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

FORM 10-Q

x
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the quarterly period ended September 30, 20062007
 
or
 
o
TRANSITION 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)
__________________

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

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act.
 
Large accelerated filer o
Accelerated filer x
Non -acceleratedNon-accelerated filer 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

As of November 6, 2006, 64,273,6812007, 86,590,393 shares of the registrant’s common stock, par value $0.001 per share, were outstanding.
 
 
Table of Contents


PART I - FINANCIAL INFORMATION
Page


Page
PART I - FINANCIAL INFORMATION
Item 1.Financial Statements1
 
 CONSOLIDATED BALANCE SHEETS -
 
  As of September 30, 20062007 (unaudited) and December 31, 200520061
    
 CONSOLIDATED STATEMENTS OF OPERATIONS (unaudited) -
 
  For the Three Months Ended September 30, 20062007 and 20052006 
  For the Nine Months Ended September 30, 20062007 and 200520062
    
 CONSOLIDATED STATEMENTS OF CASH FLOWS (unaudited) -
 
  For the Nine Months Ended September 30, 20062007 and 200520063
    
 Notes to Consolidated Financial Statements4
   
Item 2.Management’s Discussion and Analysis of Financial Condition and Results of Operations12
 9
Item 3.Quantitative and Qualitative Disclosures about Market Risk2825
Item 4.Controls and Procedures26
  
Item 4. Controls and Procedures28
PART II - OTHER INFORMATION
Item 1. Legal Proceedings29
  
PART II - OTHER INFORMATION
Item 1.Legal Proceedings26
Item 1A.Risk Factors30
 27
Item 2.Unregistered Sales of Equity Securities and Use of Proceeds36
 27
Item 3.Defaults Upon Senior Securities36
 27
Item 4.Submission of Matters to a Vote of Security Holders36
 27
Item 5.Other Information36
 27
Item 6. Exhibits37
 
Exhibits
27
Signatures3828

iii


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 Quarterly Report on Form 10-Q 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 1934.1934 (Exchange Act). 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 the terms “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. The forward-lookingForward-looking statements include all matters that are not historical facts and include, without limitation:limitation, statements concerningconcerning: our business strategy, outlook, objectives, future milestones, plans, intentions, goals, future financial conditions, our research and development programs and planning for and timing of any clinical trials; the possibility, timing and outcome of submitting regulatory filings for our products under development; remediation of manufacturing issues related to the April 2006 process validation stability failures and plans with respect to seekthe release and stability testing of recently manufactured new process validation batches of Surfaxin®; plans regarding strategic alliances and collaboration arrangements and strategic alliances with pharmaceutical companies orand others to develop, manufacture and market our drug products; the research and development of particular compoundsdrug products, technologies and technologies;aerosolization drug devices; the development of financial, clinical, manufacturing and marketing plans related to the potential approval and commercialization of our drug products, and the period of time for which our existing resources will enable us to fund our operations; and anticipated cost savings and accounting charges arising out of our recent workforce reductions and corporate restructuring.operations.

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 whichthat could cause our actual results to differ materially from any future results expressed or implied by the forward-looking statements. Examples of the risks and uncertainties include, but are not limited to:

·the risk that financial conditionswe may change;not successfully and profitably develop and market our products;
·risks relating to our research and development activities, which are time-consuming, costly and involve pre-clinical studies, clinical trials and other studies, and the risk that such trials and studies may be delayed, halted or fail;
·risks relating to the progressrigorous regulatory approval process required for approval of any products that we may develop, independently, with our research and development;development partners or pursuant to collaboration arrangements;
·the risk that we will not be ablechanges in the national or international political and regulatory environment may make it more difficult to raise additional capitalgain FDA or enter into additional collaboration agreements (including strategic alliances forother regulatory approval of our aerosol and Surfactant Replacement Therapies);drug product candidates;
· risks
·the risk that the FDA or other regulatory authorities may not accept, or may withhold or delay consideration of, any applications that we file;may file or limit approval to particular indications or other label limitations;
· risks
·the risk that, after acceptance and review of applications that we file, the FDA or other regulatory authorities will not approve the marketing and sale of aour drug product even after acceptance of an application we file for any such drug product;candidates;
·risks that we may not have successfully resolved the Chemistry, Manufacturing and Controls (CMC) and other cGMP-related matters at our manufacturing operations in Totowa, New Jersey, with respect to Surfaxin and our other Surfactant Replacement Therapies (SRT) presently under development, including those identified in connection with our April 2006 process validation stability failures and matters noted by the FDA or other regulatory authorities may delay consideration of any applications that we file;in its inspectional reports on Form FDA 483;
·risks that our recently submitted formal response to the April 2006 Approvable Letter will not satisfy the FDA;
·risks relating to our own drug manufacturing operations and the manufacturing operations of our third-party suppliers and contract manufacturers;
·risks relating to the ability of our third partydevelopment partners and third-party suppliers of materials, drug substance and device suppliersaerosolization systems and development partnersrelated components to provide us with adequate supplies of materials, drug substance and devicesexpertise to support manufacture of drug product for initiation and completion of any of our clinical studies;
· risks relating to our drug manufacturing operations;
· risks relating to the integration of our manufacturing operations into our existing operations;
·risks relating to the transfer of our manufacturing technology to third-party contract manufacturers;
·  risks relating to our ability and the ability of our collaborators and development partners to develop and successfully manufacture and commercialize products that will combine our drug products with innovative aerosolization technologies;
·risks relating to the significant, time-consuming and costly research, development, pre-clinical studies, clinical testing and regulatory approval for any products that we may develop independently or in connection withtransfer of our collaboration arrangements;manufacturing technology to third-party contract manufacturers;
·risks that financial market conditions may change, additional financings could result in equity dilution, or we will be unable to maintain the Nasdaq Global Market listing requirements, causing the price of our shares of common stock to decline;
iii
·the risk that we will not be able to raise additional capital or enter into additional strategic alliances and collaboration arrangements (including strategic alliances in support of our aerosol and other SRT);
·the risk that recurring losses, negative cash flows and the inability to raise additional capital could threaten our ability to continue as a going concern;
·risks relating to our ability to develop or otherwise provide for a successful sales and marketing organization in a timely manner, if at all, and that we or our marketing partners will not succeed in developing market awareness of our products;
·the risk that we or our development partners, collaborators or marketing partners will not be able to attract or maintain qualified personnel;
·risks relating to the maintenance, protection and expiry of the patents and licenses related to our SRT and the potential development of competing therapies and/or technologies by other companies;
· risks relating to our recent workforce reductions and corporate restructuring:
·
risks relating to the impact of securities, product liability, and other litigation or claims that hashave been and may be brought against the Companyus and itsour officers and directors;directors; and
·risks relating to reimbursement and health care reform; and
·other risks and uncertainties detailed in Part II, Item 1A: Risk Factors“Risk Factors” and elsewhere in our Annual Report on Form 10-K for the year ended December 31, 2005, and those described from time to timedocuments incorporated by reference in our future reports filed with the Securities and Exchange Commission (SEC).this report.

ii
 
Pharmaceutical and biotechnology companies have suffered significant setbacks in advanced clinical trials, even after obtaining promising earlier trial results. Data obtained from such clinical trials are susceptible to varying interpretations, which could delay, limit or prevent regulatory approval.

Except to the extent required by applicable laws or rules, we do not undertake to 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.

iiiiv

PART I - FINANCIAL INFORMATION

ITEM 1.  FINANCIAL STATEMENTS 

DISCOVERY LABORATORIES, INC. AND SUBSIDIARY
Consolidated Balance Sheets
(in thousands, except per share data)
 
September 30,
 
December 31,
  
September 30,
 
December 31,
 
 
2006
 
2005
  
2007
 
2006
 
 (Unaudited)    (Unaudited)   
ASSETS
          
Current Assets:          
Cash and cash equivalents $18,893 $47,010  $18,831 $26,173 
Restricted cash  830  647   646  829 
Available-for-sale marketable securities  –  3,251 
Available-for-sale securities  13,609  — 
Prepaid expenses and other current assets  278  560   298  565 
              
Total Current Assets  20,001  
51,468
   33,384  
27,567
 
              
Property and equipment, net of accumulated depreciation  4,604  
4,322
 
Other assets  216  218 
Property and equipment, net  7,186  
4,794
 
Deferred financing costs and other assets  1,778  2,039 
Total Assets $24,821 $56,008  $42,348 $34,400 
LIABILITIES & STOCKHOLDERS’ EQUITY
              
Current Liabilities:              
Accounts payable and accrued expenses $6,867 $7,540  $6,819 $5,953 
Credit facility, current portion  8,500  8,500 
Capitalized leases and note payable, current portion  1,922  1,568   2,146  2,015 
       
Total Current Liabilities  17,289  
17,608
   8,965  
7,968
 
       
Loan payable, non-current portion, including accrued interest  9,452  8,907 
Capitalized leases and note payable, non-current portion  2,867  
3,323
   2,768  2,687 
Other liabilities  622  239   895  516 
              
Total Liabilities  20,778  
21,170
   22,080  
20,078
 
              
Stockholders’ Equity:              
Common stock, $0.001 par value; 180,000 shares authorized; 62,725 and 61,335 shares issued, and 62,374 and 61,022 shares outstanding
at September 30, 2006 and December 31, 2005, respectively.
  63  
61
 
Common stock, $0.001 par value; 180,000 shares authorized; 84,995 and 69,871 shares issued; and 84,681 and 69,558 shares outstanding at September 30, 2007 and December 31, 2006, respectively.  85  
70
 
Additional paid-in capital  247,648  240,028   299,556  265,604 
Unearned portion of compensatory stock options  (58) (230)
Accumulated deficit  (240,453) (201,965)  (276,339) (248,298)
Treasury stock (at cost); 351 and 313 shares at September 30, 2006 and December 31, 2005, respectively.  (3,157) (3,054)
Accumulated other comprehensive loss  —  (2)
Treasury stock (at cost); 313 shares  (3,054) (3,054)
Other comprehensive income  20  — 
              
Total Stockholders’ Equity  4,043  
34,838
   20,268  
14,322
 
Total Liabilities & Stockholders’ Equity $24,821 $56,008  $42,348 $34,400 

See notes to consolidated financial statements

 
1

DISCOVERY LABORATORIES, INC. AND SUBSIDIARY
Consolidated Statements of Operations
(Unaudited)
(in thousands, except per share data)

  
Three Months Ended
 
Nine Months Ended
 
  
September 30,
 
September 30,
 
  
2006
 
2005
 
2006
 
2005
 
Revenues:         
Contracts and Grants $- $20 $- $105 
Expenses:             
Research & Development  5,204  5,676  18,728  16,660 
General & Administrative  2,723  4,817  15,429  13,182 
Restructuring Charge  -  
-
  4,805  
-
 
              
Total Operating Expenses  
7,927
  10,493  38,962  29,842 
Operating Loss  (7,927) (10,473) (38,962) (29,737)
Other income / (expense):             
Interest and other income  291  328  1,468  884 
Interest expense  (362) (261) (994) (695)
              
Other income / (expense), net  (71) 67  474  189 
              
Net Loss $(7,998)$(10,406)$(38,488)$(29,548)
              
Net loss per common share -
Basic and diluted
 $(0.13)$(0.19)$(0.62)$(0.56)
              
Weighted average number of common
shares outstanding - basic and diluted
  62,312  54,476  61,703  52,844 
  
Three Months Ended
 
Nine Months Ended
 
  
September 30,
 
September 30,
 
  
2007
 
2006
 
2007
 
2006
 
Revenue $- $- $- $- 
Expenses:             
Research and development  6,184  5,204  18,400  18,728 
General and administrative  3,147  2,723  9,366  15,429 
Restructuring charge  —  —  —  4,805 
Total expenses  9,331  7,927  27,766  38,962 
Operating loss  (9,331) (7,927) (27,766) (38,962)
Other income / (expense):             
Interest and other income  457  291  1,321  1,468 
Interest and other expense  (473) (362) (1,596) (994)
Other income / (expense), net  (16) (71) (275) 474 
Net loss $(9,347)$(7,998)$(28,041)$(38,488)
Net loss per common share - Basic and diluted $(0.11)$(0.13)$(0.35)$(0.62)
Weighted average number of common shares outstanding - basic and diluted  84,642  62,312  79,485  61,703 

See notes to consolidated financial statements
 
2

DISCOVERY LABORATORIES, INC. AND SUBSIDIARY
Consolidated Statements of Cash Flows
(Unaudited)
(in thousands)

 
Nine Months Ended
  
Nine Months Ended
 
 
September 30,
  
September 30,
 
 
2006
 
2005
  
2007
 
2006
 
Cash flows from operating activities:          
Net loss $(38,488)$(29,548) $(28,041)$(38,488)
Adjustments to reconcile net loss to net cash used
in operating activities:
              
Depreciation  685  585 
Stock-based compensation expense / 401(k) match  4,891  468 
Depreciation and amortization  1,212  685 
Stock-based compensation and 401(k) match  3,743  4,891 
Loss on disposal of property and equipment  —  16   3  — 
Changes in:              
Prepaid expenses and other current assets  282  (35)  233  282 
Accounts payable and accrued expenses  (673) (1,100)  866  (673)
Other assets  2  13   (149) 2 
Other liabilities  383  (105)
       
Other liabilities and accrued interest on loan payable  924  383 
Net cash used in operating activities  (32,918) (29,706)  (21,209) (32,918)
Cash flows from investing activities:              
Purchase of property and equipment  (967) (667)  (3,163) (967)
Restricted cash  (183) (1)  183  (183)
Purchases of marketable securities  (4,631) (30,110)  (26,800) (4,631)
Proceeds from sales or maturity of marketable securities  7,884  24,408   13,211  7,884 
       
Net cash provided by / (used in) investing activities  2,103  (6,370)
Net cash (used in) / provided by investing activities  (16,569) 2,103 
Cash flows from financing activities:              
Proceeds from issuance of securities, net of expenses  2,903  45,402   30,224  2,800 
Proceeds from credit facility  —  2,571 
Equipment financed through capital lease obligation  1,130  757   5,509  1,130 
Principal payments under capital lease obligation  (1,232) (669)  (5,297) (1,232)
Purchase of treasury stock  (103) — 
       
Net cash provided by financing activities  2,698  48,061   30,436  2,698 
Net increase / (decrease) in cash and cash equivalents  (28,117) 11,985 
Cash and cash equivalents – beginning of period  47,010  29,264 
Net decrease in cash and cash equivalents  (7,342) (28,117)
Cash and cash equivalents - beginning of period  26,173  47,010 
Cash and cash equivalents - end of period $18,893 $41,249  $18,831 $18,893 
       
Supplementary disclosure of cash flows information:              
Interest paid $964 $612  $511 $964 
Non-cash transactions:              
Unrealized gain/(loss) on marketable securities  2  (2)  20  2 

See notes to consolidated financial statements
 
3

Notes to Consolidated Financial Statements (unaudited)
 
Note 1 –- The Company and Basis of Presentation

The Company

Discovery Laboratories, Inc. (the Company)(referred to in these Notes as “we”, “us” and “our”) is a biotechnology company developing its proprietary surfactant technology as Surfactant Replacement Therapies (SRT) for respiratory disorders.disorders and diseases. Surfactants are produced naturally in the lungs and are essential for breathing. The Company’sOur technology produces a precision-engineered surfactant that is designed to closely mimic the essential properties of natural human lung surfactant. The Company believesWe believe that through this SRT technology, pulmonary surfactants have the potential, for the first time, to be developed into a series of respiratory therapies for patients in the neonatal intensive care unitNeonatal Intensive Care Unit (NICU), critical care unitPediatric Intensive Care Unit (PICU), Intensive Care Unit (ICU) and other hospital settings, to treat conditions for which there are few or no approved therapies available.

The Company’sOur SRT pipeline is focused initially focused on the most significant respiratory conditions prevalent in the NICU. The Company’s lead product is Surfaxin® (lucinactant). The Company hasNICU and PICU. We have filed a New Drug Application (NDA) with the U.S. Food and Drug Administration (FDA) for Surfaxinour lead product, Surfaxin® (lucinactant) for the prevention of Respiratory Distress Syndrome (RDS) in premature infants and hasinfants. In connection with this NDA, we recently submitted our formal response to a second Approvable Letter that we received two Approvable Letters from the FDA in connectionApril 2006. If the FDA deems our submission to be a complete response, we anticipate a six-month review period, with this NDA. In addition,a target potential approval date in the Companysecond quarter of 2008. For older children being treated in the PICU, we recently announced preliminary results for itsinitiated a Phase 2 clinical trial investigatingevaluating the use of Surfaxin in children up to two years of age suffering from Acute Respiratory Failure (ARF). We are also developing Surfaxin for the prevention and treatment of Bronchopulmonary Dysplasia (BPD) in premature infants. The Companyinfants, a debilitating and chronic lung disease typically affecting premature infants who have suffered RDS. Aerosurf™ is also developing Aerosurf™, itsour proprietary SRT in aerosolized form administered through nasal continuous positive airway pressure (nCPAP), and is being developed for the prevention and treatment of infants at risk for respiratory failure. The Company is preparingAerosurf has the potential to initiate Phase 2 clinical studies with Aerosurf, potentially obviatingobviate the need for endotracheal intubation and conventional mechanical ventilation.

As part of the Company’s ongoing effortsIn addition to address the variouspotentially treating respiratory conditions prevalent in the NICU and PICU, we believe that our SRT will also potentially address a variety of debilitating respiratory conditions affecting other pediatric, young adult and adult patients in the critical careICU and other hospital settings, the Company believes that its SRT will also potentially addresssuch as Acute Lung Injury (ALI), cystic fibrosis (CF), chronic obstructive pulmonary disease (COPD), asthma, Acute Respiratory Distress Syndrome (ARDS), cystic fibrosis and other debilitating respiratory conditions.

The Company is implementingWe have implemented a business strategy that includes: (i) undertaking actionsongoing efforts intended to gain regulatory approvals forapproval to market and sell Surfaxin for the prevention of RDS in premature infants in the United States, including (A)States; (ii) preparing to attend a meeting withfor the FDA in December 2006, with respect to which, in September 2006, we submitted an information package to the FDA addressing questions raisedpotential approval and commercial launch of Surfaxin for RDS in the second Approvable Letter, which focused onUnited States by (A) expanding our existing Medical Affairs organization to support increased educational and scientific activities, and (B) strategic planning for commercial capabilities to execute the Chemistry, Manufacturing and Controls (CMC) portionlaunch of our NDA, (B) preparing our response toSurfaxin in the second Approvable Letter, and (C) completing analysis and remediation of recent manufacturing issues (discussed in “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Plan of Operations”); (ii) investingUnited States, if approved; (iii) continued investment in development of SRT pipeline programs, including Surfaxin for neonatal and pediatric conditions and Aerosurf, which uses the aerosol-generating technology rights that we have licensed through a strategic alliance with Chrysalis Technologies (Chrysalis), a division of Philip Morris USA Inc. (Chrysalis); (iii)(iv) continued investment in enhancements to our quality systems and our manufacturing capabilities, atincluding our manufacturing facilityoperations in Totowa, New Jersey that was(which we acquired by the Company in December 20052005), to produce surfactant drug products to meet the anticipated pre-clinical, clinical and potential future commercial requirements of Surfaxin (if approved) as well as pre-clinical, clinical and future commercial needs of the Company’sour other SRT product candidates, (if approved) and potentially investing into develop new and enhanced formulations of Surfaxin and our other SRT product candidates. Our long-term manufacturing strategy includes potentially building or acquiring additional facilities to be built or acquired bymanufacturing capabilities for the Company in the future;production of our precision-engineered SRT drug products; and (iv)(v) seeking investments of additional capital andincluding potentially entering into collaboration agreements and strategic partnerships for the development and commercialization of the Company’sour SRT product candidates.
 
Basis of Presentation

The accompanying interim unaudited consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States for interim financial information in accordance with the instructions to Form 10-Q. Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States for complete financial statements. In the opinion of management, all adjustments (consisting of normally recurring accruals) considered for fair presentation have been included. Operating results for the three and nine month periodperiods ended September 30, 20062007 are not necessarily indicative of the results that may be expected for the year ending December 31, 2006.2007. Certain prior period balances have been reclassified to conform to the current period presentation. For further information, refer to the consolidated financial statements and footnotes thereto included in the Company’sour Annual Report on Form 10-K for the year ended December 31, 2005.2006.
 
4
All of the Company’s product candidates currently under development are subject to license agreements that will require the payment of future royalties.

