Akesis Pharmaceuticals (AKES) 10-Q 2008 Q3 Quarterly report

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

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

For the quarterly period ended September 30, 2008

or

¨ 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: 000-27409

AKESIS PHARMACEUTICALS, INC.

(Exact name of registrant as specified in its charter)

Nevada	84-1409219
(State or other jurisdiction of incorporation or organization)	(I.R.S. Employer Identification Number)

888 Prospect Street, Suite 320 La Jolla, California	92037
(Address of principal executive offices)	(Zip Code)

(858) 454-4311

(Registrant’s telephone number, including area code)

(Former name, former address and former fiscal year, if changed since last report)

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 such shorter period that the registrant was required to file such reports) and (2) has been subject to such filing requirements for the past 90 days.  Yes  x    No  ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. (as defined in Rule 12b-2 of the Exchange Act.)

Large accelerated filer  ¨            Accelerated filer  ¨

Non-accelerated filer            (Do not check if a smaller reporting company)  ¨            Smaller reporting company  x

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

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date:

Class	Outstanding at October 31, 2008
Common Stock	24,933,826 shares

AKESIS PHARMACEUTICALS, INC.

Form 10-Q

Table of Contents

		Page
PART I. FINANCIAL INFORMATION
Item 1.	Financial Statements	3
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	15
Item 3.	Quantitative and Qualitative Disclosures About Market Risk	22
Item 4T.	Controls and Procedures	22
PART II—OTHER INFORMATION
Item 1.	Legal Proceedings	23
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	23
Item 3.	Defaults upon Senior Securities	23
Item 4.	Submission of Matters to a Vote of Security Holders	23
Item 5.	Other Information	23
Item 6.	Exhibits	23
Signature		24
Exhibit Index		24

2

PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

Akesis Pharmaceuticals, Inc.

Condensed Consolidated Balance Sheets

	September 30, 2008			December 31, 2007
	(unaudited)			(audited)
Assets
Current assets:
Cash and cash equivalents	$	779,616		$	1,110,196
Prepaid and other current assets		62,481			221,119
Total current assets		842,097			1,331,315
Debt issuance costs, net		32,745			53,795
Total assets	$	874,842		$	1,385,110
Liabilities and Stockholders’ Equity (Deficit)
Current liabilities:
Accounts payable	$	627,278		$	73,416
Current portion of long-term debt		400,000			400,000
Loan payable to shareholder		1,000,000			—
Total current liabilities		2,027,278			473,416
Long-term debt		100,000			400,000
Total liabilities		2,127,278			873,416
Commitments and contingencies (Note 7)		—			—
Stockholders’ equity (deficit):
Convertible Preferred stock, $0.001 par value, 10,000,000 shares authorized; none issued and outstanding as of September 30, 2008 and December 31, 2007		—			—
Common stock, $0.001 par value, 50,000,000 shares authorized: 24,933,826 and 22,580,884 shares issued and outstanding at September 30, 2008 and December 31, 2007, respectively		24,934			22,581
Additional paid-in capital		14,047,381			11,704,679
Accumulated deficit		(15,324,751	)		(11,215,566	)
Total stockholders’ equity (deficit)		(1,252,436	)		511,694
Total liabilities and stockholders’ equity (deficit)	$	874,842		$	1,385,110

See accompanying notes.

3

Akesis Pharmaceuticals, Inc.

Condensed Consolidated Statements of Operations (Unaudited)

For the Three and Nine Months Ended September 30, 2008 and 2007

	Three months ended September 30,						Nine months ended September 30,
	2008			2007			2008			2007
Revenue	$	—		$	—		$	—		$	—
Operating costs and expenses:
Research and development		1,177,823			1,072,648			2,474,932			1,491,741
Selling, general and administrative		570,532			385,298			1,586,291			1,359,268
Total expenses		1,748,355			1,457,946			4,061,223			2,851,009
Loss from operations		(1,748,355	)		(1,457,946	)		(4,061,223	)		(2,851,009	)
Interest (expense) income, net		(14,962	)		4,592			(46,362	)		55,429
Loss before income taxes		(1,763,317	)		(1,453,354	)		(4,107,585	)		(2,795,580	)
Provision for income taxes		—			—			1,600			1,948
Net loss	$	(1,763,317	)	$	(1,453,354	)	$	(4,109,185	)	$	(2,797,528	)
Net loss per common share - basic and diluted	$	(0.07	)	$	(0.06	)	$	(0.17	)	$	(0.12	)
Weighted-average common shares outstanding - basic and diluted		24,933,826			22,580,884			24,203,899			22,580,884

See accompanying notes.

