per share in March 2012 and then to $1.50 per share following sources:
Exercisea public offering in May 2013.  If the market price of outstanding warrants:
·In connection with our February 2011 public offering, we issued 15-month warrants to purchase five million shares of our common stock at an exercise price of $2.94 per share (15-month warrants) of which 2,233,000 warrants have been exercised through March 21, 2012.  If the market price of our common stock should exceed $2.94 at any time prior to May 2012 (the expiration date of these warrants), and if the holders determine (in their discretion) to exercise the 15-month warrants and we have an effective registration statement covering the warrant shares, we potentially could raise up to an additional $8.1 million.
·Also in connection with the February 2011 public offering, we issued five-year warrants to purchase five million shares of our common stock at an exercise price of $3.20 per share (2011 five-year warrants).  These warrants also contain anti-dilutive provisions that adjust the exercise price if we issue any common stock, securities convertible into common stock, or other securities (subject to certain exceptions) at a value below the then-existing exercise price.  As a result of the March 2012 public offering, the exercise price of these warrants has been adjusted downward to $2.80 per share.  Thus, if the market price of our common stock should remain above $2.80 at any time prior February 2016 (the expiration date of these warrants), and if the holders determine (in their discretion) to exercise the five-year warrants and we have an effective registration statement covering the warrant shares to be issued upon exercise of the warrants, we potentially could raise up to an additional $13.9 million.
Upfrontour common stock should exceed $1.50 at any time prior to the expiration date of these warrants (February 2016) and milestone payments and co-fundingif the holders determine in their discretion to exercise these warrants (and we have an effective registration statement covering the warrant shares to be issued upon exercise of development activities associated with potential strategic alliances or other similar transactions:
·We are engaged in discussions with potential strategic partners who could provide development and commercial expertise as well as financial resources (potentially in the form of upfront payments, milestone payments, commercialization royalties and a sharing of research and development expenses) to support the development of SURFAXIN LS and AEROSURF and, if approved, the introduction of these products in Europe and various markets outside the U.S.
Secured debt arrangementsthe warrants), we potentially could receive up to fund working capital and/or investment$7.3 million. Although we believe that, in capital assets:
·In the future, if our efforts are successful, we believe that debt could potentially be a component of our capital structure and financing plans.  We could potentially enter into capital equipment financing facilities, revolving working capital lines of credit, term loans and other similar transactions to satisfy our working capital requirements.
In appropriate circumstances, tothe future, we will secure additional capital and strengthenfrom the exercise of at least a portion of our financial condition, we will also consider equity public offerings and other financing transactions:
·We have a CEFF with Kingsbridge Capital Ltd. (Kingsbridge) that could allow us, at our discretion, to raise capital (subject to certain conditions, including volume limitations) at a time and in amounts we deem suitable to support our business plans.  Based on the closing market price of our common stock on March 21, 2012 ($2.80) and assuming that all available shares are issued, the potential availability under our CEFF is approximately $2.8 million.
·In December 2011, we established an “at-the-market” program (ATM Program), which allows us, at our discretion and at such times that we may choose, to sell up to a maximum of $15 million of shares of common stock.  Based on the closing market price of our common stock on March 21, 2012 ($2.80), and assuming that the full amount available under the ATM Program ($13.4 million) is sold, we may issue up to approximately 4.8 million additional shares under the ATM Program.  See, “– Financings Pursuant to Common Stock Offerings.”
·We have agreed in connection with our March 2012 public offering that we will not issue or sell (with certain limited exceptions) securities for a period of 90 days ending in June 2012.  See, “- Financings Pursuant to Common Stock Offerings.”
Thereoutstanding warrants, there can be no assurance that the market price of our common stock will remain atequal or exceed price levels that make exercise of outstanding warrants likely or that holders of outstanding warrants will choose to exercise any or all of their warrants prior to the warrant expiration date; that wedate.  Moreover, if our outstanding warrants are exercised, such exercises likely will be successful in concluding any strategic alliance, collaboration or other financing transaction; that the CEFF will be available at any time, or, even if available, that we will utilize the CEFF prior to its expiration in June 2013; that we will issue any shares pursuanta discount to the ATM Program, or thatthen-market value of our common stock and have a dilutive effect on the entire amount provided undervalue of our shares of common stock at the ATM Program will be realized prior the expiration or earlier terminationtime of the ATM Program; or that we will undertake any financings or similar transactions, on favorable terms or otherwise.exercise.

We believe, if we are successful in implementing our strategic business plan, that the anticipated net revenues from the sales of SURFAXIN and AFECTAIR, when combined with the other sources of anticipated capital outlined above, including from potential strategic alliances and collaboration arrangements to support the SURFAXIN LS and AEROSURF development programs, potentially could be sufficient to support our future operations.  In that event, we would nevertheless continue to consider financings and similar transactions that would strengthen our financial condition and build value for our stockholders.

Although we currently believe that we will be successful in meetingable to successfully execute our strategic planning goals within the time frame set forth above,business strategy, there can be no assurance that we will successfully fundbe successful.  We will require significant additional capital to satisfy debt obligations and build our own commercial organizationsustain operations, and to complete the development and support the commercial introduction of SURFAXIN and AFECTAIR; that we will successfully executeour products.  Failure to secure the launch of SURFAXIN and AFECTAIR within the anticipated time frame; that the revenues we may realize from the sale of SURFAXIN and AFECTAIR will be in line with current expectations; that we will successfully identify one or more strategic partners or collaboration arrangements to support development and, if approved, commercial introduction of the SURFAXIN LS and AEROSURF product candidates; or that the revenues, if any, that we generate in the future will be sufficient at any time to fund the further development of our research and development programs and support our operations.  If we are unable to identify and enter into strategic alliances for the development of SURFAXIN LS and AEROSURF, and if approved, commercialization of SURFAXIN LS and AEROSURF in the European Union and other markets outside the U.S., we may be unable to fund planned clinical trials, whichnecessary additional capital would have a material adverse effect on our researchbusiness, financial condition and development programs.results of operations.

Cash Flows

As of December 31, 20112013, 2012 and 2010,2011, we had cash and cash equivalents of $86.3 million, $26.9 million and $10.2 million.  Cash outflows before financingsfinancing activities for the year ended December 31, 2011 consist2013 consisted of $22.7$40.5 million used for ongoing operating activities and $0.1$0.6 million used for debt service.purchases of property and equipment.  During 2011,2013, we raised aggregate net proceeds of $22.9$100.4 million, including $21.6a $30 million ($29.6 million net of expenses) advanced under the Deerfield Loan, $15.1 million and $53.9 million of net proceeds from registered public offerings that we completed in May 2013 and November 2013, respectively, and $1.8 million of net proceeds from a public offering in February 2011 and $1.3 million from financingsfinancing under our CEFF.the ATM Program.

Cash Flows Used In Operating Activities

Cash flowsNet cash used in operating activities werewas $40.5 million, $32.9 million, and $22.7 million and $24.3million for the years ended December 31, 2013, 2012 and 2011, and 2010, respectively.

Net cash used in operating activities is a result of our net losses for the period, adjusted for non-cash items and changes in working capital.

The increase in net cash used in operating activities from 2012 to 2013 is primarily due to (i) investment in our specialty commercial and medical affairs organization that is focused on neonatal/pediatric respiratory critical care in NICUs/PICUs across the U.S., and manufacturing and quality activities in preparation for the commercial introduction of SURFAXIN; (ii) costs to develop and manufacture clinic-ready CAGs for the AEROSURF phase 2a clinical trial, including work with third party device experts and work that began June 2012 with Battelle, which assisted in a multi-phase project to design, test, and manufacture clinic-ready CAG devices; and (iii) purchases of APIs used in the manufacture of SURFAXIN drug product and our lyophilized KL4 surfactant, for commercial use and preclinical development activities, including to complete the technical transfer and further develop our KL4 surfactant manufacturing process at DSM, and activities to develop a clinic-ready CAG and prepare for our AEROSURF phase 2 clinicalprogram.

The increase in net cash used in operating activities from 2011 to 2012 is primarily due to (i) investments in marketing, field-based sales and medical affairs capabilities, and manufacturing and quality activities in preparation for the commercial introduction of SURFAXIN; (ii) costs to develop and manufacture clinic-ready CAGs for the AEROSURF phase 2a clinical trial, including work with third party device experts and work that began June 2012 with Battelle, which assisted in a multi-phase project to design, test, and manufacture clinic-ready CAG devices; and (iii) a one-time charge associated with certain contractual cash severance obligations and stock-based compensation charges related to the changeresignation of our former Chief Executive Officer.

Investing Activities

Net cash used in fair valueinvesting activities primarily represents capital expenditures of common stock warrants ($3.6$0.6 million, $0.6 million, and $6.4$0.1 million for the years ended December 31, 2013, 2012, and 2011, and 2010, respectively), stock-based compensation, 401(k) match and depreciation expense ($2.6 million and $3.2 for the years ended December 31, 2011 and 2010, respectively), and changes in working capital.  Cash flows used in operating activities for the year ended December 31, 2010 included a one-time payment of $1.1 million to satisfy severance obligations to our former President and Chief Executive Officer.respectively.


Cash Flows Used In Investing Activities

Cash flows used in investing activities represent capital expenditures of $0.1 million for each of the years ended December 31, 2011 and 2010.

Cash Flows from Financing Activities

Cash flows fromNet cash provided by financing activities were $22.8was $100.5 million, $50.2 million, and $18.8$22.8 million for the years ended December 31, 2013, 2012, and 2011, and 2010, respectively, summarized as summarized in the chart below:follows:

(In millions) Year Ended December 31, 
(in millions) 
Years Ended
December 31,
 
 2013  2012  2011 
 2011  2010  
 
       
  
  
 
Financings pursuant to common stock offerings $21.6  $26.6  $69.0  $42.1  $21.6 
Financings under CEFFs  1.3   1.4 
Proceeds from issuance of long-term debt, net  29.6   –   – 
Financings under the 2010 CEFF  –   –   1.3 
Exercise of common stock warrants and options  0.2   6.7   – 
Financings under the ATM Programs  1.8   3.0   – 
Debt service payments  (0.1)  (9.2)  (0.1)  (0.1)  (0.1)
Cash flows from financing activities, net $22.8  $18.8  $100.5  $50.2  $22.8 

The following sections provide a more detailed discussion of our cash flows from available financing facilities and activities.

Committed Equity Financing Facility (CEFF)

Since 2004, we have maintained one or more Committed Equity Financing Facilities (CEFFs) with Kingsbridge Capital Limited (Kingsbridge), a private investment group, under which Kingsbridge is committed to purchase, subject to certain conditions, newly-issued shares of our common stock.  The CEFFs have allowed us, at our discretion, to raise capital, at the time and in amounts deemed suitable to us, to support our business plans.  We are not obligated to utilize any of the funds available under any CEFF and our ability to access funds at any time is subject to certain conditions, including stock price and volume limitations.

As of December 31, 2011, we had one CEFF dated June 11, 2010 (2010 CEFF).  Two prior CEFF agreements, dated May 22, 2008 (May 2008 CEFF) and December 12, 2008 (December 2008 CEFF), expired in June 2011 and February 2011, respectively.

2010 CEFF

The 2010 CEFF related Stock Purchase Agreement originally provided for up to 2.1 million shares, up to a maximum of $35 million, and expires in June 2013.  As of December 31, 2011, there were 1.1 million shares remaining under 2010 CEFF, up to a maximum of $32.3 million.  The shares issuable under the 2010 CEFF were registered under a 2008 Universal Shelf.

Each draw down extends for an eight-day trading period.  To initiate a draw down, the closing price of our common stock on the trading day immediately preceding the first trading day must be at least equal to $0.20 per share.  If on any trading day during the trading period, if the daily volume-weighted average price of our common stock (VWAP) is less than the Threshold Price (defined below), Kingsbridge has the right to purchase shares at the Threshold Price; otherwise no shares are purchased on that trading day and the aggregate amount that we originally designated for the overall draw down is reduced for each such day by 1/8th.  The Threshold Price is either (i) 90% of the closing market price of our common stock on the trading day immediately preceding the first trading day of the draw down period or (ii) a price that we specify at our sole discretion; but not less than $0.20 per share.  Unless Kingsbridge and we agree otherwise, a minimum of three trading days must elapse between the expiration of any draw-down period and the beginning of the next draw-down period.

With respect to each draw down, Kingsbridge is obligated to purchase (“Obligated Amount”) the amount determined under one of two methodologies that we choose at our discretion, subject to a maximum of the lesser of 3.5% of the closing market value of the outstanding shares of our common stock at the time of the draw down or $15 million.  The methodologies for determining the Obligated Amount are:
Methodology 1 – based on Threshold Price 
Obligated
Amount
 
Threshold Price is:   
Greater than $90.00 per share $7,250,000 
Greater than or equal to $75.00 but less than $90.00 per share $6,500,000 
Greater than or equal to $60.00 but less than $75.00 per share $4,250,000 
Greater than or equal to $45.00 but less than $60.00 per share $3,500,000 
Greater than or equal to $30.00 but less than $45.00 per share $2,750,000 
Greater than or equal to $18.75 but less than $30.00 per share $2,000,000 
Greater than or equal to $11.25 but less than $18.75 per share $1,350,000 
Greater than or equal to $7.50 but less than $11.25 per share $1,000,000 
Greater than or equal to $3.75 but less than $7.50 per share $500,000 
Greater than or equal to $3.00 but less than $3.75 per share $350,000 

Methodology 2
Under this method, the Obligated Amount is equal to: 8 (the trading days in the draw down period) multiplied by the adjusted average trading volume of our common stock (calculated as the average daily trading volume of the prior 40 trading days excluding the 5 trading days with the highest trading volume and the 5 trading days with the lowest trading volume) multiplied by the Threshold Price multiplied by 0.1985.

In addition, the 2010 CEFF provides that in connection with any draw down notice we may, in our sole discretion, include a request that Kingsbridge purchase an additional amount over the calculated Obligated Amount (a supplemental amount).  Kingsbridge may in its sole discretion choose to purchase all or a portion of any supplemental amount that we designate.  If we designate a supplemental amount, we may also designate a separate threshold price for that supplemental amount, provided that the supplemental amount, when aggregated with all other amounts drawn under the 2010 CEFF, may not exceed the total commitment amount available under the 2010 CEFF.  If Kingsbridge elects to purchase any of the supplemental amount, we will sell to Kingsbridge the corresponding number of shares at a price equal to the greater of (i) the daily VWAP of our common stock on the applicable trading day, or (ii) the supplemental amount threshold price designated by us, in either case less the applicable discount determined in the same manner as for the Obligated Amount.

The purchase price of shares sold to Kingsbridge under the 2010 CEFF is at a discount to the VWAP (as defined in the agreement) for each of the trading days in the draw down period as follows:

Daily VWAP 
% of VWAP
  Applicable Discount 
Greater than $6.00 per share  95.62%  4.38%
Greater than or equal to $5.00 but less than $6.00 per share  95.25%  4.75%
Greater than or equal to $4.00 but less than $5.00 per share  94.75%  5.25%
Greater than or equal to $3.00 but less than $4.00 per share  94.25%  5.75%
Greater than or equal to $2.00 but less than $3.00 per share  94.00%  6.00%
Greater than or equal to $1.25 but less than $2.00 per share  92.50%  7.50%
Greater than or equal to $0.75 but less than $1.25 per share  91.50%  8.50%
Greater than or equal to $0.50 but less than $0.75 per share  90.50%  9.50%
Greater than or equal to $0.25 but less than $0.50 per share  85.00%  15.00%
Greater than or equal to $0.20 but less than $0.25 per share  82.50%  17.50%

Kingsbridge may terminate the 2010 CEFF under certain circumstances, including if a material adverse event relating to our business continues for 10 trading days after notice of the material adverse event.


In connection with the 2010 CEFF and prior CEFFs, we issued warrants to Kingsbridge.  The following warrants are outstanding and are exercisable, in whole or in part, for cash, except in limited circumstances:

·On June 11, 2010, a warrant to purchase up to 83,333 shares of our common stock at an exercise price of $6.69 per share.  The warrant expires in December 2015.
·On December 22, 2008, a warrant to purchase up to 45,000 shares of our common stock at an exercise price of $22.70 per share, expiring in May 2014.
·On May 22, 2008, a warrant to purchase up to 55,000 shares of our common stock at an exercise price of $37.59 per share, expiring in November 2013.
·On April 17, 2006, a warrant to purchase up to 32,667 shares of our common stock at an exercise price equal to $84.29 per share.  This warrant expired unexercised in October 2011.
·
In 2004, a warrant to purchase up to 25,000 shares of our common stock at an exercise price equal to $181.12 per share.  This warrant expired unexercised in January 2010.

CEFF Financings

Financings that we completed under the 2010 CEFF are as follows:

(in thousands, except per share data)     Discounted 
Completion Date Shares Issued  Gross Proceeds  
 Average Price
Per Share
 
          
October 4, 2010  351  $973  $2.77 
November 4, 2010  166   432   2.60 
January 24, 2011  314   991   3.16 
October 10, 2011  35   69   1.97 
October 24, 2011  37   63   1.71 
November 8, 2011  129   218   1.69 
   1,032  $2,746     

There were no financings under the May 2008 CEFF or December 2008 CEFF during 2010 and 2011.

ATM Program

On December 14, 2011, we entered into a Sales Agency Agreement (Agency Agreement) with Lazard Capital Markets LLC (Lazard), under which Lazard, as our exclusive agent, may, at our discretion and at such times that we may determine from time to time, sell over a two year period up to a maximum of $15,000,000 of shares of our common stock (Shares) through an “at-the-market” program (ATM Program).  We are not required to sell any Shares at any time during the term of the ATM Program.

If we issue a sale notice to Lazard, we may designate the minimum price per share at which Shares may be sold and the maximum number of Shares that Lazard is directed to sell during any selling period.  As a result, prices are expected to vary as between purchasers and during the term of the offering.  Lazard may sell the Shares by any method deemed to be an “at-the-market” equity offering as defined in Rule 415 promulgated under the Securities Act of 1933, as amended, which may include ordinary brokers’ transactions on The Nasdaq Capital Market, or otherwise at market prices prevailing at the time of sale or prices related to such prevailing market prices, or as otherwise agreed by Lazard and us.  Either party may suspend sales under Agency Agreement by notice to the other party.

The Agency Agreement will terminate upon the earliest of: (1) the sale of all Shares subject to Agency Agreement, (2) December 14, 2013 or (3) the earlier termination of Agency Agreement in accordance with its terms.  Either party may terminate Agency Agreement at any time upon written notification to the other party.  We have agreed to pay Lazard a commission equal to 3.0% of the gross proceeds of any sales of Shares.  We also agreed to reimburse Lazard for certain expenses incurred in connection with entering into Agency Agreement and have provided Lazard with customary representations and warranties, and indemnification rights.


The Shares to be issued under the ATM Program have been registered pursuant to a prospectus supplement dated December 14, 2011 to our 2011 Universal Shelf.

As of December 31, 2011, $15.0 million remained available under the ATM Program.

ATM Financings

On March 12, 2012, we completed an offering of 350,374 shares of our common stock for an aggregate purchase price of approximately $1.56 million, resulting in net proceeds to us of approximately $1.52 million, after deducting commissions due to Lazard under the Sales Agency Agreement.

Financings Pursuant to Common Stock Offerings

Historically, we have funded, and expect to continue to fund, our business operations through various sources, including financings pursuant to common stock offerings.

2011 Universal ShelfRegistered Public Offerings

In June 2011,On November 5, 2013, we filedcompleted a universal shelf registration statement on Form S-3 (No. 333-174786) (2011 Universal Shelf) withregistered public offering of 25,000,000 shares of our common stock, at a price of $2.00 per share resulting in gross proceeds of $50.0 million ($46.8 million net proceeds).  We also granted the SEC for the proposed offering from timeunderwriters a 30-day option to time ofpurchase up to $200an additional 3,750,000 shares of common stock at an offering price of $2.00 per share.  On November 8, 2013, the underwriters exercised their option in full, resulting in additional gross proceeds of $7.5 million ($7.1 million net proceeds).

On May 10, 2013, we completed a registered public offering of 9,500,000 shares of our securities, including common stock, preferredat a price of $1.50 per share resulting in gross proceeds of $14.3 million ($13.2 million net proceeds).  We also granted the underwriters a 30-day option to purchase up to an additional 1,425,000 shares of common stock varying formsat an offering price of debt and warrant securities, or any combination$1.50 per share.  On May 28, 2013, the underwriters exercised their option to purchase 1,347,000 shares of the foregoing, on terms and conditions that will be determinedcommon stock at that time.  The 2011 Universal Shelf replaced the 2008 Universal Shelf, which simultaneously expired, and was declared effective by the SEC on June 21, 2011.  Asa price of December 31, 2011, $199.7$1.50 per share, resulting in additional gross proceeds of $2.0 million remained unissued under the 2011 Universal Shelf.($1.9 million net proceeds).

On March 21, 2012, we completed a registered public offering of 16,071,429 shares of our common stock, at a public offering price of $2.80 per share resulting in gross proceeds of $45.0 million ($42.1 million net)net proceeds).  In addition, weWe also granted the underwriters a 30-day option to purchase up to an additional 2,410,714 shares of our common stock to cover over-allotments, if any.at an offering price of $2.80 per share, which expired unexercised in April 2012.

2008 Universal Shelf

In June 2008, we filed a universal shelf registration statement on Form S-3 (No. 333-151654) (2008 Universal Shelf) with the SEC for the proposed offering from time to time of up to $150 million of our securities, including common stock, preferred stock, varying forms of debt and warrant securities, or any combination of the foregoing, on terms and conditions that will be determined at that time. Upon effectiveness of the 2011 Universal Shelf, the 2008 Universal Shelf was no longer available for proposed offerings.  The following offerings were issued pursuant to the 2008 Universal Shelf.

On February 22, 2011, we completed a registered public offering of 10 million10,000,000 shares of our common stock, 15-month15‑month warrants to purchase five million shares of our common stock, and five-year warrants to purchase five million shares of our common stock.  The securities were sold as units, with each unit consisting of one share of common stock, a 15-month warrant to purchase one half share of common stock, and a five-year warrant to purchase one half share of common stock, at a public offering price of $2.35 per unit, resulting in gross proceeds to us of $23.5 million ($21.6 million net).  The 15-month warrants expire in May 2012 and are exercisable at ahad an exercise price per share of $2.94.$2.94 and expired in May 2012.  The five-year warrants expire in February 2016 and were initially exercisable at a price per share of $3.20.  The exercise price of the five-year warrants is subject to adjustment if we issue or sell common stock or securities convertible into common stock (in each case, subject to certain exceptions) at a price (determined as set forth in the warrant) that is less than the exercise price of the warrant.  In connection with the closing of our public offering onofferings in March 21, 2012 and May 2013, the exercise price of the five-year warrants has beenwas adjusted downward to a price per share of $2.80.

$2.80 and $1.50, respectively.
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On October 12, 2010, we entered into a Securities Purchase Agreement with PharmaBio, as the sole purchaser, pursuant to which PharmaBio agreed to purchase 158,730 shares of our common stock and warrants to purchase an aggregate of 79,365 shares of common stock, sold as units with each unit consisting of one share of common stock and one warrant to purchase one-half of a share of common stock, at an offering price of $3.15 per unit.  The offering resulted in gross proceeds to us of $0.5 million.  The warrants generally will expire in October 2015 and are immediately exercisable, subject to an aggregate beneficial ownership limitation, at an exercise price per share of $4.10 per share.  If exercised in full, the warrants would result in additional proceeds to us of approximately $0.325 million.  In addition, upon 20 days’ written notice to the holder of the warrant, we may redeem any or all of the warrants at any time within 20 days following the occurrence of a “trading threshold” (as defined below) at a per-warrant redemption price of $0.001.  A “trading threshold” will be deemed to have occurred on any date that the reported volume weighted average price (VWAP) for five of the immediately preceding seven consecutive trading days exceeds $6.75, provided that the minimum average daily trading volume of our common stock during the seven-day period is at least 33,333 shares (the price and volume criteria being adjusted to take into account any share dividend, share split or other similar transaction that may occur on or after the issuance).

On June 22, 2010, we completed a public offering of 2,380,952 shares of our common stock, five-year warrants to purchase 1,190,474 shares of our common stock, and nine-month warrants to purchase 1,190,474 shares of our common stock.  The securities were sold as units, with each unit consisting of one share of common stock, a five-year warrant to purchase one half share of common stock, and a nine-month warrant to purchase one half share of common stock, at a public offering price of $4.20 per unit, resulting in gross proceeds to us of $10 million ($9.1 million net).  The five-year warrants expire on June 22, 2015 and are immediately exercisable, subject to an aggregate beneficial ownership limitation, at a price per share of $6.00.  The nine-month warrants, which were immediately exercisable, subject to an aggregate beneficial ownership limitation, at a price per share of $4.20, expired on March 22, 2011.

On April 27, 2010, we entered into a Securities Purchase Agreement with PharmaBio, as the sole purchaser, pursuant to which PharmaBio agreed to purchase 270,154 shares of common stock and warrants to purchase an aggregate of 135,077 shares of common stock, sold as units with each unit consisting of one share of common stock and one warrant to purchase one-half share of common stock, at an offering price of $8.14 per unit.  The offering resulted in gross proceeds to us of $2.2 million ($2.1 million net).  The warrants generally expire in April 2015 and have been exercisable since October 28, 2010, subject to an aggregate beneficial ownership limitation of 9.9%, at a price per share of $10.59.

In February 2010, we completed a public offering of 1,833,333 shares of our common stock and warrants to purchase 916,669 shares of our common stock, sold as units,addition, with each unit consisting of one share of common stock and a warrant to purchase one-half share of common stock, at a public offering price of $9.00 per unit, resulting in gross proceeds to us of $16.5 million ($15.1 million net).  The warrants expire in February 2015 and are immediately exercisable, subject to an aggregate share ownership limitation, at a price per share of $12.75.