Certain prior period balances have been reclassified to conform to the current period presentation.
Note 2 - Accounting Policies and Recent Accounting Pronouncements

Accounting Policies

There have been no changes to our critical accounting policies since December 31, 2006.  For more information on critical accounting policies, refer to our Annual Report on Form 10-K for the year ended December 31, 2006.  Readers are encouraged to review these disclosures in conjunction with the review of this Form 10-Q.

Recent Accounting Pronouncements
In July 2006, the Financial Accounting Standards Board (FASB) issued FASB Interpretation No. 48, "AccountingAccounting forUncertainty in Income Taxes, an interpretation of FASB Statement No. 109," (FIN 48).  FIN 48 prescribes 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.  We adopted FIN 48 is effective for fiscal years beginning after December 15, 2006.on January 1, 2007.   The company does not believe that the adoption of FIN 48 willdid not have a material impact on theirthe consolidated financial statements.

In September 2006, the FASB issued SFAS No.157, “Fair Value Measurements” (SFAS 157). SFAS 157 provides guidance for using fair value to measure assets and liabilities. The standard requires expanded information about the extent to which a company measures assets and liabilities at fair value, the information used to measure fair value, and the effect of fair value measurements on earnings. SFAS 157 will be effective for the Company’s fiscal year beginning January 1, 2008. The Company is currently reviewing the effect SFAS 157 will have on its financial statements.

Note 2 – Working Capital3 -

Cash is required to fund the Company’s working capital needs, to purchase capital assets, and to pay debt service, including principal and interest payments. The Company does not currently have any source of operating revenue and will require significant amounts of cash to continue to fund operations, clinical trials and research and development efforts until such time, if ever, that one of the Company’s products receives regulatory approval for marketing and begins to generate sales. Since the Company has not generated any revenue from the sale of any products, the Company has primarily relied upon the capital markets and debt financings as its primary sources of funding. The Company will continue to be opportunistic in accessing the capital markets to obtain financing on terms satisfactory to the Company. The Company plans to fund its future cash requirements through:

·  the issuance of equity and debt financings;
·  payments from potential strategic collaborators, including license fees and sponsored research funding;
·  sales of Surfaxin, if approved;
·  sales of the Company’s other product candidates, if approved;
·  capital lease financings; and
·  interest earned on invested capital.

Receipt of a second Approvable Letter and the occurrence of manufacturing issues in April 2006 (discussed in “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Plan of Operations”) caused the Company to modify its expectations concerning the timing of potential FDA approval and commercial launch of Surfaxin. The related decline in the market value of the Company’s common stock has made it more difficult to obtain equity and debt financing on terms that would be beneficial to the Company in the long term. In June 2006, the Company engaged Jefferies & Company, Inc., the New York-based investment banking firm, to assist the Company in identifying and evaluating strategic alternatives intended to enhance the future growth potential of the Company’s SRT pipeline and maximize shareholder value. The Company is evaluating multiple strategic alternatives including, but not limited to, potential business alliances, commercial and development partnerships, financings, business combinations and other similar opportunities. No assurances can be given that this evaluation will lead to any specific action or transaction.

After taking into account the recently implemented cost containment measures and the restructuring of the Company’s credit facility with PharmaBio Development Inc. d/b/a NovaQuest (PharmaBio), an investment group of Quintiles Transnational Corp. (discussed in“Management’s Discussion and Analysis of Financial Condition and Results of Operations - Liquidity and Capital Resources”), and before taking into account any strategic alternatives, potential financings or amounts that may be potentially available through the new Committed Equity Financing Facility (CEFF) entered into with Kingsbridge Capital Limited (Kingsbridge), a private investment group, in April 2006 (discussed in “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Liquidity and Capital Resources”), the Company believes that its current working capital is sufficient to meet planned activities into mid-2007. Use of the CEFF is subject to certain conditions, including a limitation on the total number of shares of common stock that may be issued by the Company under the CEFF (approximately 10.6 million shares were available for issuance under the CEFF as of September 30, 2006). In addition, during the eight trading day pricing period for a draw down, if the volume weighted average price of the Company’s common stock (VWAP) for any one trading day is less than the greater of (i) $2.00 or (ii) 85 percent of the closing price of the Company’s common stock for the trading day immediately preceding the beginning of the draw down period, the VWAP from that trading day will not be used in calculating the number of shares to be issued in connection with that draw down, and the draw down amount for that pricing period will be reduced by one-eighth of the draw down amount that the Company had initially specified. (Also, see discussion in Subsequent Events, Note 10) The Company anticipates using the CEFF, when available, to support working capital needs in 2006 and 2007.
5
Note 3 – Net Loss Per Share

Net loss per share is computed based on the weighted average number of common shares outstanding for the periods. Common shares issuable upon the exercise of options and warrants are not included in the calculation of the net loss per share as their effect would be anti-dilutive.

Note 4 – Stock-Based Employee Compensation

The Company has a stock-based employee compensation plan. Prior to January 1, 2006, the Company accounted for this plan under the recognition and measurement provisions of APB Opinion No. 25, -Accounting for Stock Issued to Employees, (Opinion 25) and related interpretations, as permitted by FASB Statement No. 123, Accounting for Stock-Based Compensation. Generally, no stock-based employee compensation cost was recognized in the statements of operations, as options granted under the plan had an exercise price equal to the market value of the underlying common stock on the date of the grant. Effective January 1, 2006, the Company adopted the fair value recognition provisions of FASB Statement No. 123(R), Share-Based Payment, using the modified-prospective-transition method. Under that transition method, compensation cost recognized in the three and nine months ended September 30, 2006 includes: (a) compensation cost for all share-based payments granted prior to, but not yet vested as of January 1, 2006, based on the grant date fair market value estimated in accordance with the original provisions of Statement 123, and (b) compensation cost for all share-based payments granted subsequent to January 1, 2006, based upon the grant-date fair value estimated in accordance with the provisions of Statement 123(R). Results from prior periods have not been restated.

As a result of adopting Statement 123(R) on January 1, 2006, the Company’s net loss for the three and nine months ended September 30, 2006 was $0.9 million (or $0.02 per share) and $4.1 million (or $0.06 per share), respectively, higher than if it had continued to account for share-based compensation under Opinion 25. For the three and nine months ended September 30, 2006, $0.3 million and $1.2 million of compensation expense was classified as research and development and $0.6 million and $2.9 million of compensation expense was classified as general and administrative.
For comparative purposes, the following table illustrates the effect on net loss and net loss per share if the Company had applied the fair value recognition provisions of Statement 123(R) to options granted under the Company’s stock option plan for the three and nine months ended September 30, 2005. For purposes of this pro forma disclosure, the value of the option is estimated using a Black-Scholes-Merton option-pricing formula that uses the September 30, 2005 assumptions set forth under “Stock Incentive Plan” below and amortized to expense over the options’ vesting periods.
  
Three Months Ended
 
Nine Months Ended
 
  
September 30,
 
September 30,
 
(in thousands, except per share data)
 
2005
 
2005
 
      
Net loss, as reported $(10,406)$(29,548)
        
Net loss per share, as reported $(0.19)$(0.56)
        
Add: Stock-based employee compensation expense included in reported net loss  —  — 
        
Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards  (1,163) (5,796)
        
Pro forma net loss $(11,569)$(35,344)
        
Pro forma net loss per share $(0.21)$(0.67)

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Stock Incentive Plan

The Company’s 1998 Stock Incentive Plan (the Plan) is shareholder-approved and currently allows for the grant of stock options and shares of our common stock to its eligible employees, officers, consultants, independent advisors and non-employee directors for up to 11,207,000 shares of our common stock. At September 30, options to purchase 9,554,000 shares were outstanding, and 1,653,000 shares remain available for issuance under the Plan. The Company believes that such awards better align the interests of its eligible participants with those of its shareholders. Option awards are granted with an exercise price equal to or greater than the closing sale price per share of the Company’s common stock on the Nasdaq Global Market on the option grant date. Although the terms of any award vary, option awards generally vest based upon three years of continuous service and have 10-year contractual terms.

The fair value of each option award is estimated on the date of grant using the Black-Scholes-Merton option-pricing formula that uses assumptions noted in the following table. Expected volatilities are based upon the Company’s historical volatility and other factors. The Company also uses historical data and other factors to estimate option exercises and employee terminations 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.
  
September 30, 2006
 
September 30, 2005
     
Expected volatility 101% 77%
Expected term 5 years 3.5 years
Risk-free rate 5.0% 4.1%
Expected dividends -- --
A summary of option activity under the Plan as of September 30, 2006 and changes during the period is presented below:

(in thousands, except for weighted-average data)
Options
 
Shares
 
Weighted-Average Exercise Price
 
Weighted-Average Remaining Contractual Term
 
Aggregate Intrinsic Value
 
          
Outstanding at January 1, 2006  8,440 $6.28       
Granted  904  7.08       
Exercised  (8) 3.15       
Forfeited or expired  (60) 6.97       
Outstanding at March 31, 2006  9,276 $6.35  7.3 $15,050 
Vested at March 31, 2006  6,769 $6.63  6.9 $10,650 
Exercisable at March 31, 2006  7,548 $6.23  6.8 $14,199 

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Outstanding at March 31, 2006  9,276 $6.35       
Granted  1,664  2.20       
Exercised  (2) 1.53       
Forfeited or expired  (1,140) 7.69       
Outstanding at June 30, 2006  9,798 $5.50  7.4 $476 
Vested at June 30, 2006  6,898 $6.13  6.8 $360 
Exercisable at June 30, 2006  7,491 $5.86  6.8 $360 
              
Outstanding at June 30, 2006  9,798 $5.50       
Granted  355  1.82       
Exercised  (25) 0.47       
Forfeited or expired  (574)$8.10       
Outstanding at September 30, 2006  9,554 $5.22  7.3 $584 
Vested at September 30, 2006  6,456 $5.92  6.5 $377 
Exercisable at September 30, 2006  7,048 $5.65  6.5 $377 

Based upon application of the Black-Scholes-Merton option-pricing formula described above, the weighted-average grant-date fair value of options granted during the nine months ended September 30, 2006 was $2.54. The total intrinsic value of options exercised during the nine months ended September 30, 2006 was $79,000.

A summary of the status of the Company’s nonvested shares issuable upon exercise of outstanding options and changes during the three and nine month periods are presented below:

(in thousands, except for weighted-average data)
  Option Shares Weighted-Average Grant-Date Fair Value 
      
Nonvested at January 1, 2006  1,907 $3.68 
Granted  904  4.70 
Vested  (252) 4.55 
Forfeited  (53) 5.15 
Nonvested at March 31, 2006  2,506 $3.89 
        
Granted  1,664  1.68 
Vested  (910) 2.00 
Forfeited  (360) 4.61 
Nonvested at June 30, 2006  2,900 $2.08 
        
Granted  355  1.37 
Vested  (125) 2.56 
Forfeited  (32) 3.26 
Nonvested at September 30, 2006  3,098 $2.66 

As of September 30, 2006, there was $6.3 million of total unrecognized compensation cost related to nonvested share-based compensation arrangements granted under the Plan. That cost is expected to be recognized over a weighted-average vesting period of 2.11 years.
Note 5 – Comprehensive Loss
 
Total comprehensive loss was $9.3 million and $28.0 million for the three months and nine months ended September 30, 2007, respectively, and $8.0 million and $38.5 million for the three months and nine months ended September 30, 2006, respectively, and $10.4 million and $29.6 and for the three and nine months ended September 30, 2005.respectively. Total comprehensive loss consists of the net loss and unrealized gains and losses on marketable securities.
 
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Note 6 –5 - Restricted Cash

There are cash balances that are restricted as to use and the Company discloseswe disclose such amounts separately on the Company’sour balance sheets. There are twoThe primary componentscomponent of Restricted Cash: (a)Cash is a cash security deposit in the amount of $600,000 securing a letter of credit in the same amount related to the Company’sour lease agreement dated May 26, 2004 for office space in Warrington, Pennsylvania, and (b) a cash security deposit in the amount of approximately $175,500 securing a letter of credit in the same amount issued to support two “Bond to Discharge Lien” filed in Passaic County, New Jersey, in connection with an ongoing contractor dispute arising out of work done at the Company’s manufacturing facility in Totowa, New Jersey.Pennsylvania. Beginning in March 2008,2010, the security deposit and the letter of credit related to the lease agreement will be reduced to $400,000 and will remain in effect through the remainder of the lease term. Subject to certain conditions, upon expiration of the lease in November 2009,February 2013, the letter of credit will expire. Both letters
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Note 6 - Stock-Based Employee Compensation

Our stock-based employee compensation plans (Plans) are intended to attract, retain and provide incentives for employees, officers and directors, and to align stockholder and employee interests. We use the Black-Scholes option pricing model to determine the fair value of credit are securedstock options and amortize the stock-based compensation expense over the requisite service periods of the stock options. The fair value of the stock options is determined on the date of grant using the Black-Scholes option-pricing model. The fair value of stock options is affected by our stock price and several subjective variables, including the expected stock price volatility over the term of the option, actual and projected employee stock option exercise behaviors, risk-free interest rate and expected dividends.

We use historical data and other factors to estimate the expected term, volatility and forfeiture rates within the valuation model. The risk-free interest rate is based upon the U.S. Treasury yield curve in effect at the time of grant. We have not and do not anticipate paying any cash and are recordeddividends in the Company’s balance sheetsforeseeable future and therefore use an expected dividend yield of zero in the option valuation model. We estimate forfeitures of unvested stock options at the time of grant and revise those estimates in subsequent periods if actual forfeitures differ from those estimates, resulting in recognition of stock-based compensation expense only for those options that vest.
The fair value of each stock option is estimated on the date of grant using the Black-Scholes option-pricing formula and the assumptions noted in the following table:

  
September 30,
2007
 
September 30,
2006
 
Expected volatility  97% 101%
Expected term  4 and 5 years  5 years 
Risk-free rate  4.6% 5.0%
Expected dividends  —  
—
 
The total employee stock-based compensation for the three and nine months ended September 30, 2007 and 2006 was as “Restricted Cash.”follows:

 Three Months Ended Nine Months Ended 
  September 30, September 30, 
  2007 2006 2007 2006 
(in thousands)         
Research & Development $319 $353 $1,109 $1,255 
General & Administrative  737  567  2,343  2,878 
Total $1,056 $920 $3,452 $4,133 
As of September 30, 2007, there was $7.8 million of total unrecognized compensation cost related to non-vested share-based compensation arrangements granted under the Plans. That cost is expected to be recognized over a weighted-average vesting period of 2.01 years.

As of September 30, 2007, 57,123 phantom restricted stock awards were issued and outstanding under our Amended and Restated 1998 Stock Incentive Plan (1998 Plan) and 57,123 shares were reserved for future issuance. Effective as of October 30, 2007, to replace the shares of phantom stock previously granted to each such grantee under the 1998 Plan, we entered into Stock Issuance Agreements (Agreements) pursuant to which the then-eligible grantees received in the aggregate 56,660 restricted shares of common stock. Under the Agreements, restricted shares are subject to a vesting schedule whereby such shares will fully vest on the date that our first drug product first becomes widely commercially available, as determined by management. Prior to such date, a grantee’s shares are non-transferable and subject to automatic cancellation upon the termination of such grantee’s employment for any reason.
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Note 7 –- Working Capital

Cash is required to fund our working capital needs, to purchase capital assets, and to pay debt service, including principal and interest payments. We do not currently have any source of operating revenue and will require significant amounts of cash to continue to fund operations, clinical trials and research and development efforts until such time, if ever, that one of our products receives regulatory approval for marketing and begins to generate sales. Since we have not generated any revenue from the sale of any products, we have relied upon the capital markets and debt financings as our primary sources of funding. We will continue to be opportunistic in accessing the capital markets to obtain financing on terms satisfactory to us. We plan to fund our future cash requirements through:

·the issuance of equity and debt financings;
·payments from potential strategic collaborators, including license fees and sponsored research funding;
·sales of Surfaxin, if approved;
·sales of our other product candidates, if approved;
·capital lease financings; and
·interest earned on invested capital.

After taking into account an October 2007 draw-down pursuant to our Committed Equity Financing Facility (CEFF) with Kingsbridge Capital Limited (Kingsbridge), a private investment group (see “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Liquidity and Capital Resources”) that resulted in $5.0 million of gross proceeds, and before taking into account any additional amounts that may be potentially available through our CEFF, any potential strategic collaborations, and any potential financings, we believe that our current working capital is sufficient to meet planned activities through mid 2008. Use of the CEFF is subject to certain conditions, including a limitation on the total number of shares of our common stock that we may issue under the CEFF (currently not more than approximately 5.2 million shares). In addition, if on any trading day during the eight trading day pricing period for a draw down, the volume weighted average price of our common stock (VWAP) is less than the greater of (i) $2.00 or (ii) 85 percent of the closing price of our common stock for the trading day immediately preceding the draw-down period, no shares will be issued with respect to that trading day and the total amount of the draw down for that pricing period will be reduced for each such trading day by one-eighth of the draw down amount that we had initially specified. We anticipate using the CEFF, when available, to support working capital needs for the remainder of 2007.

Note 8 - Q2 2006 Restructuring Charge

In April 2006, we received an Approvable Letter from the Company reduced its staff levels and reorganized corporate management to lower the Company’s cost structure and re-align its operations with changed business priorities. These actions were taken in response to the Company’s revised expectations concerning the timing of potential FDA approval and commercial launch offor Surfaxin for the prevention of RDS in premature infants following the April 2006and announced that ongoing analysis of data from Surfaxin process validation batches that we had manufactured as a requirement for our NDA indicated that certain stability failure.
The reduction in workforce totaled 52 employees, representing approximately 33% of the Company’s workforce, and was focused primarily on the Company’s commercial infrastructure, the development of which isparameters no longer met acceptance criteria. As a result of these events, to lower our cost structure and to re-align our operations with changed business priorities, in the Company’s near-term plans. Included in the workforce reduction were three senior executives. All affected employees were eligible for certain severance paymentsApril 2006, we reduced our staff levels and continuation of benefits. The Company expects to realize annual expense savings of approximately $8.1 million from the reduction in work force and related operating expenses. Additionally, certain commercial programs were discontinued and related costs will no longer be incurred. Such commercial program expenses totaled approximately $5.0 million for the fourth quarter of 2005 and first quarter of 2006.
The Companyreorganized corporate management. We incurred a restructuring charge of $4.8 million in the second quarter of 2006 associated with the staff reductions and the close-out of certain commercial programs, which was accounted for in accordance with Statement of Financial Accounting Standards No. 146 “Accounting for Costs Associated with Exit or Disposal Activities” and is identified separately on the Statement of Operations as Restructuring Charge. This charge included $2.5 million of severance and benefits related to staff reductions and $2.3 million for the termination of certain commercial programs..

As of September 30, 2006, payments totaling $3.52007, the remaining balance of the unpaid restructuring charge was $0.5 million, had been made related to these items and $1.3 million were unpaid. Of the $1.3 million that was unpaid as of September 30, 2006, $1.0 millionwhich was included in accounts payable and accrued expensesexpenses.

Note 9 - Debt

Capital Equipment Financing Arrangements

On May 21, 2007, we and $0.3Merrill Lynch Capital, a division of Merrill Lynch Business Financial Services Inc. (Merrill Lynch), entered into a Credit and Security Agreement (Loan Agreement), pursuant to which Merrill Lynch is providing us a $12.5 million credit facility (Facility) to fund our capital programs. Under the Facility, $9 million was classifiedmade available immediately (with up to an additional $3.5 million becoming available, at a rate of $1 million for each $10 million raised by us through business development partnerships, stock offerings and other similar financings). Approximately $4.0 million of the Facility was drawn to fund the prepayment of all our outstanding indebtedness to General Electric Capital Corporation (GECC) under the Master Security Agreement with GECC dated December 20, 2002, as amended (GECC Agreement). The right to draw funds under the Facility will expire on May 30, 2008, subject to a long-term liability. A reconciliationbest efforts undertaking by Merrill Lynch to extend the draw down period beyond the expiration date for an additional six months. The minimum advance under the Facility is $100,000. Interest on each advance will accrue at a fixed rate per annum equal to LIBOR plus 6.25%, determined on the funding date of these amounts is set forthsuch advance. Principal and interest on all advances will be payable in equal installments on the table below:first business day of each month. We may prepay advances, in whole or in part, at any time, subject to a prepayment penalty, which, depending on the period of time elapsed from the closing of the Facility, will range from 4% to 1%.
 