4

Akesis Pharmaceuticals, Inc.

Condensed Consolidated Statements of Cash Flows (Unaudited)

For the Nine Months Ended September 30, 2008 and 2007

	Nine months ended September 30,
	2008			2007
Cash flows from operating activities:
Net loss	$	(4,109,185	)	$	(2,797,528	)
Adjustments to reconcile net loss to net cash used in operating activities:
Amortization expense		21,050			20,947
Stock-based compensation		361,344			322,464
Changes in assets and liabilities:
Prepaid and other current assets		158,638			(87,845	)
Debt issuance costs, net		—			3,703
Accounts payable		553,862			125,376
Net cash used in operating activities		(3,014,291	)		(2,412,883	)
Cash flows from investing activities:
Net cash used in investing activities		—			—
Cash flows from financing activities:
Proceeds from stock issuances		1,983,711			—
Proceeds from loan payable to shareholder		1,000,000			—
Proceeds from bank loan		—			1,000,000
Principal payments on bank loan		(300,000	)		(100,000	)
Net cash provided by financing activities		2,683,711			900,000
Net decrease in cash and cash equivalents		(330,580	)		(1,512,883	)
Cash and cash equivalents at beginning of period		1,110,196			4,111,070
Cash and cash equivalents at end of period	$	779,616		$	2,598,187
Supplemental Disclosures of Cash Flow Information:
Interest paid	$	32,498		$	24,233
Income taxes paid	$	1,600		$	1,948

See accompanying notes.

5

Akesis Pharmaceuticals, Inc.

Notes to Condensed Consolidated Financial Statements (Unaudited)

1. Basis of Presentation

Akesis Pharmaceuticals, Inc., a Nevada corporation (“we” or “us��� or the “Company”), has prepared the unaudited condensed consolidated financial statements in this quarterly report in accordance with the instructions to Form 10-Q adopted under the Securities Exchange Act of 1934. Certain information and note disclosures normally included in consolidated financial statements prepared in accordance with accounting principles generally accepted in the United States have been condensed or omitted pursuant to such rules and regulations. These unaudited condensed consolidated financial statements should be read with our audited consolidated financial statements and the accompanying notes included in our Annual Report on Form 10-KSB for the fiscal year ended December 31, 2007. In our opinion, all adjustments (consisting only of normal recurring adjustments) necessary to present a fair statement of our financial position as of September 30, 2008, and the results of operations for the three-month and nine-month periods ended September 30, 2008 and 2007, have been made. The results of operations for the three-month and nine-month periods ended September 30, 2008 and 2007 are not necessarily indicative of the results for the fiscal year ending December 31, 2008 or any future periods.

2. Going Concern

We have prepared the unaudited, condensed consolidated financial statements in this quarterly report in conformity with generally accepted accounting principles (“GAAP”) in the United States on a going concern basis, which contemplates the realization of assets and the discharge of liabilities in the normal course of business for the foreseeable future. We have suffered recurring losses from operations and have a significant accumulated deficit that raises substantial doubt about our ability to continue as a going concern. Management’s plans in regard to these matters are also described below. The condensed consolidated financial statements do not include any adjustments that might result from the outcome of this uncertainty.

We have incurred losses and negative cash flows from operations since inception and we have an accumulated deficit of $15.3 million at September 30, 2008. Those losses are attributable to a lack of significant revenue since inception. We do not anticipate any meaningful revenue in future periods until such time that we are able to obtain approval to sell our proposed pharmaceutical products in the U.S. from the Food and Drug Administration (“FDA”). Additionally, our continued lack of adequate funding and working capital has prevented us from complying with the FDA’s requirements to obtain approval to sell our proposed products. Finally, if we are able to obtain FDA approval to sell our proposed products, there can be no assurance that we will be successful in selling significant quantities of those proposed products at a price that will enable us to achieve profitability.

Your attention is directed to the discussion under “Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations” set forth below as well as our audited consolidated financial statements and the accompanying notes included in our Annual Report on Form 10-KSB for the fiscal year ended December 31, 2007. In addition to routinely taking measures to control overhead costs and operating expenses, our management continues to undertake steps as part of a plan to attempt to continue to improve our liquidity with the goal of sustaining our operations. Those steps include seeking (a) to obtain additional financing; and/or (b) to enter into a strategic partnership to finance the development of our proposed products.