With respect to the warrants issued in connection with the foregoing offerings, the exercise price and number of shares of common stock issuable upon exercise are subject to adjustment in the event of any stock split, reverse stock split, stock dividend, recapitalization, reorganization or similar transaction.  The exercise price and the amount and/or type of property to be issued upon exercise of the warrants are also subject to adjustment if we engage in a “Fundamental Transaction” (such as consolidation or merger, sale or disposal of substantially all of our assets, and among others as defined in the form of the warrant).  The warrants are exercisable for cash only, except that if the related registration statement or an exemption from registration is not otherwise available for the resale of the warrant shares, the holder may exercise on a cashless basis.

Committed Equity Financing Facility (CEFF)

From 2004 through June 2013, we maintained one or more Committed Equity Financing Facilities (CEFFs) with Kingsbridge Capital Limited (Kingsbridge), a private investment group, under which Kingsbridge was committed to purchase, subject to certain conditions, newly-issued shares of our common stock.  The CEFFs allowed us, at our discretion, to raise capital, at the time and in amounts deemed suitable to us, to support our business plans.  We were not obligated to utilize any of the funds available under any CEFF and our ability to access funds at any time was subject to certain conditions, including stock price and volume limitations.

As of December 31, 2013, we have no CEFF agreements.  Three CEFF agreements, dated May 22, 2008, December 12, 2008, and June 11, 2010 (2010 CEFF) expired in June 2011, February 2011, and June 2013, respectively.  There were no financings under the May 2008 CEFF or December 2008 CEFF during 2013, 2012 and 2011.

The 2010 CEFF Agreement originally provided for the purchase of the lesser of up to 2.1 million shares or a maximum of $35 million, and expired in June 2013.  There were no financings completed under the 2010 CEFF in 2012 and 2013.

In 2011, we received $1.3 million of gross proceeds from the issuance of 514,990 shares at an average discounted price of $2.56 per share under the 2010 CEFF.

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Warrants

During the year ended December 31, 2013, holders of the February 2011 five-year warrants exercised warrants to purchase 113,800 shares of our common stock at an exercise price of $1.50 per share, resulting in proceeds to us of $170,700.

During the year ended December 31, 2012, holders of the 15‑month warrants that we issued in February 2011 exercised warrants to purchase 2,238,000 shares of our common stock at an exercise price of $2.94 per share, resulting in proceeds to us of $6.6 million.  The remaining 15-month warrants to purchase 2,762,000 shares expired unexercised on May 22, 2012.  In addition, holders of the February 2011 five-year warrants exercised warrants to purchase 51,250 shares of our common stock at an exercise price ranging from $2.80 to $3.20 per share, resulting in proceeds to us of $162,000.  For a listing of outstanding warrants, Debtsee, “Item 8 – Notes to consolidated financial statements – Note 11 – Stockholders’ Equity – Common Shares Reserved for Future Issuance – Common shares reserved for potential future issuance upon exercise of warrants.”

At-the-Market Program (ATM Program)

Stifel ATM Program

On February 11, 2013, we entered into an At-the-Market Equity Sales Agreement (ATM Agreement) with Stifel, under which Stifel, as our exclusive agent, at our discretion and at such times that we may determine from time to time, may sell over a three-year period up to a maximum of $25,000,000 of shares of our common stock (ATM Program). We are not required to sell any shares at any time during the term of the ATM Program.
If we issue a sale notice to Stifel, we may designate the minimum price per share at which shares may be sold and the maximum number of shares that Stifel is directed to sell during any selling period.  As a result, prices are expected to vary as between purchasers and during the term of the offering.  Stifel may sell the shares by any method deemed to be an “at-the-market” equity offering as defined in Rule 415 promulgated under the Securities Act of 1933, as amended, which may include ordinary brokers’ transactions on The Nasdaq Capital Market®, or otherwise at market prices prevailing at the time of sale or prices related to such prevailing market prices, or as otherwise agreed by Stifel and us.  Either party may suspend the offering under the ATM Agreement by notice to the other party.

The ATM Agreement will terminate upon the earliest of: (1) the sale of all shares subject to the ATM Agreement, (2) February 11, 2016 or (3) the termination of the ATM Agreement in accordance with its terms.  Either party may terminate the ATM Agreement at any time upon written notification to the other party in accordance with the ATM Agreement, and upon such termination, the offering will terminate.

We agreed to pay Stifel a commission equal to 3.0% of the gross sales price of any shares sold pursuant to the ATM Agreement. With the exception of expenses related to the shares, Stifel will be responsible for all of its own costs and expenses incurred in connection with the offering.

On October 15, 2013, we completed an offering under the ATM Program and issued 713,920 shares of our common stock for an aggregate purchase price of approximately $2.0 million, resulting in net proceeds to us of approximately $1.8 million, after deducting commissions.  As of December 31, 2013, approximately $23 million remained available under the ATM Program.

Lazard ATM Program

On December 14, 2011, we entered into a Sales Agency Agreement (Agency Agreement) with Lazard Capital Markets LLC (Lazard), under which Lazard, as our exclusive agent, at our discretion and at such times that we may determine from time to time, could sell over a two-year period up to a maximum of $15,000,000 of shares of our common stock through an “at-the-market” program (Lazard ATM Program).

We agreed to pay Lazard a commission equal to 3.0% of the gross proceeds of any sales under the Lazard ATM Program.  We also agreed to reimburse Lazard for certain expenses incurred in connection with entering into the Agency Agreement and provided Lazard with customary representations, warranties and indemnification rights.  In connection with initiation of coverage of our stock by an analyst affiliated with Lazard, we agreed with Lazard to terminate the Lazard ATM Program effective August 6, 2012.

On March 12, 2012, we completed an offering of 350,374 shares of our common stock for an aggregate purchase price of approximately $1.6 million, resulting in net proceeds to us of approximately $1.5 million, after deducting commissions.

Deerfield Loan

On February 13, 2013, we entered into a secured loan facility (Deerfield Loan) with affiliates of Deerfield Management Company, L.P. (Deerfield) for up to $30 million in secured financing in 2013.  As of December 31, 2013, long-term debt consists solely of amounts due under this facility as follows:

(in thousands)
Note Payable $30,000 
Unamortized discount  (11,646)
Long-term debt, net of discount $18,354 

Under the terms of the related agreement, Deerfield advanced funds to us in two separate disbursements.  Deerfield made the first disbursement, in the amount of $10 million, on February 13, 2013, upon execution of the related agreement (First Disbursement).  Deerfield made the second disbursement, in the amount of $20 million, on December 3, 2013 (Second Disbursement), following the first commercial sale of SURFAXIN.
The amount received and outstanding under the Deerfield Loan will accrue interest at an annual rate of 8.75%, payable quarterly in cash.  The Deerfield Loan agreement contains customary terms and conditions but does not require us to meet minimum financial and revenue performance covenants.  In connection with each advance, we paid Deerfield a transaction fee equal to 1.5% of the amount disbursed.  The Deerfield Loan agreement also contains various representations and warranties and affirmative and negative covenants customary for financings of this type, including restrictions on our ability to incur additional indebtedness and grant additional liens on our assets.  In addition, all amounts outstanding under the Deerfield Loan may become immediately due and payable upon (i) an “Event of Default,” as defined in the Deerfield Loan agreement, in which case Deerfield would have the right to require us to repay the outstanding principal amount of the loan, plus any accrued and unpaid interest thereon, or (ii) the occurrence of certain events as defined in the facility agreement, including, among other things, the consummation of a change of control transaction or the sale of more than 50% of our assets (a Major Transaction).

In connection with the execution of the Deerfield Loan and receipt of the First Disbursement, we issued to Deerfield warrants to purchase approximately 2.3 million shares of our common stock at an exercise price of $2.81 per share.  Upon receipt of the Second Disbursement, we issued to Deerfield warrants to purchase an additional 4.7 million shares of our common stock at an exercise price of $2.81 per share (together with the warrants issued in connection with the First Disbursement, the Deerfield Warrants).  The number of shares of common stock into which the Deerfield Warrants are exercisable and the exercise price of any Deerfield Warrant will be adjusted to reflect any stock splits, recapitalizations or similar adjustments in the number of outstanding shares of common stock.  The Deerfield Warrants will expire on the sixth anniversary of the facility agreement, February 13, 2019, and contain certain limitations that generally prevent the holder from acquiring shares upon exercise of the Deerfield Warrants or any part thereof that would result in the number of shares beneficially owned by such holder to exceed 9.985% of the total number of shares of our common stock then issued and outstanding.  For a discussion of additional rights of the holders, see, “Item 8 – Notes to consolidated financial statements – Note 9 – Deerfield Loan.”

We have recorded the loan as long-term debt at its face value of $30.0 million less debt discounts and issuance costs consisting of (i) $11.7 million fair value of the Deerfield Warrants issued upon the First Disbursement and the Second Disbursement (7 million warrants in total), and (ii) a $450,000 transaction fee.  The discount is being accreted to the $30 million loan over its term using the effective interest method.  The Deerfield Warrants are derivatives that qualify for an exemption from liability accounting as provided for in ASC Topic 815 Equipment Financing Facilities“Derivatives and Hedging – Contracts in Entity’s Own Equity” (ASC 815) and have been classified as equity.

Equipment Loan

(in thousands) 2011  2010 
       
Pennsylvania Machinery and Equipment Loan      
Short-term $66  $63 
Long-term  224   296 
Total  290   359 
         
Capitalized Leases        
Short-term  2   22 
Long-term  –   5 
Total  2   27 
         
GE Business Financial Services, Inc.        
Short-term  –   51 
Long-term  –   – 
Total  –   51 
         
         
Total Short-term  68   136 
Total Long-term  224   301 
Total $292  $437 

For the years ended December 31, 2011 and 2010,In September 2008, we incurred interest expense associated with our equipment loans of $20,000 and $56,000, respectively.

Pennsylvania Machinery and Equipment Loan Fund (MELF)

We entered into a Loan Agreement and Security Agreement with the Commonwealth of Pennsylvania, Department of Community and Economic Development (Department), effective September 8, 2008, pursuant to which the Department made a loan to us from the Machinery and Equipment Loan Fund in the amount of $500,000 (MELF Loan) to fund the purchase and installation of new machinery and equipment and the upgrade of existing machinery and equipment at our analytical and development laboratory in Warrington, Pennsylvania.  Principal and interest on the MELF Loan is payable in equal monthly installments over a period of seven years.  Interest on the principal amount accrues at a fixed rate of five percent (5.0%) per annum.  We may prepay the MELF Loan at any time without penalty.

In addition to customary terms and conditions, the MELF Loan requires us to meet certain job retention and job creation goals in Pennsylvania within a three-year period (Jobs Covenant).  If we fail to comply with the Jobs Covenant, the Department, in its discretion, may change the interest rate on the Promissory Note to a fixed rate equal to two percentage points above the current prime rate for the remainingremainder of the term.  As of September 30, 2011, the end of the three-year Jobs Covenant period, due to our efforts to conserve resources while we focused on securing the approval for SURFAXIN, we had not complied with the Jobs Covenant.  In response to a request that we filed with the Department November 2013 for a waiver, the Department granted us an extension through AugustDecember 31, 20122014 to achievecome into compliance with the Jobs Covenant and has waived any interest adjustment until that date.

Equipment Financing Facility with GE Business Financial Services Inc.

In May 2007, we entered into a Credit and Security Agreement (Credit Agreement) with GE Business Financial Services Inc. (GE, formerly Merrill Lynch Business Financial Services Inc.), as Lender, pursuant to which GE agreed to provide us a $12.5 million facility (Facility) to fund our capital programs.  The right to draw under this Facility expired and we have not received any new funding since November 2008.  As of December 31, 2011, all outstanding amounts under the Facility had been paid in full and all related security interests satisfied and released.  Advances to finance the acquisition of property and equipment were amortized over a period of 36 months and all other equipment and related costs were amortized over a period of 24 months.  The advance to prepay our prior facility was amortized over a period of 27 months.  Interest on each advance accrued at a fixed rate per annum equal to one-month LIBOR plus 6.25%, determined on the funding date of such advance.


Loan Payable – PharmaBio Development Inc.

On April 28, 2010, we restructured our $10.6 million loan with PharmaBio Development Inc (Pharma Bio), the former strategic investment subsidiary of Quintiles Transnational Corp.  The related Payment Agreement and Loan Amendment dated April 27, 2010 (PharmaBio Agreement) provided for payment in cash of (a) an aggregate of $6.6 million, representing $4.5 million in outstanding principal and $2.1 million in accrued interest, and (b) of the remaining $4 million principal amount under the loan, $2 million of which became due and were paid on each of July 30, 2010 and September 30, 2010.  All related security interests were satisfied and released.  Also under the PharmaBio Agreement, PharmaBio surrendered to us for cancellation warrants to purchase an aggregate of 159,574 shares of our common stock that we had issued previously to PharmaBio in connection with the PharmaBio loan and a previous offering of securities.
 
As of December 31, 2010, all of our obligations related to the loan with PharmaBio were paid in full.

For the year ended December 31, 2010, we incurred interest expense associated with the PharmaBio loan of $0.3 million.  Interest expense for the year ended December 31, 2010 included $0.2 million of amortization of deferred financing costs for warrants issued to PharmaBio in 2006 in consideration for restructuring the loan.

Contractual Obligations and Commitments

Future payments due under contractual obligations at December 31, 2013 are as follows:

(in thousands) 2014  2015  2016  2017  2018  
There-
after
  Total 
Operating lease obligations  1,087   1,024   934   936   158   –   4,139 
Equipment loan obligations (1)
  79   69   –   –   –   –   148 
Total
 $1,166  $1,093  $934  $936  $158  $–  $4,287 
(1)  See, Note 10 – Equipment Loan

Operating Lease Agreements

Our operating leases consist primarily of facility leases forWe lease our operations in Pennsylvania and New Jersey.  We maintain our headquarters location in Warrington, Pennsylvania.  The facility isconsists of 39,594 square feet and also serves as the main operating facilitylocation for clinicaldrug and device development, regulatory, analytical technical services, research and development, and administration.  In April 2007,January 2013, we entered into an lease amendment to extend the term an additional five years, from February 2013 through February 2018.  The total aggregate base rental payments under the lease which originally expired in February 2010 withprior to the extension were approximately $7.2 million and the total aggregate base rental payments under the extended portion of $4.6 million, was extended an additional three years through February 2013 with additional payments of $3.0 million over the extension period.lease are approximately $4.9 million.

We also lease approximately 21,000 square feet of space forat our Totowa Facility, our only manufacturing facility, in Totowa, New Jersey, at an annual rent of $150,000.  This space is specifically designedWe have secured an extension of the lease, which was originally scheduled to expire in December 2014, until June 30, 2015.  We currently are in discussions with the landlord potentially to extend the lease through the end of 2016.  We are also exploring possible alternatives that could enable longer-term utilization of the Totowa Facility for the manufacture of SURFAXIN drug product and filling of sterile pharmaceuticals in compliance with cGMP and is our only manufacturing facility.  The lease expires in December 2014, subject to the landlord’s right, upon two years’ prior notice, to terminate the lease early.  This early termination right is subject to certain conditions, including that the master tenant, a related party of the landlord, must have ceased all activities at the premises, and, depending upon the timing of the notice, if we satisfy certain financial conditions, the landlord would be obligated to make early termination payments to us.potentially lyophilized KL4 surfactant.  The total aggregate payments over the term of the lease are $1.4 million.  In connection with our manufacturing operations in Totowa, New Jersey, we have 14 employees subject to a collective bargaining arrangement that expires on December 3, 2012.  See, “Item 1 – Business – Business Operations – Manufacturing and Distribution,” and “Item 2 – Properties.”

Rent expense under allthe foregoing leases was $1.0 million for each of the years ended December 31, 20102013, 2012 and 2009 was2011, respectively.

Severance Arrangements

On September 13, 2013, our Board of Directors approved an employee severance and retention plan for employees at the Totowa Facility to take effect in the event that we are unable to secure long-term utilization of the Totowa Facility beyond the scheduled lease expiration on June 30, 2015.  The retention plan is intended to minimize employee turnover by providing severance and retention bonuses that encourage employees to stay with us through facility closing date (and beyond for certain employees).  The plan has two components: (1) plant management (three individuals) has received an award of stock options that will vest in full, and will be eligible for a retention bonus payable in June 2016, provided that they remain employed with us in June 2016; and (2) provided that they remain employed with us through the successful closure of the Totowa Facility, non-union employees (nine individuals) will be eligible to receive both severance and a retention bonus payable upon such closure.  The total cash amount expected to be paid for severance and retention through June 2016 is approximately $1.0 million.  The plan-related expense incurred during 2013 is $0.1 million and $1.1is included in research and development expense.  The related liability is $0.1 million respectively.as of December 31, 2013.

Severance ArrangementIn addition, there are 14 employees at the Totowa Facility who are subject to a collective bargaining agreement and will be eligible to receive severance upon closure of the Totowa Facility.  The plan-related expense incurred during 2013 is $30,000 and is included in research and development expense.  The related liability is $0.5 million as of December 31, 2013.
In December 2012, we entered into a separation agreement (CEO Agreement) with our former Chief Executive Officer and Chairman of the Board of Directors.  Pursuant to the CEO Agreement, the executive resigned his positions with us effective December 31, 2012, and was entitled to (i) on December 31, 2012, a cash payment equal to the sum of (a) all unpaid compensation accrued through December 31, 2012, less any applicable withholding, any unreimbursed employee business expenses (subject to submission of appropriate documentation), and a severance payment in the amount of $1,250,000, less any applicable withholding; (ii) the accelerated vesting of all outstanding stock options which remain exercisable to the end of their respective stated terms; and (iii) through July 31, 2013, reimbursement of $2,000 per month, plus a tax-gross up adjustment, for temporary living expenses.  We also agreed to pay the executive’s attorneys’ fees incurred in connection with negotiating the CEO Agreement.

OnIn July 12, 2011, we entered into a Separation of Employment Agreement and General Release Agreement (“Separation Agreement”)separation agreement (EVP Agreement) with a former executive who served as our former, Executive Vice President, General Counsel and Corporate Secretary (Former Executive).Secretary.  Pursuant to the SeparationEVP Agreement, the Former Executiveexecutive resigned his positions with us effective July 31, 2011, and was entitled to (i) payment of accrued vacation pay, (ii) the right to continue to hold a restricted stock award for 15,000 shares (RSA) without any continuing Serviceservice obligation (as defined in the RSA) requirement,, (iii) extended health benefits for up to 18 months, and, (iv) depending on the circumstances, certain outplacement services.  In addition, we agreed to paypaid the Former Executive on February 1,former executive, in 2012, severance in the amount of $400,000, which amount was reduced by any outstanding amount due under a promissory note that the Former Executiveformer execute had issued to us in 2001. As of December 31, 2011, the outstanding aggregate principal amount of the Note was $169,958.  The SeparationEVP Agreement also containscontained a general release of claims by theboth parties and a 12-month non-competition covenant by the Former Executive.former executive.

Off-Balance Sheet Arrangements

Off-Balance Sheet Arrangements

We did not have any material off-balance sheet arrangements at December 31, 20112013, 2012 or 2010,2011, or during the periods then ended.

ITEM 7A.
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
RISK.

Not applicable.

ITEM 8.
FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.

See, Index to Consolidated Financial Statements on Page F-1 attached hereto.
ITEM 9.
CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSUREDISCLOSURE.

Not applicable.
ITEM 9A.CONTROLS AND PROCEDURES.

Not applicable.

ITEM 9A.
CONTROLS AND PROCEDURES.

(a) Evaluation of disclosure controls and procedures

Our management, including our President and Chief Executive Officer (principal executive officer) and Chief Financial Officer (principal executive officer and principal financial officer), does not expect that our disclosure controls or our internal control over financial reporting will prevent all error and all fraud.  Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, have been detected.  These inherent limitations include the realities that judgments in decision-making can be faulty and that breakdowns can occur because of simple error or mistake.  Controls can also be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the controls.  The design of any system of controls is based in part on certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions.  Over time, controls may become inadequate because of changes in conditions or deterioration in the degree of compliance with policies or procedures.  Because of the inherent limitations in a cost-effective control system, misstatements due to error or fraud may occur and not be detected.  In designing and evaluating the disclosure controls and procedures, our management recognized that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives and our management necessarily was required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures.

Our President and Chief Executive Officer and our Chief Financial Officer havehas evaluated the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rule 13a-15(e) and Rule 15d-15(e) of the Exchange Act) as of the end of the period covered by this Annual Report on Form 10-K.  Based on this evaluation, our President and Chief Executive Officer and our Chief Financial Officer concluded that, as of the end of the period covered by this report, our disclosure controls and procedures were effective to ensure that information required to be disclosed by us in the reports that we file or submit under the Exchange Act is accumulated and communicated to our management, including our President and Chief Executive Officer and our Chief Financial Officer, to allow for timely decisions regarding required disclosures, and recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms.

(b) Management’s Report on Internal Control over Financial Reporting

(b)Management’s Report on our Internal Control over Financial Reporting

Our management is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Rule 13a-15(f) promulgated under the Exchange Act.  Our internal control system is designed to provide reasonable assurance to our management and board of directors regarding the preparation and fair presentation of published financial statements.  All internal control systems, no matter how well designed, have inherent limitations.  Therefore, even those systems determined to be effective can provide only reasonable assurance with respect to financial statement preparation and presentation.

Under the supervision and with the participation of our management, including ourour President and Chief Executive Officer and Chief Financial Officer, our management conducted an evaluation of the effectiveness of our internal control over financial reporting as of December 31, 2011.2013.  In making this assessment, our management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control-Integrated 1992 Framework.  Based on our assessment, our management believes that our internal control over financial reporting is effective based on those criteria, as of December 31, 2011.2013.

This annual report does not include an attestation report of ourOur independent registered public accounting firm regardinghas audited our internal control over financial reporting.  Management’s report was not subject to attestation byreporting, and issued an unqualified opinion dated March 17, 2014 on our registered public accounting firm pursuant to rules of the Securities and Exchange Commission that permit us to provide only management’s report in this Annual Report on Form 10-K.internal control over financial reporting, which opinion is included herein.

(c)Changes in internal controls

There were no changes in our internal control over financial reporting identified in connection with the evaluation described above that occurred during the quarter ended December 31, 20112013 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

Report of Independent Registered Public Accounting Firm

The Board of Directors and Stockholders
Discovery Laboratories, Inc.

We have audited Discovery Laboratories, Inc. and subsidiary’s internal control over financial reporting as of December 31, 2013, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (1992 framework) (the COSO criteria). Discovery Laboratories, Inc. and subsidiary’s management is responsible for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting included in the accompanying Management’s Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on the company’s internal control over financial reporting based on our audit.

We conducted our audit 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 effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.

A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

In our opinion, Discovery Laboratories, Inc. and subsidiary maintained, in all material respects, effective internal control over financial reporting as of December 31, 2013, based on the COSO criteria.

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of Discovery Laboratories, Inc. and subsidiary as of December 31, 2013 and 2012, and the related consolidated statements of operations, changes in stockholders' equity, and cash flows for the three years in the period ended December 31, 2013 and our report dated March 17, 2014 expressed an unqualified opinion thereon.
 
/s/ Ernst & Young
Philadelphia, Pennsylvania
March 17, 2014
ITEM 9B.
OTHER INFORMATION.

Not applicable.
PART III

Except as set forth below, the information required by Items 10 through 14 of Part III is incorporated herein by reference to our definitive proxy statement or an amendment to this annual report on Form 10-K, in either case, to be filed with the Securities and Exchange Commission within 120 days after the end of our 20112012 fiscal year.


We have adopted a Code of Business Conduct and Ethics that applies to our officers, including our principal executive, financial and accounting officers, and our directors and employees.  We have posted the Code of Business Conduct and Ethics on our Internet website at “http://www.DiscoveryLabs.com” under the “Investors”“Company” tab in the Corporate PoliciesGovernance section.  We intend to make all required disclosures on a Current Report on Form 8-K concerning any amendments to, or waivers from, our Code of Business Conduct and Ethics with respect to our executive officers and directors.  Our website and the information contained therein or connected thereto are not incorporated into this Annual Report on Form 10-K.


PART IV


The consolidated financial statements required to be filed in this Annual Report on Form 10-K are listed on the Index to Consolidated Financial Statements on page F-1 hereof.

Exhibits are listed on the Index to Exhibits at the end of this Annual Report on Form 10-K.  The exhibits required to be filed pursuant to Item 601 of Regulation S-K, which are listed on the Index in response to this Item, are incorporated herein by reference.

SIGNATURES

SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

DISCOVERY LABORATORIES, INC.
Date: March 30, 201217, 2014By:/s/ W. Thomas AmickJohn G. Cooper
W. Thomas Amick, Chairman of the Board
andJohn G. Cooper, President, Chief Executive Officer and Chief Financial Officer

Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.

Signature
Name & Title
Date
W. Thomas AmickMarch 30, 2012
/s/ W. Thomas AmickChairman of the Board and Chief Executive Officer
(Principal Executive Officer)
John G. CooperMarch 30, 2012
/s/ John G. Cooper
John G. Cooper
Director, President, Chief Executive Officer and     Chief Financial Officer
March 17, 2014
(Principal Executive and Principal Financial Officer)
John TattoryMarch 30, 2012
/s/ John Tattory
John Tattory
Vice President, Finance, and ControllerChief Accounting Officer
March 17, 2014
(Principal Accounting Officer)
Antonio Esteve, Ph.D.March 30, 2012
/s/ Antonio EsteveJohn R. Leone
John R. Leone
Director (Chairman of the Board)
March 17, 2014
Max E. Link, Ph.D.March 30, 2012
/s/ Max E. LinkJoseph M. Mahady
Joseph M. Mahady
Director
March 17, 2014
 
Bruce A. PeacockMarch 30, 2012
/s/ Bruce A. Peacock
Bruce A. Peacock
Director
March 17, 2014
Marvin E. Rosenthale, Ph.D.March 30, 2012
/s/ Marvin E. Rosenthale
Marvin E. Rosenthale, Ph.D.
Director
March 17, 2014

INDEX TO EXHIBITS

INDEX TO EXHIBITS
The following exhibits are included with this Annual Report on Form 10-K.  All management contracts or compensatory plans or arrangements are marked with an asterisk.