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(in thousands)
 Severance and Benefits Related Termination of Commercial Programs Total 
        
Restructuring Charge - Q2 2006 $2,497 $2,308 $4,805 
           
Payments / Adjustments  (2,227) (1,028) (3,255)
           
Liability as of June 30, 2006  270  1,280  1,550 
           
Payments / Adjustments - Q3 2006  (80) (129) (209)
           
Liability as of September 30, 2006 $190 $1,151 $1,341 
We may use the Facility to finance (a) new property and equipment and (b) up to approximately $1.7 million “Other Equipment” and related costs, which may include leasehold improvements, intangible property such as software and software licenses, specialty equipment, a pre-payment penalty paid to GECC and “soft costs” related to financed property and equipment (including, without limitation, taxes, shipping, installation and other similar costs). Advances to finance the acquisition of new property and equipment will be amortized over a period of 36 months. The advance related to the GECC prepayment will be amortized over a period of 27 months and Other Equipment and related costs will be amortized over a period of 24 months.

Our obligations to Merrill Lynch are secured by a security interest in (a) the financed property and equipment, including the property and equipment securing GECC at the time of prepayment, and (b) all of our intellectual property, subject to limited exceptions set forth in the Loan Agreement (Supplemental Collateral). The Supplemental Collateral will be released on the earlier to occur of (i) receipt by us of FDA approval of our NDA for Surfaxin for the prevention of RDS in premature infants, or (ii) the date on which we shall have maintained over a continuous 12-month period ending on or after March 31, 2008, measured at the end of each calendar quarter, a minimum cash balance equal to our projected cash requirements for the following 12-month period. In addition, we, PharmaBio Development Inc. d/b/a NovaQuest (PharmaBio), to which we are indebted under a separate loan arrangement (discussed below), and Merrill Lynch entered into an Intercreditor Agreement under which Merrill Lynch agreed to subordinate its security interest in the Supplemental Collateral (which does not include financed property and equipment) to the security interest in the same collateral that we previously granted to PharmaBio.

As of September 30, 2007, approximately $4.9 million was outstanding under the secured credit facility with Merrill Lynch and $3.5 million remained available for use, subject to the conditions of the Facility.

Loan with PharmaBio Development, Inc. d/b/a/ NovaQuest (PharmaBio), a strategic investment group of Quintiles Transnational Corp.

We have a loan with PharmaBio in the principal amount of $8.5 million that matures on April 30, 2010. Interest on the loan accrues at the prime lending rate, subject to change when and as such rate changes, compounded annually, and is payable on the maturity date of the loan. We may repay the loan, in whole or in part, at any time without prepayment penalty or premium. As of September 30, 2007, $9.5 million was outstanding on this loan, which was comprised of $8.5 million of principal and $1.0 million of accrued and unpaid interest. For further discussion, see “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Liquidity and Capital Resources.”

Note 8 – Treasury Stock

Occasionally, certain members of the Company’s management and certain consultants, pursuant to terms set forth in the Company’s Amended and Restated 1998 Stock Incentive Plan, tender shares of the Company’s common stock held by such persons in lieu of cash for payment for the exercise of certain stock options previously granted to such parties. There were no such shares tendered during the nine months ended September 30, 2006.

As a result of the reduction in staff in the second quarter of 2006, for the nine months ended September 30, 2006, 37,382 shares of unvested restricted stock awards were cancelled and recorded as treasury stock.

Note 9 –10 - Litigation

In connection with the shareholder class actions filed inOn March 15, 2007, the United States District Court for the Eastern District of Pennsylvania againstgranted defendant’s motion to dismiss the Company in May 2006 and consolidated in June 2006 under the caption “In re: Discovery Laboratories Securities Litigation”, aSecond Consolidated Amended Complaint was filed by the Mizla Group, the lead plaintiffs, on August 9, 2006, individually and on behalf of a class of the Company’s investors who purchased the Company’sour publicly traded securities between March 15, 2004 and June 6, 2006.2006, alleging securities laws-related violations in connection with various of our public statements. The amended complaint names as defendants the Company, the Company’shad been filed on November 30, 2006 against us, our Chief Executive Officer, Robert J. Capetola, and the Company’sour former Chief Operating Officer, Christopher J. Schaber.Schaber, under the caption “In re: Discovery Laboratories Securities Litigation” and sought an order that the action proceed as a class action and an award of compensatory damages in favor of the plaintiffs and the other class members in an unspecified amount, together with interest and reimbursement of costs and expenses of the litigation and other equitable or injunctive relief. On September 14, 2006, the Company’s counselApril 10, 2007, plaintiffs filed a Motion to Dismiss the Consolidated Amended Complaint and on November 1, 2006, the court dismissed the Consolidated Amended Complaint, without prejudice, and granted plaintiffs leave to file an amended Consolidated Amended Complaint by November 30, 2006. The Company has no information as to whether the plaintiffs plan to file an amended complaintNotice of Appeal with the court.

Two shareholder derivative complaints filed in May and June 2006, respectively, in the United States District Court for the Eastern District of Pennsylvania against the Company’s Chief Executive Officer, Robert J. Capetola, and the Company’s directors remain subject to a stipulation agreement between the parties providing that the Company is not required to respond to these consolidated complaints until 60 days following defendants’ answer or a dispositive rulingfiled an opening brief on a motion to dismissJuly 2, 2007. Defendants filed in response to the consolidated amended complaint in the class actions, described above.their opening brief on August 6, 2007, and Plaintiffs filed their reply brief on August 20, 2007.
8

If any of these actions proceed, the Company intendsWe intend to vigorously defend them.the appeal of the securities class action. The potential impact of this or any such actions, all of which generally seek unquantified damages, attorneys’ fees and expenses is uncertain. Additional actions based upon similar allegations, or otherwise, may be filed in the future. There can be no assurance that an adverse result in any such proceedings would not have a potentially material adverse effect on the Company’sour business, results of operations and financial condition.

The Company hasWe have from time to time been involved in disputes arising in the ordinary course of business, including in connection with the termination in 2006 of itscertain pre-launch commercial programs (discussed in Note 7, above).following our process validation stability failure. Such claims, with or without merit, if not resolved, could be time-consuming and result in costly litigation. While it is impossible to predict with certainty the eventual outcome of such claims, we believe the Company believes theypending matters are unlikely to have a material adverse effect on itsour financial condition or results of operations. However, there can be no assurance that the Companywe will be successful in any proceeding to which itwe are or may be a party.
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Note 10 –11 - Subsequent EventsEvent

Restructuring of Quintiles Loan

On October 25, 2006, the Company and PharmaBio agreed to restructure the existing $8.5 million credit facility (PharmaBio loan) that was scheduled to mature on December 31, 2006. Under the restructuring, the maturity date of the loan has been extended by 40 months, from December 31, 2006 to April 30, 2010. Beginning October 1, 2006, interest on the loan will accrue at the prime lending rate of Wachovia Bank, N.A., subject to change when and as such rate changes, compounded annually. Prior to October 1, 2006, interest accrued at a rate equal to the greater of 8% or the prime rate plus 2% and was payable quarterly. All unpaid interest, including interest payable with respect to the quarter ending September 30, 2006, will now be payable on the maturity date of the loan. The Company may repay the loan, in whole or in part, at any time without prepayment penalty or premium. For further discussion, see “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Liquidity and Capital Resources.”

In consideration of PharmaBio’s agreement to restructure the loan, the Company and PharmaBio entered into a Warrant Agreement, pursuant to which PharmaBio has the right to purchase 1,500,000 shares of the Company’s common stock at an exercise price equal to $3.5813 per share. The Warrant Agreement has a seven-year term and is exercisable, in whole or in part, for cash, cancellation of a portion of our indebtedness under the PharmaBio loan, or a combination of the foregoing, in an amount equal to the aggregate purchase price for the shares being purchased upon any exercise. In connection with the issuance of the warrant, the Company expects to recognize deferred financing costs as an intangible asset of approximately $1.9 million, to be amortized to interest expense ratably over the extended term of the loan.

Amendment to Capital Lease Financing Arrangement with GECC

In connection with the restructuring of the PharmaBio loan, on October 25, 2006, the Company and the Life Science and Technology Finance Division of General Electric Capital Corporation (GECC) entered into an Amendment No. 5 and Consent (GECC Amendment) to the Master Security Agreement dated December 20, 2002 between the Company and GECC. Under the GECC Amendment, GECC consented to the execution and delivery by the Company of the Security Agreement to PharmaBio and, in consideration of the consent and other amendments to the Master Security Agreement, the Company granted to GECC a security interest in substantially all of the Company’s assets, with certain exceptions.

During the month of October 2006, the Company received financing under the Master Security Agreement in the amount of $378,945 in connection with the purchase of property and equipment. GECC’s obligation to finance purchases of property and equipment under the Master Security Agreement expired October 31, 2006; however, GECC has agreed in the near term to discuss the Company’s financing needs on a month to month basis. For further discussion, see “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Liquidity and Capital Resources.”

Financing pursuant to the CEFF
In October 2006, the Company2007, we completed a financing pursuant to the CEFF resulting in proceeds of $2.3$5 million from the issuance of 1,204,8671,909,172 shares of the Company’sour common stock at an average price per share, after the applicable discount, of $1.91.
The Company is currently completing a financing pursuant to the CEFF and expects to realize proceeds of $3.0 million from the issuance of approximately 1.4 million shares of the Company’s common stock at an average price per share, after the applicable discount, of approximately $2.20.
11
$2.62.

ITEM 2.
 MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

“Management’s Discussion and Analysis of Financial Condition and Results of Operations” should be read in connection with our accompanying Consolidated Financial Statements (including the notes thereto) appearing elsewhere herein.

OVERVIEW

We are a biotechnology company developing our proprietary surfactant technology as Surfactant Replacement Therapies (SRT) for respiratory disorders and diseases. Surfactants are produced naturally in the lungs and are essential for breathing. Our technology produces a precision-engineered surfactant that is designed to closely mimic the essential properties of natural human lung surfactant. We believe that through this SRT technology, pulmonary surfactants have the potential, for the first time, to be developed into a series of respiratory therapies for patients in the neonatal intensive care unitNeonatal Intensive Care Unit (NICU), critical care unitPediatric Intensive Care Unit (PICU), Intensive Care Unit (ICU) and other hospital settings, to treat conditions for which there are few or no approved therapies available.

Our SRT pipeline is focused initially focused on the most significant respiratory conditions prevalent in the NICU. Our lead product is Surfaxin® (lucinactant).NICU and PICU. We have filed a New Drug Application (NDA) with the U.S. Food and Drug Administration (FDA) for Surfaxinour lead product, Surfaxin® (lucinactant) for the prevention of Respiratory Distress Syndrome (RDS) in premature infants and have received two Approvable Letters ininfants. In connection with this NDA.

In addition,NDA, we recently announced preliminary resultssubmitted our formal response to a second Approvable Letter that we received from the FDA in April 2006. If the FDA deems our submission to be a complete response, we anticipate a six-month review period, with a target potential approval date in the second quarter of 2008. For older children being treated in the PICU, we recently initiated a Phase 2 clinical trial investigatingevaluating the use of Surfaxin in children up to two years of age suffering from Acute Respiratory Failure (ARF). We are also developing Surfaxin for the prevention and treatment of Bronchopulmonary Dysplasia (BPD) in premature infants, a debilitating and chronic lung disease typically affecting premature infants who have suffered RDS. We are also developing Aerosurf™, a is our proprietary SRT in aerosolized form administered through nasal continuous positive airway pressure (nCPAP), and is being developed for the prevention and treatment of infants at risk for respiratory failure. We are planningAerosurf has the potential to initiate Phase 2 clinical studies with Aerosurf, potentially obviatingobviate the need for endotracheal intubation and conventional mechanical ventilation.
9

As part of our ongoing effortsIn addition to address the variouspotentially treating respiratory conditions prevalent in the NICU and PICU, we believe that our SRT will also potentially address a variety of debilitating respiratory conditions affecting other pediatric, young adult and adult patients in the critical careICU and other hospital settings, in March 2006 we announced preliminary results of a Phase 2 clinical trial to addresssuch as Acute Lung Injury (ALI), cystic fibrosis (CF), chronic obstructive pulmonary disease (COPD), asthma, Acute Respiratory Distress Syndrome (ARDS). We believe our SRT will also potentially address Acute Lung Injury (ALI), Acute Respiratory Distress Syndrome (ARDS), cystic fibrosis and other debilitating respiratory conditions.

Following receipt of our second Approvable Letter and the occurrence in April 2006 of our previously announced manufacturing issues, we revised our expectations concerning the timing of potential FDA approval and commercial launch of Surfaxin for the prevention of RDS in premature infants. In June 2006, we also determined to voluntarily withdraw the Marketing Authorization Application (MAA) that we had filed with the European Medicines Agency (EMEA) for clearance to market Surfaxin for the prevention and rescue treatment of RDS in premature infants in Europe. On September 28, 2006, we filed a briefing package with the FDA and requested a meeting. The purpose of this meeting is to clarify the issues identified by the FDA in the second Approvable Letter and reach agreement with the FDA on the appropriate path to potentially gain approval of Surfaxin for the prevention of RDS in premature infants. The FDA has notified us that a meeting has been scheduled for December 21, 2006. For further discussion, see “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Plan of Operations.”

To respond to the anticipated financial impact of our revised timing for potential FDA approval and commercial launch in the U.S. of Surfaxin for the prevention of RDS in premature infants, weWe have lowered our cost structure and re-aligned our operations to address our business priorities. In May 2006, we announced a reorganized management and a workforce reduction primarily affecting our commercial infrastructure, the development of which is no longer in our near-term plans. We also concluded our Phase 2 clinical trial of Surfaxin for the prevention and treatment of BPD in premature infants and announced preliminary results in October 2006. For a discussion of these events, see “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Results of Operations - Q2 2006 Restructuring Charge” and “Plan of Operations - Research and Development.”

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In addition, our revised expectations concerning the timing of potential FDA approval have had a significant impact on our business strategy. We are now implementingimplemented a business strategy whichthat includes:

· taking actions·ongoing efforts intended to gain regulatory approvals forapproval to market Surfaxin for the prevention of RDS in premature infants in the United States, preparingStates. We recently submitted our formal response to attend the meeting withApprovable Letter that we received from the FDA in December 2006, addressing questions raisedApril 2006. Assuming that the FDA accepts our submission as a complete response, we anticipate that the FDA will designate our submission as a Class 2 submission, thereby allowing for a six-month review period with a target approval date under the Prescription Drug User Fee Act (PDUFA) in the second Approvable Letter, which focused on the CMC portionquarter of our NDA, and preparing our response to the second Approvable Letter and completing the comprehensive investigation, analysis and remediation of our recent manufacturing issues;2008;

· investing·preparing for the potential approval and commercial launch of Surfaxin for RDS in the United States by (i) expanding our existing Medical Affairs organization to support increased educational and scientific activities, and (ii) strategic planning for commercial capabilities to execute the launch of Surfaxin in the United States, if approved;
·
continued investment in the development of our SRT pipeline programs, includingSurfaxin for neonatal and pediatric conditions and Aerosurf, which uses the aerosol-generating technology rights that we have licensed through a strategic alliance with Chrysalis Technologies, a division of Philip Morris USA Inc. (Chrysalis);

·continued investment in enhancements to our quality systems and our manufacturing capabilities, atincluding our manufacturing operationoperations in Totowa, New Jersey, whichNewJersey (which we acquired in December 20052005). We plan to (i) produce surfactant drug products to meet the anticipated clinical and commercial requirements (if approved) of Surfaxin as well as pre-clinical, clinical and potential future commercial needs (if approved) of Surfaxin and our other SRT product candidates, and (ii) potentially develop new and enhanced formulations of Surfaxin and our other SRT product candidates. We are implementing aOur long-term manufacturing strategy for the continued development of our SRT portfolio, including life cycle management of Surfaxin, potential new formulations, and expansion of our aerosol SRT products, beginning with Aerosurf. Our strategy also includes where appropriate, contracting with third-party manufacturers and potentially building or acquiring additional manufacturing capabilities for the production of our precision-engineered surfactantSRT drug and drug device combination products; and

· raising·seeking investments of additional working capital and potentially securing additionalentering into collaboration agreements and strategic partnerships for the development and commercialization of our proprietary SRT product candidates, including Surfaxin.candidates. We have engaged Jefferies & Company, Inc., the New York-based investment banking firm,continue to assist us in identifying and evaluatingevaluate a variety of strategic alternativestransactions intended to enhance the future growth potential of our surfactant replacement therapySRT pipeline and maximize shareholder value. We are evaluating multiple strategic alternativesvalue, including, but not limited to, potential business alliances, commercial and development partnerships, financings business combinations and other similar opportunities, although no assurances can be givenwe cannot assure you that this evaluationwe will lead toenter into any specific actionactions or transaction.transactions.

Since our inception, we have incurred significant losses and, as of September 30, 2006,2007, we had an accumulated deficit of $240.5 million (including historical results of predecessor companies).$276.3 million. The majority of our expenditures to date have been for and in support of research and development activities and, during 2005 and the first half of 2006, also include significant general and administrative, primarily pre-commercialization activities. Research and development expenses represent costs incurred for scientific and clinical personnel, clinical trials, regulatory filings and developing manufacturing capabilities. We expense research and development costs as they are incurred. General and administrative expenses consist primarily of Surfaxin pre-launch commercialization sales and marketing (which were discontinued following our corporate reorganization announced in May 2006), executive management, financial, business development, legal and general corporate activities and related expenses. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Plan of Operations.”

Historically, we have funded our operations with working capital provided principally through public and private equity financings, debt arrangements and strategic collaborations. As of September 30, 2006,2007, we had: (i) cash and marketable securities of $19.7$33.1 million; (ii) approximately 10.67.1 million shares potentially available for issuance (up to a maximum of $40.5 million) under our Committed Equity Financing Facility (CEFF) with Kingsbridge Capital Limited (Kingsbridge), a private investment group, subject to certain conditions that could cause the CEFF with Kingsbridge for future financings (not to exceed $47.8 million), subject to the termsbe unavailable (discussed in “Management’s Discussion and conditionsAnalysis of the agreement;Financial Condition and Results of Operations - Liquidity and Capital Resources”); (iii) a capital equipment lease financing arrangement with General Electric Capital Corporation (GECC) which was available through October 31, 2006, of which an aggregate of $7.5$9.5 million was drawn during the life of the facilityoutstanding ($8.5 million principal and after giving effect to principal payments, $5.0$1.0 million of which was still payable (after taking into account an additional $378,945 drawn in October 2006); and (iv)accrued interest as of September 30, 2007) on a $8.5 million loan from PharmaBio Development Inc. d/b/a NovaQuest (PharmaBio), anthe strategic investment group of Quintiles Transnational Corp. (Quintiles), which after a recent restructuring, is due and payable together with all accrued interest on April 30, 2010.2010; and (iv) $4.9 million debt outstanding under a $12.5 million capital equipment financing arrangement with Merrill Lynch, of which approximately $4.0 million was applied to prepay the outstanding capital equipment loan and prepayment penalties then due to General Electric Capital Corporation (GECC). See “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Liquidity and Capital Resources.”

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RESEARCH AND DEVELOPMENT

Research and development expenses for the three and nine months ended September 30, 20062007 were $5.2$6.2 million and $18.7$18.4 million, respectively,respectively. Research and development expenses for the three and nine months ended September 30, 20052006 were $5.7$5.2 million and $16.7$18.7 million, respectively. These costs are charged to operations as incurred and are tracked by category rather than by project. Research and development costs consist primarily of expenses associated with research, and pre-clinical operations,formulation development, manufacturing development, clinical and regulatory operations and other direct preclinical and clinical trials activities.projects.

These cost categories typically include the following expenses:

Research and Pre-Clinical Operations

Research and pre-clinical operations, primarily conducted at our operations located in California, reflects activities associated with research prior to the initiation of any potential human clinical trials as well as analytical chemistry activities to support the continued development of Surfaxin. Pre-clinical activities predominantly represent projects associated with the development of aerosolized and other related formulations of our precision-engineered lung surfactant and engineering of aerosol delivery systems to potentially treat a range of respiratory disorders prevalent in the NICU and the hospital. Research and pre-clinical operations costs primarily reflect expenses incurred for personnel, consultants, facilities and research and development arrangements with collaborators (including a research funding and option agreement with The Scripps Research Institute which expired in February 2005).