Our monthly recurring cash expenditures are approximately $125,000, which includes principal and interest payments on our bank debt. Based on these circumstances, our existing cash reserves may be exhausted in a matter of months. As a result, we may have to cease operations unless we are able to obtain an infusion of additional cash. In that regard, we are actively pursuing potential sources of financing for the Company, but there can be no assurance we can successfully complete a financing before we exhaust our cash resources. Accordingly, our ability to continue as a going concern is uncertain and dependent upon obtaining additional capital and/or entering into a strategic partner relationship. These condensed consolidated financial statements do not include any adjustments to the amounts and classification of assets and liabilities that might be necessary should we be unable to continue in business.

3. The Company

One of our predecessors, Akesis Delaware, was incorporated on April 27, 1998, for the purpose of direct marketing to consumers an established over-the-counter product for lowering blood glucose levels in the treatment of diabetes. Effective December 9, 2004, pursuant to the Agreement and Plan of Merger and Reorganization, dated as of September 27, 2004 (the “Merger Agreement”), among Akesis Delaware, another of our predecessors, Liberty Mint, Ltd., a Nevada corporation (“Liberty”), and Ann Arbor Acquisition Corporation, a wholly-owned subsidiary of Liberty (“MergerSub”), MergerSub merged with and into Akesis Delaware, with Akesis Delaware as the surviving corporation and wholly-owned subsidiary of Liberty. Effective January 11, 2005, the combined company changed its name to Akesis Pharmaceuticals, Inc. and its trading symbol to AKES.OB.

6

Akesis Pharmaceuticals, Inc.

Notes to Condensed Consolidated Financial Statements (Unaudited)—(Continued)

Despite the legacy businesses of our predecessors, we are currently an early stage biopharmaceutical company engaged in the discovery, development and commercialization of ethical pharmaceuticals for the treatment of metabolic diseases, such as diabetes, obesity, dyslipidemias, and muscle wasting. We have been granted patents and filed patent applications for a proprietary therapy for use in the treatment of Type 2 diabetes.

We intend to use our primary proprietary compound, AKP-020, to develop a prescription treatment for Type 2 diabetes. This product is in an early stage of development. In June 2008, we completed a Phase IIa clinical trial for AKP-020 under an open Investigational New Drug Application (“IND”) filed with the FDA. Vanadium containing compounds have demonstrated preliminary and published evidence of lowering and controlling blood glucose levels in animal models of diabetes and in patients with Type 2 diabetes. As well, we are aggressively pursuing the potential in-licensure of additional assets to expand our pipeline of potential metabolic-disease therapies.

4. Summary of Significant Accounting Policies

Principles of consolidation

The acquisition of Akesis Delaware by Liberty described in Note 3 has been accounted for as a recapitalization of Akesis Delaware. Since Akesis Delaware is the surviving entity, the accompanying consolidated financial statements reflect its historical results of operations prior to the acquisition. The accounts of the Company and Akesis Delaware have been consolidated as of December 9, 2004, the effective date of the acquisition described in Note 3.

Use of estimates

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

Business risk and concentrations of credit risk

The Company’s business is in the healthcare industry and it plans to sell products that may not be successful in the marketplace. Financial instruments which potentially subject the Company to concentrations of credit risk consist primarily of cash and cash equivalents, including money market accounts. Substantially all of our cash and cash equivalents are maintained with one financial institution in the United States. Deposits held with that financial institution exceed the amount of insurance provided on such deposits. Those deposits may be redeemed upon demand and, therefore, bear minimal risk.

Fair value of financial instruments

Effective January 1, 2008, the Company adopted Statement of Financial Accounting Standards (“SFAS”) No. 157, “Fair Value Measurements” (“SFAS No. 157”). SFAS No. 157 provides guidance for using fair value to measure assets and liabilities and requires expanded information about the extent to which companies measure assets and liabilities at fair value, the information used to measure fair value, and the effect of fair value measurements on earnings. The standard applies whenever other standards require (or permit) assets or liabilities to be measured at fair value. The adoption of SFAS No. 157 did not have a material effect on the Company’s condensed consolidated financial statements.

The carrying amounts of the Company’s cash and cash equivalents, prepaid and other current assets and accounts payable and accrued liabilities as of September 30, 2008, approximate fair market value based on Level I inputs (quoted prices in active markets) because of their short-term nature. The fair value of the note payable as of September 30, 2008, approximates the carrying value of the note because the stated interest rate for the note is at current market rates. The Company has no assets or liabilities that were valued on the basis of Level II inputs (significant observable inputs) or Level III inputs (significant unobservable inputs).

Cash and cash equivalents

Cash equivalents consist of highly liquid investments with original maturities of three months or less when purchased.