Exhibit No.
DescriptionMethod of Filing
3.1Amended and Restated Certificate of Incorporation filed as of August 1, 2013, including amendments reflected in a Certificate of Amendment to the Restated Certificate of Incorporation of Discovery Laboratories, Inc. (Discovery), as amended asfiled on December 27, 2010, and in a Certificate of andAmendment to the Restated Certificate of Incorporation of Discovery filed on October 3, 2011Incorporated by reference to Exhibit 3.1 to Discovery'sDiscovery’s Quarterly Report on Form 8-K,10-Q, as filed with the SEC on October 3, 2011.August 8, 2013.
3.2Certificate of Designations, Preferences and Rights of Series A Junior Participating Cumulative Preferred Stock of Discovery, dated February 6, 2004Incorporated by reference to Exhibit 2.2 to Discovery’s Form 8-A, as filed with the SEC on February 6, 2004.
3.3Amended and Restated By-Laws of Discovery, as amended effective September 3, 2009Incorporated by reference to Exhibit 3.1 to Discovery’s Current Report on Form 8-K, as filed with the SEC on September 4, 2009.
4.1Shareholder Rights Agreement, dated as of February 6, 2004, by and between Discovery and Continental Stock Transfer & Trust CompanyIncorporated by reference to Exhibit 10.1 to Discovery’s Current Report on Form 8-K, as filed with the SEC on February 6, 2004.
4.2Class C Investor Warrant, dated April 17, 2006, issued to Kingsbridge Capital LimitedIncorporated by reference to Exhibit 4.1 to Discovery’s Current Report on Form 8-K, as filed with the SEC on April 21, 2006.
4.3Warrant Agreement, dated November 22, 2006Incorporated by reference to Exhibit 4.1 to Discovery’s Current Report on Form 8-K, as filed with the SEC on November 22, 2006.
4.4Warrant Agreement dated May 22, 2008 by and between Kingsbridge Capital Limited and DiscoveryIncorporated by reference to Exhibit 4.1 to Discovery’s Current Report on Form 8-K as filed with the SEC on May 28, 2008.
4.5Warrant Agreement dated December 12, 2008 by and between Kingsbridge Capital Limited and DiscoveryIncorporated by reference to Exhibit 4.1 to Discovery’s Current Report on Form 8-K, as filed with the SEC on December 15, 2008.
4.64.3Form of StockWarrant to Purchase WarrantCommon Stock issued in May 2009Incorporated by reference to Exhibit 10.3 to Discovery’s Current Report on Form 8-K, as filed with the SEC on May 8, 2009.
4.74.4Form of StockWarrant to Purchase WarrantCommon Stock issued in February 2010Incorporated by reference to Exhibit 4.1 to Discovery’s Current Report on Form 8-K, as filed with the SEC on February 18, 2010.
4.84.5Warrant Agreement, dated as of April 30, 2010, by and between Discovery and PharmaBioIncorporated by reference to Exhibit 4.1 to Discovery’s Current Report on Form 8-K, as filed with the SEC on April 28, 2010.
 
Exhibit No.DescriptionMethod of Filing
4.94.6Warrant Agreement dated June 11, 2010 by and between Kingsbridge Capital Limited and DiscoveryIncorporated by reference to Exhibit 4.1 to Discovery’s Current Report on Form 8-K, as filed with the SEC on June 14, 2010.
Exhibit No.
DescriptionMethod of Filing
 
4.104.7Form of Five-YearSeries I Warrant to Purchase Common Stock issued on June 22, 2010 (Five-Year Warrant)Incorporated by reference to Exhibit 4.1 to Discovery’s Current Report on Form 8-K, as filed with the SEC on June 17, 2010.
4.114.8Form of Short-Term Warrant issued on June 22, 2010Incorporated by reference to Exhibit 4.2 to Discovery’s Current Report on Form 8-K, as filed with the SEC on June 17, 2010.
4.12
Warrant Agreement, dated as of October 12, 2010, by and between Discovery and PharmaBio
Incorporated by reference to Exhibit 4.1 to Discovery’s Current Report on Form 8-K, as filed with the SEC on October 13, 2010.
4.13.4.9Form of Voting Agreement between RSA Holders and Discovery dated November 12, 2010Incorporated by referenceSeries I Warrant to Exhibit 4.13 to Discovery’s Annual Report on Form 10-KSB for the year ended December 31, 2010, as filed with the SEC on March 31, 2011.
4.14Form of Five-Year WarrantPurchase Common Stock issued on February 22, 2011 (Five-Year Warrant)Incorporated by reference to Exhibit 4.1 to Discovery’s Current Report on Form 8-K, as filed with the SEC on February 16, 2011.
4.154.10Form of Short Term Warrant dated February 13, 2013, issued onto affiliates of Deerfield Management Co., LLP (Deerfield) under a Facility Agreement dated as of February 22, 201113, 2012 between Discovery and DeerfieldIncorporated by reference to Exhibit 4.24.1 to Discovery’s Current Report on Form 8-K, as filed with the SEC on February 16, 2011.June 14, 2013.
4.11Form of Warrant dated December 3, 2013, issued to affiliates of  Deerfield Management Co., LLP (Deerfield) on December 3, 2013 under a Facility Agreement dated as of February 13, 2012 between Discovery and DeerfieldIncorporated by reference to Exhibit 4.1 to Discovery’s Current Report on Form 8-K, as filed with the SEC on December 6, 2013.
10.1+
Sublicense Agreement, dated as of October 28, 1996, between Johnson & Johnson, Ortho Pharmaceutical Corporation and Acute Therapeutics, Inc.Incorporated by reference to Exhibit 10.6 to Discovery’s Registration Statement on Form SB-2/A, as filed with the SEC on April 18, 1997 (Commission File Number 333-19375).
10.2Registration Rights Agreement, dated June 16, 1998, among Discovery, Johnson & Johnson Development Corporation and The Scripps Research InstituteIncorporated by reference to Exhibit 10.28 to Discovery’s Annual Report on Form 10-KSB for the year ended December 31, 1998, as filed with the SEC on April 9, 1999.
10.3 +Amended and RestateRestated License Agreement by and between Discovery and Philip Morris USA Inc., d/b/a/ Chrysalis Technologies, dated March 28, 2008Incorporated by reference to Exhibit 10.4 to Discovery’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2008, as filed with the SEC on May 9, 2008.
10.410.3 +License Agreement by and between Discovery and Philip Morris Products S.A., dated March 28, 2008Incorporated by reference to Exhibit 10.5 to Discovery’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2008, as filed with the SEC on May 9, 2008.
10.4+
 
Exhibit No.DescriptionMethod of Filing
10.5*Form of Notice of Grant of Stock Option under the 1998 Stock Incentive PlanIncorporated by reference to Exhibit 10.2 to Discovery’s Quarterly Report on Form 10-QSB for the quarter ended September 30, 1999, as filed with the SEC on November 17, 1999.
10.6*Discovery’s 2007 Long Term Incentive PlanIncorporated by reference to Exhibit 1.1 to Discovery’s Current Report on Form 8-K, as filed with the SEC on June 28, 2007.
10.7*Form of 2007 Long-Term Incentive Plan Stock Option AgreementIncorporated by reference to Exhibit 10.3 to Discovery’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2007, as filed with the SEC on August 9, 2007.
10.8*Form of Stock Issuance Agreement, dated as of October 30, 2007, between Discovery and the GranteesIncorporated by reference to Exhibit 10.1 to Discovery’s Current Report on Form 8-K, as filed with the SEC on November 5, 2007.
10.8*Form of Restricted Stock Award (RSA) Agreement dated September 27, 2010Incorporated by reference to Exhibit 10.1 to Discovery’s Current Report on Form 8-K, as filed with the SEC on October 1, 2010.
10.10*Form of 2011 Long-Term Incentive Plan Stock Option AgreementIncorporated by reference to Appendix II  to Discovery’s Definitive Proxy Statement on Form DEF 14A, as filed with the SEC on August 15, 2011 (Commission File Number 000-26422).
10.11*Renewal of Interim CEO Agreement dated July 2, 2010 between W. Thomas Amick and DiscoveryIncorporated by reference to Exhibit 10.8 to Discovery’s Quarterly Report on Form 10-Q dated June 30, 2010, as filed with the SEC on August 9, 2010.
10.12*Employment Agreement dated as of October 18, 2010 between Discovery and W. Thomas AmickIncorporated by reference to Exhibit 10.5 to Discovery’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2010, as filed with the SEC on November 15, 2010.
10.13*Amendment dated August 11, 2011 to the Employment Agreement dated as of October 18, 2010 between Discovery and W. Thomas AmickIncorporated by reference to Exhibit 10.2 to Discovery’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2011, as filed with the SEC on August 15, 2011.
10.14*Amended and Restated Employment Agreement, dated as of May 4, 2006, by and between Discovery and John G. CooperIncorporated by reference to Exhibit 10.2 to Discovery’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2006, as filed with the SEC on May 10, 2006.
10.15*Amendment to the Amended and Restated Employment Agreement dated as of May 4, 2006 between John G. Cooper and Discovery Laboratories, Inc.Incorporated by reference to Exhibit 10.3 to Discovery’s Current Report on Form 8-K, as filed with the SEC on January 3, 2008.
Exhibit No.DescriptionMethod of Filing
10.16+Amended and Restated Sublicense and Collaboration Agreement made as of December 3, 2004, between Discovery and Laboratorios del Dr. Esteve, S.A.Incorporated by reference to Exhibit 10.28 to Discovery’s Annual Report on Form 10-K for the year ended December 31, 2004, as filed with the SEC on March 16, 2005.
10.17+10.5+Amended and Restated Supply Agreement, dated as of December 3, 2004, by and between Discovery and Laboratorios del Dr. Esteve, S.A.Incorporated by reference to Exhibit 10.29 to Discovery’s Annual Report on Form 10-K for the year ended December 31, 2004, as filed with the SEC on March 16, 2005.
 
10.6*Discovery’s 2007 Long Term Incentive PlanIncorporated by reference to Exhibit 1.1 to Discovery’s Current Report on Form 8-K, as filed with the SEC on June 28, 2007.
Exhibit No.
DescriptionMethod of Filing
 
10.1810.7*Form of 2007 Long-Term Incentive Plan Stock Option AgreementIncorporated by reference to Exhibit 10.3 to Discovery’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2007, as filed with the SEC on August 9, 2007.
10.8*
Discovery’s 2011 Long-Term Incentive PlanIncorporated by reference to Appendix II to Discovery’s Definitive Proxy Statement on Form DEF 14A, as filed with the SEC on August 15, 2011 (Commission File Number 000-26422).
10.9*Form of Employee Option Agreement under Discovery’s 2011 Long-Term Incentive PlanIncorporated by reference to Exhibit 10.2 to Discovery’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2012, as filed with the SEC on May 15, 2012.
10.10*Form on Non-Employee Director Agreement under Discovery’s 2011 Long-Term Incentive PlanIncorporated by reference to Exhibit 10.3 to Discovery’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2012, as filed with the SEC on May 15, 2012.
10.11*Employment Agreement dated as of May 4, 2012 between Discovery and John G. CooperIncorporated by reference to Exhibit 10.1 to Discovery’s Current Report on Form 8-K, as filed with the SEC on May 10, 2012.
10.12*Employment Agreement dated as of April 1, 2013, between Discovery Laboratories, Inc. and John G. CooperIncorporated by reference to Exhibit 10.1 to Discovery’s Current Report on Form 8-K, as filed with the SEC on April 2, 2013.
10.13*Employment Agreement dated as of May 4, 2012 between Discovery and Thomas F. MillerIncorporated by reference to Exhibit 10.3 to Discovery’s Current Report on Form 8-K, as filed with the SEC on May 10, 2012 as amended by Exhibit 10.1 to Discovery’s Current Report on Form 8-K/A, as filed with the SEC on May 11, 2012.
10.14*Employment Agreement dated as of April 1, 2013, between Discovery Laboratories, Inc. and Thomas F. Miller, Ph.D., MBAIncorporated by reference to Exhibit 10.1 to Discovery’s Current Report on Form 8-K, as filed with the SEC on April 2, 2013.
10.15*
Employment Agreement dated as of April 1, 2013, between Discovery Laboratories, Inc. and Russell G. ClaytonFiled herewith.
10.16*
Employment Agreement dated as of April 1, 2013, between Discovery Laboratories, Inc. and Mary B. TempletonFiled herewith.
Exhibit No.
DescriptionMethod of Filing
10.17
Assignment of Lease and Termination and Option Agreement, dated as of December 30, 2005, between Laureate Pharma, Inc. and DiscoveryIncorporated by reference to Exhibit 10.1 to Discovery’s Annual Report on Form 10-K for the year ended December 31, 2005, as filed with the SEC on March 16, 2006.
10.18Extension, dated as of July 16, 2013, of Lease dated as of December 3, 2004, between Discovery, as successor-in-interest to Laureate Pharma, Inc., and Norwell Land Company, with respect to property at 710 Union Blvd., Totowa, NJ 07512
Incorporated by reference to Exhibit 10.1 to Discovery’s Quarterly Report on Form 10-Q, as filed with the SEC on August 8, 2013.
10.19Lease Agreement dated May 26, 2004, and First Amendment to Lease Agreement, dated April 2, 2007, by and between TR Stone Manor Corp. and Discovery Laboratories, Inc.
Incorporated by reference to Exhibits 10.1 and 10.2 to Discovery’s Current Report on Form 8-K, as filed with the SEC on April 6, 2007.
10.20Payment Agreement and LoanSecond Amendment  (amending the Second Amended and Restated Loanto Lease Agreement, dated as of December 10, 2001, amended and restated as of October 25, 2006) dated April 27, 2010,January 3, 2013 by and between DiscoveryTR Stone Manor Corp. and PharmaBioDiscoveryIncorporated by reference to Exhibit 1.1 to Discovery’s Current Report on Form 8-K, as filed with the SEC on April 28, 2010.
10.21Third Amended Promissory Note dated April 27, 2010 (amending and restating the Second Amended Promissory Note dated as of October 25, 2006), payable to PharmaBioIncorporated by reference to Exhibit 1.2 to Discovery’s Current Report on Form 8-K, as filed with the SEC on April 28, 2010.
10.22Securities Purchase Agreement dated April 27, 2010, by and between Discovery and PharmaBioIncorporated by reference to Exhibit 1.3 to Discovery’s Current Report on Form 8-K, as filed with the SEC on April 28, 2010.
10.23Securities Purchase Agreement dated October 12, 2010 by and between PharmaBio and DiscoveryIncorporated by reference to ExhibitExhibits 10.1 to Discovery’s Current Report on Form 8-K, as filed with the SEC on  October 13, 2010.January 8, 2013.
10.24Registration Rights Agreement, dated as of May 22, 2008, by and between Kingsbridge Capital and DiscoveryIncorporated by reference to Exhibit 10.2 to Discovery’s Current Report on Form 8-K, as filed with the SEC on May 27, 2008.
10.25Registration Rights Agreement, dated as of December 12, 2008, by and between Kingsbridge Capital and DiscoveryIncorporated by reference to Exhibit 10.2 to Discovery’s Current Report on Form 8-K, as filed with the SEC on December 15, 2008.
10.26Common Stock Purchase Agreement dated as of June 11, 2010, by and between Kingsbridge Capital Limited and Discovery.Incorporated by reference to Exhibit 10.1 to Discovery’s Current Report on Form 8-K, as filed with the SEC on June 14, 2010.
Exhibit No.DescriptionMethod of Filing
10.27+10.21Supply Agreement dated as of December 22, 2010 between by and between Corden Pharma (formerly Genzyme Pharmaceuticals LLC)LLC, now known as Corden Pharma) and DiscoveryIncorporated by reference to Exhibit 10.1 to Discovery’s Current Report on Form 8-K, as filed with the SEC on December 29, 2010.
10.28*10.22Separation of EmploymentProduct Development and Supply Agreement and General Release between Discovery and David L. Lopez, Esq., C.P.A.Lacey Manufacturing Company, a Division of Precision Engineered Products, LLCIncorporated by reference to Exhibit 10.1 to Discovery’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2012, as filed with the SEC on May 15, 2012.
10.23Research and Development Services Agreement between Discovery  and Battelle Memorial Institute, dated June 22, 2012Incorporated by reference to Exhibit 10.4 of Discovery’s Quarterly Report on Form 10-Q, as filed with the SEC on August 14, 2012.
10.24Facility Agreement dated as of February 13, 2013, between Discovery and DeerfieldIncorporated by reference to Exhibit 10.1 to Discovery’s Current Report on Form 8-K/A, as filed with the SEC on March 15, 2013.
10.25Registration Rights Agreement dated as of February 13, 2013, between Discovery and DeerfieldIncorporated by reference to Exhibit 10.2 to Discovery’s Current Report on Form 8-K/A, as filed with the SEC on March 15, 2013.
Exhibit No.
DescriptionMethod of Filing
10.26Security Agreement dated as of February 13, 2013, between Discovery and DeerfieldIncorporated by reference to Exhibit 10.3 to Discovery’s Current Report on Form 8-K/A, as filed with the SEC on March 15, 2013.
10.27At-the-Market Equity Offering Sales Agreement dated February 11, 2013 between Discovery and Stifel Nicolaus & Company, IncorporatedIncorporated by reference to Exhibit 10.1 to Discovery’s Current Report on Form 8-K, as filed with the SEC on July 18, 2011.February 13, 2013.
10.2910.28Sales AgencyPharmaceutical Manufacturing and Supply Agreement dated December 14, 2011,August 7, 2013 between Discovery and Lazard Capital Markets LLCDSM Pharmaceuticals, Inc.Incorporated by reference to Exhibit 10.110.2 to Discovery’s CurrentQuarterly Report on Form 8-K,10-Q, as filed with the SEC on December 14, 2011.
August 8, 2013.
10.29Master Services Agreement dated October 24, 2013 between Discovery and DSMIncorporated by reference to Exhibit 10.2 to Discovery’s Quarterly Report on Form 10-Q, as filed with the SEC on November 12, 2013.
21.1
Subsidiaries of DiscoveryFiled herewith.
23.1
Consent of Ernst & Young LLP, independent registered public accounting firmFiled herewith.
31.1
Certification of Chief Executive Officer and Principal ExecutiveChief Financial Officer pursuant to Rule 13a-14(a) of the Exchange ActFiled herewith.
31.2
Certification of Chief Financial Officer and Principal Accounting Officer pursuant to Rule 13a-14(a) of the Exchange ActFiled herewith.
32.1
Certification of Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002Filed herewith.
101.1The following consolidated financial statements from the Discovery Laboratories.Laboratories, Inc. Annual Report on Form 10-K for the year ended December 31, 2011,2013, formatted in Extensive Business Reporting Language ("XBRL"(“XBRL”): (i) Balance Sheets as of December 31, 20112013, December 31, 2012 and December 31, 2010,2011, (ii) Statements of Operations for the years ended December 31, 20112013, December 31, 2012, and December 31, 2010,2011, (iii) Statements of Changes in Equity for the years ended December 31, 20112013, December 31, 2012, and December 31, 2010,2011, (iv) Statements of Cash Flows for the years ended December 31, 20112013, December 31, 2012, and December 31, 2010,2011, and (v) Notes to consolidated financial statementsstatements.
101.INSInstance DocumentFiled herewith.
101.SCHXBRL Taxonomy Extension Schema DocumentFiled herewith.
Exhibit No.
DescriptionMethod of Filing
 
101.CALXBRL Taxonomy Extension Calculation Linkbase DocumentFiled herewith.
101.DEFXBRL Taxonomy Extension Definition Linkbase DocumentFiled herewith.
101.LABXBRL Taxonomy Extension Label Linkbase DocumentFiled herewith.
101.PREXBRL Taxonomy Extension Presentation Linkbase DocumentFiled herewith.

+Confidential treatment requested as to certain portions of these exhibits.  Such portions have been redacted and filed separately with the Commission.
+           Confidential treatment requested as to certain portions of these exhibits.  Such portions have been redacted and filed separately with the Commission.

*           A management contract or compensatory plan or arrangement required to be filed as an exhibit to this annual report pursuant to Item 15(b) of Form 10-K.

*A management contract or compensatory plan or arrangement required to be filed as an exhibit to this annual report pursuant to Item 15(b) of Form 10-K.
85
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DISCOVERY LABORATORIES, INC.  AND SUBSIDIARY

Contents

Contents
Page
Consolidated Financial Statements
Report of Independent Registered Public Accounting FirmF-2
Balance Sheets as of December 31, 20112013 and December 31, 20102012F-3
Statements of Operations for the years ended December 31, 20112013, 2012, and December 31, 20102011F-4
Statements of Changes in Stockholders’ Equity for the years ended December 31, 20112013, 2012, and December 31, 20102011F-5
Statements of Cash Flows for the years ended December 31, 20112013, 2012, and December 31, 20102011F-6
Notes to consolidated financial statementsF-7

DISCOVERY LABORATORIES, INC.  AND SUBSIDIARY

Report of Independent Registered Public Accounting Firm

The Board of Directors and Stockholders
Discovery Laboratories, Inc.

We have audited the accompanying consolidated balance sheets of Discovery Laboratories, Inc. and subsidiary (the “Company”) as of December 31, 20112013 and 2010,2012, and the related consolidated statements of operations, changes in stockholders' equity, and cash flows for each of the three years then ended.in the period ended December 31, 2013.  These financial statements are the responsibility of the Company's management.  Our responsibility is to express an opinion on these 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 financial statements are free of material misstatement. We were not engaged to perform an audit of the company’s internal control over financial reporting.  Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting.  Accordingly, we express no such opinion.  An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements,statements. An audit also includes assessing the accounting principles used and significant estimates made by management, andas well as evaluating the overall financial statement presentation.  We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Discovery Laboratories, Inc. and subsidiary at December 31, 20112013 and 2010,2012, and the consolidated results of their operations and their cash flows for each of the three years thenin the period ended December 31, 2013, in conformity with U.S. generally accepted accounting principles.

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), Discovery Laboratories, Inc. and subsidiary's internal control over financial reporting as of December 31, 2013, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission  (1992 framework) and our report dated March 17, 2014 expressed an unqualified opinion thereon.
 
/s/ Ernst &and Young LLP
Philadelphia, Pennsylvania
March 30, 2012
 
Philadelphia, Pennsylvania
March 17, 2014
F-2
F - 2

DISCOVERY LABORATORIES, INC.  AND SUBSIDIARY

Consolidated Balance Sheets
(in thousands, except share and per share data)

 
 December 31,  December 31, 
 
 2013  2012 
ASSETS 
  
 
Current Assets: 
  
 
Cash and cash equivalents $86,283  $26,892 
Accounts receivable  67   – 
Inventory, net  112   195 
Prepaid expenses and other current assets  777   719 
Total current assets  87,239   27,806 
 
        
Property and equipment, net  1,656   1,737 
Restricted cash  325   400 
Other assets  97   – 
Total assets  89,317   29,943 
 
        
LIABILITIES & STOCKHOLDERS’ EQUITY        
Current Liabilities:        
Accounts payable $1,433  $1,166 
Accrued expenses  4,785   4,159 
Deferred revenue  139   – 
Common stock warrant liability  5,425   6,305 
Equipment loans, current portion  73   69 
Total current liabilities  11,855   11,699 
 
        
Long-term debt, net of discount of $11,646 at December 31, 2013 and $0 at December 31, 2012  18,354   – 
Equipment loans, non-current portion  69   148 
Other liabilities  538   443 
Total liabilities $30,816  $12,290 
 
        
Stockholders’ Equity:        
Preferred stock, $0.001 par value; 5,000,000 shares authorized; no shares issued or outstanding  –   – 
Common stock, $0.001 par value; 150,000,000 and 100,000,000 shares authorized at December 31, 2013 and 2012, respectively; 84,659,111 and 43,673,636 shares issued at December 31, 2013 and 2012, respectively; 84,638,219 and 43,652,744 shares outstanding at December 31, 2013 and 2012, respectively  85   44 
Additional paid-in capital  541,420   455,398 
Accumulated deficit  (479,950)  (434,735)
Treasury stock (at cost); 20,892 shares at December 31, 2013 and 2012  (3,054)  (3,054)
Total stockholders’ equity $58,501  $17,653 
Total liabilities & stockholders’ equity $89,317  $29,943 
See notes to consolidated financial statements
DISCOVERY LABORATORIES, INC.  AND SUBSIDIARY
Consolidated Statements of Operations
(Inin thousands, except per share data)

  December 31,  December 31, 
  2011  2010 
ASSETS      
Current Assets:      
Cash and cash equivalents $10,189  $10,211 
Prepaid expenses and other current assets  442   285 
Total current assets  10,631   10,496 
         
Property and equipment, net  2,293   3,467 
Restricted cash  400   400 
Other assets  -   174 
Total assets $13,324 ��$14,537 
         
LIABILITIES & STOCKHOLDERS’ EQUITY        
Current Liabilities:        
Accounts payable $1,111  $1,685 
Accrued expenses  2,972   3,286 
Common stock warrant liability  6,996   2,469 
Equipment loans and capitalized leases, current portion  68   136 
Total current liabilities  11,147   7,576 
         
Equipment loans and capitalized leases, non-current portion  224   301 
Other liabilities  689   634 
Total liabilities  12,060   8,511 
         
Stockholders’ Equity:        
Preferred stock, $0.001 par value; 5,000 shares authorized; no shares issued or outstanding  –   – 
Common stock, $0.001 par value; 100,000 and 50,000 authorized; 24,603 and 13,822 shares issued, 24,582 and 13,801 shares outstanding  25   14 
Additional paid-in capital  401,713   385,521 
Accumulated deficit  (397,420)  (376,455)
Treasury stock (at cost); 21 shares  (3,054)  (3,054)
Total stockholders’ equity  1,264   6,026 
Total liabilities & stockholders’ equity $13,324  $14,537 
 
 Year Ended December 31, 
 
 
  
 
 
 2013  2012  2011 
 
 
  
  
 
Grant revenue
 $388  $195  $582 
Expenses:            
Cost of product sales517--
 Research & development  27,661   21,570   17,230 
Selling, general & administrative  16,718   16,444   7,864 
Total expenses  44,896   38,014   25,094 
Operating loss  (44,508)  (37,819)  (24,512)
 
            
Change in fair value of common stock warrant liability  761   555   3,560 
 
            
Other income / (expense):            
Interest and other income  3   6   13 
Interest and other expense  (1,471)  (57)  (26)
Other income / (expense), net  (1,468)  (51)  (13)
 