Manufacturing Development

Manufacturing development primarily reflects costs incurred to develop current good manufacturing practices (cGMP) manufacturing capabilities in order to provide clinical and anticipated commercial scale drug supply. Manufacturing development activities includeinclude: (1) costs associated with operating our manufacturing facilityoperations in Totowa, New Jersey (which we acquired from our then-contract manufacturer, Laureate Pharma, Inc. (Laureate) in December 2005) to support the production of clinical and anticipated commercial drug supply for the Company’sour SRT programs, such as employee expenses, depreciation, the purchase of drug substances, quality control and assurance activities, and analytical services; and (2) continued investment in the Company’sour quality assurance and analytical chemistry capabilities, including implementation of enhancements to quality controls, process assurances and documentation requirements that support the production process and expanding theand upgrading our quality operations to meet production needs for our SRT pipeline in accordance with cGMP. In addition, manufacturing activities includecGMP; and (3) expenses associated with our ongoing comprehensive investigation analysis of the April 2006 Surfaxin process validation stability failure, and remediation of the Company’sour related manufacturing issues.issues and such activities associated with obtaining data and other information necessary for our formal response to the Surfaxin Approvable Letter.

Unallocated Development --- Clinical, Regulatory and RegulatoryFormulation Development Operations

Clinical, regulatory and regulatoryformulation development operations reflect the preparation, implementation and management of our clinical trial activities in accordance with current good clinical practices (cGCPs). and research and development of aerosolized and other related formulations of our precision-engineered lung surfactant, engineering of aerosol delivery systems and analytical chemistry activities to support the continued development of Surfaxin. Included in unallocated clinical, developmentregulatory and regulatoryformulation development operations are costs associated with personnel, supplies, facilities, fees to consultants, and other related costs for clinical trial implementation and management, clinical quality control and regulatory compliance activities, data management and biostatistics.biostatistics, including such activities associated with obtaining data and other information necessary for our formal response to the Surfaxin Approvable Letter.

Direct Expenses --Pre-Clinical and Clinical TrialsProgram Expenses

Direct pre-clinical and clinical program expenses include pre-clinical activities associated with the development of SRT formulations prior to the initiation of any potential human clinical trials includeand activities associated with conducting clinical trials, including patient enrollment costs, external site costs, expense of clinical drug supply and external costs such as contract research consultant fees and expenses.
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The following summarizes our research and development expenses by each of the foregoing categories for the three and nine months ended September 30, 20062007 and 2005:

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2006:
 
( in thousands)
 
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
Research and Development Expenses:
 
2006(1)
 
2005
 
2006(1)
 
2005
 
          
Research and pre-clinical operations $470 $448 $1,538 $1,803 
Manufacturing development  2,341  2,950  7,732  6,997 
Unallocated development - clinical and regulatory operations  1,753  1,874  6,291  5,356 
Direct clinical trial expenses  640  404  3,167  2,504 
Total Research and Development Expenses
 $5,204 $5,676 $18,728 $16,660 

(1) Included in research and development expenses for the three and nine months ended September 30, 2006 is a charge of $0.3 million and $1.2 million associated with stock-based employee compensation in accordance with the provisions of FAS No. 123(R).
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
( in thousands)
 
2007
 
2006
 
2007
 
2006
 
Research and Development Expenses:
         
Manufacturing development $3,141 $2,341 $8,408 $7,732 
Unallocated development - clinical and regulatory operations  1,994  1,753  6,329  6,291 
Direct pre-clinical and clinical program expenses  1,049  1,110  3,663  4,705 
Total Research & Development Expenses
 $6,184 $5,204 $18,400 $18,728 

Due to the significant risks and uncertainties inherent in the clinical development and regulatory approval processes, the nature, timing and costs of the efforts necessary to complete projects in development are not reasonably estimable. Results from clinical trials may not be favorable and data from clinical trials are subject to varying interpretation and may be deemed insufficient by the regulatory bodies reviewing applications for marketing approvals. As such, clinical development and regulatory programs are subject to risks and changes that may significantly impact cost projections and timelines.

Currently, none of our drug product candidates are available for commercial sale. All of our potential products are in regulatory review, clinical or pre-clinical development. The status and anticipated completion date of each of our lead SRT programs are discussed in “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Plan of Operations,Operations.” below. Successful completion of development of our SRT is contingent on numerous risks, uncertainties and other factors, some of which are described in detail in the “Risk Factors” section entitled “Risk Factors.”contained in our most recent Annual Report on Form 10-K.

Development risk factors include, but are not limited to:

·Completion of pre-clinical and clinical trials of our SRT product candidates with the scientific results that are sufficient to support further development and/or regulatory approval;
·Receipt of necessary regulatory approvals;
·Obtaining adequate supplies of surfactant active drug substances, manufactured to our specifications and on commercially reasonable terms;
· Obtaining capital necessary to fund our operations, including our research and development efforts, manufacturing requirements and clinical trials;
·Obtaining strategic partnerships and collaboration agreements for the development of our SRT pipeline, including Surfaxin;
·  Performance of our third-party collaborators and suppliers on whom we rely for supply of drug substances, medical device components and related services necessary to manufacture our SRT drug product candidates, including Surfaxin;Surfaxin and Aerosurf;
·Timely resolution ofWhether we have successfully resolved the Chemistry, Manufacturingchemistry, manufacturing and Controlscontrols (CMC) and cGMP-related matters at our manufacturing operations in Totowa, New Jersey with respect to Surfaxin, and our other SRTs presently under development, including those we havematters identified in connection with our recentthe April 2006 process validation stability failures and matters that werethose noted by the FDA in its inspectional reports on Form FDA 483;
·Successful manufacture at our manufacturing operations in Totowa of our SRT drug product candidates, including Surfaxin, at our operations in New Jersey;Surfaxin;
·Successful development and implementation of a manufacturing strategy for the Chrysalis aerosolization device and related materials to support clinical studies and commercialization of Aerosurf; and
·ObtainingProviding for additional manufacturing operations,capabilities, for which we presently have limited resources.
·Obtaining capital necessary to fund our operations, including our research and development efforts, manufacturing requirements and clinical trials;

Because these factors, many of which are outside our control, could have a potentially significant effect on our 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:

·Slow patient enrollment;
 
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·Long treatment time required to demonstrate effectiveness;
·Lack of sufficient clinical supplies and material;
·Adverse medical events or side effects in treated patients;
·Lack of compatibility with complimentary technologies;
·LackFailure of effectiveness of thea product candidate being tested;to demonstrate effectiveness; and
·Lack of sufficient funds.

If we do not successfully complete clinical trials, we will not receive regulatory approval to market our SRT products. If we do notFailure to obtain and maintain regulatory approval and generate revenues from the sale of our products such a failure would have a material adverse effect on our value, financial condition and results of operations.


CORPORATE PARTNERSHIP AGREEMENTS

Chrysalis Technologies, a Division of Philip Morris USA Inc.

In December 2005, we entered into a strategic alliance with Chrysalis to develop and commercialize aerosol SRT to address a broad range of serious respiratory conditions, such as ALI, neonatal respiratory failure, chronic obstructiveALI, CF, COPD, asthma, and others. Through this alliance, we gained exclusive rights to Chrysalis’ aerosolization technology for use with pulmonary disorder, asthma, cystic fibrosis and others.surfactants for all respiratory diseases. The alliance unites two complementary respiratory technologies - our precision-engineered surfactant technology with Chrysalis’ novel aerosolization device technology that is being developed to enable the delivery ofdeliver therapeutics to the deep lung.

Chrysalis has developed a proprietary aerosol generation technology that is being designed with the potential to enable targeted upper respiratory or deep lung delivery of therapies for local or systematic applications. The Chrysalis technology is designed to produce high-quality, low velocity aerosols for possible deep lung aerosol delivery. Aerosols are created by pumping the drug formulation through a small, heated capillary wherein the excipient system is substantially converted to the vapor state. Upon exiting the capillary, the vapor stream quickly cools and slows in velocity yielding a dense aerosol with a defined particle size. The defined particle size can be readily controlled and adjusted through device modifications and drug formulation changes.

The alliance focuses on therapies for hospitalized patients, including those in the NICU, pediatric intensive care unit (PICU)PICU and the adult intensive care unit (ICU),ICU, and can be expanded into other hospital applications and ambulatory settings. We and Chrysalis are utilizing our respective capabilities and resources to support and fund the design and development of integratedcombination drug-device systems that can be uniquely customized to address specific respiratory diseases and patient populations. Chrysalis is responsible for developing the design for the aerosolaerosolization device platform, patient interface and disposable dose packets.packets and patient interface. We are responsible for aerosolized SRT drug formulations, clinical and regulatory activities, and the manufacturing and commercialization of the combination drug-device products. We have exclusive rights to Chrysalis’ aerosolization technology for use with pulmonary surfactants for all respiratory diseases and conditions in hospital and ambulatory settings. Generally, Chrysalis will receive a tiered royalty on product sales: the base royalty generally applies to aggregate net sales of less than $500 million per contract year; the royalty generally increases on aggregate net sales in excess of $500 million per contract year, and generally increases further on aggregate net sales of alliance products in excess of $1 billion per contract year.

Our lead neonatal program utilizing the Chrysalis technology is Aerosurf, an aerosolized formulation administered via nCPAP to treat premature infants in the NICU at risk for RDS. We are also planning an adult program utilizing the Chrysalis aerosolization technology to develop aerosolized SRT administered as a prophylactic for patients in the hospital at risk for ALI.

Laboratorios del Dr. Esteve, S.A.

In December 2004, we further restructured our strategic alliance with Laboratorios del Dr. Esteve, S.A. (Esteve) for the development, marketing and sales of our productsproducts. We had first entered into the alliance in 1999 and had revised it in 2002 to broaden the territory to include all of Europe, Central and Latin America.South America, and Mexico. Under the revised alliance,2004 restructuring, we regained full commercialization rights in key European markets, Central America and South America forto our SRT, including Surfaxin for the prevention of RDS in premature infants and the treatment of ARDS in adults.adults, in key European markets, Central America, and South America. Esteve will focus on Andorra, Greece, Italy, Portugal, and Spain, and now has development and marketing rights to a broader portfolio of potential SRT products. Esteve will pay us a transfer price on sales of Surfaxin and other SRT. 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 revised territory. We also agreed to pay to Esteve 10% of any cash up-front and milestone fees (not to exceed $20 million in the aggregate) that we may receive in connection with any future strategic collaborations for the development and commercialization of Surfaxin for RDS, ARDS or certain other SRTs in the territory for which we had previously granted a license to Esteve. Esteve has agreed to make stipulated cash payments to us upon itsour achievement of certain milestones, primarily upon receipt of marketing regulatory approvals for the covered products. In addition, Esteve has agreed to contribute to Phase 3 clinical trials for the covered products by conducting and funding development performed in the revised territory.

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In October 2005, Esteve sublicensed the distribution rights to Surfaxin in Italy to Dompe Farmaceutici S.p.A. (Dompe)Dompé farmaceutici s.p.a. (Dompé), a privately owned Italian company. Under the sublicense agreement, DompeDompé will be responsible for sales, marketing and distribution of Surfaxin in Italy.


PLAN OF OPERATIONS

We have incurred substantial losses since inception and expect to continue to expend substantial amounts for continued product research, development, manufacturing, and general business activities. We will need to generate significant revenues from product sales, related royalties and transfer prices to achieve and maintain profitability.

Through September 30, 2007, we had no revenues from any product sales, and had not achieved profitability on a quarterly or annual basis. Our ability to achieve profitability depends upon, among other things, our ability to develop products, obtain regulatory approval for products under development and enter into collaboration and other agreements for product development, manufacturing and commercialization. In addition, our results are dependent upon the performance of our strategic partners and suppliers. Moreover, we may never achieve significant revenues or profitable operations from the sale of any of our products or technologies.

Through September 30, 2007, we had not generated taxable income. At December 31, 2006, net operating losses available to offset future taxable income for Federal tax purposes were approximately $229.8 million. The future utilization of such loss carryforward may be limited pursuant to regulations promulgated under Section 382 of the Internal Revenue Code. In addition, we had a research and development tax credit carryforward of $5.2 million at December 31, 2006. The Federal net operating loss and research and development tax credit carryforwards expire beginning in 2008 through 2026.

We anticipate that during the next 12 to 24 months:

Research and Development

We will focus our research, development and regulatory activities in an effort to develop a pipeline of potential SRT for respiratory diseases. The drug development, clinical trial and regulatory process is lengthy, expensive and uncertain and subject to numerous risks including, without limitation, the applicable risks discussed in herein and those contained in the “Risk Factors” section herein and those contained in our most recent Annual Report on Form 10-K. See “Management’s Discussion and Analysis - Research and Development.”

Our major research and development projects include:

SRT for Neonatal Intensive Care Unitand Pediatric Indications

  In order to address the most prevalent respiratory disorders affecting infants in the NICU and PICU, we are conducting several NICU and PICU therapeutic programs targeting respiratory conditions cited as some of the most significant unmet medical needs for the neonatal and pediatric community.

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Surfaxin for the Prevention of RDS in Premature Infants

In April 2006, we received a second Approvable Letter from the FDA for Surfaxin for the prevention of RDS in premature infants. Specifically, the FDA requested certain information primarily focused on the CMCChemistry, Manufacturing and Controls (CMC) section of the NDA. The informationour NDA, predominately involves the further tightening of active ingredient andinvolving drug product specifications and stability, analytical methods and related controls. Consistent with previous reviews, the FDA did not have any clinical or statistical comments. Also in April 2006, ongoing analysis of data from Surfaxin process validation batches that werehad been manufactured for us in 2005 by our contract manufacturer, Laureate Pharma, Inc. (Laureate), as a requirement for our NDA indicated that certain stability parameters had not been achieved.no longer met acceptance criteria. We immediately conducted a comprehensive investigation, which focused on analysis of manufacturing processes, analytical methods and method validation and active pharmaceutical ingredient suppliers. As a result of this process validation stability failure, three new process validation batches will have to be manufacturedour investigation, we identified a most probable root cause, and submitted to ongoing process validation stability testing.executed a corrective action and preventative action (CAPA) plan.

On September 28,In December 2006, we submitted an information package and requestedattended a meeting with the FDA. The information package coveredFDA, the purpose of which was to clarify certain of the key CMC matters containedidentified by the FDA in the second Approvable Letter, and providedprovide information concerning the status and interim findings of our comprehensive investigation into the April 2006 Surfaxin process validation stability failure and our efforts to remediate the related manufacturing issues. The purpose of the meeting is to clarify the issues, identified by the FDA in the second Approvable Letter and reach agreement withobtain guidance from the FDA on the appropriate path to potentially gain approval of Surfaxin for the prevention of RDS in premature infants. TheFollowing that meeting and consistent with the guidance obtained from the FDA, has notified us that a meeting has been scheduled for December 21, 2006.

Although our comprehensive investigation intoin February 2007, we completed the manufacture of three new Surfaxin process validation stability failure is ongoing, we have developed and analyzed substantial data and believe that we will be able to remediate the Surfaxin manufacturing issues to our satisfaction and, to meet FDA requirements for our NDA, expect to manufacture newbatches. These process validation batches priorhave been, and will continue to year-end 2006. Once we have achieved satisfactory Surfaxinbe, subjected to ongoing comprehensive stability testing on pre-specified testing dates, initially every three months, in accordance with an established protocol that complies with guidelines established by the International Conference on Harmonisation of Technical Requirements for Registration of Pharmaceuticals for Human Use (ICH). Under this comprehensive testing protocol, these process validation batches have demonstrated acceptable stability testing over an acceptable period (currently contemplatedthrough six months and continue to be six months)monitored.

In October 2007, we completed the projects and have finalized our responsecompiled the additional data that we thought necessary to address the secondoutstanding CMC issued identified in the Approvable Letter we will submit to the FDAand submitted our formal response to FDA. Those projects were developed based on the guidance that we received at our December 2006 meeting with the FDA. Our formal response also included the six-month stability data from our new process validation batches. We expect that the FDA will advise us in mid-November whether it has accepted our submission as a complete response and provide a review classification that determines the targeted review timeframe. Assuming that our submission is deemed complete, we anticipate that the FDA will designate our submission as a Class 2 submission, thereby allowing for a six-month review period with a target approval date under PDUFA in the second Approvable Letter. The FDA will then advise us if it will accept the submitted response to the second Approvable Letter as a “complete” response and the time frame in which it will complete its reviewquarter of the NDA.2008.

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In September 2006, we announced that, although our comprehensive investigation is ongoing, we believe we have identified a most probable root cause of the process validation stability failures. Our investigation continues, however, and may identify other contributing factors or causes for the process validation stability failure. The investigation is being conductedWe voluntarily withdrew in compliance with FDA cGMP requirements and covers, among other things, analysis of manufacturing processes; equipment and process validation; manufacturing components; drug substances manufacturers; review and assessment of out-of-specification and deviation reports; analytical methods and method validation; and change control documentation. As part of the investigation,June 2006the Marketing Authorization Application (MAA) filed in addition to a variety of audits, tests and experiments, we have manufactured three “investigation batches” of Surfaxin that have passed the critical release specification assays, with stability monitoring ongoing. These investigation batches are not designated as process validation batches but are expected to provide significant data that will support comprehensive investigation report and a corrective action and preventative action (CAPA) plan.

In October 2004 we filed an MAA with the EMEAEuropean Medicines Agency (EMEA) for clearance to market Surfaxin for the prevention and rescue treatment of RDS in premature infants in Europe. At the time of the Surfaxin process validation stability failure, we had responded to the Day 180 List of Outstanding Issues from the Committee for Medicinal Products for Human Use (CHMP) and had met with the EMEA to discuss our response. BecauseEurope because our manufacturing issues would not be resolved within the regulatory time frames mandated by the EMEA we determined in June 2006 to voluntarily withdrawprocedure. Our withdrawal of the MAA precluded final resolution of certain outstanding clinical issues related to the Surfaxin Phase 3 clinical trials, which had been the focus of a recent EMEA clinical expert meeting and were expected to be reviewed at a planned Oral Explanation before the Committee for SurfaxinMedicinal Products for the prevention and rescue treatment of RDSHuman Use (CHMP) in premature infants.late June 2006. We plan in the future to have further discussions with the EMEA and develop a strategy to potentially gain approval for Surfaxin in Europe.

Surfaxin for BPD in Premature Infants

In October 2006, we announced preliminary results of our recently completed Phase 2 clinical trial of Surfaxin for the prevention and treatment of BPD. The BPD Phase 2 clinical trial was a double-blind, controlled trial designed to enroll up to 210 very low birth weight premature infants born at risk for developing BPD. Total enrollment in the trial was 136 premature infants who received either Surfaxin standard dose (175 mg/kg), Surfaxin low dose (90 mg/kg), or sham air as a control. The study’s objective was to determine the safety and tolerability of administering Surfaxin as a therapeutic approach for the prevention and treatment of BPD and was not powered to determine statistically significant differences in outcomes. Key preliminary findings observed in this Phase 2 BPD trial include: a positive acute pharmacological response to Surfaxin therapy evidenced by a reduction in supplemental oxygen and ventilatory support; a lower incidence of death or BPD in patients receiving the Surfaxin standard dose compared with control (57.8% vs. 65.9%, respectively); a higher survival rate through 36 weeks post-menstrual age (PMA) in patients receiving the Surfaxin standard dose compared with control (88.9% vs. 84.1%, respectively); a reduction in duration of mechanical ventilation (approximately four less days) and need for supplemental oxygen in patients receiving the Surfaxin standard dose compared with control; and Surfaxin therapy was generally safe and well tolerated with generally no differences between the Surfaxin treatment groups and the control group in common complications of prematurity. By chance, infants assigned to the Surfaxin low dose treatment group were significantly sicker, with more pre-existing medical risk factors, such that the data from this treatment group cannot be easily interpreted and no meaningful conclusions can be drawn. We believe that the foregoingthese results suggest that Surfaxin may potentially represent a novel therapeutic option for infants at risk for BPD.
Comprehensive analysis ofBPD and anticipate determining the data from this trial is ongoing. Following this analysis, in collaboration with our Steering Committee and Investigators, we expect to present the study results to the medical community and submit the data for publication in a peer review journal. Presently there are no approved therapiesnext development steps for this disease. The FDA previously granted us Orphan Drug Status and Fast Track designations for Surfaxin for the prevention and treatment of BPD.program by early 2008.

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Surfaxin for Acute Respiratory Failure

In June 2007, we initiated a Phase 2 clinical trial evaluating the use of Surfaxin in children up to two years of age suffering from ARF. This Phase 2 clinical trial is a multicenter, randomized, masked, placebo-controlled trial that will compare Surfaxin to standard of care with sham air control. Approximately 180 children under the age of two with ARF will receive standard of care and be randomized to receive either Surfaxin at 5.8 mL/kg of body weight (expected weight range up to 15 kg) or sham air control. The trial is being conducted at approximately 20 sites throughout the United States, Chile, and Europe. The objective of the study is to evaluate the safety and tolerability of Surfaxin administration and to assess whether such treatment can decrease the duration of mechanical ventilation in young children with ARF. The trial is expected to be completed by mid-year 2008.