7

Akesis Pharmaceuticals, Inc.

Notes to Condensed Consolidated Financial Statements (Unaudited)—(Continued)

Property and equipment

Property and equipment are stated at cost and depreciated using the straight-line method over the estimated useful lives of the related assets ranging from 3 to 5 years. Maintenance and repairs are charged to expense as incurred, and improvements and betterments are capitalized. When assets are retired or otherwise disposed of, the cost and accumulated depreciation and amortization are removed from the accounts and any resulting gain or loss is reflected in operations in the period realized.

Recognition of expenses in outsourced contracts

Pursuant to management’s assessment of the services that have been performed on clinical trials and other contracts, we recognize expenses as the services are provided. Such management assessments include, but are not limited to: (1) an evaluation of the work that has been completed during the period, (2) measurement of progress prepared internally and/or provided by the third-party service provider, (3) analyses of data that justify the progress, and (4) management’s judgment.

In June 2008, we entered into a revised letter of payment authorization (the “Authorization Letter”) with Charles River Laboratories, Inc. (“CRL”). Pursuant to this Authorization Letter, CRL will perform two 13-week non-clinical safety studies (each a “Preclinical Safety Study” and together, the “Preclinical Safety Studies”), the first of which is currently in progress, on the Company’s lead product candidate, AKP-020. CRL previously completed a set of similar 28-day preclinical safety studies for the Company.

Pursuant to the Authorization Letters, we agreed to pay to CRL certain fees based, in part, on the progress of the Preclinical Safety Studies, which we authorized the initiation of in August 2008. If each Preclinical Safety Study is completed, we anticipate that these fees will total approximately $1,200,000, of which, as of September 30, 2008, based on the criterion described above, we have expensed and recorded in research and development expenses approximately $844,000, of which approximately $389,000 is included in accounts payable in the accompanying financial statements as of that date. The remaining amount will be incurred across multiple reporting periods. However, if we elect to terminate either Preclinical Safety Study prior to the completion thereof, we will only be obligated to pay CRL a pro rata portion of the fees applicable to such Preclinical Safety Study based on the progress of such Preclinical Safety Study at the time of termination.

Patent-related costs

All costs associated with application for patents are expensed as incurred and classified as research and development expenses in our consolidated statements of operations. Such patent-related costs for the three and nine months ended September 30, 2007 have been reclassified to conform to the classification for the three and nine months ended September 30, 2008.

Acquired contractual rights

Payments to acquire contractual rights to a licensed technology or drug candidate are expensed as incurred when there is uncertainty in receiving future economic benefits from the acquired contractual rights. We consider the future economic benefits from the acquired contractual rights to a drug candidate to be uncertain until such drug candidate is approved by the FDA or when other significant risk factors are abated.

Income taxes

Income taxes are accounted for in accordance with SFAS No. 109, “Accounting for Income Taxes” (“SFAS No. 109”). Under this method, deferred tax assets and liabilities are determined based on the difference between the financial statement and tax basis of assets and liabilities and net operating loss and credit carryforwards using enacted tax rates in effect for the year in which the differences are expected to reverse. Valuation allowances are established when necessary to reduce deferred tax assets to the amounts expected to be realized.

Research and development

Research and development costs are expensed as incurred. Such costs include the cost of in-licensed technology, consultants, patent costs and clinical trials.

8

Akesis Pharmaceuticals, Inc.

Notes to Condensed Consolidated Financial Statements (Unaudited)—(Continued)

Stock-based compensation

Compensation costs for all share-based awards to employees, outside directors and consultants are measured based on the grant date fair value of those awards and is recognized over the period during which the employee, outside director or consultant is required to perform service in exchange for the award (generally over the vesting period of the award). The cost of share-based compensation awards is recognized during the period based on the value of the portion of share-based payment awards that is ultimately expected to vest during the period, and is amortized under the multiple option methodology prescribed by SFAS No. 123(R), “Share Based Payments” (“SFAS No. 123(R)”).

As share-based compensation expense recognized in the consolidated statement of operations for the three-month and nine-month periods ended September 30, 2008 and 2007 is based on awards ultimately expected to vest, it has been reduced for estimated forfeitures. SFAS No. 123(R) requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. The estimation of the number of stock awards that will ultimately be forfeited requires judgment, and to the extent actual results or updated estimates differ from the Company’s current estimates, such amounts are required by SFAS No. 123(R) to be recorded as a cumulative adjustment in the period in which estimates are revised.