            
Net loss $(45,215) $(37,315) $(20,965)
Net loss per common share – basic and diluted $(0.82) $(0.95) $(0.93)
Weighted average number of common shares outstanding – basic and diluted  55,258   39,396   22,660 


See notes to consolidated financial statements

DISCOVERY LABORATORIES, INC.  AND SUBSIDIARY
 
Consolidated Statements of Operations
(In thousands, except per share data)
  Year Ended December 31, 
  2011  2010 
       
Grant Revenue $582  $– 
         
Expenses:        
Research & development  17,230   17,136 
General & administrative  7,864   8,392 
Total expenses  25,094   25,528 
Operating loss  (24,512)  (25,528)
         
Change in fair value of common stock warrant liability  3,560   6,422 
         
Other income / (expense):        
Interest and other income  13   288 
Interest and other expense  (26)  (357)
Other income / (expense), net  (13)  (69)
         
Net loss $(20,965) $(19,175)
Net loss per common share - basic and diluted $(0.93) $(1.65)
Weighted average number of common shares outstanding - basic and diluted  22,660   11,602 



DISCOVERY LABORATORIES, INC. AND SUBSIDIARY

Consolidated Statements of Changes in Stockholders’ Equity
For Years Ended December 31, 2011 and 2010
(In thousands)
(In thousands)
 
Common Stock
  
    Treasury Stock   
 
 Shares  Amount  
Additional
Paid-in
Capital
  
Accumulated
Deficit
  Shares  Amount  Total 
 
 
  
  
  
  
  
  
 
Balance – January 1, 2011  13,822  $14  $385,521  $(376,455)  (21) $(3,054) $6,026 
Net loss  –   –   –   (20,965)  –   –   (20,965)
Issuance of common stock, restricted stock awards  1   –   –   –   –   –   – 
Issuance of common stock, 401(k) Plan employer match  265   –   497   –   –   –   497 
Issuance of common stock, February 2011 financing  10,000   10   13,513   –   –   –   13,523 
Issuance of common stock, CEFF financings  515   1   1,315   –   –   –   1,316 
Stock-based compensation expense  –   –   867   –   –   –   867 
Balance – December 31, 2011  24,603  $25  $401,713  $(397,420)  (21) $(3,054) $1,264 
Net loss  –   –   –   (37,315)  –   –   (37,315)
Issuance of common stock, March 2012 financing  16,072   16   42,074   –   –   –   42,090 
Issuance of common stock, ATM financing  350   1   1,460   –   –   –   1,461 
Issuance of common stock, 401(k) Plan employer match  317   –   763   –   –   –   763 
Exercise of common stock warrants  2,289   2   6,875   –   –   –   6,877 
Exercise of stock options for cash  3   –   6   –   –   –   6 
Issuance of common stock, consultants  40   –   96   –   –   –   96 
Stock-based compensation expense  –   –   2,411   –   –   –   2,411 
Balance – December 31, 2012  43,674  $44  $455,398  $(434,735)  (21) $(3,054) $17,653 
Net loss  –   –   –   (45,215)  –   –   (45,215)
Issuance of common stock, May 2013 financing  10,847   11   15,102   –   –   –   15,113 
Issuance of common stock, November 2013 financing  28,750   29   53,836   –   –   –   53,865 
Issuance of common stock, ATM financing  714   1   1,795   –   –   –   1,796 
Issuance of common stock warrants, Deerfield  –   –   11,729   –   –   –   11,729 
Issuance of common stock, 401(k) Plan employer match  510   –   959   –   –   –   959 
Exercise of common stock warrants  114   –   290   –   –   –   290 
Exercise of stock options for cash  18   –   34   –   –   –   34 
Issuance of common stock, consultants  32   –   67   –   –   –   67 
Stock-based compensation expense  –   –   2,210   –   –   –   2,210 
Balance – December 31, 2013  84,659  $85  $541,420  $(479,950)  (21) $(3,054) $58,501 
 
  Common Stock  Additional Paid-in  Accumulated  Treasury Stock    
  Shares  Amount  Capital  Deficit  Shares  Amount  Total 
                      
Balance – January 1, 2010  8,446  $8  $361,622  $(357,280)  (21) $(3,054) $1,296 
Comprehensive loss:                            
Net loss  –   –   –   (19,175)  –   –   (19,175)
Total comprehensive loss  –   –   –   –   –   –   (19,175)
Issuance of common stock, restricted stock awards  155   –   –   –   –   –   – 
Issuance of common stock, 401(k) employer match  61   1   223   –   –   –   224 
Issuance of common stock, February 2010 financing  1,833   2   9,379   –   –   –   9,381 
Issuance of common stock, April 2010 financing  270   –   2,105   –   –   –   2,105 
Issuance of common stock, June 2010 financing  2,381   2   9,092   –   –   –   9,094 
Issuance of common stock, October 2010 financing  159   –   452   –   –   –   452 
Issuance of common stock, CEFF financings  517   1   1,242   –   –   –   1,243 
Stock-based compensation expense  –   –   1,406   –   –   –   1,406 
Balance – December 31, 2010  13,822  $14  $385,521  $(376,455)  (21) $(3,054) $6,026 
Comprehensive loss:                            
Net loss  –   –   –   (20,965)  –   –   (20,965)
Total comprehensive loss  –   –   –   –   –   –   (20,965)
Issuance of common stock, restricted stock awards  1   –   –   –   –   –   – 
Issuance of common stock, 401(k) employer match  265   –   497   –   –   –   497 
Issuance of common stock, February 2011 financing  10,000   10   13,513   –   –   –   13,523 
Issuance of common stock, CEFF financings  515   1   1,315   –   –   –   1,316 
Stock-based compensation expense  –   –   867   –   –   –   867 
Balance – December 31, 2011  24,603  $25  $401,713  $(397,420)  (21) $(3,054) $1,264 
See notes to consolidated financial statements


DISCOVERY LABORATORIES, INC.  AND SUBSIDIARY

Consolidated Statements of Cash Flows
(In thousands)

 
 Year Ended December 31, 
 
 
  
  
 
 
 2013  2012  2011 
Cash flows from operating activities: 
  
  
 
Net loss $(45,215) $(37,315) $(20,965)
Adjustments to reconcile net loss to net cash used in operating activities:            
Depreciation and amortization  707   1,150   1,234 
Provision for excess inventory  514   –   – 
Stock–based compensation and 401(k) Plan employer match  3,236   3,270   1,364 
Fair value adjustment of common stock warrants  (761)  (555)  (3,560)
Amortization of discount of long-term debt  534   –   – 
Loss on disposal of equipment  –   42   45 
Reduction in required restricted cash under lease agreement75––
Changes in:            
Inventory  (431)  (195)  – 
Accounts receivable  (67)  –  –
Prepaid expenses and other current assets(58)(277)(157)
Accounts payable  267   55   (574)
Accrued expenses  626   1,187   (314)
Deferred revenue  139   –   – 
Other assets  (115)  –   174 
Other liabilities  95   (246)  55 
Net cash used in operating activities  (40,454)  (32,884)  (22,698)
 
            
Cash flows from investing activities:            
Purchase of property and equipment(608)(636)(106)
Net cash used in investing activities  (608)  (636)  (106)
 
            
Cash flows from financing activities:            
Proceeds from issuance of securities, net of expenses  70,774   43,551   22,927 
Proceeds from issuance of long-term debt  30,000   –   – 
Payment of debt issuance costs  (450)  –   – 
Proceeds from exercise of common stock warrants and options  204   6,747   – 
Principal payments under equipment loans  (75)  (75)  (145)
Net cash provided by financing activities  100,453   50,223   22,782 
Net increase / (decrease) in cash and cash equivalents  59,391   16,703   (22)
Cash and cash equivalents – beginning of year  26,892   10,189   10,211 
Cash and cash equivalents – end of year $86,283  $26,892  $10,189 
 
            
Supplementary disclosure of cash flows information:            
Interest paid $920  $13  $20 
(In thousands)

  Year Ended December 31, 
  2011  2010 
Cash flow from operating activities:      
Net loss $(20,965) $(19,175)
Adjustments to reconcile net loss to net cash used in  operating activities:        
Depreciation and amortization  1,234   1,549 
Stock–based compensation and 401(k) match  1,364   1,634 
Fair value adjustment of common stock warrants  (3,560)  (6,422)
Loss / (gain) on sale of equipment  45   (16)
Changes in:        
Prepaid expenses and other current assets  (157)  (52)
Accounts payable  (574)  391 
Accrued expenses  (314)  (166)
Other assets  174   4 
Other liabilities and accrued interest on loan payable  55   (2,017)
Net cash used in operating activities  (22,698)  (24,270)
         
Cash flow from investing activities:        
Purchase of property and equipment  (106)  (101)
Net cash used in investing activities  (106)  (101)
         
Cash flow from financing activities:        
Proceeds from issuance of securities, net of expenses  22,927   27,977 
Principal payments of loan payable  -   (8,500)
Principal payments under equipment loan and capital lease obligations  (145)  (636)
Net cash provided by financing activities  22,782   18,841 
Net decrease in cash and cash equivalents  (22)  (5,530)
Cash and cash equivalents – beginning of year  10,211   15,741 
Cash and cash equivalents – end of year $10,189  $10,211 
         
Supplementary disclosure of cash flows information:        
Interest paid $20  $2,123 
Non-cash transactions:        
Equipment acquired through capitalized lease $-  $48 
See notes to consolidated financial statements


DISCOVERY LABORATORIES, INC.  AND SUBSIDIARY

Note 1 – The Company and Description of Business

Discovery Laboratories, Inc. (referred to as “we,” “us,” or the “Company”) is a specialty biotechnology company focused on creating life-saving products for critical carecritical-care patients with respiratory disease and improving the standard of care in pulmonary medicine.  Our proprietary drug technology produces a synthetic, peptide-containing surfactant (KL4 surfactant) that is structurally similar to pulmonary surfactant, a substance produced naturally in the lung and essential for normal respiratory function and survival.  We are developing our KL4 surfactant in liquid, lyophilized and aerosolized dosage forms.  We are also developing novel drug delivery technologies potentially to enable efficient delivery of inhaled therapies, including our aerosolized KL4 surfactant.  We believe that our proprietary technologies may make it possible, for the first time, to develop a significant pipeline of products to address a variety of respiratory diseases for which there frequently are few or no approved therapies.

On March 6, 2012,We are initially focused on improving the U.S. Food and Drug Administration (FDA) granted us marketing approval for SURFAXIN® (lucinactant) for the preventionmanagement of respiratory distress syndrome (RDS) in premature infants at high risk for RDS.  SURFAXIN is the first synthetic, peptide-containing surfactant approved for use in neonatal medicine and provides healthcare practitioners with an alternative to the animal-derived surfactants that today are the standard of care to manage RDS in premature infants.  We are implementing a plan that, if successful, is intended to result in the commercial introduction of SURFAXIN in the United States in the fourth quarter of 2012.

Our strategy is initially to focus on the development of our KL4 surfactant and aerosol technologies to improve the management of RDS in premature infants.  RDS is a serious respiratory condition caused by insufficient surfactant production in underdeveloped lungs of premature infants, andinfants.  RDS is the most prevalent respiratory disease in the neonatal intensive care unitNeonatal Intensive Care Unit (NICU).  RDS and can result in long-term respiratory problems, developmental delay and death.  Mortality

Our first KL4 surfactant drug product, SURFAXIN® (lucinactant) Intratracheal Suspension for the prevention of RDS in premature infants at high risk for RDS, was approved by the United States Food and morbidity rates associatedDrug Administration (FDA) in 2012.  SURFAXIN is our KL4 surfactant in liquid form and is the first synthetic, peptide-containing surfactant approved by the FDA and the only alternative to animal-derived surfactants currently used in the United States (U.S.).  Since November 2013, SURFAXIN has been commercially available in the U.S.

Premature infants with severe RDS havecurrently are treated with surfactants that can only be administered by endotracheal intubation supported with mechanical ventilation, both invasive procedures that may each result in serious respiratory conditions and other complications.  To avoid such complications, many neonatologists treat infants with less severe RDS by less invasive means, typically nasal continuous positive airway pressure (nCPAP).  Unfortunately, a significant number of premature infants on nCPAP will not meaningfully improved overrespond well (an outcome referred to as nCPAP failure) and thereafter may require delayed surfactant therapy.  Since neonatologists currently cannot predict which infants will experience nCPAP failure, neonatologists are faced with difficult choices in treating infants with less severe RDS.  This is because the last decade.  Wemedical outcomes for those infants who experience nCPAP failure and receive delayed surfactant therapy may be less favorable than the outcomes for infants who receive surfactant therapy in the first hours of life.

AEROSURF® is an investigational combination drug/device product that combines our KL4 surfactant with our proprietary capillary aerosol generator (CAG).  With AEROSURF, neonatologists potentially will be able to administer aerosolized KL4 surfactant to premature infants supported with nCPAP, without having to use invasive intubation and mechanical ventilation.  By enabling delivery of our KL4 surfactant using less invasive procedures, we believe that AEROSURF will address a serious unmet medical need and potentially enable the RDS market is presently underserved, and that our RDS programs, beginning with SURFAXIN and, if approved, SURFAXIN LS™ and AEROSURF®, have the potential to greatly improve the managementtreatment of RDS and, collectively over time, to become the global standarda significantly greater number of care for premature infants with RDS.RDS who could benefit from surfactant therapy but are currently not treated.

SURFAXIN LS is ourWe are also developing a lyophilized (freeze-dried) dosage form of SURFAXINour KL4 surfactant that is stored as a powder and resuspendedreconstituted to liquid form prior to use.  We are developing SURFAXIN LSuse with the objective of improving ease of use for healthcare practitioners, as well as potentially to prolong shelf life and eliminate the need for cold-chain storage.  We are implementing ainitially developing this dosage form for use in our AEROSURF development program.  We are also planning to seek regulatory plan intendedadvice to determine if we could gain marketing authorization for a lyophilized dosage form of SURFAXIN LSunder a development plan that would be both capital efficient and capable of implementation within a reasonable time.  If feasible, we would likely implement such a development plan and would plan to introduce it commercially as a life-cycle extension of SURFAXIN under the name SURFAXIN LS™, in the United States,U.S. and potentially in other markets.

DISCOVERY LABORATORIES, INC.  AND SUBSIDIARY
To support the European Unioncommercial introduction of SURFAXIN in the U.S. and our other major markets worldwide.  AEROSURF is a drug/device combination product that combines our KL4 surfactant pipeline products, if approved, we have established our own specialty respiratory critical care commercial and medical affairs team.  This team includes medical professionals with experience in neonatal/pediatric respiratory critical care, and has focused on products that address neonatal indications, beginning with SURFAXIN.  We believe that this team will be positioned to efficiently introduce our proprietary capillary aerosol generator (CAG)other KL4 surfactant products under development, if approved, including AEROSURF and potentially SURFAXIN LS and future applications of our novel AFECTAIRaerosolized KL®4 ventilator circuit / patient interface connectors.  We are developingsurfactant.

In addition, we recognize that our commercial and medical affairs team could potentially support introductions of other synergistic pipeline products, including products  owned or developed by third parties for the NICU/PICU.  To that end, we would consider potential transactions focused on securing commercial rights to such synergistic products, including in the form of product acquisitions, in-licensing agreements or distribution, marketing or co-marketing arrangements.

In the future, we expect that we may be able to leverage the information, data and know-how that we gain from our development efforts with SURFAXIN and AEROSURF for premature infants with or at riskto support development of RDS.  Premature infants with RDS currently are treated with surfactants that can only be administered by endotracheal intubation supported with mechanical ventilation, both invasive procedures that frequently result ina potential product pipeline to address serious critical care respiratory conditions in larger children and complications.  Asadults in pediatric and adult intensive care units (PICUS and ICUs), including Acute Lung Injury (ALI), Chronic Obstructive Pulmonary Disorder (COPD) and Cystic Fibrosis (CF).  At the present time, however, we are focusing our resources primarily on the commercial introduction of SURFAXIN and development of AEROSURF through phase 2 clinical trials.  Once we have achieved these objectives, we believe we would be in a consequence, neonatologists will not treat infants who could benefit from surfactant therapy unlessbetter position to assess the potential benefits of surfactant therapy outweighother development programs to address the risks associated with such invasive administration procedures.  AEROSURF potentially will provide practitioners with the ability to deliver surfactant therapy using a less-invasive method.  For this reason, we believe that AEROSURF, if approved, potentially may enable the treatmentcritical care needs of a significantly greater number of premature infants at risk for RDS who could benefit from surfactant therapy but are currently not treated.
AFECTAIR, a series of disposable ventilator circuit / patient interface connectors, was initially developed for usepatients in the NICU as part of our AEROSURF development program.  AFECTAIR devicesPICU and ICU.

We also have developed a disposable aerosol-conducting airway connector for infants that is intended to simplify the delivery of inhaled therapiesaerosolized medications (including our aerosolized KL4 surfactant) and other inhaled therapies to critical-care patients requiring ventilatory support by introducing the inhaled therapysupport.  This device introduces aerosolized medications directly at the patient interface and minimizingminimizes the number of connections in the ventilator circuit.  We initially developed a ventilator circuit / patient interface connector to be used with our CAG in the NICU.  To benefit all critical care patients who require inhaled therapies and who are receiving ventilatory support, we are developing AFECTAIR devices in different sizes for use in NICUs, pediatric intensive care units (PICUs) and adult intensive care units (ICUs), and to be compatible with a variety of aerosol generating devices.  In February 2012, we successfullyhave registered our initial AFECTAIRthis device which is intended for use with jet nebulizers and other aerosol generators, in the United States as a Class I, exempt medical device.  We believe that AFECTAIR has the potential to become a new standard of care for the delivery of inhaled therapies to critical care patients.  We are implementing a regulatory and manufacturing plan that, if successful, is intended to result in the commercial introduction of the initial AFECTAIR device in the United StatesU.S. under the name AFECTAIR® and the European Unionit is currently commercially available in the fourth quarter of 2012, and a second AFECTAIR device, AFECTAIR DUO, in mid-2013.
U.S.

DISCOVERY LABORATORIES, INC. AND SUBSIDIARY
We are preparingThe reader is referred to, and encouraged to read in its entirety “Item 1 – Business” of this Annual Report on Form 10-K for the commercial introductions, beginning in late 2012, of SURFAXIN in the United States, and AFECTAIR in the United States and the European Union and other markets worldwide thereafter.  To accomplish our objectives, in the United States, we plan to build our own, in-house, specialty respiratory critical care commercial and medical affairs organization that will specialize in neonatal indications, beginning with SURFAXIN.  We also expect that our commercial and medical affairs organization will be able to leverage the experience and relationships that we gain with the introduction of SURFAXIN to efficiently support the introductions of SURFAXIN LS and AEROSURF, if approved.  We also expect that our in-house organization will also work inyear ended December 31, 2013, which contains a coordinated manner with a network of third-party distributors to execute the commercial introduction of the AFECTAIR devices.
In major markets outside the United States, an important priority is to secure the strategic resources to support the continued development and commercial introductiondiscussion of our RDS products.  A key goal for us in 2012 is to secure one or more strategic alliances and/or collaboration arrangements potentially to share researchBusiness and development expenses for our SURFAXIN LS and AEROSURF development programs, and, if approved, to support the commercial introduction of these products in Europe and elsewhere.  We may also seek strategic alliances and/or collaboration arrangements to support the potential commercial introduction of SURFAXIN in countries where regulatory marketing authorization is facilitated by the recent approval of SURFAXIN by the FDA.  We are engaged in discussions with potential strategic partners who could provide development and commercial expertiseBusiness Strategy, as well as financial resources (potentially in the form of upfront payments, milestone payments, commercialization royaltiesinformation concerning our proprietary technologies and a sharing of researchour current and development expenses).  There can be no assurance, however, that we will be successful in concluding any strategic alliance, collaboration or other similar transaction.planned KL4 pipeline programs.

Note 2 –  Liquidity Risks and Management’s Plans

We have incurred substantial losses since inception, due to investments in research and development, manufacturing, and, potentialmore recently, commercialization and medical affairs activities, and we expect to continue to incur substantial losses over the next several years.  Historically, we have funded our business operations through various sources, including public and private securities offerings, draw downs under a seriesdebt facilities, strategic alliances, the use of Committed Equity Financing Facilitiescommitted equity financing facilities (CEFFs), and at-the-market equity programs, and capital equipment financings.

As of December 31, 2013, we had cash and cash equivalents of $86.3 million and $30 million ($18.4 million net of discount) of long-term debt facilities,under our Deerfield Loan with affiliates of Deerfield Management  Company, L.P. (Deerfield).  See, “Note 9 – Deerfield Loan.”  During 2013, we raised aggregate gross proceeds of $75.8 million through public offerings of our common stock, including under our ATM Program.  In February 2013, we entered into the Deerfield Loan and, strategic alliances.  We expectupon execution of the agreement, Deerfield advanced to us $10 million ($9.85 million net of transaction fee).  In May 2013, we completed a public offering of 10.847 million shares of common stock, including 1.347 million shares under an option granted to and exercised by the underwriters, at an offering price of $1.50 per share, resulting in gross proceeds of $16.3 million ($15.1 million net of commissions, discounts and expenses).  In October 2013, we completed an offering under the ATM Program and issued 713,920 shares of our common stock resulting in net proceeds to us of approximately $1.8 million (net of  commissions).  In November 2013, we completed a public offering of 28.75 million shares of common stock, including 3.75 million shares under an option granted to and exercised by the underwriters for over-allotments, at an offering price of $2.00 per share resulting in gross proceeds of $57.5 million ($53.9 million net of commissions, discounts and expenses).  In December 2013, we received an additional $20 million under the Deerfield Loan ($19.7 million net of transaction fee), which became due under the Deerfield Loan upon the first commercial sale of SURFAXIN.  Before any additional financings, including under our ATM Program, we anticipate that we will have sufficient cash available to fund our business operations primarily through a combination, or all, of public offerings, including our CEFF and At-the-Market (ATM) Program (see, Note 10); anticipated revenue from the commercial introduction of SURFAXIN® and AFECTAIR®; strategic alliances; the exercise of outstanding warrants; and debt facilities.service obligations through the third quarter of 2015.

DISCOVERY LABORATORIES, INC.  AND SUBSIDIARY
 
Our future capital requirements depend upon many factors, primarily the success of our efforts to (i) to execute the commercial introduction of SURFAXIN and AFECTAIR in the United States and other markets,U.S.; (ii) advance the AEROSURF development program to completion of the phase 2 clinical program as planned (ii) toin the second half of 2015; and (iii) secure one or more strategic alliances or other collaboration arrangements to support the development and, if approved, commercial introduction of AEROSURF and potentially SURFAXIN LS™ and AEROSURF®in the European Union and markets outside the U.S., (iii)  We believe that, if we are able to complete the AEROSURF phase 2 clinical program on a timely basis and obtain encouraging results, and if we are able to successfully advance the commercial introduction of SURFAXIN, LS and AEROSURF development programsour ability to enter into a significant strategic alliance will be in a positionenhanced.  There can be no assurance, however, that our efforts will be successful, or that we will be able to initiate planned Phase 3 and Phase 2 clinical trials, respectively, and (iv) to procure theobtain additional capital necessary and desirable to support our activities when needed on acceptable terms, if at all.

Even if we succeed with the commercial introduction of SURFAXIN, given the time required to secure formulary acceptance at our target hospitals, we expect our revenues from SURFAXIN to be modest in the first 12-24 months and then increase slowly over time.  For the next several years, we expect that our cash outflows for marketing, commercial and medical activities, development programs, operations and debt service will far outpace the rate at which we may generate revenues.  Therefore, to execute our business strategy and fund our operations over the long term, we will require significant additional infusions of capital until such time as the net revenues from ourthe sale of approved products, from potential strategic alliance and other collaboration arrangementsalliances and from other sources such as future warrant exercises, are sufficient to offset our cash flow requirements.  To secure the necessary capital to fund our development programs, we would prefer to enter into strategic alliances or collaboration arrangements with partners having broad experience in markets outside the U.S., including regulatory and product-development expertise as well as an ability to commercialize our products, if approved.  Such alliances typically would also provide financial resources, in the form of upfront payments, milestone payments, commercialization royalties and a sharing of research and development expenses.  Collaboration, co-marketing and other similar arrangements would provide, in addition to an ability to introduce our products in markets outside the U.S., a sharing of revenues.  Under our ATM Program (see, “Note 11 – Stockholders' Equity – At-the-Market Program (ATM Program)”), subject to market conditions, we may sell up to approximately $23 million of common stock at such times and in such amounts that we deem appropriate, subject to a 3% commission.  However, use of the ATM Program is subject to market and other conditions and the ATM Program could be cancelled at any time by either party.  We also may consider public and private equity offerings or other financing transactions, including potentially secured equipment financing facilities or other similar transactions.  There can be no assurance, however, that our AEROSURF and other research and development projects will be successful, that our products under development will obtain necessary regulatory approval in the U.S. and other markets, that any approved product, including SURFAXIN, will be commercially viable, that the ATM Program will be available when needed, if at all, or that we will be able to obtain additional capital when needed on acceptable terms, if at all.  Even if we succeed in raising additional capital and developing and subsequently commercializing product candidates, we may never achieve sufficient sales revenue to achieve or maintain profitability.

The accompanying financial statements have been prepared assuming that we will continue as a going concern, which contemplates the realization of assets and satisfaction of liabilities in the normal course of business.  For the next several years, our ability to continue as a going concern will be dependent on our ability to raise additional capital, to fund our research and development and commercial programs and meet our obligations, including debt service, on a timely basis.  If we are unable to successfully raise sufficient additional capital when needed, we will likely not have sufficient cash flows and liquidity to fund our business operations, which could significantly limit our ability to continue as a going concern.  In that event, we may be forced to further limit our programs and consider other means of creating value for our stockholders, such as licensing the development and commercialization of products that we consider valuable and would otherwise likely develop ourselves.  If we are unable to raise the necessary capital, we may be forced to curtail all of our activities and, ultimately, potentially cease operations.  Even if we are able to raise additional capital, such financings may only be available on unattractive terms, or could result in significant dilution of stockholders’ interests and, in such event, the market price of our common stock may decline.  The balance sheets do not include any adjustments relating to recoverability and classification of recorded asset amounts or the amounts and classification of liabilities that might be necessary should we be unable to continue in existence.