Aerosurf, Aerosolized SRT
  Aerosurf is our precision-engineered aerosolized SRT administered via nCPAP intended to treat premature infants at risk for respiratory failure.
In September 2005, we completed and announced the results of our first pilot Phase 2 clinical study of Aerosurf, which was designed as an open label, multicenter study to evaluate the feasibility, safety and tolerability of Aerosurf delivered using a commercially-available aerosolization device (Aeroneb Pro®) via nCPAP for the prevention of RDS in premature infants administered within 30 minutes of birth over a three hour duration. The study showed that it is feasible to deliver Aerosurf via nCPAP and that the treatment was generally safe and well tolerated.

In December 2005, we entered into a strategic alliance with Chrysalis. The alliance unites two highly complementary respiratory technologies - our precision-engineered surfactant technology with Chrysalis’ novel aerosolization device technology that is being developed to enable the delivery of therapeutics to the deep lung. Through this alliance, we gained exclusive rights to their aerosolization technology for use with pulmonary surfactants for all respiratory diseases. Our lead neonatal program utilizing the Chrysalis technology is Aerosurf administered via nCPAP to treat premature infants in the NICU at risk for neonatal respiratory disorders. We are presently collaborating with Chrysalis on the development of a prototype aerosolization devicesystem to deliver SurfaxinAerosurf to patients in the NICUNICU. We have also met with and if successful, planreceived guidance from the FDA with respect to initiatethe design of a pilotproposed Phase 2 clinical studyprogram utilizing Chrysalis’ technology. We and Chrysalis, together with third-party engineers and manufacturers, are presently collaborating on the development and optimization of Aerosurf utilizing the Chrysalis aerosolization technologythis novel system as well as next generation drug device systems. Initiation of our Phase 2 clinical program is anticipated in the middlefirst half of 2007. This timeline may be affected by any delay in our joint development activities related to the aerosolization device or by our efforts to remediate our manufacturing issues, discussed above.2008.

SRT for Critical Care and Hospital Indications

In March 2006, we completed and announced preliminary results of a Phase 2 clinical trial for the treatment of ARDS in adults using our precision-engineered surfactant delivered via bronchoscopic segmental lavage (Surfactant Lavage). The ARDS Phase 2 clinical trial was an open-label, controlled, multi-center, international study of Surfactant Lavage for the treatment of ARDS in adults that was designed to enroll up to 160 patients. Total enrollment in the trial was 124 patients.

The objective of the Surfactant Lavage was to restore functional surfactant levels in the patients’ lungs, thereby improving oxygenation in order to remove critically ill patients from mechanical ventilation sooner. Following our analysis of this trial, we plan to submit the data for publication in a peer review journal. We plan to seek potential partners, with which we can apply the scientific and clinical observations generated from this trial to support the design of potential future trials to treat ARDS.

We are also evaluating the potential development of aerosol formulations of SRT to potentially address ALI, cystic fibrosis, and other respiratory conditions. In December 2005, we entered into a strategic alliance with Chrysalis to develop and commercialize aerosolizedour proprietary precision-engineered SRT to address a broad range of seriousrespiratory disorders such as CF, ALI, COPD, asthma, and other debilitating respiratory conditions. Our lead adult program utilizing the Chrysalis technology is the development of aerosolized SRT administered as a prophylactic for patients in the hospital at risk for ALI. Given our current priority to focus on developing the SRT pipeline for the NICU, we will be assessing the timing and further prioritization of these adult programs.

Manufacturing

Our precision-engineered surfactant product candidates, including Surfaxin, must be manufactured in compliance with cGMPs established by the FDA and other international regulatory authorities. Surfaxin is a complex drug and, unlike many drugs, contains four active ingredients. Surfaxin isIt must be aseptically manufactured at our facility as a sterile, liquid suspension. The manufacturing process to produce Surfaxin is complex, must be conducted in a sterile environment,suspension and requires ongoing monitoring of the stability and conformance to product specifications of each of the four active ingredients.

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We willplan to invest in and support our manufacturing strategy for the production of our precision-engineered SRT to meet anticipated clinical needs and, if approved, commercial needs in the United States, Europe and other markets:

Current Manufacturing - New Jersey OperationsCapabilities

In December 2005, we purchased theour manufacturing operations offrom Laureate (our contract manufacturer at that time) that are critical to the production of Surfaxin and our SRT clinical programs. This facility is our only validated clinical facility in which we produce clinical grade material of our drug substance. We will use this pharmaceutical manufacturing and development facility for the production of Surfaxin and for the development and new formulations of Surfaxin and the development of aerosol formulations including Aerosurf. In connection with our acquisition of the facility, we entered into a transitional services arrangement under which Laureate agreed to provide us with certain limited manufacturing-related support services through December 2006. In July 2006, we completed the transition and terminated the arrangement with Laureate. Owning the Totowa operation has provided us with direct operational control and, have transitionedwe believe, potentially improved economics for the Laureate support activities toproduction of clinical and potential commercial supply of our facility.lead product, Surfaxin, and our SRT pipeline products. This facility is the only facility in which we produce our drug product.
 
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In April 2006, ongoing analysis of data fromour initial Surfaxin process validation batches that werehad been manufactured for us in 2005 by our then contract manufacturer, Laureate, as a requirement for our NDA indicated that certain stability parameters had not been achieved.no longer met acceptance criteria. We immediately initiated a comprehensive investigation, which focused on analysis of manufacturing processes, analytical methods and method validation and active pharmaceutical ingredient suppliers, to determine the cause of the failure. As a result of this investigation, we developed a corrective action and preventative action (CAPA) plan to remediate the related manufacturing issues.
In anticipation of our December 2006 meeting with the FDA, we submitted an information package that covered certain of the key CMC matters identified in the Approvable Letter and provided information concerning the status and interim findings of our comprehensive investigation and our efforts to remediate the related manufacturing issues. Following our meeting with the FDA, and consistent with the guidance obtained at the meeting, in February 2007, we completed the manufacture of three new Surfaxin process validation batches. These process validation batches have been, and will continue to be, subjected to ongoing comprehensive stability failure, we willtesting under an established protocol that complies with ICH guidelines and, to date, have to manufacturedemonstrated acceptable stability through six months. For a discussion of the status of the new Surfaxin process validation batches and submit them to ongoing process validation stability testing. Although our comprehensive investigation is ongoing, we have developed and analyzed substantial data and believe that we will be able to remediate the Surfaxin manufacturing issues to our satisfaction and, to meet FDA requirements for our NDA, expect to manufacture new process validation batches prior to year-end 2006. Once we have achieved satisfactory Surfaxin process validation stability testing over an acceptable period (currently contemplated to be six months) and have finalized ourrecent response to the second Approvable Letter, weplease see “MD&A - Research and Development, Surfaxin for the Prevention of RDS in Premature Infants.”
Our manufacturing strategy includes continuing investment in our analytical and quality systems to support our manufacturing and development activities. We recently completed construction of a new analytical and development laboratory in our Warrington, Pennsylvania corporate headquarters. When fully operational, the new laboratory will submit to the FDA our formal response to the second Approvable Letter. The FDA will then advise us if it will accept the submitted response to the second Approvable Letter as a “complete” response and the time frame in which it will complete its reviewconsolidate all of the NDA.analytical, quality and development activities that are presently located in Doylestown, Pennsylvania and Mountain View, California. The laboratory will expand our capabilities by providing additional capacity to conduct analytical testing and opportunities to leverage our newly consolidated professional expertise across a broad range of projects. Our analytical testing activities predominantly involve release and stability testing of raw materials as well as commercial and clinical drug product supply. We will continuealso expect to invest in manufacturingperform development work with respect to our aerosolized SRT and regulatory activities intended to gain FDA approval, including in supportnovel formulations of our response to the second Approvable Letter and the continuing comprehensive investigation and remediation of our recent manufacturing issues.product candidates.
 
Longer-TermLong-Term Manufacturing Capabilities
 
We are planning to have manufacturing capabilities, primarily through our manufacturing operation in Totowa, New Jersey that should allow for sufficient commercial production of Surfaxin, if approved, to supply the potential worldwide demand for our RDS, ARF and BPD programs and all of our anticipated production requirements for Aerosurf.

We view theour acquisition of our New Jersey manufacturing facilityoperations in Totowa as an initial step of our manufacturing strategy for the continued development of our SRT portfolio, including life cycle management of Surfaxin for new indications, potential new formulations and formulation enhancements, and expansion of our aerosol SRT products, beginning with Aerosurf. The lease for our New Jersey manufacturingTotowa facility extends through December 2014. In addition to the customary lease terms and conditions, the lease contains an early termination option, first beginning in December 2009. The early termination option can only be exercised by the landlord upon a minimum of two years prior notice and, in the earlier years, payment to us of significant early termination amounts, subject to certain conditions.amounts. Taking into account this early termination option, forwhich may cause us to move out of our Totowa New Jersey, facility as early as December 2009, our long-term manufacturing strategy includes where appropriate, contracting with third-party manufacturers and potentially building or acquiring additional manufacturing capabilities, as well as using contract manufacturers, for the production of our precision-engineered surfactantSRT drug products.
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Aerosol Devices and Related Componentry

ForTo manufacture aerosolization systems for our planned clinical trials, we intend on utilizingexpect to utilize third-party contract manufacturers, suppliers and assemblers forassemblers. The manufacturing process will require assembly of the key device sub-components that comprise the aerosolization devicessystems, including the aerosol-generating device, the disposable dose delivery packet and related componentrypatient interface system necessary to administer our aerosolized SRT in patients. We expect that third-party vendors will manufacture these key device sub-components, and ship them to one central location for assembly and integration into the aerosolization system. Once assembled, critical/product contact components and/or assemblies are packaged and sterilized. Each of the aerosolization systems will be quality-control tested prior to release for use in our aerosolclinical trials or, potentially, for commercial use. To complete the combination drug-device product, we plan to manufacture the SRT drug product candidates.at our Totowa, New Jersey facility.

See the applicable risks discussed herein and in the “Risk Factors” section herein and those contained in our most recent Annual Report on Form 10-K.
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General and Administrative

We intend to invest in general and administrative resources in the near term primarily to support our legal requirements, intellectual property portfolios (including building and enforcing our patent and trademark positions), our business development initiatives, financial systems and controls, management information technologies, and general management capabilities.

Potential Collaboration Agreements and Strategic Partnerships

We will needintend to generate significant revenues fromseek investments of additional capital and potentially enter into collaboration agreements and strategic partnerships for the development and commercialization of our SRT product sales, related royaltiescandidates. To assist us in identifying and transfer pricesevaluating strategic alternatives intended to achieveenhance the future growth potential of our SRT pipeline and maintain profitability. Through September 30,maximize shareholder value, in June 2006, we had no revenues from any product sales,engaged Jefferies & Company, Inc. (Jefferies), a New York-based investment banking firm, under an exclusive arrangement that we terminated in June 2007. We continue to evaluate a variety of strategic transactions, including, but not limited to, potential business alliances, commercial and had not achieved profitability on a quarterly or annual basis. Our ability to achieve profitability depends upon, amongdevelopment partnerships, financings and other things, our ability to develop products, obtain regulatory approval for products under development andsimilar opportunities, although we cannot assure you that we will enter into agreements for product development, manufacturing and commercialization. In addition, our results are dependent upon the performance of our strategic partners and suppliers. Moreover, we may never achieve significant revenuesany specific actions or profitable operations from the sale of any of our products or technologies.transactions.

Through September 30, 2006, we had not generated taxable income. OnCRITICAL ACCOUNTING POLICIES

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.

There have been no changes to our critical accounting policies since December 31, 2005, net operating losses available2006.  For more information on critical accounting policies, refer to offset future taxable incomeour Annual Report on Form 10-K for Federal tax purposes were approximately $187.0 million. The future utilization of such loss carryforward may be limited pursuant to regulations promulgated under Section 382 of the Internal Revenue Code. In addition, we had a research and development tax credit carryforward of $3.8 million atyear ended December 31, 2005. The Federal net operating loss and research and development tax credit carryforwards expire beginning2006.  Readers are encouraged to review these disclosures in 2009 through 2024.conjunction with the review of this Form 10-Q.

RESULTS OF OPERATIONS

The net loss for the three and nine month periodsmonths ended September 30, 2007 were $9.3 million (or $0.11 per share) and $28.0 million (or $0.35 per share), respectively. The net loss for the three and nine months ended September 30, 2006 waswere $8.0 million (or $0.13 per share) and $38.5 million (or $0.62 per share), respectively. The net loss for the three and nine month periods ended September 30, 2005 was $10.4 million (or $0.19 per share) and $29.5 million (or $0.56 per share), respectively.

On January 1, 2006, we adopted Financial Accounting Standards No. 123(R) (FAS 123(R)) using the modified prospective method, which resulted in the recognition of stock compensation expenses in the statement of operationsRevenue

We did not earn revenue during the three and nine months ended September 30, 2006 without adjusting the prior year three and nine month periods. The net loss for the three and nine months ended September 30, 2006 includes $0.9 million (or $0.02 per share) and $4.1 million (or $0.06 per share), respectively, of stock-based compensation expenses as a result of our adoption of FAS 123(R). Additionally, included in the GAAP net loss for the nine months ended September 30, 2006 is a restructuring charge of $4.8 million,2007 or $0.08 per share, related to the staff reductions and the close-out of certain commercial programs in the second quarter of 2006. Excluding these charges, the net loss for the three and nine months ended September 30, 2006 was $7.1 million (or $0.11 per share) and $29.6 million (or $0.48 per share), respectively.

Revenues

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Revenue for the three and nine months ended September 30, 2006 was $0. Revenue for the three and nine months ended September 30, 2005 was $20,000 and $105,000, respectively. The revenue in 2005 was associated with our corporate partnership agreement with Esteve to develop, market and sell Surfaxin in Southern Europe.

Research and Development Expenses

Research and development expenses for the three and nine months ended September 30, 20062007 were $5.2$6.2 million and $18.7$18.4 million, respectively,respectively. Research and development expenses for the three and nine months ended September 30, 20052006 were $5.7$5.2 million and $16.7$18.7 million, respectively. For a description of expenses and research and development activities, see “Management’s Discussion and Analysis - Research and Development.” For a description of the clinical programs included in research and development, see “Management’s Discussion and Analysis - Plan of Operations.”

Research and development cost consist primarily of expenses associated with researchfor the three and pre-clinical operations, manufacturing development, clinical and regulatory operations and other direct clinical trial activities. The change asnine months ended September 30, 2007 compared to the same prior year periods in 2006 primarily reflects:

(i)manufacturingManufacturing development activities (included in research and development expenses) include (1)to support the production of clinical and commercial drug supply for our SRT programs, including Surfaxin, in conformance with cGMPs. Expenses associated with manufacturing development activities for the three and nine months ended September 30, 2007 were $3.1 million and $8.4 million, respectively, as compared to $2.3 million and $7.7 million for the three and nine months ended September 30, 2006, respectively. Manufacturing development expenses for 2007 primarily consist of (i) costs associated with operating our manufacturing facilityoperations in Totowa, New Jersey (which we acquired from our then-contract manufacturer, Laureate in December 2005) to support the production of clinical and anticipated commercial drug supply for the Company’sour SRT programs, such as employee expenses, depreciation, the purchase of drug substances, quality control and assurance activities, and analytical services; and (2)programs; (ii) continued investment in the Company’sour quality assurance and analytical chemistry capabilities including implementation of enhancements to quality controls, process assurances and documentation requirements that support the production process and expanding theand upgrading our quality operations to meet production needs for our SRT pipeline in accordance with cGMP. In addition, manufacturing activities includecGMP; (iii) expenses associated with our ongoing comprehensive investigation analysis of the April 2006 Surfaxin process validation stability failure and remediation of the Company’sour related manufacturing issues.issues; and (iv) activities to develop additional formulations of our SRT; and

(ii)Research and development activities, excluding manufacturing development activities, associated with infrastructure development, including clinical trial management, regulatory compliance, data management and biostatistics, and medical and scientific affairs activities as well as direct program expenses to advance our SRT pipeline. Expenses related to manufacturingassociated with research and development activities for the three and nine months ended September 30, 20062007 were $2.3$3.1 million and $7.7$10.0 million, respectively, as compared to $3.0 million and $7.0 million for the three and nine months ended September 30, 2005, respectively. The increase in expenses for the nine months ended September 30, 2006 is primarily associated with the ownership of our manufacturing operation in Totowa, New Jersey, which we purchased from Laureate Pharma, Inc. (our contract manufacturer at that time) in December 2005. Expenditures in 2005 for manufacturing activities included improvements and enhancements to Laureate’s Totowa, New Jersey facility in response to the FDA inspectional observations on Form FDA 483. Additionally, there was a charge of $0.1 million and $0.3 million for the three and nine months ended September 30, 2006, respectively, associated with stock-based employee compensation in accordance with the provisions of SFAS No. 123R.

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(ii)            research and development activities, excluding manufacturing development activities, were $2.9 million and $11.0 million for the three and nine months ended September 30, 2006, respectively, as comparedrespectively. Research and development expenses for 2007 primarily include: (i) costs associated with obtaining data and other information necessary for our formal response to $2.7 millionthe Surfaxin Approvable Letter; (ii) activities associated with the ongoing Phase 2 clinical trial evaluating the use of Surfaxin for ARF in children up to two years of age; and $9.7 million(iii) development activities related to Aerosurf. The decrease in expenses for the three and nine months ended September 30, 2005, respectively. These2007 compared to the same period last year primarily reflects personnel and related costs are primarily associated with clinical trial implementationincurred in 2006, in anticipation of the potential approval and management, clinical quality control and regulatory compliance activities, data management and biostatistics, the developmentcommercial launch of aerosolized and other related formulations of our precision-engineered lung surfactant and engineering of aerosol delivery systems, including, among other things: (A) regulatory activities associated with Surfaxin for the prevention of RDS in premature infants; (B) clinical activities forinfants, that were later reduced as a result of staff reductions and a reorganization of corporate management that occurred immediately after the Phase 2 trial for ARDS in adults and the Phase 2 trial for BPD in premature infants; and (C) development activities related to Aerosurf for neonatal respiratory disorders. Additionally, there were charges of $0.2 million and $1.2 million for the three and nine months ended September 30,April 2006 respectively, associated with stock-based employee compensation in accordance with the provisions of SFAS No. 123R.Surfaxin process validation stability failure.

General and Administrative Expenses

General and administrative expenses for the three and nine months ended September 30, 20062007 were $3.1 million and $9.4 million, respectively, as compared to $2.7 million and $15.4 million respectively, and for the three and nine months ended September 30, 2005, were $4.8 million2006, respectively. The decrease is primarily due to costs incurred in 2006 in anticipation of the potential approval and $13.2 million, respectively.commercial launch of Surfaxin for the prevention of RDS in premature infants. After the April 2006 process validation stability failure, we took immediate steps to lower our costs and suspended pre-launch commercial activities, reduced personnel and reorganized corporate management. General and administrative expenses in 2006costs for 2007 primarily include but are not limited to, the costs ofassociated with executive management, cost to defend the recently dismissed class action lawsuit, evaluatingevaluation of various strategic business alternatives, financial and legal management and other administrative costs.

The decrease in general and administrative expenses as compared to the same prior year periods primarily reflects, the discontinuance of commercial activities in the second quarter of 2006 to respond to the April 2006 Approvable Letter and Surfaxin process validation stability failure. For the three and nine months ended September 30, 2006, costs associated with these commercial activities were $0 million and $5.9 million, respectively, as compared to $2.7 million and $7.2 million for the three and nine months ended September 30, 2005, respectively. The costs associated with the discontinuance of commercial activities are a component of the Q2 2006 restructuring charge. Additionally, there is a charge of $0.6 million and $2.9 million for the three and nine months ended September 30, 2006, respectively, associated with stock-based employee compensation in accordance with the provisions of SFAS No. 123R.
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Q2 2006 Restructuring Charge

In April 2006, we reducedreceived an Approvable Letter from the FDA for Surfaxin for the prevention of RDS in premature infants and announced that ongoing analysis of data from Surfaxin process validation batches that we had manufactured as a requirement for our staff levels and reorganized corporate managementNDA indicated that certain stability parameters no longer met acceptance criteria. As a result of these events, to lower our cost structure and re-align our operations with changed business priorities. These actions were takenpriorities, in response to our revised expectations concerning the timing of potential FDA approval and commercial launch of Surfaxin for the prevention of RDS in premature infants following the April 2006, Surfaxin process validation stability failure.
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we reduced our staff levels and reorganized corporate management. The reduction in workforce, which included three senior executives, totaled 52 employees, representing approximately 33% of our workforce, and was focused primarily on our commercial infrastructure, the development of which is no longer in our near-term plans. Included in the workforce reduction were three senior executives.infrastructure. All affected employees were eligible for certain severance payments and continuation of benefits. We expect to realize annual expense savingsAdditionally, a number of approximately $8.1 million from the reduction in work force and related operating expenses. Additionally, certainpre-launch commercial programs were discontinued and related costs will no longer be incurred.discontinued. Such commercial program expenses totaled approximately $5.0 million for the fourth quarter of 2005 and first quarter of 2006.