We have no awards with market or performance conditions. Excess tax benefits, as defined by SFAS No. 123(R), will be recognized as an addition to additional paid-in capital. The effect of the SFAS No. 123(R) fair value method resulted in a non-cash stock-based compensation charge of $118,963, $361,344, $90,129 and $322,464 on the Company’s reported results of operations for the three and nine months ended September 30, 2008 and 2007, respectively.

Stock offering costs

Expenses incurred in connection with common stock issuances are recorded as a reduction to additional paid-in capital on the condensed consolidated balance sheets. Such expenses consist of third-party related offering expenses.

Debt issuance costs

Debt issuance costs incurred to obtain debt financing are deferred and included on the consolidated balance sheets. The costs are amortized over the term of the debt. The amortization expense is included in interest expense on the consolidated statements of operations.

Net loss per share

Basic and diluted net loss per share is computed in accordance with SFAS No. 128, “Earnings per Share.” Basic loss per share includes no dilution and is computed by dividing net loss by the weighted-average number of shares of common stock outstanding for the period. Diluted loss per share reflects the potential dilution of securities that could share in the Company’s earnings, such as common stock equivalents which may be issued upon exercise of outstanding common stock options and/or warrants to purchase common stock. Diluted loss per share is identical to basic loss per share for all periods reported because inclusion of common stock equivalents would be anti-dilutive.

As of September 30, 2008 and 2007, the following options and warrants to purchase shares of common stock were excluded from the computation of diluted net loss per share, as the inclusion of such shares would be anti-dilutive:

	September 30,
	2008	2007
Stock options	3,050,000	1,690,000
Stock warrants	2,079,241	1,726,300

Effect of new accounting standards

In October 2008, the Financial Accounting Standards Board (“FASB”) issued FASB Staff Position FAS 157-3, “Determining the Fair Value of a Financial Asset When the Market for That Asset Is Not Active (FSP)” (“FSP FAS 157-3”), which clarifies the application of SFAS No. 157, “Fair Value Measurements”, in a market that is not active and provides an illustrative example. The illustrative example is intended to demonstrate how the fair value of a financial asset is determined when the market for that financial asset is inactive. FSP FAS 157-3 is effective October 10, 2008. The Company does not expect the adoption of FSP FAS 157-3 to affect future reporting or disclosures.

9

Akesis Pharmaceuticals, Inc.

Notes to Condensed Consolidated Financial Statements (Unaudited)—(Continued)

In September 2008, the FASB issued FASB Staff Position FAS 133-1 and FASB Interpretation No. 45-4, “Disclosures about Credit Derivatives and Certain Guarantees: An Amendment of SFAS No. 133 and FASB Interpretation No. 45; and Clarification of the Effective Date of SFAS No. 161” (the “FSP”). The FSP is intended to improve disclosures about credit derivatives by requiring more information about the potential adverse effects of changes in credit risk on the financial position, financial performance, and cash flows of the sellers of credit derivatives. It amends SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities” (“SFAS No. 133”), to require disclosures by sellers of credit derivatives, including credit derivatives embedded in hybrid instruments. The FSP also amends FASB Interpretation No. 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness to Others” (“FIN 45”), to require an additional disclosure about the current status of the payment/performance risk of a guarantee. The provisions of the FSP that amend SFAS No. 133 and FIN 45 are effective for reporting periods ending after November 15, 2008. Finally, the FSP clarifies that the disclosures required by SFAS No. 161, “Disclosures about Derivative Instruments and Hedging Activities—an Amendment of SFAS No. 133” (SFAS No. 161”) should be provided for any reporting period beginning after November 15, 2008. The Company does not expect the adoption of the FSP to affect future reporting or disclosures.

In May 2008, the FASB issued SFAS No. 163, “Accounting for Financial Guarantee Insurance Contracts – an Interpretation of SFAS No. 60” (“SFAS No. 163”), which requires that an insurance enterprise recognize a claim liability prior to an event of default (insured event) when there is evidence that credit deterioration has occurred in an insured financial obligation. SFAS No. 163 also clarifies how SFAS No. 60 applies to financial guarantee insurance contracts, including the recognition and measurement to be used to account for premium revenue and claim liabilities. SFAS No. 163 is effective as of the beginning of the first fiscal year beginning after December 15, 2008. The Company does not expect the adoption of SFAS No. 163 to affect future reporting or disclosures.