As of December 31, 2011, we had cash and cash equivalents of $10.2 million.  From January 1, 2012 through March 21, 2012, (i) holders of 15-month warrants we issued in February 2011 have exercised warrants to purchase 2,233,000 shares of our common stock at an exercise price of $2.94 per share, resulting in proceeds to us of $6.6 million; and (ii) holders of the five-year warrants we issued in February 2011 have exercised warrants to purchase 46,250 shares of our common stock at an exercise price of $3.20 per share, resulting in proceeds to us of $148,000.  In addition, on March 7, 2012, we delivered a sales notice under our ATM Program to sell shares of common stock.  We terminated the offering on March 8, 2012.  As a result of that offering, we issued an aggregate 350,374 shares of common stock at an aggregate purchase price of approximately $1.56 million, resulting in net proceeds to us of approximately $1.52 million, after deducting commissions due to the sales agent.  On March 21, 2012, we completed a public offering of 16,071,429 shares of common stock for net proceeds to us (after underwriter fees and anticipated expenses) of approximately $42.1 million.  In addition, we granted the underwriters a 30-day option to purchase up to an additional 2,410,714 shares of common stock at a public offering price of $2.80 per share, with respect to which we potentially could realize additional net proceeds to us of $6.3 million.


DISCOVERY LABORATORIES, INC. AND SUBSIDIARY

As of December 31, 2011 and March 21, 2012, of the 1002013, 150 million shares of common stock were authorized under our Amended and Restated Certificate of Incorporation we hadand approximately 42.1 million shares of common stock were available for issuance and not otherwise reservedreserved.

DISCOVERY LABORATORIES, INC.  AND SUBSIDIARY
In addition, as of December 31, 2013, we had outstanding warrants to purchase approximately 14.8 million shares of our common stock at various prices, exercisable on different dates into 2019.  Of these warrants, 7 million warrants were issued to Deerfield in connection with the Deerfield Loan at an exercise price of $2.81 per share.  The Deerfield Warrants may be exercised for future issuance,cash or on a cashless basis.  In lieu of paying cash upon exercise, the holders also may elect to reduce the principal amount of the Deerfield loan in an amount sufficient to satisfy the exercise price of the Deerfield Warrants.  In addition to the Deerfield Warrants, we have outstanding warrants to purchase approximately 56.5 million and 40.04.8 million shares of common stock respectively.

To execute our business strategy over time,that were issued in February 2011, are exercisable for five-years, and contain anti-dilution provisions that adjust the exercise price if we anticipate potentially securing additional infusions of capital fromissue any common stock, securities convertible into common stock, or other securities (subject to certain exceptions) at a combination of some or allvalue below the then-existing exercise price of the warrants.  These warrants were originally issued with an exercise price of $3.20 per share and thereafter adjusted downward, first to $2.80 per share in March 2012 and then to $1.50 per share following sources:
Exercisea public offering in May 2013.  If the market price of outstanding warrants:
·In connection with our February 2011 public offering, we issued 15-month warrants to purchase five million shares of our common stock at an exercise price of $2.94 per share (15-month warrants) of which 2,233,000 warrants have been exercised through March 21, 2012.  If the market price of our common stock should exceed $2.94 at any time prior to May 2012 (the expiration date of these warrants), and if the holders determine (in their discretion) to exercise the 15-month warrants and we have an effective registration statement covering the warrant shares, we potentially could raise up to an additional $8.1 million.
·Also in connection with the February 2011 public offering, we issued five-year warrants to purchase five million shares of our common stock at an exercise price of $3.20 per share (2011 five-year warrants).  These warrants also contain anti-dilutive provisions that adjust the exercise price if we issue any common stock, securities convertible into common stock, or other securities (subject to certain exceptions) at a value below the then-existing exercise price.  As a result of the March 2012 public offering, the exercise price of these warrants has been adjusted downward to $2.80 per share.  Thus, if the market price of our common stock should remain above $2.80 at any time prior February 2016 (the expiration date of these warrants), and if the holders determine (in their discretion) to exercise the five-year warrants and we have an effective registration statement covering the warrant shares to be issued upon exercise of the warrants, we potentially could raise up to an additional $13.9 million.
Upfrontour common stock should exceed $1.50 at any time prior to the expiration date of these warrants (February 2016) and milestone payments and co-fundingif the holders determine in their discretion to exercise these warrants (and we have an effective registration statement covering the warrant shares to be issued upon exercise of development activities associated with potential strategic alliances or other similar transactions:
·We are engaged in discussions with potential strategic partners who could provide development and commercial expertise as well as financial resources (potentially in the form of upfront payments, milestone payments, commercialization royalties and a sharing of research and development expenses) to support the development of SURFAXIN LS and AEROSURF and, if approved, the introduction of these products in Europe and various markets outside the U.S.
Secured debt arrangementsthe warrants), we potentially could receive up to fund working capital and/or investment$7.3 million. Although we believe that, in capital assets:
·In the future, if our efforts are successful, we believe that debt could potentially be a component of our capital structure and financing plans.  We could potentially enter into capital equipment financing facilities, revolving working capital lines of credit, term loans and other similar transactions to satisfy our working capital requirements.
In appropriate circumstances, tothe future, we will secure additional capital and strengthenfrom the exercise of at least a portion of our financial condition, we will also consider equity public offerings and other financing transactions:
·
We have a CEFF with Kingsbridge Capital Ltd. (Kingsbridge) that could allow us, at our discretion, to raise capital (subject to certain conditions, including volume limitations) at a time and in amounts we deem suitable to support our business plans.  Based on the closing market price of our common stock on March 21, 2012 ($2.80) and assuming that all available shares are issued, the potential availability under our CEFF is approximately $2.8 million.  See, Note 10.
·In December 2011, we established an “at-the-market” program (ATM Program), which allows us, at our discretion and at such times that we may choose, to sell up to a maximum of $15 million of shares of common stock.  Based on the closing market price of our common stock on March 21, 2012 ($2.80), and assuming that the full amount available under the ATM Program ($13.4 million) is sold, we may issue up to approximately 4.8 million additional shares under the ATM Program.  See, “– Financings Pursuant to Common Stock Offerings.”

DISCOVERY LABORATORIES, INC. AND SUBSIDIARY

·We have agreed in connection with our March 2012 public offering that we will not issue or sell (with certain limited exceptions) securities for a period of 90 days ending in June 2012.  See, “- Financings Pursuant to Common Stock Offerings.”
Thereoutstanding warrants, there can be no assurance that the market price of our common stock will remain atequal or exceed price levels that make exercise of outstanding warrants likely or that holders of outstanding warrants will choose to exercise any or all of their warrants prior to the warrant expiration date; that wedate.  Moreover, if our outstanding warrants are exercised, such exercises likely will be successful in concluding any strategic alliance, collaboration or other financing transaction; that the CEFF will be available at any time, or, even if available, that we will utilize the CEFF prior to its expiration in June 2013; that we will issue any shares pursuanta discount to the ATM Program, or thatthen-market value of our common stock and have a dilutive effect on the entire amount provided undervalue of our shares of common stock at the ATM Program will be realized prior the expiration or earlier terminationtime of the ATM Program; or that we will undertake any financings or similar transactions, on favorable terms or otherwise.exercise.

We believe, if we are successful in implementing our strategic business plan, that the anticipated net revenues from the sale of SURFAXIN and AFECTAIR, when combined with the other sources of anticipated capital outlined above, including from potential strategic alliances and collaboration arrangements to support the SURFAXIN LS and AEROSURF development programs, potentially could be sufficient to support our future operations.  In that event, we would nevertheless continue to consider financings and similar transactions that would strengthen our financial condition and build value for our stockholders.

Although we currently believe that we will be successful in meetingable to successfully execute our strategic planning goals within the time frame set forth above,business strategy, there can be no assurance that we will successfully fundbe successful.  We will require significant additional capital to satisfy debt obligations and build our own commercial organizationsustain operations, and to complete the development and support the commercial introduction of SURFAXIN and AFECTAIR; that we will successfully executeour products.  Failure to secure the launch of SURFAXIN and AFECTAIR within the anticipated time frame; that the revenues we may realize from the sale of SURFAXIN and AFECTAIR will be in line with current expectations; that we will successfully identify one or more strategic partners or collaboration arrangements to support development and, if approved, commercial introduction of the SURFAXIN LS and AEROSURF product candidates; or that the revenues, if any, that we generate in the future will be sufficient at any time to fund the further development of our research and development programs and support our operations.  If we are unable to identify and enter into strategic alliances for the development of SURFAXIN LS and AEROSURF, and if approved, commercialization of SURFAXIN LS and AEROSURF in the European Union and other markets outside the U.S., we may be unable to fund planned clinical trials, whichnecessary additional capital would have a material adverse effect on our researchbusiness, financial condition and development programs.results of operations.

Note 3 –  Accounting Policies and Recent Accounting Pronouncements

The consolidated financial statements and accompanying notes are prepared in accordance with accounting principles generally accepted in the United States.

Consolidation

The consolidated financial statements include all of the accounts of Discovery Laboratories, Inc. and its inactive subsidiary, Acute Therapeutics, Inc.  All intercompany transactions and balances have been eliminated in consolidation.

Use of estimates

The preparation of financial statements, in conformity with accounting principles generally accepted in the United States, requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period.  Actual results could differ from those estimates.

Cash and cash equivalents

Cash and cash equivalents are held in U.S. banks and consist of liquid investments and money market funds with a maturity from date of purchase of 90 days or less that are readily convertible into cash.

We consider cash and cash equivalents as amounts on hand, on deposit in financial institutions and all highly liquid marketable securities purchased with a maturity of three months or less.


DISCOVERY LABORATORIES, INC. AND SUBSIDIARY

Fair value of financial instruments

Our financial instruments consist principally of cash and cash equivalents and restricted cash.  The fair values of our cash equivalents are based on quoted market prices.  The carrying amount of cash equivalents is equal to their respective fair values at December 31, 20112013 and December 31, 2010.2012, respectively.  Other financial instruments, including accounts payable and accrued expenses, are carried at cost, which we believe approximates fair value.
DISCOVERY LABORATORIES, INC.  AND SUBSIDIARY
Accounts receivable
Trade accounts receivable are recorded net of allowances for prompt payment discounts and doubtful accounts.

Inventory

Inventories, which are recorded at the lower of cost or market, include materials, labor, and other direct and indirect costs and are valued at cost using the first-in, first-out method. The Company capitalizes inventories produced in preparation for commercial launches when the related product candidates receive regulatory approval and that the related costs will be recoverable through the commercial sale of the product.  Costs incurred prior to FDA approval of SURFAXIN drug product and registration of our initial AFECTAIR device have been recorded in our statement of operations as research and development expense.  Inventory is evaluated for impairment through consideration of factors such as the net realizable value, lower of cost or market, obsolescence, and expiry. Inventories do not have carrying values that exceed either cost or net realizable value.

We evaluate our expiry risk by evaluating current and future product demand relative to product shelf life. We build demand forecasts by considering factors such as, but not limited to, overall market potential, market share, market acceptance and hospital ordering practices.

Property and equipment

Property and equipment are recorded at cost and depreciated using the straight-line method over the estimated useful lives of the assets (generally three to ten years).  Leasehold improvements are amortized over the shorter of the estimated useful lives or the remaining term of the lease.  Repairs and maintenance costs are charged to expense as incurred.

Long-lived assetsRestricted cash

Restricted cash consists of a certificate of deposit held by our bank as collateral for a letter of credit in the same notional amount held by our landlord to secure our obligations under our Lease Agreement dated May 26, 2004 and amended January 3, 2013  for our headquarters location in Warrington, Pennsylvania (See, Note 14 – Commitments, for further discussion on our leases).  Under terms of the lease agreement, the required restricted cash balance was reduced to $325,000 in October 2013.

Long-lived assets

Our long-lived assets, primarily consisting of equipment, are reviewed for impairment when events or changes in circumstances indicate the carrying amount of an asset may not be recoverable, or its estimated useful life has changed significantly.  When an asset’sthe undiscounted cash flows of an asset are less than its carrying value, an impairment is recorded and the asset is written down to its estimated value.  No impairment was recorded during the years ended December 31, 20112013, 2012, and 2010,2011 as management believes there are no circumstances that indicate the carrying amount of the assets will not be recoverable.
Financing costs related to long-term debt
Costs associated with obtaining long-term debt, including the fair value of warrants issued in connection with the debt and transaction fees, are amortized over the term of the related debt using the effective interest method.

Grant Revenue
F - 11
DISCOVERY LABORATORIES, INC.  AND SUBSIDIARY
Deferred revenue
 
Deferred revenue reflects amounts related to SURFAXIN sales to our specialty distributor, which are deferred and recognized as revenue once product has been sold through to the hospital and all revenue recognition criteria have been met.

Product Sales

Revenues from product sales are recognized when (1) persuasive evidence of an arrangement exists, (2) delivery has occurred or services have been rendered, (3) the price is fixed or determinable and (4) collectability is reasonably assured.   

Our products are distributed in the U.S. using a specialty distributor.  Under this model, the specialty distributor purchases and takes physical delivery and title of product, and then sells to hospitals.  We began the commercial introduction of SURFAXIN in the fourth quarter of 2013 and, for that reason, we currently cannot make a reasonable estimate of future product returns when product is delivered to the specialty distributor.  Therefore, we currently do not recognize revenue upon product shipment to the specialty distributor, even though the distributor is invoiced upon product shipment.  Instead, we recognize revenue once product has been sold through to the hospital and all revenue recognition criteria have been met.  Once product has been delivered to the hospital, the risk of material returns is significantly mitigated. As of December 31, 2013, we have deferred revenue recognition on all product sales since the inception of the commercial launch of SURFAXIN in November 2013.  We will recognize those revenues at the point in time when all revenue recognition criteria have been met.

We will begin to recognize revenue at the time of shipment of product to our specialty distributor when we can reasonably estimate expected distributor sales deductions and returns. In developing estimates for sales returns we consider the shelf life of the product, expected demand based on market data and return rates of other surfactant products. 

Product sales are recorded net of accruals for estimated chargebacks, discounts, specialty distributor deductions and returns.

·Chargebacks.  Chargebacks are discounts that occur when contracted customers purchase directly from our specialty distributor.  Contracted customers, which currently consist primarily of member hospitals of Group Purchasing Organizations, generally purchase the product at a discounted price.  Our specialty distributor, in turn, charges back the difference between the price initially paid by the specialty distributor and the discounted price paid to the specialty distributor by the customer.  The allowance for specialty distributor chargebacks is based on known sales to contracted customers.

·Sales discounts:  Sales discounts are offered to certain contracted customers based upon a customer’s historical volume of surfactant product purchases.  Customers must enter into a Letter of Participation (LOP) with us to receive sales discounts.  Sales discounts are calculated on a quarterly basis based upon the customer’s quarterly purchases of SURFAXIN, as provided in the LOP.  The allowance for sales discounts is based on known sales to contracted customers.

·Specialty distributor deductions. Our specialty distributor is offered various forms of consideration including allowances, service fees and prompt payment discounts. Specialty distributor allowances and service fees are provided in our contractual agreement and are generally a percentage of the purchase price paid by the specialty distributor. The specialty distributor is offered a prompt pay discount for payment within a specified period.

·Returns.  Sales of our products are not subject to a general right of return; however, we will accept product that is damaged or defective when shipped or for expired product up to 6 months subsequent to its expiry date.  Product that has been administered to patients is no longer subject to any right of return.

DISCOVERY LABORATORIES, INC.  AND SUBSIDIARY
Grant Revenue

We recognize grant revenue when persuasive evidence of an arrangement exists, delivery has occurred or services have been rendered, the price is fixed and determinable, and collectability is reasonably assured.

We recognized $0.4 million and $0.2 million of grant revenue for the years ended December 31, 2013 and 2012, respectively, for funds received and expended under a $0.6 million Small Business Innovation Research (SBIR) Phase I award to Discovery Labs from National Institute of Health’s (NIH) National Institute of Allergy and Infectious Diseases (NIAID) Center for Medical Counter Measures Against Radiation and Nuclear Threats to assess the ability of KL4 surfactant to mitigate the effects of acute radiation exposure to the lung, including acute pneumonitis and delayed lung injury.

For the year ended December 31, 2011, grant revenue represents funds received and expended under a $0.6 million Fast Track Small Business Innovation Research Grant (SBIR)SBIR from the National Institutes of HealthNIH to support the development of aerosolized KL4 surfactant for RDS.  The amount of the award was approximately $582,000 and the grant revenue was recognized in the period in which the related expenditures were incurred.   For the year ended December 31, 2010, we received grant proceeds, recorded as other income, of $244,480 under the Patient Protection and Affordable Care Act of 2010 to reimburse costs incurred in 2009 to advance our aerosolized KL4 surfactant program for the prevention of neonatal RDS.

Research and development

We track research and development expense by activity, as follows: (a) product development and manufacturing, (b) medical and regulatory operations, and (c) direct preclinical and clinical programs.   Research and development costs consist primarily of expenses associated with ourexpense includes personnel, facilities, manufacturing and quality operations, pharmaceutical and device development, research, clinical, regulatory, other preclinical and clinical activities and medical affairs.  Research and development costs are charged to operations as incurred.

Stock-based compensation

Stock-based compensation is accounted for under the fair value recognition provisions of Accounting Standards Codification (ASC) Topic 718 “Stock Compensation” (ASC Topic 718).  See, Note 1112 – Stock Options and Stock-based Employee Compensation, for a detailed description of our recognition of stock-based compensation expense.  The fair value of stock option grants is recognized evenly over the vesting period of the options or over the period between the grant date and the time the option becomes non-forfeitable by the employee, whichever is shorter. Stock option expense is generally included in research and development and selling, general and administrative expenses in the accompanying Consolidated Statements of Operations.

Warrant accounting

We account for common stock warrants in accordance with applicable accounting guidance provided in Accounting Standards CodificationASC Topic 815 “Derivatives and Hedging – Contracts in Entity’s Own Equity” (ASC Topic 815), as either derivative liabilities or as equity instruments depending on the specific terms of the warrant agreement.  We classify derivative warrant liabilities on the consolidated balance sheet as a current liability,liabilities, which isare revalued at each balance sheet date subsequent to the initial issuance.  We use the Black-Scholes or trinomial pricing models, depending on the applicable terms of the warrant agreement, to value the derivative warrant liabilities.  Changes in the fair value of the warrants are reflected in the consolidated statement of operations as “Change in the fair value of common stock warrant liability.”  See, Note 8 – Common Stock Warrant Liability, for a detailed description of our accounting for derivative warrant liabilities.

Income taxes

DISCOVERY LABORATORIES, INC. AND SUBSIDIARY

Income taxes

We account for income taxes in accordance with Accounting Standards Codification (ASC)ASC Topic 740, “Accounting for Income Taxes.”  ASC Topic 740 requires the recognition of deferred tax liabilities and assets for the expected future tax consequences of temporary differences between financial statement carrying amounts and the tax basis of assets and liabilities.

DISCOVERY LABORATORIES, INC.  AND SUBSIDIARY
We use a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return.  Because we have never realized a profit, management has fully reserved the net deferred tax asset since realization is not assured.

Net loss per common share

Basic net loss per common share is computed by dividing the net loss by the weighted average number of common shares outstanding for the periods.period. For the years ended December 31, 2013, 2012, and 2011, and 2010, 15.4 million and 5.3 millionthe number of shares of common stock respectively, were potentially issuable upon the exercise of certain stock options and warrants.  Due to ourwarrants was 20.2 million, 11.9 million and 15.4 million shares, respectively. As a result of the net loss, theselosses for all periods presented, all potentially issuable sharesdilutive securities were not included inanti-dilutive and therefore have been excluded from the calculationcomputation of diluted net loss per share as the effect would be anti-dilutive, therefore basic and dilutive net loss per share are the same.share. We do not have any components of other comprehensive income (loss).
Concentration of Suppliers

Concentration of Suppliers

We currently obtain the active pharmaceutical ingredients (APIs) of our KL4surfactant drug products from single-source suppliers.  In addition, we rely on a number of third-party institutions and laboratories that perform various studies as well as quality control release and stability testing and other activities related to our KL4 surfactant development and manufacturing activities.  At the present time, several of these laboratories are single-source providers.  The loss of one or more of theseour single-source suppliers or testing laboratories could have a material adverse effect upon our operations.

Business segmentsMajor customer and concentration of credit risk

We currently sell our products to one exclusive pharmaceutical specialty distributor in the U.S.  We periodically assess the financial strength of our specialty distributor and establish allowances for anticipated uncollectible amounts, if necessary.  As of December 31, 2013, we have not recorded an allowance for doubtful accounts.

Business segments

We currently operate in one business segment, which is the research and development of products focused on surfactant replacement therapies for respiratory disorders and diseases.diseases, and the manufacture and commercial sales of approved products.  We are managed and operated as one business.  A single management team that reports to the Chief Executive Officer comprehensively manages the entire business.  We do not operate separate lines of business with respect to our product candidates.

Recent Accounting Pronouncements

In May 2011, the FASB amended theThe Company did not adopt any new accounting guidance for fair value to develop common requirements between U.S. Generally Accepted Accounting Principles and International Financial Reporting Standards.  The amendments, which are effective for interim and annual periods beginning after December 15, 2011, require entities to (i) provide information about valuation techniques and unobservable inputs used in Level 3 fair value measurements, and (ii) provide a narrative description of the sensitivity of Level 3 measurements to changes in unobservable inputs. The adoption of this update is not expected to havepronouncements during 2013 that had a material impacteffect on ourthe Company’s consolidated financial statements.

In June 2011, the FASB issued accounting guidance related to the presentation of comprehensive income.  The guidance, which is effective for interim and annual periods beginning after December 15, 2011, require entities to present all components of comprehensive income in either (i) a single continuous statement of comprehensive income or (ii) in a statement of net income and statement of other comprehensive income.  The adoption of this update is not expected to have a material impact on our consolidated financial statements.


DISCOVERY LABORATORIES, INC. AND SUBSIDIARY
Note 4 – Fair Value Measurements

Fair value is defined as the exchange price that would be received for an asset or paid to transfer a liability in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date.

Valuation techniques used to measure fair value must maximize the use of observable inputs and minimize the use of unobservable inputs.  The fair value hierarchy is based on three levels of inputs, of which the first two are considered observable and the last unobservable, as follows:

·Level 1 – Quoted prices in active markets for identical assets and liabilities.
·Level 2 – Inputs other than Level 1 that are observable, either directly or indirectly, 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.
·Level 3 – Unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities.

DISCOVERY LABORATORIES, INC.  AND SUBSIDIARY
Fair Value on a Recurring Basis

Assets and liabilities measured at fair value on a recurring basis are categorized in the table below as of December 31, 20112013 and 2010:2012:

 Fair Value  Fair value measurement using  Fair Value  Fair value measurement using 
(in thousands) 
December 31,
2011
  Level 1  Level 2  Level 3  December 31, 2013  Level 1  Level 2  Level 3 
             
  
  
  
 
Assets:             
  
  
  
 
Money markets $9,377  $9,377  $–  $– 
Cash and cash equivalents $86,283  $86,283  $–  $– 
Certificate of deposit  400   400   –   –   325   325   –   – 
Total Assets $9,777  $9,777  $–  $–  $86,608  $86,608  $–  $– 
Liabilities:                                
Common stock warrant liability $6,996  $$ –  $–  $6,996 
Common stock warrants $5,425  $$ –  $–  $5,425 

  Fair Value  Fair value measurement using 
(in thousands) 
December 31,
2010
  Level 1  Level 2  Level 3 
             
Assets:            
Money markets $9,690  $9,690  $–  $– 
Certificate of deposit  600   600   –   – 
Total Assets $10,290  $10,290  $–  $– 
Liabilities:                
Common stock warrant liability $2,469  $$ –  $–  $2,469 

 
 Fair Value  Fair value measurement using 
(in thousands) December 31, 2012  Level 1  Level 2  Level 3 
Assets: 
  
  
  
 
Cash and cash equivalents $26,892  $26,892  $–  $– 
Certificate of deposit  400   400   –   – 
Total Assets $27,292  $27,292  $–  $– 
Liabilities:                
Common stock warrants $6,305  $$ –  $–  $6,305 
 
F-13

DISCOVERY LABORATORIES, INC. AND SUBSIDIARY

The following table summarizes changes in the activityfair value of Level 3 inputsthe common stock warrants measured on a recurring basis using Level 3 inputs for 2012 and 2013:

(in thousands)  
 
  
Balance at January 1, 2012 $6,996 
Issuance of common stock warrants  (136)
Change in fair value of common stock warrant liability  (555)
Balance at December 31, 2012 $6,305 
Exercise of warrants (1)
  (119)
Change in fair value of common stock warrant liability  (761)
Balance at December 31, 2013 $5,425 
(1)
See, Note 8 – Common Stock Warrant Liability.

The significant unobservable inputs used in the year endedfair value measurement of the common stock warrants measured on a recurring basis are the historical volatility of our common stock market price, expected term of the applicable warrants, and the risk-free interest rate based on the U.S. Treasury yield curve in effect at the measurement date.  In addition to the significant unobservable inputs noted above, certain fair value measurements also take into account an assumption of the likelihood and timing of the occurrence of an event that would result in an adjustment to the exercise price in accordance with the anti-dilutive pricing provisions in the warrant.  Any significant increases or decreases in the unobservable inputs, with the exception of the risk-free interest rate, may result in significantly higher or lower fair value measurements.
DISCOVERY LABORATORIES, INC.  AND SUBSIDIARY
 December 31, 
Significant Unobservable Input Assumptions of Level 3 Valuations 2013  2012 
 
  
 
Historical volatility  62% -76%  56% -80%
Expected term (in years)  0.4 – 2.1   1.4 – 3.2 
Risk-free interest rate  0.08% - 0.44%  0.16% - 0.36%

Fair Value of Long-Term Debt

At December 31, 2011:
(2013, the estimated fair value of the Company's Deerfield Loan was $23.6 million compared to a carrying value, net of discounts, of $18.4 million.  We had no long-term debt as of December 31, 2012.  The estimated fair value of the Deerfield Loan was based on discounting the future contractual cash flows to the present value.  This analysis utilizes certain Level 3 unobservable inputs, including current cost of capital.  Considerable judgment is required to interpret market data and to develop estimates of fair value.  The estimates presented are not necessarily indicative of amounts we could realize in thousands)a current market exchange.  The use of alternative market assumptions and estimation methodologies could have a material effect on these estimates of fair value.
  