We incurred a restructuring charge of $4.8 million in the second quarter of 2006 associated with the staff reductions and the close-out of certain commercial programs, which was accounted for in accordance with Statement of Financial Accounting Standards No. 146 “Accounting for Costs Associated with Exit or Disposal Activities” and is identified separately on theour Statement of Operations as a Restructuring Charge. This charge included $2.5 million of severance and benefits related to staff reductions and $2.3 million for the termination of certain pre-launch commercial programs.
As of September 30, 2006, payments totaling $3.52007, the remaining balance of the unpaid restructuring charge totals $0.5 million, had been made related to these items and $1.3 million were unpaid. Of the $1.3 million that was unpaid as of September 30, 2006, $1.0 million waswhich is included in accounts payable and accrued expenses and $0.3 million was classified as a long-term liability.expenses.

Other Income/Income and (Expense)

Other income and (expense) for the three and nine months ended September 30, 2006 was2007 were ($71,000)16,000) and $474,000, respectively, compared to $67,000($257,000) million, respectively. Other income and $189,000(expense) for the three and nine months ended September 30, 2005.2006 were ($71,000) and $474,000 million, respectively.

IncludedInterest and other income for the three and nine months ended September 30, 2007 was $0.5 million and $1.3 million, respectively, as compared to $0.3 million and $1.5 million for the three and nine months ended September 30, 2006, respectively. The increase for the three months ended September 30, 2007 as compared to the same period last year is primarily due to an increase in other incomeour average outstanding cash balance and a general increase in earned market interest rates. The decrease for the nine months ended September 30, 2006 was $280,0002007 as compared to the same period last year is primarily due to proceeds of proceeds$0.3 million in the first quarter of 2006 from the sale of our Commonwealth of Pennsylvania research and development tax credits.

Interest, incomeamortization and other expenses for the three and nine months ended September 30, 20062007 was $0.3$0.5 million and $1.2$1.6 million, respectively, as compared to $0.3$0.4 million and $0.9$1.0 million for the three and nine months endedmonth ending September 30, 2005.2006, respectively. The increase is primarily due to a general increase in earned market interest rates.

Interest expense for the three and nine months ended September 30, 2006 was ($0.4) million and ($1.0) million, respectively, compared to ($0.3) million and ($0.7) million for the three and nine months ended September 30, 2005. The increase is primarily due toto: (i) interest expense related to the amortization of deferred financing costs associated with warrants issued to PharmaBio in October 2006 in consideration for renegotiating the terms on the existing $8.5 million loan and (ii) a prepayment penalty of $0.2 million incurred in the second quarter of 2007 associated with the prepayment of our credit facility and capital lease financing arrangements.outstanding indebtedness with GECC. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Liquidity and Capital Resources.”

LIQUIDITY AND CAPITAL RESOURCES

Working Capital

Cash is required to fund our working capital needs, to purchase capital assets,We have incurred substantial losses since inception and to pay our debt service, including principal and interest payments. We do not currently have any source of operating revenue and will require significant amounts of cashexpect to continue to fundmake significant investments for continued product research, development, manufacturing and commercialization activities. Historically, we have funded our operations our clinical trialsprimarily through the issuance of equity securities and the use of debt and capital lease facilities.

We are subject to risks customarily associated with the biotechnology industry, which requires significant investment for research and development. There can be no assurance that our research and development efforts until such time, if ever,projects will be successful, that one of our products has receiveddeveloped will obtain necessary regulatory approval, for marketing. Because we have not generatedor that any revenue from the sale of any products, we have primarily relied on the capital markets and debt financings as our source of funding. Weapproved product will continue to be opportunistic in accessing the capital markets to obtain financing on terms satisfactory to us. commercially viable.
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We plan to fund our future cash requirementsresearch, development, manufacturing and potential commercialization activities through:

·the issuance of equity and debt financings;
·payments from potential strategic collaborators, including license fees and sponsored research funding;
·sales of Surfaxin, if approved;
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·sales of our other product candidates, if approved;
·capital lease financings; and
·interest earned on invested capital.

ReceiptOur capital requirements will depend on many factors, including the success of a second Approvable Letterthe product development and the occurrence of manufacturing issuescommercialization plan. Even if we succeed in April 2006 (discussed in “Management’s Discussiondeveloping and Analysis of Financial Condition and Results of Operations - Plan of Operations”) caused ussubsequently commercializing product candidates, we may never achieve sufficient sales revenue to modify our expectations concerning the timing of potential FDA approval and commercial launch of Surfaxin. The related decline in market value of our common stock has made it more difficultachieve or maintain profitability. There is no assurance that we will be able to obtain equity and debt financing onadditional capital when needed with acceptable terms, that would be beneficial to us in the long term. We have engaged Jefferies & Company, Inc., the New York-based investment banking firm, toif at all.

To assist us in identifying and evaluating strategic alternatives intended to enhance the future growth potential of our SRT pipeline and maximize shareholder value.value, in 2006, we engaged Jefferies under an exclusive arrangement that we terminated in June 2007. In November 2006, we raised $10 million in a private placement transaction and, in April 2007, we raised $30.2 million ($28.1 million net) in a registered direct offering. We are evaluating multiplecontinue to evaluate a variety of strategic alternativestransactions, including, but not limited to, potential business alliances, commercial and development partnerships, financings business combinations and other similar opportunities. No assurances can be givenopportunities, although we cannot assure you that this evaluationwe will lead toenter into any specific actionactions or transaction.transactions.

After taking into accountWe have a CEFF that allows us to raise capital, subject to certain conditions, at the recently implemented cost containment measurestime and the restructuring of the PharmaBio loan and before taking into account any strategic alternatives, potential financings orin amounts that may be potentially available through the CEFF, we believe that our current working capital is sufficientdeemed suitable to meet planned activities into mid-2007.us, during a three-year period ending on May 12, 2009. Use of the CEFF is subject to certain conditions (discussed at “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Liquidity and Capital Resources - Committed Equity Financing Facility”, below), including a limitation on the total number of shares of common stock that we may issue under the CEFF (approximately 10.6(currently not more than approximately 5.2 million shares were available for issuance under the CEFF as of September 30, 2006)shares). In addition, during the eight trading day pricing period for a draw down, if the VWAP for any one trading day is less than the greater of (i) $2.00 or (ii) 85 percent of the closing price of our common stock for the trading day immediately preceding the beginning of the draw down period, the VWAP from that trading day will not be used in calculating the number of shares to be issued in connection with that draw down, and the draw down amount for that pricing period will be reduced by one-eighth of the draw down amount we had initially specified. We anticipate using the CEFF, when available, to support working capital needs in 2006 and 2007.

We will need additional financing from investors or collaborators to complete research and development, manufacturing, and commercialization of our current product candidates under development, and satisfy debt obligations. Working capital requirements will depend upon numerous factors, including, without limitation, the progress of our research and development programs, clinical trials, the timing and cost of obtaining regulatory approvals, remediation of manufacturing issues, costs implementing programs related to our response to the second Approvable Letter, including tightening of active ingredient and drug product specifications and related quality controls, levels of resources that we devote to the further development of manufacturing and product development capabilities, the cost of drug substances, devices and materials used in our manufacturing activities, technological advances, status of competitors, ability to establish collaborative arrangements and strategic partnerships with other organizations, the ability to defend and enforce intellectual property rights, litigation and regulatory activities, and the establishment of additional strategic or licensing arrangements with other companies or acquisitions.

Cash, Cash Equivalents and Marketable Securities

As of September 30, 2006,2007, we had cash, cash equivalents, restricted cash and marketable securities of $19.7$33.1 million, as compared to $50.9$27.0 million as of December 31, 2006. The increase is primarily due to: (i) in April 2007, a registered direct offering of 14,050,000 shares of our common stock to select institutional investors. The shares were priced at $2.15 per share resulting in gross proceeds of $30.2 million ($28.1 million net). This offering was made pursuant to our October 2005 a decreaseuniversal shelf registration statement; (ii) proceeds of $31.2 million. The decrease primarily consists of cash used in operating and investing activities of $34.1$2.0 million offset by $2.2 million of proceeds from a financing pursuant to the CEFF that resulted in the issuance of 1,078,519 shares of our common stock(discussed below); and $0.7(iii) $1.5 million of proceeds from the exerciseuse of stock optionsthe secured credit facility with Merrill Lynch; offset by (iv) $25.9 million used in operating activities, purchases of capital expenditures and warrants.principal payments on capital lease arrangements.

In October 2006,2007, we completed a financing pursuant to the CEFF resulting in proceeds of $2.3$5 million from the issuance of 1,204,8671,909,172 shares of our common stock at an average price per share, after the applicable discount, of $1.91.$2.62.
We are currently completing a financing pursuant to the CEFF and expect to realize proceeds of $3.0 million from the issuance of approximately 1.4 million shares of our common stock at an average price per share, after the applicable discount, of approximately $2.20.
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Committed Equity Financing Facility (CEFF)

In April 2006, we entered into a new Committed Equity Financing Facility (CEFF)CEFF with Kingsbridge, Capital Limited (Kingsbridge), a private investment group, in which Kingsbridge committed to purchase, subject to certain conditions, the lesser of up to $50 million or up to 11,677,047 shares of our common stock. Our previous Committed Equity Financing Facility, which was entered into with Kingsbridge in July 2004 (2004 CEFF) and under which had capital of up to $47.6 million remained available, automatically terminated on May 12, 2006, the date on which the SECSecurities and Exchange Commission (SEC) declared effective the registration statement filed in connection with the new CEFF. We currently have approximately 8.0 million shares available for issuance under the CEFF for future financings (not to exceed $42.5 million in gross proceeds).
 
This
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The CEFF allows us to raise capital, subject to certain conditions that we must satisfy, at the time and in amounts deemed suitable to us, during a three-year period that began on May 12, 2006. We are not obligated to utilize the entire $50 million available under this CEFF.
 
The purchase price of the shares sold to Kingsbridge will beunder the CEFF is at a discount ranging from 6 to 10 percent of the volume weighted average of the price of our common stock (VWAP) for each of the eight trading days following our election to sell shares, orinitiation of a “draw down” under the CEFF. The discount on each of these eight trading days will beis determined as follows:
 

VWAP*
 
% of VWAP (Applicable Discount)
 
Greater than $10.50 per share  94% (6)%
Less than or equal to $10.50 but greater than $7.00 per share  92% (8)%
Less than or equal to $7.00 but greater than or equal to $2.00 per share  90% (10)%
VWAP*
 
% of VWAP (Applicable Discount)
Greater than $10.50 per share 94% (6)%
Less than or equal to $10.50 but greater than $7.00 per share 92% (8)%
Less than or equal to $7.00 but greater than or equal to $2.00 per share 90% (10)%
_____
* As such term is set forth in the Common Stock Purchase Agreement.

DuringIf on any trading day during the eight trading day pricing period for a draw down, if the VWAP for any one trading day is less than the greater of (i) $2.00 or (ii) 85 percent of the closing price of our common stock for the trading day immediately preceding the beginning of the draw down period, the VWAP fromno shares will be issued with respect to that trading day will not be used in calculatingand the numbertotal amount of shares to be issued in connection with that draw down, and the draw down amount for that pricing period will be reduced for each such trading day by one-eighth of the draw down amount that we had initially specified.

Our ability to require Kingsbridge to purchase our common stock is subject to various limitations. Each draw down is limited to the lesser of 2.5 percent of the closing price market value of our outstanding shares of our common stock at the time of the draw down or $10 million. Unless Kingsbridge agrees otherwise, a minimum of three trading days must elapse between the expiration of any draw down pricing period and the beginning of the next draw down pricing period. In addition, Kingsbridge may terminate the CEFF under certain circumstances, including if a material adverse effect relating to our business continues for ten10 trading days after notice of the material adverse effect.
In 2006, in connection with the new CEFF, we issued a Class C Investor Warrant to Kingsbridge to purchase up to 490,000 shares of our common stock at an exercise price of $5.6186 per share, which is fully exercisable beginning October 17, 2006 and for a period of five years thereafter. The warrant must be exercisedis exercisable for cash, except in limited circumstances.

In connectioncircumstances, with the new CEFF, we issued a Class C Investor Warrantexpected total proceeds to Kingsbridge to purchase up to 490,000 sharesus, if exercised, of our common stock at an exercise price of $5.6186 per share, which is fully exercisable beginning October 17, 2006 and for a period of five years thereafter. The warrant must be exercised for cash, except in limited circumstances.approximately $2.8 million.
 
In May 2006,February 2007, we entered intocompleted a financing pursuant to the CEFF resulting in proceeds of $2.2$2 million from the issuance of 1,078,519942,949 shares of our common stock at an average price per share, after the applicable discount, of $2.03.$2.12.

In October 2006,2007, we completed a financing pursuant to the CEFF resulting in proceeds of $2.3$5 million from the issuance of 1,204,8671,909,172 shares of our common stock at an average price per share, after the applicable discount, of $1.91.$2.62.

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We are currently completing a financing pursuant toAs of October 12, 2007, there were approximately 5.2 million shares available for issuance under the CEFF and expect(up to realize proceedsa maximum of $3.0$35.5 million from the issuance of approximately 1.4 million shares of our common stock at an average price per share, after the applicable discount, of approximately $2.20.in gross proceeds) for future financings.

In 2004, and in connection with the 2004 CEFF, we issued a Class B Investor warrant to Kingsbridge to purchase up to 375,000 shares of our common stock at an exercise price equal to $12.0744 per share. The warrant, which expires in January 2010, must be exercisedis exercisable in whole or in part for cash, except in limited circumstances, forwith expected total proceeds, equal toif exercised, of approximately $4.5 million, if exercised.million. As of September 30,December 31, 2006, the Class B Investor Warrant had not been exercised in whole or in part.exercised.

Potential Financings under the October 2005 Universal Shelf Registration Statement

In October 2005, we filed a universal shelf registration statement on Form S-3 with the SEC for the proposed offering, from time to time, of up to $100.0$100 million of our debt or equity securities. In December 2005, we completed a registered direct offering of 3,030,304 shares of our common stock to select institutional investors resulting in gross proceeds to us of $20.0$20 million. In April 2007, we completed a registered direct offering of 14,050,000 shares of our common stock to select institutional investors resulting in gross proceeds of $30.2 million.
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The universal shelf registration statement may permit us, from time to time, to offer and sell up to an additional approximately $80.0$49.8 million of equity or debt securities. There can be no assurance, however, that we will be able to complete any such offerings of securities. Factors influencing the availability of additional financing include the progress of our research and development activities, investor perception of our prospects and the general condition of the financial markets, among others.

Investments in Property and Equipment

In October, we completed the construction of a new research and analytical laboratory in our Warrington, Pennsylvania corporate headquarters. The new laboratory will consolidate the analytical and development activities that are presently located in Doylestown, Pennsylvania, and Mountain View, California, including analytical testing of raw materials and commercial and clinical drug product supply, as well as research and development of our aerosol SRT and other novel formulations. The consolidation of scientific and analytical resources into one facility will allow us to leverage professional and scientific expertise and improve both operational efficiency and financial economics.

The investment in the new laboratory will be $3.3M ($2.6M is reflected on the balance sheet as property and equipment at September 30, 2007 and the remainder is anticipated in the fourth quarter 2007). We anticipate that approximately 95% of the total project will be financed utilizing: (i) our existing secured credit facility with Merrill Lynch; (ii) $650,000 from the Commonwealth of Pennsylvania (including a $500,000 loan from the Machinery and Equipment Loan Fund and grants of up to $150,000 through the Opportunities Grant Program and Customized Job Training Funds); and (iii) a $400,000 landlord contribution under our existing lease agreement.

Debt Facilities

Credit FacilityLoan with PharmaBio an Investment Group of Quintiles Transnational Corp.

We entered into a collaboration arrangement with Quintiles Transnational Corp. (Quintiles), in 2001, to provide certain commercialization services inPharmaBio, the United States for Surfaxin for the prevention of RDS in premature infants and Meconium Aspiration Syndrome in full-term infants. In connection with the commercialization agreement, PharmaBio, Quintiles strategic investment group of Quintiles, extended to us a secured, revolving credit facility of $8.5 to $10.0$10 million to fund pre-marketing activities associatedin 2001. In 2004 and in October 2006, we amended and restated the loan documents and restructured the loan. As a result of the restructuring, we now have a loan with the launch of SurfaxinPharmaBio in the United States. The facility was renegotiated in November 2004. At September 30, 2006,principal amount of $8.5 million was outstanding under the credit facility. On October 25, 2006, we and PharmaBio agreed to restructure the existing $8.5 million credit facility (PharmaBio loan) that was scheduled to maturematures on December 31, 2006. Under the restructuring, the maturity date of the PharmaBio loan has been extended by 40 months, from December 31, 2006 to April 30, 2010. Prior to October 1, 2006, interest accrued at a rate equal to the greater of 8% or the prime rate plus 2% and was payable quarterly. Beginning onSince October 1, 2006, interest on the loan will accruehas accrued at the prime lending rate, of Wachovia Bank, N.A., subject to change when and as such rate changes, compounded annually. All unpaid interest, including interest payable with respect to the quarter ending September 30, 2006, will now be payable on April 30, 2010, the maturity date of the PharmaBio loan. We may repay the loan, in whole or in part, at any time without prepayment penalty or premium.

In connection with the restructuring, on October 25, 2006, we and PharmaBio entered into a Second Amended and Restated Loan Agreement (Loan Agreement) and a Second Amended and Restated Security Agreement (Security Agreement). Pursuant to the Loan Agreement, we have issued to PharmaBio a Second Amended and Restated Promissory Note (Note), which replaces and supersedes the note dated as of December 10, 2001 as amended and restated as of November 3, 2004. Our obligationaddition, our obligations to PharmaBio under the Note, the Loan Agreement and the Security Agreementloan documents are now secured by an interest in substantially all of our assets, subject to limited exceptions set forth in the Security Agreement (the PharmaBio Collateral).

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OnAlso in October 25, 2006, in consideration of PharmaBio’s agreement to restructure the loan, we and PharmaBio entered into a Warrant Agreement with PharmaBio, pursuant to which PharmaBio has the right to purchase 1,500,0001.5 million shares of our common stock par value $0.001 per share, at an exercise price equal to $3.5813 per share, which represents a 30% premium over the VWAP (as reported by Bloomberg, L.P.) of our common stock for the ten trading days immediately preceding the date of the Warrant Agreement.share. The warrants granted under the Warrant Agreement have a seven-year term and are exercisable, in whole or in part, for cash, cancellation of a portion of our indebtedness under the Loan Agreement,PharmaBio loan agreement, or a combination of the foregoing, in an amount equal to the aggregate purchase price for the shares being purchased upon any exercise. Under the Warrant Agreement, we have agreed to filefiled a registration statement with the SEC within 45 days of October 25, 2006 with respect to the resale of the shares issuable upon exercise of the warrants. The warrants were issued to PharmaBio in

As of September 30, 2007, the outstanding balance under the loan was $9.5 million ($8.5 million of pre-restructured principal and $1.0 million of accrued interest) and was classified as a private transaction exempt from registration pursuant to Section 4(2) oflong-term loan payable on the Securities Act of 1933, as amended.Consolidated Balance Sheets.