In May 2008, the FASB issued SFAS No. 162, “The Hierarchy of Generally Accepted Accounting Principles” (“SFAS No. 162”), which identifies the sources of accounting principles and the framework for selecting the principles to be used in the preparation of financial statements of nongovernmental entities that are presented in conformity with GAAP. SFAS No. 162 is effective 60 days following the approval by the U.S. Securities and Exchange Commission (the “SEC”) of the Public Company Accounting Oversight Board amendments to AU Section 411, “The Meaning of Present Fairly in Conformity With Generally Accepted Accounting Principles”. The Company does not expect the adoption of SFAS No. 162 to affect future reporting or disclosures.

In March 2008, the FASB issued SFAS No. 161, which is intended to improve financial reporting about derivative instruments and hedging activities by requiring enhanced disclosures to enable investors to better understand their effects on an entity’s financial position, financial performance and cash flows. It is effective for financial statements issued for fiscal years and interim periods beginning after November 15, 2008. The Company does not expect the adoption of SFAS No. 161 to affect future reporting or disclosures.

In December 2007, the FASB issued SFAS No. 160, “Noncontrolling Interests in Consolidated Financial Statements – an Amendment of Accounting Research Bulletin No. 51”, which requires all entities to report noncontrolling (minority) interests in subsidiaries in the same way—as equity in the consolidated financial statements. Moreover, SFAS No. 160 eliminates the diversity that currently exists in accounting for transactions between an entity and noncontrolling interests by requiring they be treated as equity transactions. SFAS No. 160 is effective as of the beginning of the first fiscal year beginning after December 15, 2008. The Company does not expect the adoption of SFAS No. 160 to affect future reporting or disclosures.

In December 2007, the FASB issued SFAS No. 141(R), “Business Combinations” (“SFAS No. 141(R)”), which creates greater consistency in the accounting and financial reporting of business combinations, resulting in more complete, comparable, and relevant information for investors and other users of financial statements. The new standard requires the acquiring entity in a business combination to recognize all (and only) the assets acquired and liabilities assumed in the transaction; establishes the acquisition-date fair value as the measurement objective for all assets acquired and liabilities assumed; and requires the acquirer to disclose to investors and other users all of the information they need to evaluate and understand the nature and financial effect of the business combination. SFAS No. 141(R) is effective as of the beginning of the first fiscal year beginning after December 15, 2008. The Company has not determined the effect of the adoption of SFAS No. 141(R) on future reporting or disclosures.

10

Akesis Pharmaceuticals, Inc.

Notes to Condensed Consolidated Financial Statements (Unaudited)—(Continued)

5. Loan Payable to Shareholder

In September 2008, the Company entered into a Note and Warrant Purchase Agreement (the “Purchase Agreement”) with Avalon Ventures VII, L.P. (“Avalon “). Avalon is a current stockholder, owning 7,670,442 shares of the Company’s stock, or 31% of shares outstanding as of September 30, 2008. Pursuant to the Purchase Agreement, the Company has the ability to sell to Avalon one or more convertible promissory notes (each, a “Note”) in an aggregate principal amount of up to $2.0 million, each of which will be issued together with a corresponding Warrant (as defined below) (the “Bridge Financing”).

Each Note has an interest rate of 8% per annum and will mature on February 1, 2009 (the “Maturity Date”). In the event of the closing of a preferred stock financing resulting in aggregate proceeds to the Company of at least $2.0 million (including via conversion of each Note) prior to the Maturity Date (a “Qualifying Financing”), the entire amount of the principal balance under any and all Notes issued pursuant to the Purchase Agreement, together with any accrued but unpaid interest thereon (collectively, the “Loan Balance”), will automatically convert into that number of shares of the Company’s preferred stock sold and issued to investors in connection with such Qualifying Financing (the “Qualifying Financing Shares”) as is determined by dividing the then-outstanding Loan Balance by the price per Qualifying Financing Share paid by investors in connection with the Qualifying Financing.

Each Note will be issued together with a five-year warrant (each, a “Warrant”) to purchase additional shares of Qualifying Financing Shares at a price per share equal to the price per Qualifying Financing Share paid by investors in the Qualifying Financing (subject to adjustment as provided in each Warrant). The number of Qualifying Financing Shares available for purchase under each Warrant shall be equal to the quotient of: (i) 15% of the initial principal amount of the corresponding Note issued to Avalon; divided by: (ii) the applicable exercise price.

Pursuant to the Purchase Agreement, an initial closing of the Bridge Financing was held on September 29, 2008, and involved the sale to Avalon of a Note (and a corresponding Warrant) representing an initial principal amount of $1.0 million. The issuance of the Note and Warrant under the Purchase Agreement was exempt from registration by virtue of Section 4(2) of the Securities Act of 1933, as amended.