Fair Value Measurements of
Common Stock Warrants Using
Significant Unobservable Inputs
 
  (Level 3) 
    
Balance at December 31, 2010 $2,469 
Issuance of common stock warrants  8,087 
Change in fair value of common stock warrant liability  (3,560)
Balance at December 31, 2011 $6,996 
 
Note 5 – Restricted CashInventory

Restricted cash consists of a security deposit held by our bank as collateral for a letter of credit in the same notional amount held by our landlord to secure our obligations under our Lease Agreement dated May 26, 2004 for our headquarters location in Warrington, Pennsylvania (See, Note 13 – Commitments, for further discussion on our leases).  Under termsInventory is comprised of the lease agreement the required restricted cash balancefollowing:

 December 31, 
(in thousands) 2013  2012 
    
Raw materials $52  $195 
Finished goods  60   – 
 $112  $195 

Raw materials costs in inventory of $52,000 as of December 31, 2011 and 2010 was $400,000, respectively.  The notional amount2013 consisted of the letterportion of credit (andraw materials anticipated to be used in the manufacture of commercial product that were purchased after October 4, 2013, the date the FDA agreed to our updated product specifications for SURFAXIN that allowed us to proceed with the commercial introduction of SURFAXIN.  Raw materials on hand as of December 31, 2013 that were purchased prior to October 4, 2013 were $1.6 million.  These raw materials have a carrying value of zero, as the costs to purchase this material were expensed as research and development expense in the period purchased, and accordingly are not reflected in the inventory balances shown above.  The majority of these raw materials are anticipated to be used in manufacturing development and research and development activities.  The remaining portion of these raw materials  are anticipated to be used in the manufacture of commercial product.

Raw materials costs in inventory of $195,000 as of December 31, 2012 consisted of the portion of raw materials anticipated to be used in the manufacture of commercial product that were purchased after the FDA agreed granted us marketing approval for SURFAXIN (March 2012).  Due to a delay in commercial availability of SURFAXIN drug product until the fourth quarter of 2013, previously capitalized raw material costs of $195,000 as of December 31, 2012 were charged to research and development expense in the first quarter of 2013, as these raw materials were no longer expected to be used in the manufacture of commercial product.
Inventory reserves were $0.5 million as of December 31, 2013 and $0 as of December 31, 2012. The inventory reserves in 2013 primarily reflect costs of SURFAXIN related security deposit) will remain at $400,000finished goods inventories that are not anticipated to be recoverable through the remaindercommercial sale of the lease term.  Subjectproduct during the initial launch period due to certain conditions, upon expirationproduct expiration.  These reserves ensure that the inventory carrying values do not exceed net realizable value.

DISCOVERY LABORATORIES, INC.  AND SUBSIDIARY
 
Note 6 – Property and Equipment

Property and equipment as of December 31, 2011 and 2010 wasis comprised of the following:

 
 December 31, 
(in thousands) 2013  2012 
 
    
Manufacturing, laboratory & office equipment $8,383  $7,775 
Furniture & fixtures  816   816 
Leasehold improvements  2,711   2,711 
Subtotal  11,910   11,302 
Accumulated depreciation and amortization  (10,254)  (9,565)
Property and equipment, net $1,656  $1,737 

  December 31, 
(in thousands) 2011  2010 
       
Equipment $7,428  $7,418 
Furniture  815   801 
Leasehold improvements  2,875   2,838 
Subtotal  11,118   11,057 
Accumulated depreciation and amortization  (8,825)  (7,590)
Property and equipment, net $2,293  $3,467 

Equipment primarily consists of: (i) manufacturing equipment to produce our KL4 surfactant products, including SURFAXIN® and AEROSURF®, for use in our preclinical studies, clinical trials and potential commercial needs; (ii) laboratory equipment for manufacturing, analytical, research and development activities; and (iii) computers and office equipment to support our overall business activities.

Leasehold improvements primarily consist of construction of an analytical and development laboratory in our Warrington, Pennsylvania headquarters, which was completed in 2007.  The activities conducted in our laboratory include release and stability testing of raw materials as well as preclinical, clinical and commercial drug product supply.  We also perform development work with respect to our aerosolized and lyophilized dosage forms of our KL4 surfactant.  The laboratory will be amortized through the end of the lease term for our Warrington, Pennsylvania headquarters in 2013.  In addition, in 2007, we built a microbiology laboratory at our manufacturing facility in Totowa, New Jersey, to support production of our drug product candidates.  The microbiology laboratory will be amortized through the end of the lease term for our Totowa, New Jersey facility in 2014.June 2015.

Depreciation expense on property and equipment for the years ended December 31, 2013, 2012, and 2011 was $0.7 million, $0.9 million, and 2010 was $1.3 million, and $1.4 million, respectively.


DISCOVERY LABORATORIES, INC. AND SUBSIDIARY
Note 7 – Accrued Expenses

Accrued expenses as of December 31, 2011 and 2010 wereare comprised of the following:

  December 31, 
(in thousands) 2011  2010 
       
Accrued compensation (1)
 $957  $760 
Accrued manufacturing  917   796 
Accrued research and development  461   689 
Accrued accounting and legal fees  315   395 
All other accrued expenses  322   646 
Total accrued expenses $2,972  $3,286 
 
 December 31, 
(in thousands) 2013  2012 
 
    
Salaries, bonus & benefits $1,849  $1,206 
Manufacturing operations  1,707   926 
Research and development  270   734 
Professional fees  393   428 
Sales and marketing  161   279 
All other  405   586 
Total accrued expenses $4,785  $4,159 

(1)
Accrued compensation primarily consists of employee incentive arrangements (pursuant to plans approved by our Board) and employees’ unused earned vacation.  As of December 31, 2011, accrued compensation also included contractual severance arrangements for our former Executive Vice President and General Counsel (See, Note 13 – Commitments).
Note 8 – Common Stock Warrant Liability

We account for common stock warrants in accordance with applicable accounting guidance provided in ASC Topic 815, either as derivative liabilities or as equity instruments depending on the specific terms of the warrant agreement.

The form of warrant agreement for the registered warrants that we issued in our May 2009 and February 2010 public offerings generally provide that, in the event a related registration statement or an exemption from registration is not available for the issuance or resale of the warrant shares upon exercise of the warrant, the holder may exercise the warrant on a cashless basis.  Notwithstanding the availability of cashless exercise, under generally accepted accounting principles (GAAP) provide that these registered warrants are deemed to be subject to potential net cash settlement and must be classified as derivative liabilities because (i) under the federal securities laws, it may not be within our absolute control to provideproviding freely-tradable shares upon exercise of the warrants may not be within our control in all circumstances, and (ii) the warrant agreements do not expressly stateprovide that there is no circumstance in which we may be required to effect a net cash settlement of the warrants.  The applicable accounting principlesguidance expressly do not allow forprecludes an evaluation of the likelihood that an event would result in a cash settlement.settlement could occur.  Accordingly, the May 2009 and February 2010 warrants have been classified as derivative liabilities and reported, at each balance sheet date, at estimated fair value determined using the Black-Scholes option pricingoption-pricing model.

DISCOVERY LABORATORIES, INC.  AND SUBSIDIARY
The form of warrant agreement for the registered five-year warrants that we issued in the February 2011 public offering (February 2011 five-year warrants) expressly provide that under no circumstances will we be required to effect a net cash settlement of these warrants.  However, these warrants contain anti-dilutive provisions that adjust the exercise price if we issue any common stock, securities convertible into common stock, or other securities (subject to certain exceptions) at a value below the then-existing exercise price of the February 2011 five-year warrants.  DueAlthough by their express terms, these warrants are not subject to potential cash settlement, due to the nature of the anti-dilution provisions, these warrants have been classified as derivative liabilities and reported, at each balance sheet date, at estimated fair value determined using a trinomial pricing model.


DISCOVERY LABORATORIES, INC. AND SUBSIDIARY

Selected terms and estimated fair value of warrants accounted for as derivative liabilitiesare as follows:

 
  
 
   
 
Fair Value of Warrants
(in thousands)
Issuance
Date
 Number of Warrant Shares Issuable  
Exercise
Price
 
Warrant
Expiration
Date
 
Value at
Issuance
Date
  December 31,
 2013  2012 
 
 
  
 
 
 
  
  
 
5/13/2009  466,667  $17.25 5/13/2014 $3,360  $–  $– 
2/23/2010  916,669   12.75 2/23/2015  5,701   6   104 
2/22/2011  4,834,950   1.50 2/22/2016  8,004   5,419   6,201 
 
        
 
     $5,425  $6,305 

In addition, the February 2011 five-year warrants contain anti-dilution provisions that adjust the exercise price if we issue any common stock, securities convertible into common stock, or other securities (subject to certain exceptions) at a value below the then-existing exercise price of the warrants.  Accordingly, the exercise price of these warrants at issuance of $3.20 was adjusted downward to $2.80 per share at the time of the March 2012 public offering and to $1.50 per share at the time of the May 2013 public offering.

During the year ended December 31, 2013, holders of the February 2011 and 2010 are as follows:five-year warrants exercised warrants to purchase 113,800 shares of common stock for total proceeds of $170,700.  During the year ended December 31, 2012, holders of the February 2011 five-year warrants exercised warrants to purchase 51,250 shares of common stock for total proceeds of $162,000.

         
Fair Value of Warrants
(in thousands)
 
Issuance
Date
 
Number of
Warrant Shares
Issuable
  
Exercise
Price
 
Warrant
Expiration
Date
 
Value at
Issuance
Date
  
December 31,
2011
  
December 31,
2010
 
                 
5/13/2009  466,667  $17.25 5/13/2014 $3,360  $82  $782 
2/23/2010  916,669   12.75 2/23/2015  5,701   554   1,687 
2/22/2011  5,000,000   3.20 2/22/2016  8,087   6,360     
               $6,996  $2,469 

Changes in the estimated fair value of warrants classified as derivative liabilities are reported in the accompanying Consolidated Statement of Operations as the “Change in fair value of common stock warrants.”

Note 9 –Deerfield Loan

On February 13, 2013, we entered into a secured loan facility (Deerfield Loan) with affiliates of Deerfield Management Company, L.P. (Deerfield) for up to $30 million in secured financing in 2013.  As of December 31, 2013, long-term debt consists solely of amounts due under this facility as follows:

(in thousands)
Note Payable $30,000 
Unamortized discount  (11,646)
Long-term debt, net of discount $18,354 

Under the terms of the related agreement, Deerfield advanced funds to us in two separate disbursements.  Deerfield made the first disbursement, in the amount of $10 million, on February 13, 2013, upon execution of the related agreement (First Disbursement).  Deerfield made the second disbursement, in the amount of $20 million, on December 3, 2013 (Second Disbursement), following the first commercial sale of SURFAXIN.

DISCOVERY LABORATORIES, INC.  AND SUBSIDIARY
 
The loan may be prepaid in whole or in part without penalty at any time.  In addition, the principal amount of the loan may be reduced to the extent that holders of the notes elect to apply all or a portion of the principal amount outstanding under the loan to satisfy the exercise price of all or a portion of the Deerfield Warrants (discussed below) upon exercise.  The principal amount of the loan is payable in equal annual installments on the fourth, fifth and sixth anniversaries of the Deerfield Loan agreement, provided that the amount payable on the fourth anniversary shall be deferred for one year if either (i) our “Net Sales” (defined below) for the immediately preceding 12-month period are at least $20 million, or (ii) our “Equity Value” (defined below) is at least $200 million; and provided further, that the amount payable on the fifth anniversary (together with any amount deferred on the fourth anniversary) shall be deferred until the sixth anniversary if either (i) our “Net Sales” for the immediately preceding 12-month period are at least $30 million, or (ii) our “Equity Value” is at least $250 million.  For the purposes of the foregoing deferrals of principal, “Net Sales” means, without duplication, the gross amount invoiced by us or on our behalf, any of our subsidiaries or any direct or indirect assignee or licensee for products, sold globally in bona fide, arm’s length transactions, less customary deductions determined without duplication in accordance with generally accepted accounting principles; and “Equity Value” means, with respect to each measurement date, the product of (x) the number of issued and outstanding shares of our common stock on such measurement date multiplied by (y) the per share closing price of our common stock on such measurement date.  Accordingly, if the milestones are achieved in each year, payment of the principal amount could be deferred until the sixth anniversary date of the loan, on February 13, 2019.

The amount received and outstanding under the Deerfield Loan will accrue interest at an annual rate of 8.75%, payable quarterly in cash.  The Deerfield Loan agreement contains customary terms and conditions but does not require us to meet minimum financial and revenue performance covenants.  In connection with each advance, we paid Deerfield a transaction fee equal to 1.5% of the amount disbursed.  The Deerfield Loan agreement also contains various representations and warranties and affirmative and negative covenants customary for financings of this type, including restrictions on our ability to incur additional indebtedness and grant additional liens on our assets.  In addition, all amounts outstanding under the Deerfield Loan may become immediately due and payable upon (i) an “Event of Default,” as defined in the Deerfield Loan agreement, in which case Deerfield would have the right to require us to repay the outstanding principal amount of the loan, plus any accrued and unpaid interest thereon, or (ii) the occurrence of certain events as defined in the facility agreement, including, among other things, the consummation of a change of control transaction or the sale of more than 50% of our assets (a Major Transaction).

In connection with the execution of the Deerfield Loan and receipt of the First Disbursement, we issued to Deerfield warrants to purchase Note 9approximately 2.3 million shares of our common stock at an exercise price of $2.81 per share.  Upon receipt of the Second Disbursement, we issued to Deerfield warrants to purchase an additional 4.7 million shares of our common stock at an exercise price of $2.81 per share (together with the warrants issued in connection with the First Disbursement, the Deerfield Warrants).  The number of shares of common stock into which the Deerfield Warrants are exercisable and the exercise price of any Deerfield Warrant will be adjusted to reflect any stock splits, recapitalizations or similar adjustments in the number of outstanding shares of common stock.

The Deerfield Warrants will expire on the sixth anniversary of the facility agreement, February 13, 2019, and contain certain limitations that generally prevent the holder from acquiring shares upon exercise of the Deerfield Warrants or any part thereof that would result in the number of shares beneficially owned by such holder to exceed 9.985% of the total number of shares of our common stock then issued and outstanding.  A holder of the Deerfield Warrants may exercise all or a portion of such Deerfield Warrants either for cash or on a cashless basis.  In connection with a Major Transaction, as defined in the Deerfield Warrants, to the extent of consideration payable to stockholders in cash in connection with such Major Transaction, the holder may have the option to redeem the Deerfield Warrants or that portion of the Deerfield Warrant for cash in an amount equal to the Black-Scholes value (as defined in the Deerfield Warrants) of the Deerfield Warrants or that portion of the Deerfield Warrants redeemed.  In addition, in connection with a Major Transaction, to the extent of any consideration payable to stockholders in securities, or in the event of an Event of Default, the holder may have the option to exercise the Deerfield Warrants and receive therefor that number of shares of Common Stock that equals the Black-Scholes value of the Deerfield Warrants or that portion of the Deerfield Warrants exercised.  Prior to a holder exercising the Deerfield Warrants for shares in such transactions, the Company may elect to terminate the Deerfield Warrants or that portion of the Deerfield Warrants being exercised and pay the holder cash in an amount equal to the Black-Scholes value of the Deerfield Warrants.

We have recorded the loan as long-term debt at its face value of $30.0 million less debt discounts and issuance costs consisting of (i) $11.7 million fair value of the Deerfield Warrants issued upon the First Disbursement and the Second Disbursement (7 million warrants in total), and (ii) a $450,000 transaction fee.  The discount is being accreted to the $30 million loan over its term using the effective interest method.  The Deerfield Warrants are derivatives that qualify for an exemption from liability accounting as provided for in ASC Topic 815 “Derivatives and Hedging – DebtContracts in Entity’s Own Equity” (ASC 815) and have been classified as equity.

DISCOVERY LABORATORIES, INC.  AND SUBSIDIARY
The fair value of the Deerfield Warrants at issuance was calculated using the Black-Scholes option-pricing model.  The significant Level 3 unobservable inputs used in valuing the Deerfield Warrants are the historical volatility of our common stock market price, expected term of the warrants, and the risk-free interest rate based on the U.S. Treasury yield curve in effect at the measurement date.  Any significant increases or decreases in the unobservable inputs, with the exception of the risk-free interest rate, would have resulted in a significantly higher or lower fair value measurement.

Significant Unobservable Input
Assumptions of Level 3 Valuations
Historical volatility101%
Expected term (in years)5.2 – 6.0
Risk-free interest rate1.2% – 1.5%

The following amounts comprise the Deerfield Loan interest expense for the periods presented:

        (in thousands) December 31, 
 2013  2012  2011 
      
Cash interest expense $911  $–  $– 
Non-cash amortization of debt discounts  534   –   – 
Amortization of debt costs  18   –   – 
Total Deerfield Loan interest expenses $1,463  $–  $– 

Cash interest expense represents interest at an annual rate of 8.75% on the outstanding principal amount for the period, paid in cash on a quarterly basis.  Non-cash amortization of debt discount represents the amortization of transaction fees and the fair value of the warrants issued in connection with the Deerfield Loan.  The amortization of debt costs represents legal costs incurred in connection with the Deerfield Loan.

Note 10 – Equipment LoansLoan

Our equipment loan liabilities as of December 31, 2011 and 2010 are as follows:comprises the following:

(in thousands) 2011  2010 
       
Pennsylvania Machinery and Equipment Loan      
Short-term $66  $63 
Long-term  224   296 
Total  290   359 
         
Capitalized Leases        
Short-term  2   22 
Long-term  –   5 
Total  2   27 
         
GE Business Financial Services, Inc.        
Short-term  –   51 
Long-term  –   – 
Total  –   51 
         
Total Short-term  68   136 
Total Long-term  224   301 
Total $292  $437 
(in thousands) December 31, 
 2013  2012 
    
Short-term  73   69 
Long-term  69   148 
 
 $142  $217 

For the years ended December 31, 2011 and 2010,In September 2008, we incurred interest expense associated with our equipment loans of $20,000 and $56,000, respectively.

Pennsylvania Machinery and Equipment Loan Fund (MELF)

We entered into a Loan Agreement and Security Agreement with the Commonwealth of Pennsylvania, Department of Community and Economic Development (Department), effective September 8, 2008, pursuant to which the Department made a loan to us from the Machinery and Equipment Loan Fund in the amount of $500,000 (MELF Loan) to fund the purchase and installation of new machinery and equipment and the upgrade of existing machinery and equipment at our analytical and development laboratory in Warrington, Pennsylvania.  Principal and interest on the MELF Loan is payable in equal monthly installments over a period of seven years.  Interest on the principal amount accrues at a fixed rate of five percent (5.0%) per annum.  We may prepay the MELF Loan at any time without penalty.


DISCOVERY LABORATORIES, INC.  AND SUBSIDIARY

In addition to customary terms and conditions, the MELF Loan requires us to meet certain job retention and job creation goals in Pennsylvania within a three-year period (Jobs Covenant).  If we fail to comply with the Jobs Covenant, the Department, in its discretion, may change the interest rate on the Promissory Note to a fixed rate equal to two percentage points above the current prime rate for the remainder of the term.  As of September 30, 2011, the end of the three-year Jobs Covenant period, due to our efforts to conserve resources while we focused on securing approval for SURFAXIN,®, we had not complied with the Jobs Covenant.  In response to a request that we filed with the Department in November 2013 for a waiver, the Department granted us an extension through AugustDecember 31, 20122014 to come into compliance with the Jobs Covenant and has waived any interest adjustment until that date.

For the years ended December 31, 2013, 2012, and 2011, we incurred interest expense of $9,000, $13,000 and $20,000, respectively, on our outstanding equipment loan.

Equipment Financing Facility with GE Business Financial Services Inc.Note 11 – Stockholders’ Equity

In May 2007, we entered into a Credit and Security Agreement (Credit Agreement) with GE Business Financial Services Inc. (GE, formerly Merrill Lynch Business Financial Services Inc), as Lender, pursuant to which GE agreed to provide us a $12.5 million facility (Facility) to fund our capital programs.  The right to draw under this Facility expired and we have not received any new funding since November 2008.  As of December 31, 2011, all outstanding amounts under the Facility were paid in full and all related security interests satisfied and released.  Advances to finance the acquisition of property and equipment were amortized over a period of 36 months and all other equipment and related costs were amortized over a period of 24 months.  The advance to prepay our prior facility was amortized over a period of 27 months.  Interest on each advance accrued at a fixed rate per annum equal to one-month LIBOR plus 6.25%, determined on the funding date of such advance.Registered Public Offerings

Loan Payable – PharmaBio Development Inc.

On April 28, 2010,November 5, 2013, we restructured our $10.6 million loan with PharmaBio Development Inc (Pharma Bio), the former strategic investment subsidiarycompleted a registered public offering of Quintiles Transnational Corp.  The related Payment Agreement and Loan Amendment dated April 27, 2010 (PharmaBio Agreement) provided for payment in cash of (a) an aggregate of $6.6 million, representing $4.5 million in outstanding principal and $2.1 million in accrued interest, and (b) of the remaining $4 million principal amount under the loan, $2 million of which became due and were paid on each of July 30, 2010 and September 30, 2010.  All related security interests satisfied and released.  Also under the PharmaBio Agreement, PharmaBio surrendered to us for cancellation warrants to purchase an aggregate of 159,57425,000,000 shares of our common stock, thatat a price of $2.00 per share resulting in gross proceeds of $50.0 million ($46.8 million net proceeds).  We also granted the underwriters a 30-day option to purchase up to an additional 3,750,000 shares of common stock at an offering price of $2.00 per share.  On November 8, 2013, the underwriters exercised their option in full, resulting in additional gross proceeds of $7.5 million ($7.1 million net proceeds).

On May 10, 2013, we had issued previously to PharmaBio in connection with the PharmaBio loan andcompleted a previousregistered public offering of securities.
As of December 31, 2010, all9,500,000 shares of our obligations relatedcommon stock, at a price of $1.50 per share resulting in gross proceeds of $14.3 million ($13.2 million net proceeds).  We also granted the underwriters a 30-day option to purchase up to an additional 1,425,000 shares of common stock at an offering price of $1.50 per share.  On May 28, 2013, the loan with PharmaBio were paidunderwriters exercised their option to purchase 1,347,000 shares of common stock at a price of $1.50 per share, resulting in fulladditional gross proceeds of $2.0 million ($1.9 million net proceeds).

ForOn March 21, 2012, we completed a registered public offering of 16,071,429 shares of our common stock, at a price of $2.80 per share resulting in gross proceeds of $45.0 million ($42.1 million net proceeds).  We also granted the year ended December 31, 2010, we incurred interest expense associated with the PharmaBio loanunderwriters a 30-day option to purchase up to an additional 2,410,714 shares of $0.3 million.  Interest expense for the year ended December 31, 2010 included $0.2 million,common stock at an offering price of amortization of deferred financing costs for warrants issued to PharmaBio$2.80 per share, which expired unexercised in 2006 in consideration for restructuring the loan.April 2012.

Note 10 – Stockholders’ Equity

Registered Public Offerings and Private Placements
On February 22, 2011, we completed a registered public offering of 10 million10,000,000 shares of our common stock, 15-month15‑month warrants to purchase five million shares of our common stock, and five-year warrants to purchase five million shares of our common stock.  The securities were sold as units, with each unit consisting of one share of common stock, a 15-month warrant to purchase one half share of common stock, and a five-year warrant to purchase one half share of common stock, at a public offering price of $2.35 per unit, resulting in gross proceeds to us of $23.5 million ($21.6 million net).  The 15-month warrants expire in May 2012 and are exercisable at ahad an exercise price per share of $2.94.$2.94 and expired in May 2012.  The five-year warrants expire in February 2016 and were initially exercisable at a price per share of $3.20.  The exercise price of the five-year warrants is subject to adjustment if we issue or sell common stock or securities convertible into common stock (in each case, subject to certain exceptions) at a price (determined as set forth in the warrant) that is less than the exercise price of the warrant.  In connection with the closing of our public offering onofferings in March 21, 2012 and May 2013, the exercise price of the five-year warrants has beenwas adjusted downward to a price per share of $2.80.  See, Note 17 – Subsequent Events.$2.80 and $1.50, respectively.


DISCOVERY LABORATORIES, INC. AND SUBSIDIARY

On October 12, 2010, we entered into a Securities Purchase Agreement with PharmaBio, as the sole purchaser, pursuant to which PharmaBio agreed to purchase 158,730 shares of our common stock and warrants to purchase an aggregate of 79,365 shares of common stock, sold as units with each unit consisting of one share of common stock and one warrant to purchase one-half of a share of common stock, at an offering price of $3.15 per unit.  The offering resulted in gross proceeds to us of $0.5 million.  The warrants generally will expire in October 2015 and are immediately exercisable, subject to an aggregate beneficial ownership limitation, at an exercise price per share of $4.10 per share.  If exercised in full, the warrants would result in additional proceeds to us of approximately $0.325 million.  In addition, upon 20 days’ written notice to the holder of the warrant, we may redeem any or all of the warrants at any time within 20 days following the occurrence of a “trading threshold” (as defined below) at a per-warrant redemption price of $0.001.  A “trading threshold” will be deemed to have occurred on any date that the reported volume weighted average price (VWAP) for five of the immediately preceding seven consecutive trading days exceeds $6.75, provided that the minimum average daily trading volume of our common stock during the seven-day period is at least 33,333 shares (the price and volume criteria being adjusted to take into account any share dividend, share split or other similar transaction that may occur on or after the issuance).