Capital Lease and Note Payable Financing Arrangements with Merrill Lynch Capital

On May 21, 2007, we and Merrill Lynch Capital, a division of Merrill Lynch Business Financial Services Inc. (Merrill Lynch), entered into a Credit and Security Agreement (Loan Agreement), pursuant to which Merrill Lynch is providing us a $12.5 million credit facility (Facility) to fund our capital programs. Under the Facility, $9 million was made available immediately (with up to an additional $3.5 million becoming available, at a rate of $1 million for each $10 million raised by us through business development partnerships, stock offerings and other similar financings). Approximately $4.0 million of the Facility was drawn to fund the prepayment of all our outstanding indebtedness to General Electric Capital Corporation (GECC) under the Master Security Agreement with GECC dated December 20, 2002, as amended (GECC Agreement). The right to draw funds under the Facility will expire on May 30, 2008, subject to a best efforts undertaking by Merrill Lynch to extend the draw down period beyond the expiration date for an additional six months. The minimum advance under the Facility is $100,000. Interest on each advance will accrue at a fixed rate per annum equal to LIBOR plus 6.25%, determined on the funding date of such advance. Principal and interest on all advances will be payable in equal installments on the first business day of each month. We may prepay advances, in whole or in part, at any time, subject to a prepayment penalty, which, depending on the period of time elapsed from the closing of the Facility, will range from 4% to 1%.
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We may use the Facility to finance (a) new property and equipment and (b) up to approximately $1.7 million “Other Equipment” and related costs, which may include leasehold improvements, intangible property such as software and software licenses, specialty equipment, a pre-payment penalty paid to GECC and “soft costs” related to financed property and equipment (including, without limitation, taxes, shipping, installation and other similar costs). Advances to finance the acquisition of new property and equipment will be amortized over a period of 36 months. The advance related to the GECC prepayment will be amortized over a period of 27 months and Other Equipment and related costs will be amortized over a period of 24 months.

Our obligations to Merrill Lynch are secured by a security interest in (a) the financed property and equipment, including the property and equipment securing GECC at the time of prepayment, and (b) all of our intellectual property, subject to limited exceptions set forth in the Loan Agreement (Supplemental Collateral). The Supplemental Collateral will be released on the earlier to occur of (i) receipt by us of FDA approval of our NDA for Surfaxinfor the prevention of RDS in premature infants, or (ii) the date on which we shall have maintained over a continuous 12-month period ending on or after March 31, 2008, measured at the end of each calendar quarter, a minimum cash balance equal to our projected cash requirements for the following 12-month period. In addition, we, Merrill Lynch and PharmaBio entered into an Intercreditor Agreement under which Merrill Lynch agreed to subordinate its security interest in the Supplemental Collateral (which does not include financed property and equipment) to the security interest in the same collateral that we previously granted to PharmaBio (discussed above).

OurAs of September 30, 2007, approximately $4.9 million was outstanding under the Facility ($2.1 million classified as current liabilities and $2.8 million as long-term liabilities) and $3.5 million remained available for use, subject to the conditions of the Facility. In the quarter ending September 30, 2007, we used $1.3 million under this Facility, primarily to finance the new laboratory.

Previously, our capital lease financing arrangements havehad been primarily with the Life Science and Technology Finance Division of General Electric Capital Corporation (GECC) pursuantGECC. Pursuant to a Master Security Agreement dated December 20, 2002 (Master Security Agreement). The Master Security Agreement, which previously had been extended, expired October 31, 2006; however, GECC has agreed in the near term to discuss our capital financing needs on a month to month basis. We are also considering alternative capital financing arrangements. There is no assurance, however, that we will receive additional financing from GECC or secure an alternate source to finance our capital lease needs in the future.

Under the Master Security Agreement, we purchased capital equipment, including manufacturing, information technology systems, laboratory, office and other related capital assets and subsequently financefinanced those purchases through capital leases. The capital leases are secured by the related assets. Laboratory and manufacturing equipment is financed over 48 months and all other equipment is financed over 36 months. Interest rates vary in accordance with changes in the three and four year treasury rates. As of September 30, 2006, $4.8 million is outstanding ($1.9 million classified as current liabilities and $2.9 million as long-term liabilities) and $1.5 million remained available for future use, subject to certain conditions. In October 2006, we drew an additional $378,945 in connection with the purchase of property and equipment.

In connection with the restructuring of the PharmaBio loan, on October 25, 2006, we and GECC entered into an Amendment No. 5 and Consent (GECC Amendment) to the Master Security Agreement, pursuant to which GECC consented to our execution and delivery of the Security Agreement to PharmaBio and, in consideration of the consent and other amendments to the Master Security Agreement, we granted to GECC, as additional collateral under the Master Security Agreement, a security interest in the PharmaBio Collateral. We, GECC and PharmaBio also entered into an Intercreditor Agreement, pursuant to which GECC agreed to subordinate its security interest in the PharmaBio Collateral to PharmaBio’s security interest in the PharmaBio Collateral. GECC retains a first priority security interest in the property and equipment financed under the Master Security Agreement, which are not a part of the PharmaBio Collateral. Under the GECC Amendment, GECC will release its security interest in the PharmaBio Collateral upon (a) receipt by us of FDA approval for Surfaxin for the prevention of RDS in premature infants or (b) the occurrence of certain milestones to be agreed. If the parties are unable to agree on milestones or if we elect to prepay all of our indebtedness to GECC at a time when GECC holds a security interest in the PharmaBio Collateral, we may do so without prepayment penalty.GECC.

Lease Agreements

We maintain facility leases for our operations in Pennsylvania, New Jersey and California.

We maintain our headquarters in Warrington, Pennsylvania. The facility is 39,594 square feet and serves as the main operating facility for clinical development, regulatory, sales and marketing, and administration. TheIn April 2007, the lease, expireswhich originally expired in February 2010 with total aggregate payments of $4.6 million.million, was extended an additional three years through February 2013 with additional payments of $3.0 million over the extension period.

We lease a 21,000 square foot pharmaceutical manufacturing and development facility in Totowa, New Jersey, that is specifically designed for the production of sterile pharmaceuticals in compliance with cGMP requirements. The lease expires in December 2014 with total aggregate payments since inception of the lease of $1.4 million ($150,000 per year). The lease contains an early termination option, first beginning in December 2009. The early termination option can only be exercised by the landlord upon a minimum of two years prior notice and payment of significant early termination amounts to us, subject to certain conditions.

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In August 2006, we extended the lease onreduced our leased office and analytical laboratory space in Doylestown, Pennsylvania. We reduced our leased spacePennsylvania from approximately 11,000 square feet to approximately 5,600 square feet. We maintainfeet and extended the Doylestown facility for the continuation of analytical laboratory activities under a lease that expiresexpired in MayAugust 2007 and is subject to extensions on a monthly basis. We are currently consolidating the activities at this location into our new laboratory space in Warrington, Pennsylvania and expect to terminate this lease in the first half of 2008.

We lease office and laboratory space in Mountain View, California. The facility is 16,800 square feet and houses our aerosol and formulation development operations.activities. We are currently consolidating these activities into our new laboratory space in Warrington, Pennsylvania. The lease expires in June 2008 with total aggregate payments since inception of the lease of $804,000.

If we are successful in commercializing our SRT portfolio, we expect that our needs for additional leased space will increase.

Future Capital Requirements

Unless and until we can generate significant cash from our operations, we expect to continue to require substantial additional funding to conduct our business, including our manufacturing, and research and product development activities and to repay our indebtedness. Our operations will not become profitable before we exhaust our current resources; therefore, we will need to raise substantial additional funds through additional debt or equity financings or through collaborative ventures with potential corporate partners. We may in some cases elect to develop products on our own instead of entering into collaboration arrangements and this would increase our cash requirements. Other than our CEFF with Kingsbridge and our capital equipment financing facility with Merrill Lynch, the use of which are subject to certain conditions, we currently do not have anyno contractual arrangements under which we may obtain additional financing.

On June 20, 2006, we announced that we had engaged Jefferies & Company, Inc., the New York-based investment banking firm, toTo assist us in identifying and evaluating strategic alternatives intended to generate additional funds and enhance the future growth potential of our surfactant replacement therapySRT pipeline and maximize shareholder value.value, in 2006, we engaged Jefferies under an exclusive arrangement that we terminated in June 2007. In November 2006, we raised $10 million in a private placement transaction and, in April 2007, we raised $30.2 million ($28.1 million net) in a registered direct offering. We are considering multiplecontinue to evaluate a variety of strategic alternatives,transactions, including, but not limited to, potential business alliances, commercial and development partnerships, financings business combinations and other similar opportunities. No assurances can be givenopportunities, although we cannot assure you that this evaluationwe will lead toenter into any specific actionactions or transaction.transactions.

If a transaction involving the issuance of additional equity and debt securities is concluded, such a transaction may result in additional dilution to our shareholders. We cannot be certain that additional funding will be available when needed or on terms acceptable to us, if at all. If we fail to receive additional funding or enter into business alliances or other similar opportunities, we may have to reduce significantly the scope of or discontinue our planned research, development and manufacturing activities, which could significantly harm our financial condition and operating results.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
ITEM3.QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Our exposure to market risk is confined to our cash, cash equivalents and available for sale securities. We place our investments with high quality issuers and, by policy, limit the amount of credit exposure to any one issuer. We currently do not hedge interest rate or currency exchange exposure. We classify highly liquid investments purchased with a maturity of three months or less as “cash equivalents” and commercial paper and fixed income mutual funds as “available for sale securities.” Fixed income securities may have their fair market value adversely affected due to a rise in interest rates and we may suffer losses in principal if forced to sell securities that have declined in market value due to a change in interest rates.
 
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ITEM 4.CONTROLS AND PROCEDURES
CONTROLS AND PROCEDURES
 
(a) Evaluation of disclosure controls and procedures
 
Our management, including our Chief Executive Officer and Chief Financial Officer, dodoes not expect that our disclosure controls or our internal control over financial reporting will prevent all error and all fraud. A control system, no matter how well designed and operated, can provide only reasonable, not absolute, assurance that the control system’s objectives will be met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. 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, within the Companycompany 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.
 
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Our Chief Executive Officer and our Chief Financial Officer have 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 Quarterly Report on Form 10-Q. Based on this evaluation, theour Chief Executive Officer and our Chief Financial Officer concluded that as of the end of the period covered by this report theour disclosure controls and procedures were effective in their design to ensure that information required to be disclosed by us in the reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’sSEC's rules and forms.

(b) Changes in internal controls

There were no changes in internal controls over financial reporting or other factors that could materially affect those controls subsequent to the date of our evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.


PART II –- OTHER INFORMATION

ITEM 1. 1. LEGAL PROCEEDINGS

In connection with the shareholder class actions filed inOn March 15, 2007, the United States District Court for the Eastern District of Pennsylvania againstgranted defendant’s motion to dismiss the Company in May 2006 and consolidated in June 2006 under the caption “In re: Discovery Laboratories Securities Litigation”, aSecond Consolidated Amended Complaint was filed by the Mizla Group, the lead plaintiffs, on August 9, 2006, individually and on behalf of a class of the Company’s investors who purchased the Company’sour publicly traded securities between March 15, 2004 and June 6, 2006.2006, alleging securities laws-related violations in connection with various of our public statements. The amended complaint names as defendants the Company, the Company’shad been filed on November 30, 2006 against us, our Chief Executive Officer, Robert J. Capetola, and the Company’sour former Chief Operating Officer, Christopher J. Schaber.Schaber, under the caption “In re: Discovery Laboratories Securities Litigation” and sought an order that the action proceed as a class action and an award of compensatory damages in favor of the plaintiffs and the other class members in an unspecified amount, together with interest and reimbursement of costs and expenses of the litigation and other equitable or injunctive relief. On September 14, 2006, the Company’s counselApril 10, 2007, plaintiffs filed a Motion to Dismiss the Consolidated Amended Complaint and on November 1, 2006, the court dismissed the Consolidated Amended Complaint, without prejudice, and granted plaintiffs leave to file an amended Consolidated Amended Complaint by November 30, 2006. The Company has no information as to whether the plaintiffs plan to file an amended complaintNotice of Appeal with the court.

Two shareholder derivative complaints filed in May and June 2006, respectively, in the United States District Court for the Eastern District of Pennsylvania against the Company’s Chief Executive Officer, Robert J. Capetola, and the Company’s directors remain subject to a stipulation agreement between the parties providing that the Company is not required to respond to these consolidated complaints until 60 days following defendants’ answer or a dispositive rulingfiled an opening brief on a motion to dismissJuly 2, 2007. Defendants filed in response to the consolidated amended complaint in the class actions, described above.their opening brief on August 6, 2007, and Plaintiffs filed their reply brief on August 20, 2007.
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If any of these actions proceed, the Company intendsWe intend to vigorously defend them.the appeal of the securities class action. The potential impact of this or any such actions, all of which generally seek unquantified damages, attorneys’ fees and expenses is uncertain. Additional actions based upon similar allegations, or otherwise, may be filed in the future. There can be no assurance that an adverse result in any such proceedings would not have a potentially material adverse effect on the Company’sour business, results of operations and financial condition.

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The Company hasWe have from time to time been involved in disputes arising in the ordinary course of business, including in connection with the termination in 2006 of itscertain pre-launch commercial programs (discussed in Note 7, above).following our process validation stability failure. Such claims, with or without merit, if not resolved, could be time-consuming and result in costly litigation. While it is impossible to predict with certainty the eventual outcome of such claims, we believe the Company believes theypending matters are unlikely to have a material adverse effect on itsour financial condition or results of operations. However, there can be no assurance that the Companywe will be successful in any proceeding to which itwe are or may be a party.

ITEM 1A.1A. RISK FACTORS
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.

The riskIn addition to the risks, uncertainties and other factors set forth below have been revised based on recent events related toherein, see the Company and described elsewhere in this report. These risk factors should be read together with the factors discussed in Part I, Item 1A - Risk Factors“Risk Factors” section contained in our most recent Annual Report on Form 10-K for the year ended December 31, 2005.

The risks described in this report and in our Annual Report on Form 10-K are not the only risks we face. Additional risks and uncertainties not currently known to us or that we currently deem to be immaterial also may materially adversely affect our business, financial condition and/or operating results.10-K.

Refocusing our business subjects us to risks and uncertainties.ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

Since we received our second Approvable Letter from the FDA, we have been reassessing the business environment, our position within the biotechnology industry and our relative strengths and weaknesses. As a result of this reassessment, we have implemented significant changes to our operations as part of our overall business strategy. For example, we have reduced the size of our workforce and made changes to senior management. Additional changes to our business will be considered as our management seeks to strengthen financial and operational performance. These changes may be disruptive to our established organizational culture and systems. In addition, consideration and planning of strategic changes diverts management attention and other resources from day to day operations.

We may fail to realize the benefits that we expect from our cost-savings initiatives.

We have undertaken and expect to continue to undertake cost-savings initiatives. However, we cannot assure you that we will realize on-going cost savings or any other benefits from these initiatives. Even if we realize the benefits of our cost savings initiatives, any cash savings that we achieve may be offset by other costs, such as costs related to ongoing development activities and pre-clinical and clinical studies. Staff reductions may reduce our workforce below the level needed to effectively manage our business and service our development programs. Our failure to realize the anticipated benefits of our cost-savings initiatives could have a material adverse effect on our business, results of operations and financial condition.

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 of our products.

To sell Surfaxin or any of our other products under development, we must receive regulatory approvals for each product. The FDA and foreign regulators extensively and rigorously regulate the testing, manufacture, distribution, advertising, pricing and marketing of drug products like our products. This approval process includes preclinical studies and clinical trials of each pharmaceutical compound to establish the safety and effectiveness of each product and the confirmation by the FDA and foreign regulators that, in manufacturing the product, we maintain good laboratory and manufacturing practices during testing and manufacturing. Even if favorable testing data is generated by clinical trials of drug products, the FDA or EMEA may not accept or approve an NDA or MAA filed by a pharmaceutical or biotechnology company for such drug product. To market our products outside the United States, we also need to comply with foreign regulatory requirements governing human clinical trials and marketing approval for pharmaceutical products.

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We have filed an NDA with the FDA for Surfaxin for the prevention of RDS in premature infants. As part of the review of the Surfaxin NDA, the FDA, in January 2005, issued a Form FDA 483 to our then contract manufacturer, Laureate. The FDA cited inspectional observations related to basic quality controls, process assurances and documentation requirements that support the commercial production process necessary to comply with cGMPs. The FDA issued an Approvable Letter to us in February 2005 regarding our NDA. To address the Form FDA 483 inspectional observations, we and Laureate implemented improved quality systems and documentation controls believed to support the FDA’s regulatory requirements for the approval of Surfaxin. In October 2005, the FDA accepted our responses to the Approvable Letter as a complete response thereby establishing April 2006 as its target to complete its review of our NDA. In April 2006, ongoing analysis of data from Surfaxin process validation batches that were manufactured as a requirement for our NDA, indicated that certain stability parameters had not been achieved and, therefore, three additional process validation batches will have to be produced. In September 2006, we announced that, although our comprehensive investigation is ongoing, we believe we have identified a most probable root cause of the process validation stability failures. Our investigation continues, however, and may identify other contributing factors or causes for the process validation stability failure. There can be no assurance that we have identified or will identify the definitive root cause of the process validation stability failure. If we are unable to identify a definitive root cause, we may not be able to manufacture our drug product successfully within our expected timeline, if at all. The investigation is being conducted in compliance with FDA cGMP requirements, covers, among other things, manufacturing processes, test methods, and drug substance suppliers. As part of the investigation, in addition to a variety of audits, tests and experiments, we have manufactured three “investigation batches” of Surfaxin that have passed the critical release specification assays, with stability monitoring ongoing. These investigation batches are not designated as process validation batches but are expected to provide significant data that will support our comprehensive investigation report and a corrective action and preventative action (CAPA) plan. Also in April 2006, the FDA issued a second Approvable Letter to us, requesting certain information primarily focused on the CMC section of the NDA. The information predominately involves the further tightening of active ingredient and drug product specifications and related controls. On September 28, 2006, we filed a briefing package and requested a meeting with the FDA. The purpose of this meeting is to clarify the issues identified by the FDA in the second Approvable Letter and reach agreement with the FDA on the appropriate path to potentially gain approval of Surfaxin for the prevention of RDS in premature infants. The FDA has notified us that a meeting has been scheduled for December 21, 2006. Once we have achieved satisfactory Surfaxin process validation stability testing over an acceptable period (currently contemplated to be six months) and have finalized our response to the second Approvable Letter, we will submit to the FDA our formal response to the second Approvable Letter. At that time, the FDA will advise us if it will accept our response to the second Approvable Letter as a complete response and the time frame in which it will complete its review. Even if the FDA accepts our response as a complete response, the FDA might still delay its approval of our NDA or reject our NDA, which would have a material adverse effect on our business.

We filed an MAA with the EMEA for clearance to market Surfaxin for the prevention and rescue treatment of RDS in premature infants in Europe. At the time of the Surfaxin process validation stability failure, we had responded to the Day 180 List of Outstanding Issues from the Committee for Medicinal Products for Human Use (CHMP) and had met with the EMEA to discuss our response. Because our manufacturing issues would not be resolved within the regulatory time frames mandated by the EMEA, we determined in June 2006 to voluntarily withdraw the MAA for Surfaxin for the prevention and rescue treatment of RDS in premature infants. We plan in the future to have further discussions with the EMEA and develop a strategy to potentially gain approval for Surfaxin in Europe.
See also Item 2: “Management’s Discussion and Analysis of Financial Condition and Results of Operation - Overview and Plan of Operations.”

Our pending NDA for Surfaxin for the prevention of RDS in premature infants may not be approved by the FDA in a timely manner or at all, which would adversely impact our ability to commercialize this product.

We submitted an NDA to the FDA for Surfaxin for the prevention of RDS in premature infants. In April 2006, we received a second Approvable Letter from the FDA. Specifically, the FDA requested certain information primarily focused on the CMC section of the NDA. The information predominately involves the further tightening of active ingredient and drug product specifications and related controls. . Thereafter, we learned that ongoing analysis of data from Surfaxin process validation batches that were manufactured as a requirement for our NDA indicated that certain stability parameters had not been achieved and, therefore, three new Surfaxin process validation batches will have to be produced. These events have caused us to revise our expectations concerning the timing of potential FDA approval of our NDA. We are conducting a comprehensive investigation with a view to identify a definitive root cause of the process validation stability failure and implement a corrective action and preventative action (CAPA) plan. When we are satisfied that we have remediated our manufacturing issues, we will manufacture new process validation batches and, after we have achieved satisfactory Surfaxin process validation stability testing over an acceptable period (currently contemplated to be six months) and have finalized our response to the second Approvable Letter, we will submit to the FDA our formal response to the second Approvable Letter. Nevertheless, the FDA may request additional information from us, including data from additional clinical trials. Ultimately, the FDA may not approve Surfaxin for RDS in premature infants. Any failure to obtain FDA approval or further delay associated with the FDA’s review process would adversely impact our ability to commercialize our lead product.

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The manufacture of our products is a highly exacting and complex process, and if we or one of our materials suppliers encounter problems manufacturing our products, our business could suffer.