Kevin Kinsella, a beneficial owner of the Company’s common stock, a holder of warrants to purchase common stock and member of the Company’s Board of Directors, is a managing member of Avalon. Jay Lichter, the Company’s Chairman of the Board of Directors and an option holder, is a member of an Avalon affiliate.

The Purchase Agreement and Bridge Financing were unanimously approved by a special committee of the Company’s board of directors comprised entirely of disinterested directors.

6. Long-Term Debt

In December 2006, the Company entered into a loan and security agreement with Square 1 Bank (the “Bank”) that provided for a loan of up to $1.0 million to finance general corporate purposes, which amount the Company borrowed in June 2007. The loan is payable in 30 monthly principal payments of $33,333 (in each case, plus monthly interest payments equal to the Bank’s prime rate plus 0.75%) and matures in December 2009. At September 30, 2008, the interest rate for the loan was5.75%. The Company has granted a security interest in favor of the Bank in substantially all of its tangible assets as collateral for the loans under the loan and security agreement, and the agreement imposes certain limitations on the Company’s ability to engage in certain transactions. In connection with the agreement, the Company also issued to the Bank a warrant to purchase up to 50,000 shares of its common stock. The warrant is exercisable for seven years from the date of issuance at an exercise price per share of $0.60. The fair value of the warrant issued to the Bank was determined to be $55,505 using a Black-Scholes model, which amount was recorded as debt issuance costs and is being amortized over the life of the agreement. Interest expense, excluding amortization of debt issuance costs, for the three and nine months ended September 30, 2008 and 2007 was $8,021, $30,859, $, $20,996 and $26,996, respectively. Amortization of debt issuance costs for the three and nine months ended September 30, 2008 and 2007 was $7,017, $21,050, $7,017 and $20,947, respectively.

11

Akesis Pharmaceuticals, Inc.

Notes to Condensed Consolidated Financial Statements (Unaudited)—(Continued)

Loan maturities following September 30, 2008, are as follows:

Twelve months ended September 30, 2009	$	400,000
Twelve months ended September 30, 2010		100,000
	$	500,000

7. Commitments, Contingencies and Related Party Lease

The Company leases approximately 200 square feet of office space located in La Jolla, California on a month-to-month basis from Avalon. From January 1, 2007 through January 31, 2008, the Company also sublet approximately 100 square feet of office space in San Diego, California from Sirion Therapeutics, Inc. (“Sirion”). Jay Lichter, the Company’s Chairman of the Board of Directors, is a former officer and current consultant to Sirion, and Kevin Kinsella is a current member of the Board of Directors of Sirion. The Board of Directors has determined that the rent charged to the Company for both leases is fair and reasonable. The Company recorded rent expense during the three and nine months ended September 30, 2008 and 2007 of $3,825, $11,600, $5,150 and $15,650, respectively.

8. Stock-based Compensation

Stock-based compensation expense for the three and nine months ended September 30, 2008 and 2007 was $118,963, $361,344, $90,129 and $322,464, respectively. Since we have a net operating loss carryforward as of December 31, 2007, no excess tax benefits for the tax deductions related to share-based awards were recognized in the consolidated statement of operations. At the present time, we intend to issue new common shares upon the exercise of stock options. None of the share-based awards are classified as a liability as of September 30, 2008.

As of September 30, 2008, there are 2,615,000 shares of common stock subject to nonstatutory stock options granted to executive officers, an outside director and a consultant at exercise prices ranging from $0.51 to $1.50. Those stock options vest through various dates ending between December 12, 2008 and December 16, 2011, subject to the officers’, director’s and consultants’ continued employment with or service to the Company on any such date. In addition, in the event of a change of control of the Company, if the option is not assumed or an equivalent option is not substituted by the successor corporation or a parent or subsidiary of the successor corporation, the officers, director and consultants shall fully vest in and have the right to exercise the options as to all of the shares of common stock subject to the options as to which the officers, director and consultants would not otherwise be vested or exercisable. During the nine months ended September 30, 2008 and 2007 nonstatutory stock options to acquire 1,065,000 and 500,000 shares of our common stock, respectively, were granted.