On June 22, 2010, we completed a public offering of 2,380,952 shares of our common stock, five-year warrants to purchase 1,190,474 shares of our common stock, and nine-month warrants to purchase 1,190,474 shares of our common stock.  The securities were sold as units, with each unit consisting of one share of common stock, a five-year warrant to purchase one half share of common stock, and a nine-month warrant to purchase one half share of common stock, at a public offering price of $4.20 per unit, resulting in gross proceeds to us of $10 million ($9.1 million net).  The five-year warrants expire on June 22, 2015 and are immediately exercisable, subject to an aggregate beneficial ownership limitation, at a price per share of $6.00.  The nine-month warrants, which were immediately exercisable, subject to an aggregate beneficial ownership limitation, at a price per share of $4.20, expired on March 22, 2011.

On April 27, 2010, we entered into a Securities Purchase Agreement with PharmaBio, as the sole purchaser, pursuant to which PharmaBio agreed to purchase 270,154 shares of common stock and warrants to purchase an aggregate of 135,077 shares of common stock, sold as units with each unit consisting of one share of common stock and one warrant to purchase one-half share of common stock, at an offering price of $8.14 per unit.  The offering resulted in gross proceeds to us of $2.2 million ($2.1 million net).  The warrants generally expire in April 2015 and have been exercisable since October 28, 2010, subject to an aggregate beneficial ownership limitation of 9.9%, at a price per share of $10.59.

In February 2010, we completed a public offering of 1,833,333 shares of our common stock and warrants to purchase 916,669 shares of our common stock, sold as units, with each unit consisting of one share of common stock and a warrant to purchase one-half share of common stock, at a public offering price of $9.00 per unit, resulting in gross proceeds to us of $16.5 million ($15.1 million net).  The warrants expire in February 2015 and are immediately exercisable, subject to an aggregate share ownership limitation, at a price per share of $12.75.

The foregoing offerings were issued pursuant to our 2008 Universal Shelf.  See, this Note – Common Shares Reserved for Future Issuance – Universal Shelf Registration Statements – 2008 Universal Shelf.  With respect to the warrants issued in connection with the foregoing offerings, the exercise price and number of shares of common stock issuable upon exercise are subject to adjustment in the event of any stock split, reverse stock split, stock dividend, recapitalization, reorganization or similar transaction.  The exercise price and the amount and/or type of property to be issued upon exercise of the warrants are also subject to adjustment if we engage in a “Fundamental Transaction” (such as consolidation or merger, sale or disposal of substantially all of our assets, and among others as defined in the form of the warrant).  The warrants are exercisable for cash only, except that if the related registration statement or an exemption from registration is not otherwise available for the resale of the warrant shares, the holder may exercise on a cashless basis.


DISCOVERY LABORATORIES, INC.  AND SUBSIDIARY
At-the-Market Program (ATM Program)

Committed Equity Financing Facility (CEFF)

Since 2004, we have maintained one or more Committed Equity Financing Facilities (CEFFs) with Kingsbridge Capital Limited (Kingsbridge), a private investment group, under which Kingsbridge is committed to purchase, subject to certain conditions, newly-issued shares of our common stock.  The CEFFs have allowed us, at our discretion, to raise capital, at the time and in amounts deemed suitable to us, to support our business plans.  We are not obligated to utilize any of the funds available under any CEFF and our ability to access funds at any time is subject to certain conditions, including stock price and volume limitations.

As of December 31, 2011, we had one CEFF dated June 11, 2010 (2010 CEFF).  Two prior CEFF agreements, dated May 22, 2008 (May 2008 CEFF) and December 12, 2008 (December 2008 CEFF), expired in June 2011 and February 2011, respectively.

2010 CEFF

The 2010 CEFF related Stock Purchase Agreement originally provided for up to 2.1 million shares, up to a maximum of $35 million, and expires in June 2013.  As of December 31, 2011, there were 1.1 million shares remaining under 2010 CEFF, up to a maximum of $32.3 million.  The shares issuable under the 2010 CEFF are registered under the 2011 Universal Shelf.  See, this Note – Universal Shelf Registration Statements.

Each draw down extends for an eight-day trading period.  To initiate a draw down, the closing price of our common stock on the trading day immediately preceding the first trading day must be at least equal to $0.20 per share.  If on any trading day during the trading period, if the daily volume-weighted average price of our common stock (VWAP) is less than the Threshold Price (defined below), Kingsbridge has the right to purchase shares at the Threshold Price; otherwise no shares are purchased on that trading day and the aggregate amount that we originally designated for the overall draw down is reduced for each such day by 1/8th.  The Threshold Price is either (i) 90% of the closing market price of our common stock on the trading day immediately preceding the first trading day of the draw down period or (ii) a price that we specify at our sole discretion; but not less than $0.20 per share.  Unless Kingsbridge and we agree otherwise, a minimum of three trading days must elapse between the expiration of any draw-down period and the beginning of the next draw-down period.

With respect to each draw down, Kingsbridge is obligated to purchase (“Obligated Amount”) the amount determined under one of two methodologies that we choose at our discretion, subject to a maximum of the lesser of 3.5% of the closing market value of the outstanding shares of our common stock at the time of the draw down or $15 million.  The methodologies for determining the Obligated Amount are:
Methodology 1 – based on Threshold Price Obligated Amount 
Threshold Price is:   
Greater than $90.00 per share $7,250,000 
Greater than or equal to $75.00 but less than $90.00 per share $6,500,000 
Greater than or equal to $60.00 but less than $75.00 per share $4,250,000 
Greater than or equal to $45.00 but less than $60.00 per share $3,500,000 
Greater than or equal to $30.00 but less than $45.00 per share $2,750,000 
Greater than or equal to $18.75 but less than $30.00 per share $2,000,000 
Greater than or equal to $11.25 but less than $18.75 per share $1,350,000 
Greater than or equal to $7.50 but less than $11.25 per share $1,000,000 
Greater than or equal to $3.75 but less than $7.50 per share $500,000 
Greater than or equal to $3.00 but less than $3.75 per share $350,000 

Methodology 2
Under this method, the Obligated Amount is equal to: 8 (the trading days in the draw down period) multiplied by the adjusted average trading volume of our common stock (calculated as the average daily trading volume of the prior 40 trading days excluding the 5 trading days with the highest trading volume and the 5 trading days with the lowest trading volume) multiplied by the Threshold Price multiplied by 0.1985.


DISCOVERY LABORATORIES, INC. AND SUBSIDIARY

In addition, the 2010 CEFF provides that in connection with any draw down notice we may, in our sole discretion, include a request that Kingsbridge purchase an additional amount over the calculated Obligated Amount (a supplemental amount).  Kingsbridge may in its sole discretion choose to purchase all or a portion of any supplemental amount that we designate.  If we designate a supplemental amount, we may also designate a separate threshold price for that supplemental amount, provided that the supplemental amount, when aggregated with all other amounts drawn under the 2010 CEFF, may not exceed the total commitment amount available under the 2010 CEFF.  If Kingsbridge elects to purchase any of the supplemental amount, we will sell to Kingsbridge the corresponding number of shares at a price equal to the greater of (i) the daily VWAP of our common stock on the applicable trading day, or (ii) the supplemental amount threshold price designated by us, in either case less the applicable discount determined in the same manner as for the Obligated Amount.

The purchase price of shares sold to Kingsbridge under the 2010 CEFF is at a discount to the VWAP (as defined in the agreement) for each of the trading days in the draw down period as follows:

Daily VWAP % of VWAP  Applicable Discount 
Greater than $6.00 per share  95.62%  4.38%
Greater than or equal to $5.00 but less than $6.00 per share  95.25%  4.75%
Greater than or equal to $4.00 but less than $5.00 per share  94.75%  5.25%
Greater than or equal to $3.00 but less than $4.00 per share  94.25%  5.75%
Greater than or equal to $2.00 but less than $3.00 per share  94.00%  6.00%
Greater than or equal to $1.25 but less than $2.00 per share  92.50%  7.50%
Greater than or equal to $0.75 but less than $1.25 per share  91.50%  8.50%
Greater than or equal to $0.50 but less than $0.75 per share  90.50%  9.50%
Greater than or equal to $0.25 but less than $0.50 per share  85.00%  15.00%
Greater than or equal to $0.20 but less than $0.25 per share  82.50%  17.50%

Kingsbridge may terminate the 2010 CEFF under certain circumstances, including if a material adverse event relating to our business continues for 10 trading days after notice of the material adverse event.

In connection with the 2010 CEFF and prior CEFFs, we issued the following warrants to Kingsbridge, all of which are exercisable, in whole or in part, for cash, except in limited circumstances:

·On June 11, 2010, a warrant to purchase up to 83,333 shares of our common stock at an exercise price of $6.69 per share.  The warrant expires in December 2015 and is exercisable, in whole or in part, for cash, except in limited circumstances.
·On December 22, 2008, a warrant to purchase up to 45,000 shares of our common stock at an exercise price of $22.70 per share, expiring in May 2014.
·On May 22, 2008, a warrant to purchase up to 55,000 shares of our common stock at an exercise price of $37.59 per share, expiring in November 2013.
·On April 17, 2006, a warrant to purchase up to 32,667 shares of our common stock at an exercise price equal to $84.29 per share.  This warrant expired unexercised in October 2011.
·In 2004, a warrant to purchase up to 25,000 shares of our common stock at an exercise price equal to $181.12 per share.  This warrant expired unexercised in January 2010.

F-20
DISCOVERY LABORATORIES, INC. AND SUBSIDIARY
CEFF Financings

Financings that we completed under the 2010 CEFF are as follows:

(in thousands, except per share data)

Completion Date Shares Issued  Gross Proceeds  
Discounted
Average Price
Per Share
 
          
October 4, 2010  351  $973  $2.77 
November 4, 2010  166   432   2.60 
January 24, 2011  314   991   3.16 
October 10, 2011  35   69   1.97 
October 24, 2011  37   63   1.71 
November 8, 2011  129   218   1.69 
   1,032  $2,746     

There were no financings under the May 2008 CEFF or December 2008 CEFF during 2010 and 2011.

Stifel ATM Program

On December 14, 2011,February 11, 2013, we entered into aan At-the-Market Equity Sales Agency Agreement (Agency(ATM Agreement) with Lazard Capital Markets LLC (Lazard),Stifel, under which Lazard,Stifel, as our exclusive agent, may, at our discretion and at such times that we may determine from time to time, may sell over a two yearthree-year period up to a maximum of $15,000,000$25,000,000 of shares of our common stock (Shares) through an “at-the-market” program (ATM Program). We are not required to sell any Sharesshares at any time during the term of the ATM Program.Program.

If we issue a sale notice to Lazard,Stifel, we may designate the minimum price per share at which Sharesshares may be sold and the maximum number of Sharesshares that LazardStifel is directed to sell during any selling period.  As a result, prices are expected to vary as between purchasers and during the term of the offering.  LazardStifel may sell the Sharesshares by any method deemed to be an “at-the-market” equity offering as defined in Rule 415 promulgated under the Securities Act of 1933, as amended, which may include ordinary brokers’ transactions on The Nasdaq Capital Market®, or otherwise at market prices prevailing at the time of sale or prices related to such prevailing market prices, or as otherwise agreed by LazardStifel and us.  Either party may suspend salesthe offering under Agencythe ATM Agreement by notice to the other party.party.

The AgencyATM Agreement will terminate upon the earliest of: (1) the sale of all Sharesshares subject to Agencythe ATM Agreement, (2) December 14, 2013February 11, 2016 or (3) the earlier termination of Agencythe ATM Agreement in accordance with its terms.  Either party may terminate Agencythe ATM Agreement at any time upon written notification to the other party.  party in accordance with the ATM Agreement, and upon such termination, the offering will terminate.

We haveagreed to pay Stifel a commission equal to 3.0% of the gross sales price of any shares sold pursuant to the ATM Agreement. With the exception of expenses related to the shares, Stifel will be responsible for all of its own costs and expenses incurred in connection with the offering.

On October 15, 2013, we completed an offering under the ATM Program and issued 713,920 shares of our common stock for an aggregate purchase price of approximately $2.0 million, resulting in net proceeds to us of approximately $1.8 million, after deducting commissions.  As of December 31, 2013, approximately $23 million remained available under the ATM Program.

Lazard ATM Program

On December 14, 2011, we entered into a Sales Agency Agreement (Agency Agreement) with Lazard Capital Markets LLC (Lazard), under which Lazard, as our exclusive agent, at our discretion and at such times that we may determine from time to time, could sell over a two-year period up to a maximum of $15,000,000 of shares of our common stock through an “at-the-market” program (Lazard ATM Program).

We agreed to pay Lazard a commission equal to 3.0% of the gross proceeds of any sales of Shares.under the Lazard ATM Program.  We also agreed to reimburse Lazard for certain expenses incurred in connection with entering into the Agency Agreement and have provided Lazard with customary representations, and warranties and indemnification rights.  In connection with initiation of coverage of our stock by an analyst affiliated with Lazard, we agreed with Lazard to terminate the Lazard ATM Program effective August 6, 2012.

The Shares to be issued under the ATM Program have been registered pursuant to a prospectus supplement dated December 14, 2011 to our 2011 Universal Shelf.  See, Note 17 – Subsequent Events.

As of December 31, 2011, $15.0 million remained available under the ATM Program.

ATM Financings

On March 12, 2012, we completed an offering of 350,374 shares of our common stock for an aggregate purchase price of approximately $1.56$1.6 million, resulting in net proceeds to us of approximately $1.52$1.5 million, after deducting commissions duecommissions.

Committed Equity Financing Facility (CEFF)

From 2004 through June 2013, we maintained one or more Committed Equity Financing Facilities (CEFFs) with Kingsbridge Capital Limited (Kingsbridge), a private investment group, under which Kingsbridge was committed to Lazardpurchase, subject to certain conditions, newly-issued shares of our common stock.  The CEFFs allowed us, at our discretion, to raise capital, at the time and in amounts deemed suitable to us, to support our business plans.  We were not obligated to utilize any of the funds available under the Sales Agency Agreement.any CEFF and our ability to access funds at any time was subject to certain conditions, including stock price and volume limitations.

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DISCOVERY LABORATORIES, INC.  AND SUBSIDIARY
As of December 31, 2013, we did not have an active CEFF.  Three CEFF agreements, dated May 22, 2008, December 12, 2008, and June 11, 2010 (2010 CEFF) expired in June 2011, February 2011, and June 2013, respectively.  There were no financings under the May 2008 CEFF or December 2008 CEFF during 2013, 2012 and 2011.  The 2010 CEFF Agreement originally provided for the purchase of the lesser of up to 2.1 million shares or a maximum of $35 million, and expired in June 2013.  There were no financings completed under the 2010 CEFF in 2012 and 2013.  In 2011, we received $1.3 million of gross proceeds from the issuance of 514,990 shares at an average discounted price of $2.56 per share under the 2010 CEFF.

401(k) Plan Employer Match

We have a voluntary 401(k) savings plan (401(k) Plan) covering eligible employees that allows for periodic discretionary company matches equal to a percentage of each participant’s contributions (up to the maximum deduction allowed, excluding “catch up” amounts).  We currently provide for the company match in the form of newly-issuedby issuing shares of common stock whichthat are registered pursuant to a registration statement on Form S-8 filed with the U.S. Securities and Exchange Commission (SEC) on Form S-8..  For the years ended December 31, 20112013, 2012 and 2010,2011, the match resulted in the issuance of 265,185510,047, 316,543, and 61,158,265,185, shares of common stock, respectively.  Expenses associated with the 401(k) match for the years ended December 31, 2013, 2012, and 2011 were $1.0 million, $0.8 million and $0.5 million, respectively.

Common Shares Reserved for Future Issuance

Common shares reserved for potential future issuance upon exercise of warrants

The chart below summarizes shares of our common stock reserved for future issuance upon the exercise of warrants.
(in thousands, except  price per share data) December 31,  
Exercise
Price
 
Expiration
Date
  2011  2010   
           
Former Employee Warrant  30   -  $3.20 3/18/2016
Investor Warrants – February 2011 Financing  5,000   -  $3.20 2/22/2016
Investor Warrants – February 2011 Financing  5,000   -  $2.94 5/22/2012
PharmaBio – October  2010 Financing  79   79  $4.10 10/13/2015
Investor Warrants – June 2010 Financing  1,190   1,190  $4.20 6/22/2015
Investor Warrants – June 2010 Financing  -   1,190  $6.00 3/22/2011
Kingsbridge – 2010 CEFF  83   83  $6.69 12/11/2015
PharmaBio – April 2010 Financing  135   135  $10.59 4/30/2015
Investor Warrants – February 2010 Financing  917   917  $12.75 2/23/2015
Investor Warrants – May 2009 Financing  467   467  $17.25 5/13/2014
Kingsbridge – December 2008 CEFF  45   45  $22.70 6/12/2014
Kingsbridge – May 2008 CEFF  55   55  $37.59 11/22/2013
Private Placement – 2006  -   154  $47.70 11/22/2011
Class C Investor Warrants – 2006 CEFF  -   33  $84.29 10/17/2011
Total  13,001   4,348      
warrants:

(in thousands, except  price per share data) December 31,  Exercise Expiration
 
 2013  2012  Price Date
 
       
Deerfield – 2013 loan  7,000   –  $2.81 2/13/2019
Former employee  30   30  $3.20 3/18/2016
Investors – February 2011 financing  4,835   4,949  $1.50 2/22/2016
PharmaBio – October 2010 financing  79   79  $4.10 10/13/2015
Investors – June 2010 financing  1,190   1,190  $6.00 6/22/2015
Kingsbridge – June 2010 CEFF  83   83  $6.69 12/11/2015
PharmaBio – April 2010 financing  135   135  $10.59 4/30/2015
Investors – February 2010 financing  917   917  $12.75 2/23/2015
Investors – May 2009 financing  467   467  $17.25 5/13/2014
Kingsbridge – December 2008 CEFF  45   45  $22.70 6/12/2014
Kingsbridge – May 2008 CEFF  -   55  $37.59 11/22/2013
Total  14,781   7,950     

Common shares reserved for potential future issuance upon exercise of stock options or granting of additional equity incentive awards

In October 2011, our stockholders approved the adoption of the 2011 EquityLong-Term Incentive Plan (the 2011 Plan).  The 2011 Plan provides for the grant of long-term equity and cash incentive compensation awards and replacesreplaced the 2007 Long-Term Incentive Plan (the 2007 Plan).  The 2011 Plan continues many of the features of the 2007 Plan, but is updated to reflect changes to The Nasdaq Capital Market rules regarding equity compensation, other regulatory changes and market and corporate governance developments.  Awards outstanding under the 2007 and 1998 Planour previous, expired plan (1998 Plan) will continue to be governed by the terms of the respective plans and the agreements under which they were granted, although any shares returnable to the 2007 Plan as a result of cancellations, expirations and forfeitures will be returned to, and become available for issuance under, the 2011 Plan.  Shares returnable to the 1998 Plan as a result of cancellations, expirations and forfeitures will not become available for issuance under the 1998 Plan or the 2011 Plan.

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DISCOVERY LABORATORIES, INC.  AND SUBSIDIARY

Stock options and awards outstanding and available for future issuance as of December 31, 20112013 and 2010 are as follows:

(in thousands) As of December 31, 
  2011  2010 
       
2011 Plan(1)
      
Outstanding  1,709   – 
Available for Future Grants  2,106   – 
Total  3,815   – 
         
2007 Plan        
Outstanding  297   564 
Available for Future Grants  –   3 
Total  297   567 
         
1998 Plan        
Outstanding  432   533 
Available for Future Grants  –   – 
Total  432   533 
         
Total Outstanding  2,438   1,097 
Total Available for Future Grants  2,106   3 
Total  4,544   1,100 
(1) See, Note 11 – Stock Options and Stock-based Employee Compensation – Long-Term Incentive Plans.

Universal Shelf Registration Statements

2011 Universal Shelf

In June 2011, we filed a universal shelf registration statement on Form S-3 (No. 333-174786) (2011 Universal Shelf) with the SEC for the proposed offering from time to time of up to $200 million of our securities, including common stock, preferred stock, varying forms of debt and warrant securities, or any combination of the foregoing, on terms and conditions that will be determined at that time.  The 2011 Universal Shelf was declared effective by the SEC on June 21, 2011.  As of December 31, 2011, $199.7 million remained unissued under the 2011 Universal Shelf.

2008 Universal Shelf

In June 2008, we filed a universal shelf registration statement on Form S-3 (No. 333-151654) (2008 Universal Shelf) with the SEC for the proposed offering from time to time of up to $150 million of our securities, including common stock, preferred stock, varying forms of debt and warrant securities, or any combination of the foregoing, on terms and conditions that will be determined at that time.  Upon effectiveness of the 2011 Universal Shelf, the 2008 Universal Shelf expired.  See, in this note – Registered Public Offering and Private Placements, for offerings made pursuant to the 2008 Universal Shelf.

DISCOVERY LABORATORIES, INC. AND SUBSIDIARY

Common shares reserved for potential future issuance under CEFF arrangements

Common shares reserved for potential future financings under our CEFF arrangements2012 are as follows:

 As of December 31, 
 2013  2012 
    
Stock Options Outstanding    
2011 Plan(1)
  4,919   3,365 
2007 Plan  258   277 
1998 Plan  251   355 
Total Outstanding  5,428   3,997 
Available for Future Grants under 2011 Plan  2,894   2,966 
Total  8,322   6,963 

(in thousands) 
Potential future issuance
as of December 31,
 
 Expiration 2011  2010 
        
2010 CEFFJune 11, 2013  1,074   1,589 
May 2008 CEFFJune 18, 2011  -   851 
December 2008 CEFFFebruary 6, 2011  -   475 
(1)  See, Note 12 – Stock Options and Stock-based Employee Compensation – Long-Term Incentive Plans.

Common shares reserved for potential future issuance under our 401(k) Plan

As of December 31, 20112013 and 2010,2012, we had 342,833166,243 and 58,018 shares,26,290, respectively, reserved for potential future issuance under the 401(k) Plan.

Note 1112 – Stock Options and Stock-based Employee Compensation

Long-Term Incentive Plans

In October 2011, our stockholders approved the 2011 Plan, which replaced the 2007 Plan.  (See, Note 1011 – Common shares reserved for potential future issuance upon exercise of stock options or granting of additional equity incentive awards.  The purpose of the 2011 Plan is to (i) encourage eligible participants to acquire a proprietary interest in our company, (ii) provide employees incentives to contribute to our future success, thereby enhancing stockholder value, and (iii) attract and retain exceptionally qualified individuals upon whom, in large measure, our sustained progress, growth and profitability depend.)  The 2011 Plan continues many of the features of the 2007 Plan, but is updated to reflect changes to The Nasdaq Capital Market rules regarding equity compensation, other regulatory changes and market and corporate governance developments.   Awards outstanding under the 2007 Plan and 1998 Plan continue to be governed by the terms of that planthose plans and the applicable award agreements.

Under the 2011 Plan, we may grant awards for up to 3.77.8 million shares of our common stock.  Additionally, any shares returnable to the 2007 Plan as a result of cancellations, expirations, and forfeitures will become available for issuance under the 2011 Plan.  As of December 31, 2011,Awards under the 2011 Plan may include stock options, stock appreciation rights (SARs), restricted stock awards with respect to 1,709,000 shares are outstanding, 114,721 shares have been made available for issuance from the 2007 Plan(RSAs), restricted stock units, other performance and 2,105,721 shares are available for grant.  stock-based awards, and dividend equivalents.

An administrative committee (the Committee – currently the Compensation Committee of the Board of Directors) or Committee delegates may determine the types, the number of shares covered by, and the terms and conditions of, such awards.  Eligible participants may include any of our employees, directors, advisors or consultants.

AwardsAs of December 31, 2013, under the plans may include:

Stock Options and Stock Appreciation Rights (SARs)

The Committee may award nonqualified2011 Plan, there were 4,919,333 stock options incentiveoutstanding, 18,936 restricted stock options,units (“RSUs”) that vest in June 2014 and 2,894,374 shares available for grant.  No SARs, RSAs, other performance and stock-based awards, or SARs with a term of not more than ten years and a purchase price not less than 100% ofdividend equivalents have been granted under the fair market value on the date of grant.  The Committee will establish the vesting schedule for stock options and the method of payment for the exercise price, which may include cash, shares, or other awards.  2011 Plan.  Although individual grants may vary, option awards generally are exercisable upon vesting, vest based upon three years of continuous service, and have a 10-year term.  In addition, awards under the 2011 Plan must comply with the provisions of Section 162(m) of the Internal Revenue Code.

DISCOVERY LABORATORIES, INC.  AND SUBSIDIARY

Restricted Stock and Restricted Stock Units

The Committee may grant restricted stock awards (RSAs) and restricted stock units and, among other things, establish the applicable restrictions, including any limitation on voting rights or the receipt of dividends, and will establish the manner and timing under which restrictions may lapse.  If employment is terminated during the applicable restriction period (other than as a result of death or disability), shares of restricted stock and restricted stock units still subject to restriction will be forfeited, except as determined otherwise by the Committee.

Performance Awards and Other Stock-Based Awards

The Committee may grant performance awards, which may be denominated in cash, shares, other securities or other awards and payable to, or exercisable by, the participant upon the achievement of performance goals during performance periods, as established by the Committee.  The Committee may grant other stock-based awards that are denominated or payable in shares, under the terms and conditions as the Committee determines.

Dividend Equivalents

The Committee may grant dividend equivalent awards that entitle the participant receiving such award the right to receive payments equivalent to dividends or interest with respect to the number of shares and on the terms as determined by the Committee.  The Committee may provide that the amounts (if any) of such awards will be deemed to have been reinvested in additional shares or otherwise reinvested.

No SARs, Performance Awards or Dividend Equivalents have been granted under any 2011 Plan.  During 2010, there were 154,333 RSAs granted under the 2007 Plan.  The RSA’s granted to non-officer employees vested on the first anniversary of the grant date.  The RSA’s granted to officers provided for vesting on the earliest of (i) the second anniversary of the grant date; (ii) FDA marketing approval for SURFAXIN®; or (iii) the effective date of a strategic alliance or collaboration agreement as determined by the Board of Directors.  These RSAs vested on March 6, 2012 upon the issuance of FDA marketing approval for SURFAXIN.  As of December 31, 2011 and 2010, there were 128,334 and 154,333 unvested restricted stock awards outstanding, respectively.