The FDA and foreign regulators require manufacturers to register manufacturing facilities. The FDA and foreign regulators also inspect these facilities to confirm compliance with cGMP or similar requirements that the FDA or foreign regulators establish. We or our materials suppliers may face manufacturing or quality control problems causing product production and shipment delays or a situation where we or the supplier may not be able to maintain compliance with the FDA’s cGMP requirements, or those of foreign regulators, necessary to continue manufacturing our drug substance. Manufacturing or quality control problems have already and may again occur at our Totowa facility or at our materials suppliers. Such problems, including, for example, our recent product stability testing program issues, require potentially complex, time-consuming and costly investigations to determine the root causes of such problems and may also require detailed and time-consuming remediation efforts, which can further delay the regulatory approval process. Any failure to comply with cGMP requirements or other FDA or foreign regulatory requirements could adversely affect our clinical research activities and our ability to market and develop our products.

In December 2005, we acquired Laureate’s clinical manufacturing facility in Totowa, New Jersey. The facility has been qualified to produce appropriate clinical grade material of our drug product for use in our ongoing clinical studies. With this acquisition, we now maintain a complete manufacturing facility and we will be manufacturing our products. We currently own certain specialized manufacturing equipment, employ certain manufacturing managerial personnel, and we expect to invest in additional manufacturing equipment. However, we may be unable to produce Surfaxin and our other SRT drug candidates to appropriate standards for use in clinical studies or commercialization. If we do not successfully develop our manufacturing capabilities, it will adversely affect the sales of our products.

In connection with the development of Aerosurf, we expect to rely on third-party contract manufacturers to manufacture the Chrysalis drug device products and components to support our clinical studies and potential commercialization of Aerosurf. Certain of the drug device components must be manufactured in a sterile environment, subject to ongoing monitoring of conformance to product specifications of each device. The manufacturer must be registered with and qualified by the FDA and must conduct its manufacturing activities in compliance with cGMP requirements, or those of foreign regulators. We may be unable to identify a qualified manufacturer to meet our requirements or the manufacturer we identify may be unable to timely comply with FDA, or other foreign regulatory agency, requirements to manufacture the drug product devices or such manufacturer may not manufacture to our specifications for use in clinical studies or, if approved, commercialization. If we do not successfully identify and enter into a contractual agreement with drug device and components manufacturers, it will adversely affect the timeline of our plans for development, the development plan and, if approved, commercialization of Aerosurf.

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If the parties we depend on for supplying our active drug substance and certain manufacturing-related services do not timely supply these products and services, it may delay or impair our ability to develop, manufacture and market our products.

We rely on suppliers for our active drug substances and third parties for certain manufacturing-related services to produce material that meets appropriate content, quality and stability standards for use in clinical trials of our products and, after approval, for commercial distribution. To succeed, clinical trials require adequate supplies of drug substance and drug product, which may be difficult or uneconomical to procure or manufacture. The manufacturing process for the drug product devices used in Aerosurf includes the integration of a number of products, many of which are comprised of a large number of subcomponent parts, that we expect will be produced by one or more manufacturers. We and our suppliers may not be able to (i) produce our drug substances, drug product or drug product devices to appropriate standards for use in clinical studies, (ii) perform under any definitive manufacturing, supply or service agreements with us or (iii) remain in business for a sufficient time to successfully produce and market our product candidates. If we do not maintain important manufacturing and service relationships, we may fail to find a replacement supplier or required vendor or develop our own manufacturing capabilities which could delay or impair our ability to obtain regulatory approval for our products and substantially increase our costs or deplete profit margins, if any. If we do find replacement manufacturers and suppliers, we may not be able to enter into agreements with them on terms and conditions favorable to us and, there could be a substantial delay before a new facility could be qualified and registered with the FDA and foreign regulatory authorities.

We will need additional capital and our ability to continue all of our existing planned research and development activities is uncertain. Any additional financing could result in equity dilution.

We will need substantial additional funding to conduct our presently planned research and product development activities. Based on our current operating plan, we believe that our currently available working capital will be adequate to satisfy our capital needs into mid-2007, before taking into account any amounts that may be available through the CEFF. Our future capital requirements will depend on a number of factors that are uncertain, including the results of our research and development activities, clinical studies and trials, competitive and technological advances and the regulatory process, among others. We will likely need to raise substantial additional funds through collaborative ventures with potential corporate partners and through additional debt or equity financings. We may also continue to seek additional funding through new capital lease arrangements, if available. We may in some cases elect to develop products on our own instead of entering into collaboration arrangements. This would increase our cash requirements for research and development.

We have not entered into arrangements to obtain any additional financing other than the CEFF with Kingsbridge, the PharmaBio loan and our capital equipment lease financing arrangement with GECC, which expired on October 31, 2006. Our use of the CEFF is subject to certain conditions, discussed in “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Liquidity and Capital Resources - Committed Equity Financing Facility” above. In addition, Kingsbridge has the right under certain circumstances to terminate the CEFF, including upon the occurrence of a material adverse event.

Our equipment lease financing arrangement with GECC expired on October 31, 2006. We continue to engage in discussions with GECC, which has agreed in the near term to discuss our financing needs on a month to month basis, and are considering alternative arrangements with other financing entities, there is no assurance that our discussions with GECC will be successful or that any alternative arrangements will be successfully concluded. If we are successful in arranging for property and lease financing arrangements, there is no assurance that such arrangements will be on terms that are favorable to us or sufficient to meet our capital financing needs over the term of the arrangement. If we do not obtain additional capital financing, we may not be able to execute on our business plan, in particular our manufacturing strategy, and be forced to delay or scale back our activities.

On June 20, 2006, we announced that we have engaged Jefferies & Company, Inc., the New York-based investment banking firm, to assist us in identifying and evaluating strategic alternatives intended to generate additional funds and enhance the future growth potential of our surfactant replacement therapy pipeline and maximize shareholder value. We are considering multiple strategic alternatives, including, but not limited to, potential business alliances, commercial and development partnerships, financings, business combinations and other similar opportunities. No assurances can be given that this evaluation will lead to any specific action or transaction or generate additional capital for us.

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If we seek additional financing, such additional financing could include unattractive terms or result in significant dilution of stockholders’ interests and share prices may decline. If we fail to receive additional funding or enter into business alliances or other similar opportunities, we may have to delay, scale back or discontinue certain of our research and development operations, and consider licensing the development and commercialization of products that we consider valuable and which we otherwise would have developed ourselves. If we are unable to raise required capital, we may be forced to limit many, if not all, of our research and development programs and related operations, curtail commercialization of our product candidates and, ultimately, cease operations. See also “Risk Factors: Our Committed Equity Financing Facilities may have a dilutive impact on our stockholders.”

Furthermore, if the market price of our common stock declines as a result of the dilutive aspects of such potential financings, we could cease to meet the financial requirements to maintain the listing of our securities on The Nasdaq Global Market. See“Risk Factors: The market price of our stock may be adversely affected by market volatility.”

Our Committed Equity Financing Facilities may have a dilutive impact on our stockholders.

The issuance of shares of our common stock under the CEFF and upon exercise of the warrants we issued to Kingsbridge 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 CEFF, we will issue shares of our common stock to Kingsbridge at a discount of between 6% and 10% of the daily volume weighted average price of our common stock during a specified period of trading days after we access the CEFF. Issuing shares at a discount will further dilute the interests of other stockholders.

To the extent that Kingsbridge sells shares of our common stock issued under the CEFF to third parties, 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 may not be able to meet the conditions we are required to meet under the CEFF and we may not be able to access any portion of the approximately 8.0 million shares potentially available for issuance for future financings (not to exceed $42.5 million), subject to the terms and conditions of the CEFF.

In addition, we are dependent upon the financial ability of Kingsbridge to fund the CEFF. Any failure by Kingsbridge to perform its obligations under the CEFF could have a material adverse effect upon us.

We do not have sales and marketing experience and our lack of experience may restrict our success in commercializing our product candidates.

We do not have experience in marketing or selling pharmaceutical products. As a result of our recent manufacturing problems, we discontinued our commercial activities, which are no longer in our near-term plans. To achieve commercial success for Surfaxin, or any other approved product, we will be dependent upon entering into arrangements with others to market and sell our products.

We may be unable to establish satisfactory arrangements for marketing, sales and distribution capabilities necessary to commercialize and gain market acceptance for Surfaxin or our other product candidates. To obtain the expertise necessary to successfully market and sell Surfaxin, or any other product, will require the development of collaborative commercial arrangements and partnerships. Our ability to make that investment and also execute our current operating plan is dependent on numerous factors, including, the performance of third party collaborators with whom we may contract. Accordingly, we may not have sufficient funds to successfully commercialize Surfaxin or any other potential product in the United States or elsewhere.

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We depend upon key employees and consultants in a competitive market for skilled personnel. If we are unable to attract and retain key personnel, it could adversely affect our ability to develop and market our products.
We are highly dependent upon the principal members of our management team, especially our Chief Executive Officer, Dr. Capetola, and our directors, as well as our scientific advisory board members, consultants and collaborating scientists. Many of these people have been involved in our formation or have otherwise been involved with us for many years, have played integral roles in our progress and we believe that they will 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.
In order to lower our cost structure and re-align our operations with business priorities, in April 2006, we reduced our staff levels and reorganized our corporate structure. The workforce reduction totaled 52 employees, representing approximately 33% of our workforce, and was focused primarily on commercial infrastructure, the development of which is no longer in our near-term plans. Included in the workforce reduction were three senior executives. As a consequence of this reduction in force, our dependence on our remaining management team is increased. If we find it necessary or advisable to hire additional managers, a portion of the expected cost savings from our recent restructuring might not be realized.
To retain and provide incentives to certain of our key continuing executives, we entered into amended and new employment agreements with our executive management and other officers, which agreements provide for employment for a stated term, subject to automatic renewal, severance payments in the event of termination of employment, enhanced severance benefits in the event of a change of control and equity incentives in the form of stock and option grants. Although these employment agreements generally include non-competition covenants and provide for severance payments that are contingent upon the applicable employee’s refraining from competition with us, the applicable noncompete provisions can be difficult and costly to monitor and enforce. The loss of any of these persons’ services would adversely affect our ability to develop and market our products and obtain necessary regulatory approvals. Further, we do not maintain key-man life insurance.
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. We 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 suit from their former employers.

While we attempt to provide competitive compensation packages to attract and retain key personnel, some of our competitors are likely to have greater resources and more experience than we have, making it difficult for us to compete successfully for key personnel.

A substantial number of our securities are eligible for future sale and this could affect the market price for our stock and our ability to raise capital.

The market price of our common stock could drop due to sales of a large number of shares of our common stock or the perception that these sales could occur. As of September 30, 2006 we had 62,374,235 shares of common stock issued and outstanding.

We have a universal shelf registration statement on Form S-3 (File No. 333-128929), filed with the SEC on October 11, 2005, for the proposed offering from time to time of up to $100 million of our debt or equity securities, of which $80 million is remaining. We have no immediate plans to sell any securities under this registration statement. However, we may issue securities from time to time in response to market conditions or other circumstances on terms and conditions that will be determined at such time.

Additionally, there are 375,000 shares of our common stock that are currently reserved for issuance with respect to the Class B Investor Warrant and approximately 8.0 million shares of our common stock that are currently reserved for issuance under the CEFF, including 490,000 shares reserved for issuance with respect to the Class C Investor Warrant. See “Risk Factors: Our Committed Equity Financing Facility may have a dilutive impact on our stockholders.”

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As of September 30, 2006, up to 12,407,431, shares of our common stock were issuable upon exercise of outstanding options and warrants. 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. This exercise, or the possibility of this exercise, may impede our efforts to obtain additional financing through the sale of additional securities or make this financing more costly, and may reduce the price of our common stock.

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

We are potentially susceptible to litigation. For example, as a public company, we are subject to claims asserting violations of securities laws, as well as derivative actions. In particular, in early May 2006, four shareholder class actions and two derivative actions were filed in the United States District Court for the Eastern District of Pennsylvania against the Company and its Chief Executive Officer, Robert J. Capetola, Ph.D. Certain of the complaints also named other officers of the Company and certain of its directors. The class actions were consolidated under a Consolidated Amended Complaint, filed on August 9, 2006, and on November 1, 2006, the court dismissed the Consolidated Amended Complaint without prejudice and granted plaintiffs leave to file an amended Consolidated Amended Complaint by November 30, 2006. We have no information as to whether the plaintiffs plan to file an amended complaint with the court. Nevertheless, even if plaintiffs do not file a new complaint, additional actions may be filed against the Company arising out of the same or different events. Although we will aggressively defend any such actions, an adverse result in one or more of them could have a potentially material adverse effect on the Company’s business, results of operations and financial condition.
ITEM 2.UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
During the three and nine months ended September 30, 2006,2007, we did not issue any unregistered shares of common stock pursuant to the exercise of outstanding warrants and options, we issued an aggregate of 25,472 shares of our common stock at various exercise prices ranging from $.0026 to $1.50 per share for an aggregate consideration equal to $12,045. We claimed the exemption from registration provided by Section 4(2) of the Securities Act for these transactions. No broker-dealers were involved in the sale and no commissions were paid.

We have a voluntary 401(k) savings plan covering eligible employees. Effective January 1, 2003, we allowed for periodic discretionary matches of newly issued shares of our common stock with the amount of any such match determined as a percentage of each participant’s cash contribution. The total fair market value of our match of our common stock to the 401(k) for the three months ended September 30, 2006 was $80,394, resulting in the issuance of 44,270 shares.

options. There were no stock repurchases induring the three and nine months ended September 30, 2006, however, during the nine months ended September 30, 2006, 37,382 shares of unvested restricted stock awards were cancelled and recorded as treasury stock.2007.

ITEM 3.DEFAULTS UPON SENIOR SECURITIES
ITEM 3.DEFAULTS UPON SENIOR SECURITIES

None.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
 
None.

ITEM 4.SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERSITEM 5. OTHER INFORMATION

None.
ITEM 5.OTHER INFORMATION
None.
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ITEM 6.  EXHIBITS

Exhibits are listed on the Index to Exhibits at the end of this Quarterly Report. The exhibits required by Item 601 of Regulation S-K, listed on such Index in response to this Item, are incorporated herein by reference.
 
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SIGNATURES

Pursuant to the requirements 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.
(Registrant)
 
 		 
 		 
 
Date: November 9, 2006 8, 2007By:  /s/ Robert J. Capetola
 
Robert J. Capetola, Ph.D.
President and Chief Executive Officer
   



Date: November 9, 20068, 2007By:  /s/ John G. Cooper
 
John G. Cooper
Executive Vice President and Chief Financial Officer
(PrincipalOfficer (Principal Financial Officer)
 
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INDEX TO EXHIBITS

The following exhibits are included with this Quarterly Report. All management contracts or compensatory plans or arrangements, if any, are marked with an asterisk.Report on Form 10-Q.

Exhibit No. Description Method of Filing
     
3.1 Restated Certificate of Incorporation of Discovery, dated September 18, 2002. Incorporated by reference to Exhibit 3.1 to Discovery’s Annual Report on Form 10-K for the fiscal year ended December 31, 2002, as filed with the SEC on March 31, 2003.
     
3.2 Amended and Restated By-Laws of Discovery.Incorporated by reference to Exhibit 3.2 to Discovery’s Annual Report on Form 10-K for the fiscal year ended December 31, 2003, as filed with the SEC on March 15, 2004.
3.3Certificate of Designations, Preferences and Rights of Series A Junior Participating Cumulative Preferred Stock of Discovery, dated February 6, 2004.Incorporated by reference to Exhibit 2.2 to Discovery’s Form 8-A, as filed with the SEC on February 6, 2004.
3.4Certificate of Amendment to the Certificate of Incorporation of Discovery, dated as of May 28, 2004. Incorporated by reference to Exhibit 3.1 to Discovery’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2004, as filed with the SEC on August 9, 2004.
     
3.33.5 Certificate of Amendment to the Restated Certificate of Incorporation of Discovery, dated as of July 8, 2005. Incorporated by reference to Exhibit 3.1 to Discovery’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2004, as filed with the SEC on August 8, 2005.
3.4Amended and Restated By-Laws of Discovery.Incorporated by reference to Exhibit 3.2 to Discovery’s Annual Report on Form 10-K for the fiscal year ended December 31, 2003, as filed with the SEC on March 15, 2004.
3.5Certificate of Designations, Preferences and Rights of Series A Junior Participating Cumulative Preferred Stock of Discovery, dated February 6, 2004.Incorporated by reference to Exhibit 2.2 to Discovery’s Form 8-A, as filed with the SEC on February 6, 2004.
     
4.1 Shareholder Rights Agreement, dated as of February 6, 2004, by and between Discovery and Continental Stock Transfer & Trust Company. Incorporated by reference to Exhibit 10.1 to Discovery’s Current Report on Form 8-K, as filed with the SEC on February 6, 2004.
     
4.2 Form of Class E Warrant.Incorporated by reference to Exhibit 4.1 to Discovery’s Current Report on Form 8-K, as filed with the SEC on March 29, 2000.
4.3Form of Unit Purchase Option issued to Paramount Capital, Inc.Incorporated by reference to Exhibit 4.4 to Discovery’s Annual Report on Form 10-KSB for the fiscal year ended December 31, 1999, as filed with the SEC on March 30, 2000.
4.4Form of Class A Investor Warrant. Incorporated by reference to Exhibit 4.1 to Discovery’s Current Report on Form 8-K, as filed with the SEC on June 20, 2003.
     
4.5 4.3 Class B Investor Warrant dated July 7, 2004, issued to Kingsbridge Capital Limited. Incorporated by reference to Exhibit 4.1 to Discovery’s Current Report on Form 8-K as filed with the SEC on July 9, 2004.
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Exhibit No.DescriptionMethod of Filing
     
4.64.4 Warrant Agreement, dated as of November 3, 2004, by and between Discovery and QFinance, Inc. Incorporated by reference to Exhibit 4.1 of Discovery’s Quarterly Report on Form 10-Q, as filed with the SEC on November 9, 2004.
     
4.74.5 Class C Investor Warrant, dated April 17, 2006, issued to Kingsbridge Capital Limited Incorporated by reference to Exhibit 4.1 to Discovery’s Current Report on Form 8-K, as filed with the SEC on April 21, 2006.
     
4.84.6 Registration Rights Agreement, dated as of July 7, 2004, by and between Kingsbridge Capital Limited and Discovery. Incorporated by reference to Exhibit 10.2 to Discovery’s Current Report on Form 8-K, as filed with the SEC on July 9, 2004.
Exhibit No.DescriptionMethod of Filing
     
4.94.7 Registration Rights Agreement, dated as of April 17, 2006, by and between Discovery and Kingsbridge Capital Limited.Limited and Discovery. Incorporated by reference to Exhibit 10.2 to Discovery’s Current Report on Form 8-K, as filed with the SEC on April 21, 2006.
     
4.104.8 Second Amended and Restated Promissory Note, dated as of October 25, 2006, issued to PharmaBio Development Inc. (“PharmaBio”)(PharmaBio) Incorporated by reference to Exhibit 4.1 to Discovery’s Current Report on Form 8-K, as filed with the SEC on October 26, 2006.
     
4.114.9 Warrant Agreement, dated as of October 25, 2006, by and between Discovery and PharmaBio Incorporated by reference to Exhibit 4.2 to Discovery’s Current Report on Form 8-K, as filed with the SEC on October 26, 2006.
     
10.14.10 Amendment No.5 and Consent,Warrant Agreement, dated as of October 25,November 22, 2006 to the Master Security Agreement between General Electric Capital Corporation and Discovery Incorporated by reference to Exhibit 10.34.1 to Discovery’s Current Report on Form 8-K, as filed with the SEC on October 26,November 22, 2006.
     
10.210.1 Second Amended and Restated LoanStock Issuance Agreement dated as of December 10, 2001, amended and restated as of October 25, 2006, by and between Discovery and PharmaBio30, 2007 Incorporated by reference to Exhibit 10.1 to Discovery’s Current Report on Form 8-K, as filed with the SEC on October 26, 2006.
10.3Second Amended and Restated Security Agreement, dated as of December 10, 2001, amended and restated as of October 25, 2006, by and between Discovery and PharmaBioIncorporated by reference to Exhibit 10.2 to Discovery’s Current Report on Form 8-K, as filed with the SEC on October 26, 2006.30, 2007.
     
31.1 Certification of Chief Executive Officer Pursuantpursuant to Rule 13a-14(a) of the Exchange Act. Filed herewith.
     
31.2 Certification of Chief Financial Officer and Principal Accounting Officer Pursuantpursuant to Rule 13a-14(a) of the Exchange Act. Filed herewith.
     
32.1 Certification of Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as Adopted Pursuantadopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. Filed herewith.

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