A summary of stock option activity under our long-term incentive plans during the periods ended December 31, 2011 and 2010, respectively, is presented below:

(in thousands, except for weighted-average data)    
Stock Options Shares  
Weighted-
Average
Exercise
Price
 
Weighted-
Average
Remaining
Contractual
Term (In Yrs)
    
Outstanding at December 31, 2010  943  $56.06 
 
Granted  1,771   1.84 
 
Forfeited or expired  (276)  44.95 
 
Outstanding at December 31, 2011  2,438  $17.97 
 
Granted  1,724   2.63 
 
Exercised  (3)  1.83 
 
Forfeited or expired  (162)  24.39 
 
Outstanding at December 31, 2012  3,997  $11.11 
 
Granted  1,928   2.30 
 
Exercised  (18)  1.85 
 
Forfeited or expired  (479)  28.09 
 
Outstanding at December 31, 2013  5,428  $6.51 8.0
 
        
    
Exercisable at December 31, 2013  2,346  $12.01 6.9
(in thousands, except for weighted-average data)
Stock Options 
Price Per Share
(range)
  Shares  
Weighted-
Average
Exercise
Price
 
Weighted-
Average
Remaining
Contractual
Term (In Yrs)
           
           
Outstanding at December 31, 2009 $7.35– $156.45   1,065  $56.46  
              
Granted $2.55 – $5.85   20   3.19  
Exercised  –   –   –  
Forfeited or expired $5.40 – $137.55   (142)  51.93  
Outstanding at December 31, 2010 $2.55 – $156.45   943  $56.06  
              
Granted $1.58 – $3.41   1,771  $1.84  
Exercised  –   –   –  
Forfeited or expired $1.83 – $137.55   (276) $44.95  
Outstanding at December 31, 2011 $1.58 – $156.45   2,438  $17.97 8.1
              
Exercisable at December 31, 2011 $2.55 – $156.45   667  $60.73 4.2
(in thousands, except for weighted-average data)      
Restricted Stock Units Shares  
Weighted-
Average
Exercise
Price
  
Weighted-
Average
Remaining
Contractual
Term (In Yrs)
 
      
Outstanding at December 31, 2012  –  $–  
 
Awarded  19   –  
 
Outstanding at December 31, 2013  19  $–   0.4 
 
            
Exercisable at December 31, 2013  –  $–   0.0 
 
Based upon application of the Black-Scholes option-pricing formula described below, the weighted-average grant-date fair value of options and awards granted during the years ended December 31, 2013, 2012, and 2011 was $1.79, $2.02, and 2010$1.45, respectively.  The weighted-average grant-date fair value of RSUs granted during the year ended December 31, 2013 was $1.45$1.69.  There were no RSUs granted during the years ended December 31, 2012 and $2.48, respectively.2011.  For the year ended December 31, 2013, there were 18,208 options exercised, resulting in approximately $34,000 in proceeds.  For the year ended December 31, 2012, there were 3,334 options exercised, resulting in approximately $6,000 in proceeds.  There were no options exercised during the yearsyear ended December 31, 2011 and 2010, respectively.2011.  The total intrinsic value of options outstanding, vested, and exercisable as of December 31, 20112013 is $1,155, $0$0.8 million, $0.5 million, and $0,$0.5 million, respectively.
DISCOVERY LABORATORIES, INC.  AND SUBSIDIARY
A summary of nonvested shares issuable upon exercise of outstanding options and changes during 2011 is presented below:
(shares in thousands) 
Option
Shares
  
Weighted-
Average Grant-
Date Fair Value
 
       
Non-vested at December 31, 2010  64  $10.05 
Granted  1,771   1.84 
Vested  (59)  10.86 
Forfeited  (5)  7.43 
Non-vested at December 31, 2011  1,771  $1.85 
The following table provides detail with regard to options outstanding, vested and exercisable at December 31, 2011:2013:

(shares in thousands)(shares in thousands)     Outstanding   Vested and Exercisable(shares in thousands)  Outstanding Vested and Exercisable
Price per sharePrice per share  Shares  
Weighted-
Average
Price
per Share
 
Weighted-
Average
Remaining
Contractual
Life
 Shares  
Weighted-
Average
Price
per Share
 
Weighted-
Average
Remaining
Contractual
Life
Price per share  Shares  
Weighted-
Average Price
per Share
 
Weighted-
Average
Remaining
 Contractual Life
 Shares  
Weighted-
Average Price
per Share
 
Weighted-
Average
Remaining
Contractual Life
$1.58 - $3.60   1,783  $1.85 9.58 Years  13  $3.08 8.84 Years1.58 - $156.45   5,428  $6.51 8.0 Years  2,346  $12.01 6.9 Years
$3.61 – $10.95   12  $9.69 6.66 Years  12  $9.73 7.85 Years
$10.96 – $156.45   643  $62.78 4.05 Years  642  $62.87 4.21 Years
    2,438        667      

Stock-Based Compensation

We recognized stock-based compensation expense in accordance ASC Topic 718 for the years ended December 31, 2013, 2012, and 2011, of $2.2 million, $2.4 million and 2010, of $0.9 million, and $1.4 million, respectively.

Stock-based compensation expense was classified as follows:

 December 31, 
(in thousands) 2013  2012  2011 
      
Research and development $784  $487  $289 
Selling, general and administrative  1,426   1,924   578 
Total $2,210  $2,411  $867 
  December 31, 
(in thousands) 2011  2010 
       
Research and development $289  $479 
General and administrative  578   931 
Total $867  $1,410 
On December 31, 2012, our former Chief Executive Officer resigned from his position and as a member of our Board.  Under the terms of a separation agreement that we entered into with the former CEO, all of the former CEO’s outstanding options vested immediately and all such options shall remain exercisable to the end of their stated terms.  We recognized $0.8 million in stock option modification costs related to these items.

The fair value of each option award is estimated on the date of grant using the Black-Scholes option-pricing formula that uses assumptions noted in the following table.  Expected volatilities are based upon the historical volatility of our common stock and other factors.  We also use historical data and other factors to estimate option exercises, employee terminations and forfeiture rates within the valuation model.  The risk-free interest rates are based upon the U.S. Treasury yield curve in effect at the time of the grant.
DISCOVERY LABORATORIES, INC. AND SUBSIDIARY

 December 31, December 31, 
 2011 2010 2013  2012  2011 
          
Weighted average expected volatility 113% 112%  109%  111%  113%
Weighted average expected term 4.8 years 4.9 years 4.7 years  4.6 years  4.8 years 
Weighted average risk-free interest rate 1.08% 1.47%  0.73%  0.74%  1.08%
Expected dividends – –  –   –   – 

The total fair value of the underlying shares of the options vested during 2013, 2012, and 2011, and 2010, equals $0.6$1.9 million, $2.2 million and $1.5$0.6 million, respectively.  As of December 31, 2011,2013, there was $2.5$4.0 million of total unrecognized compensation cost related to non-vested share-based compensation arrangements granted under the 2011 Plan.  That cost is expected to be recognized over a weighted-average vesting period of 2.71.7 years.

DISCOVERY LABORATORIES, INC.  AND SUBSIDIARY
Note 1213 –  Corporate Partnership, Licensing and Research Funding Agreements

Laboratorios del Dr. Esteve, S.A.

We have a strategic alliance with Laboratorios del Dr. Esteve, S.A. (Esteve) for the development, marketing and sales of a broad portfolio of potential KL4 surfactant products in Andorra, Greece, Italy, Portugal, and Spain.  Antonio Esteve, Ph.D., a principal of Esteve, served as a member of our Board of Directors from May 2002 until January 2013.  Esteve will pay us a transfer price on sales of our KL4 surfactant products.  We will be responsible for the manufacture and supply of all of the covered products and Esteve will be responsible for all sales and marketing in the territory.  Esteve is obligated to make stipulated cash payments to us upon our achievement of certain milestones, primarily upon receipt of marketing regulatory approvals for the covered products.  In addition, Esteve has agreed to contribute to Phasephase 3 clinical trials for the covered products by conducting and funding development performed in the territory.  As part of a 2004 restructuring of this alliance in December 2004,which Esteve returned certain rights to us in consideration of Esteve returning commercialization rights in portions of the territory originally licensed to Esteve, including key European markets and Latin Americacertain territories (Former Esteve Territories), we agreed to pay to Esteve 10% of any cash up front and milestone fees (up to a maximum aggregate of $20 million in the aggregate)million) that we may receive in connection with any strategic collaborations for the development and/or commercialization of certain of our KL4 surfactant products in the Former Esteve Territories.

Licensing and Research Funding Agreements

Philip Morris USA Inc. and Philip Morris Products S.A.

Under license agreements with Philip Morris USA Inc. (PMUSA) and Philip Morris Products S.A. (PMPSA), we hold exclusive worldwide licenses to our capillary aerosolizationthe CAG technology for use with pulmonary surfactants (alone or in combination with any other pharmaceutical compound(s)) for all respiratory diseases and conditions (the foregoing uses in each territory, the Exclusive Field), and an exclusive license in the United StatesU.S. for use with other (non-surfactant)certain non-surfactant drugs to treat a wide range of pediatric and adult respiratory indications in hospitals and other health care institutions.  We generally are obligated to pay royalties at a rate equal to a low single-digit percent of sales of products sold in the Exclusive Field (as defined in the license agreements) in the territories, including sales of aerosol devices and related components that are not based on the capillary aerosolization technology (unless we exercise our right to terminate the license with respect to a specific indication).  We also agreed in the future to pay minimum royalties quarterly beginning in 2014, but are entitled to a reduction of future royalties in an amount equal to the excess of any minimum royalty paid over royalties actually earned in prior periods.

Johnson & Johnson and Ortho Pharmaceutical Corporation

We, Johnson & Johnson (J&J) and its wholly-owned subsidiary, Ortho Pharmaceutical Corporation, are parties to a license agreement granting to us an exclusive worldwide license to the J&J proprietary KL4 surfactant technology, including SURFAXIN®.technology.  Under the license agreement, we are obligated to pay fees of up to $2.5 million in the aggregate upon our achievement of certain milestones, primarily upon receipt of marketing regulatory approvals for certain designated products.  In addition, weWe have paid $450,000$950,000 to date for milestones that have been achieved.achieved including a $500,000 milestone payment in 2012 that became due as a result of the FDA’s approval of SURFAXIN. In addition, we are required to make royalty payments at different rates, depending upon type of revenue and country, in amounts in the range of a high single-digit percent of net sales (as defined in the license agreement) of licensed products sold by us or sublicensees, or, if greater, a percentage of royalty income from sublicensees in the low double digits.

DISCOVERY LABORATORIES, INC.  AND SUBSIDIARY

Note 1314 – Commitments

Future payments due under contractual obligations at December 31, 20112013 are as follows:

(in thousands) 2014  2015  2016  2017  2018  
There-
after
  Total 
Operating lease obligations  1,087   1,024   934   936   158   –   4,139 
Equipment loan obligations (1)
  79   69   –   –   –   –   148 
Total
 $1,166  $1,093  $934  $936  $158  $–  $4,287 
(1)
See, Note 10 – Equipment Loan

(in thousands) 2012  2013  2014  2015  2016  
There-
after
  Total 
Equipment loan obligations (1)
 $80  $85  $85  $71  $–   –  $321 
Operating lease obligations  1,166   320   150   –   –   –   1,636 
Former Exec. VP Severance Commitment  435   –   –   –   –   –   435 
Total $1,681  $405  $235  $71  $–  $–  $2,392 
(1)  See, Note 9 – Debt.
Operating Leases

Our operating leases consist primarily of facility leases for our operations in Pennsylvania and New Jersey.

We maintain our headquarters in Warrington, Pennsylvania.  The facility is 39,594 square feet and serves as the main operating facility for clinicaldrug and device development, regulatory, analytical technical services, research and development, and administration.  In April 2007,January 2013, the lease which originally expired in February 2010 with total aggregate payments of $4.6 million, was extendedamended to extend the term an additional threefive years through February 2013 with additional2018.  The total aggregate base rental payments of $3.0 million overunder the lease prior to the extension period.were approximately $7.2 million and the total aggregate base rental payments under the extended portion of the lease are approximately $4.9 million.

We lease approximately 21,000 square feet of space for our manufacturing operations in Totowa, New Jersey, at an annual rent of $150,000.  This space is specifically designed for the manufacture and filling of sterile pharmaceuticals in compliance with cGMP and is our only manufacturing facility.  ThisWe have secured an extension of the lease, expireswhich was scheduled to expire in December 2014, subjectuntil to June 30, 2015 for aggregate base rental payments of $306,250 under the landlord’s right, in certain circumstances and upon two years’ prior notice, to terminate the lease early.  In addition, depending upon the timing of the notice, if we satisfy certain financial conditions at the time, the landlord would be obligated to make early termination payments to us.  The total aggregate payments over the term of the lease are $1.4 million.  In connection with our manufacturing operations in Totowa, New Jersey, we have 14 employees subject to a collective bargaining arrangement that expires on December 3, 2012.  extension period.  For a discussion of our manufacturing strategy, see,See, “Item 1 – Business – Business Operations – Manufacturing and Distribution,” in our Annual Report on Form 10-K.

Rent expense under all of these leases was $1.0 million for each of the years ended December 31, 20112013, 2012, and 2010 was $1.0 million and $1.0 million,2011, respectively.

Severance ArrangementRetention Plan

On July 12, 2011,September 13, 2013, our Board of Directors approved an employee severance and retention plan for employees at the Totowa Facility to take effect in the event that we entered into a Separationare unable to secure long-term utilization of Employment Agreementthe Totowa Facility beyond the scheduled lease expiration on June 30, 2015.  The retention plan is intended to minimize employee turnover by providing severance and General Release Agreement (“Separation Agreement”) with our former, Executive Vice President, General Counsel and Corporate Secretary (Former Executive).  Pursuantretention bonuses that encourage employees to the Separation Agreement, the Former Executive resigned his positionsstay with us effective July 31, 2011,through facility closing date (and beyond for certain employees).  The plan has two components: (1) plant management (three individuals) has received an award of stock options that will vest in full, and was entitled to (i) payment of accrued vacation pay, (ii) the right to continue to holdwill be eligible for a restricted stock award for 15,000 shares (RSA) without any continuing Service (as definedretention bonus payable in the RSA) requirement, (iii) extended health benefits for up to 18 months, and, (iv) depending on the circumstances, certain outplacement services.  In addition, we agreed to pay the Former Executive on February 1, 2012 severance in the amount of $400,000, which amount was reduced by any outstanding amount due under a promissory noteJune 2016, provided that the Former Executive had issued tothey remain employed with us in 2001.  AsJune 2016; and (2) provided that they remain employed with us through the successful closure of the Totowa Facility, non-union employees (nine individuals) will be eligible to receive both severance and a retention bonus payable upon such closure.  The total cash amount expected to be paid for severance and retention through June 2016 is approximately $1.0 million.  The plan-related expense incurred during 2013 is $0.1 million and is included in research and development expense.  The related liability is $0.1 million as of December 31, 2011,2013.

In addition, there are 14 employees at the outstanding aggregate principal amountTotowa Facility who are subject to a collective bargaining agreement and will be eligible to receive severance upon closure of the Note was $169,958.Totowa Facility.  The Separation Agreement also contains a general releaseplan-related expense incurred during 2013 is $30,000 and is included in research and development expense.  The related liability is $0.5 million as of claims by the parties and a 12-month non-competition covenant by the Former Executive.December 31, 2013.

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DISCOVERY LABORATORIES, INC.  AND SUBSIDIARY

Note 1415 – Litigation

We are not aware of any pending or threatened legal actions that would, if determined adversely to us, have a material adverse effect on our business and operations.

We have from time to time been involved in disputes and proceedings arising in the ordinary course of business, including in connection with the conduct of our clinical trials.  In addition, as a public company, we are also potentially susceptible to litigation, such as claims asserting violations of securities laws.  Any such claims, with or without merit, if not resolved, could be time-consuming and result in costly litigation.  There can be no assurance that an adverse result in any future proceeding would not have a potentially material adverse effect on our business, results of operations and financial condition.

Note 1516 –  Income Taxes

Since our inception, we have never recorded a provision or benefit for Federal and state income taxes.

The reconciliation of the income tax benefit computed at the Federal statutory rates to our recorded tax benefit for the years ended December 31, 20112013, 2012, and 20102011 is as follows:

(in thousands) December 31, 
  2011  2010 
Income tax benefit, statutory rates $7,128  $6,519 
State taxes on income, net of Federal benefit  1,633   1,206 
Research and development tax credit  662   656 
Employee Related  (1,758)  (4,746)
Warrant Valuation Related  1,210   2,184 
Other  –   18 
Income tax benefit  8,875   5,837 
Valuation allowance  (8,875)  (5,837)
Income tax benefit $–  $– 
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DISCOVERY LABORATORIES, INC. AND SUBSIDIARY
(in thousands) December 31, 
 
 2013  2012  2011 
Income tax benefit, statutory rates $15,373  $12,687  $7,128 
State taxes on income, net of Federal benefit  2,922   2,288   1,633 
Research and development tax credit  517   332   662 
Employee related  (766)  (988)  (1,758)
Warrant valuation related  259   189   1,210 
Income tax benefit  18,305   14,508   8,875 
Valuation allowance  (18,305)  (14,508)  (8,875)
Income tax benefit $–  $–  $– 

The tax effects of temporary differences that give rise to deferred tax assets and deferred tax liabilities, at December 31, 20112013 and 2010,2012, are as follows:

(in thousands) December 31, 
 
 2013  2012 
Long-term deferred tax assets: 
  
 
Net operating loss carryforwards (Federal and state) $175,258  $160,522 
Research and development tax credits  10,604   9,412 
Compensation expense on stock  3,276   3,154 
Charitable contribution carryforward  7   7 
Inventory reserve  198   – 
Deferred revenue  53   – 
Other accrued  1,024   524 
Depreciation  2,714   2,665 
Capitalized research and development  1,326   1,516 
Total long-term deferred tax assets  194,460   177,800 
Less:  valuation allowance  (194,460)  (177,800)
Deferred tax assets, net of valuation allowance $–  $– 

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DISCOVERY LABORATORIES, INC.  AND SUBSIDIARY
 
(in thousands) December 31, 
  2011  2010 
Long-term deferred tax assets:      
Net operating loss carryforwards(Federal and state)
 $147,045  $132,994 
Research and development tax credits  9,080   8,447 
Compensation expense on stock  3,535   5,126 
Charitable contribution carryforward  7   7 
Other accrued  608   607 
Depreciation  2,682   2,493 
Capitalized research and development  1,740   1,932 
Total long-term deferred tax assets  164,697   151,606 
         
Long-term deferred tax liabilities  –   – 
Net deferred tax assets  164,697   151,606 
Less:  valuation allowance  (164,697)  (151,606)
Deferred tax assets, net of valuation allowance $–  $– 
We are in a net deferred tax asset position at December 31, 20112013 and 20102012 before the consideration of a valuation allowance.  Because we have never realized a profit, management has fully reserved the net deferred tax asset since realization is not assured.  It is our policy to classify interest and penalties recognized on uncertain tax positions as a component of income tax expense. There was neither interest nor penalties accrued as of December 31, 2013 or 2012, nor were any incurred in 2013, 2012, or 2011.

At December 31, 20112013 and 2010,2012, we had available carryforward net operating losses for Federal tax purposes of $363.3$432.1 million and $329.7$396.7 million, respectively, and a research and development tax credit carryforward of $9.1$10.6 million and $8.4$9.4 million, respectively.  The Federal net operating loss and research and development tax credit carryforwards began to expire in 2008 and will continue through 2031.  Approximately $3.1 million of the $363.3 million net operating loss carryforwards expire prior to 2013.2033.

At December 31, 2011,2013, we had available carryforward Federal and State net operating losses of $5.2 million and $0.4 million, respectively, related to stock-based compensation, the tax effect of which will result in a credit to equity as opposed to income tax expense, to the extent these losses are utilized in the future.

At December 31, 20112013 and 2010,2012, we had available carryforward losses of approximately $360.1$433.7 million and $319.9$392.6 million, respectively, for state tax purposes.  Of the $360.1$433.7 million state tax carryforward losses, $325.6$399.5 million is associated with the state of Pennsylvania, with the remainder associated with New Jersey and California.the other 10 states within which we have established tax nexus.

Utilization of net operating loss (NOL) and research and development (R&D) credit carryforwards may be subject to a substantial annual limitation under Section 382 of the Internal Revenue Code of 1986 due to ownership change limitations that have occurred previously or that could occur in the future.  These ownership changes may limit the amount of NOL and R&D credit carryforwards that can be utilized annually to offset future taxable income and tax, respectively.  There also could be additional ownership changes in the future, which may result in additional limitations in the utilization of the carryforward NOLs and credits.

A full valuation allowance has been provided against our research and development credits and, if a future assessment requires an adjustment, an adjustment would be offset by an adjustment to the valuation allowance.  Thus, there would be no impact to the consolidated balance sheet or statement of operations if an adjustment were required.
DISCOVERY LABORATORIES, INC.  AND SUBSIDIARY

Note 1617 –   Selected Quarterly Financial Data (Unaudited)

The following table contains unaudited statement of operations information for each quarter of 20112013 and 2010.2012.  The operating results for any quarter are not necessarily indicative of results for any future period.

2011 Quarters Ended:   
2013 Quarters Ended:    
(in thousands, except per share data) Mar. 31  June 30  Sept. 30  Dec. 31  Total Year  Mar. 31  June 30  Sept. 30  Dec. 31  Total Year 
Grant Revenues $381  $201  $–  $–  $582 
Grant revenues $72  $182  $60  $74  $388 
Expenses:                                        
Cost of sales  –   –   –   517   517 
Research and development  4,620   4,615   3,981   4,014   17,230   8,472   6,863   6,574   5,752   27,661 
General and administrative  1,820   1,966   2,189   1,889   7,864 
Selling, General and administrative  4,220   4,129   4,299   4,070   16,718 
Total expenses  6,440   6,581   6,170   5,903   25,094   12,692   10,992   10,873   10,339   44,896 
Operating loss  (6,059)  (6,380)  (6,170)  (5,903)  (24,512)  (12,620)  (10,810)  (10,813)  (10,265)  (44,508)
Change in fair value of common stock warrant liability  2,228   (1,693)  1,422   1,603   3,560   162   2,525   (1,059)  (867)  761 
Other expense, net  (6)  (3)  (3)  (1)  (13)  (177)  (342)  (352)  (597)  (1,468)
Net loss $(3,837) $(8,076) $(4,751) $(4,301) $(20,965) $(12,635) $(8,627) $(12,224) $(11,729) $(45,215)
Net loss per common share - basic and diluted $(0.21) $(0.34) $(0.20) $(0.18) $(0.93)
Weighted average number of common shares outstanding  18,114   24,027   24,106   24,309   22,660 
Net loss per common share - basic $(0.29) $(0.18) $(0.22) $(0.16) $(0.82)
Net loss per common share - diluted  (0.29)  (0.22)  (0.22)  (0.16)  (0.82)
Weighted average number of common shares outstanding - basic  43,657   49,135   54,792   73,129   55,258 
Weighted average number of common shares outstanding - diluted  43,657   49,866   54,792   73,129   55,258 
 
2010 Quarters Ended:   
(in thousands, except per share data) Mar. 31  June 30  Sept. 30  Dec. 31  Total Year 
Grant Revenues $–  $–  $–  $–  $– 
Expenses:                    
Research and development  4,133   4,363   4,727   3,913   17,136 
General and administrative  2,932   1,865   1,476   2,119   8,392 
Total expenses  7,065   6,228   6,203   6,032   25,528 
Operating loss  (7,065)  (6,228)  (6,203)  (6,032)  (25,528)
Change in fair value of common stock warrant liability  1,230   5,519   (365)  38   6,422 
Other expense, net  (223)  (84)  (16)  254   (69)
Net loss $(6,058) $(793) $(6,584) $(5,740) $(19,175)
Net loss per common share -  basic and diluted $($0.66) $(0.07) $(0.51) $(0.42) $(1.65)
Weighted average number of common shares outstanding  9,180   10,695   12,945   13,525   11,602 

Note 17 – Subsequent Events

We evaluated all events or transactions that occurred after December 31, 2011 up through the date we issued these financial statements.  During this period we did not have any material recognized subsequent events, however, there were four nonrecognized subsequent events described below:
2012 Quarters Ended: 
 
(in thousands, except per share data) Mar. 31  June 30  Sept. 30  Dec. 31  Total Year 
Grant Revenues $–  $–  $–  $195  $195 
Expenses:                    
Research and development  4,533   5,206   5,743   6,088   21,570 
General and administrative  2,047   3,610   4,255   6,532   16,444 
Total expenses  6,580   8,816   9,998   12,620   38,014 
Operating loss  (6,580)  (8,816)  (9,998)  (12,425)  (37,819)
Change in fair value of common stock warrant liability  (3,434)  1,680   (3,309)  5,618   555 
Other expense, net  (2)  (2)  (39)  (8)  (51)
Net loss $(10,016) $(7,138) $(13,346) $(6,815) $( 37,315)
Net loss per common share -  basic and diluted $(0.37) $(0.16) $(0.31) $(0.16) $(0.95)
Weighted average number of common shares outstanding  27,162   43,369   43,444   43,521   39,396 
 
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DISCOVERY LABORATORIES, INC. AND SUBSIDIARY
From January 1, 2012 through March 21, 2012, (i) holders of 15-month warrants we issued in February 2011 have exercised warrants to purchase 2,233,000 shares of our common stock at an exercise price of $2.94 per share, resulting in proceeds to us of $6.6 million; and (ii) holders of the five-year warrants we issued in February 2011 have exercised warrants to purchase 46,250 shares of our common stock at an exercise price of $3.20 per share, resulting in proceeds to us of $148,000.

On March 12, 2012, we completed an offering under out ATM Program of 350,374 shares of our common stock for an aggregate purchase price of approximately $1.56 million, resulting in net proceeds to us of approximately $1.52 million, after deducting commissions due to Lazard under the Sales Agency Agreement.

On March 21, 2012, we completed a registered public offering of 16,071,429 shares of our common stock, at a price of $2.80 per share resulting in gross proceeds of $45.0 million ($42.1 million net).  In addition, we granted the underwriters a 30-day option to purchase up to an additional 2,410,714 shares of common stock at a public offering price of $2.80 per share, with respect to which we potentially could realize additional net proceeds to us of $6.3 million.
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