The Company’s Board of Directors also authorized and reserved 1,500,000 shares of common stock pursuant to a 2005 Stock Plan in January 2005 for option grants to employees, directors and consultants. Currently outstanding options to acquire a total of 435,000 shares of our common stock have been granted pursuant to such 2005 Stock Plan to an outside director and certain consultants. The stock options are nonqualified stock options with a term of 10 years and an exercise price ranging from $0.46 to $1.94 per share. The options vest through various dates ending between January 24, 2009 and July 17, 2011, subject to the director’s and consultants’ continued service to the Company on any such vesting date. In addition, in the event of a change of control of the Company, if the option is not assumed or an equivalent option is not substituted by the successor corporation or a parent or subsidiary of the successor corporation, the director shall fully vest in and have the right to exercise the options as to all of the shares of common stock subject to the options as to which the director would not otherwise be vested or exercisable. During the nine months ended September 30, 2008 and 2007, options to acquire 45,000 and 190,000 shares of our common stock, respectively, were granted under the 2005 Stock Plan.

The fair value of each option award is estimated on the date of grant using the Black-Scholes method for option pricing, and is amortized over the vesting period of the option using the multiple option methodology in accordance with the provisions of SFAS No. 123(R). The key assumptions in the Black-Scholes model are as follows: expected volatility, annual expected termination rate, and risk-free interest rate. Expected volatilities are based on historical volatility of our common stock and other factors. The expected forfeiture rate of options granted is based on our management’s estimate since our operating history is too brief to have established historical rates for employee termination and option exercises. The risk-free interest rates are based on the U.S. Treasury yield for a period consistent with the expected term of the option in effect at the time of the grant.

12

Akesis Pharmaceuticals, Inc.

Notes to Condensed Consolidated Financial Statements (Unaudited)—(Continued)

The following is a summary of the status of the nonstatutory options and the options under the 2005 Stock Plan for the nine months ended September 30, 2008:

	Number of Shares	Weighted Average Exercise Price Per Share		Weighted Average Remaining Contractual Term (in years)	Aggregate Intrinsic Value (in millions)
Balance at December 31, 2007	1,940,000	$	0.91	8.82	$	—
Granted	1,110,000		0.67
Exercised	—		—
Expired	—		—
Cancelled	—		—
Balance at September 30, 2008	3,050,000	$	0.82	8.67	$	—
Exercisable at September 30, 2008	1,286,105	$	1.00	7.92	$	—

A summary of the status of our non-vested stock options as of September 30, 2008 and changes during the nine months then ended are presented below.

	Number of shares		Average Grant- Date Fair Value Per Share
Non-vested at December 31, 2007	1,121,394		$	0.37
Granted	1,110,000		$	0.48
Vested	(467,499	)	$	0.86
Cancelled	—			—
Non-vested at June 30, 2008	1,763,895		$	0.53

As of September 30, 2008, there was approximately $486,000 of total unrecognized compensation cost, related to non-vested stock options, which is expected to be recognized over a weighted-average period of approximately 2.25 years. The total fair value of shares vested during the three and nine months ended September 30, 2008 and 2007 was approximately $161,000, $401,000, $89,000 and $358,000, respectively.

9. Common Stock

In March 2008, the Company entered into a financing with Avalon where it sold 2,352,942 shares of its common stock at a purchase price of $0.85 per share. In addition, the Company issued warrants to purchase up to 352,941 shares of its common stock in connection with the financing. The warrants are exercisable for shares of the Company’s common stock until the earlier of March 25, 2011 or the date of a change of control of the Company at an exercise price per share of $0.85. The net proceeds from the financing after deducting expenses related to the financing were approximately $2 million. All the shares and warrants issued in connection with the financing were exempt from registration by virtue of Section 4(2) of the Securities Act of 1933, as amended.

13

Akesis Pharmaceuticals, Inc.

Notes to Condensed Consolidated Financial Statements (Unaudited)—(Continued)

As of September 30, 2008 and 2007, 2,079,241 and 1,726,300, respectively, shares of common stock were purchaseable under outstanding warrants. The weighted average exercise price of the outstanding warrants is $0.93 per share. During the nine months ended September 30, 2008 and 2007, warrants to purchase 352,941 and zero, respectively, shares of common stock were issued by the Company as described above. During the nine months ended September 30, 2008 and 2007, no warrants were exercised, adjusted or expired.

10. Income Taxes

At December 31, 2007, Akesis Delaware had no federal income tax expense or benefit but did have federal and state tax net operating loss carryforwards of approximately $8.0 million and $5.4 million, respectively. The federal and state net operating loss carryforwards will begin to expire in 2018 and 2014, respectively, unless previously utilized. Pursuant to Internal Revenue Code Section 382 and 383, use of Akesis Delaware’s net operating loss carryforwards may be limited if a cumulative change in ownership of more than 50% occurs within a three-year period. No assessment has been made as to whether such a change in ownership has occurred. The Company incurred zero, $1,600, zero and $1,948 of statutory minimum state tax expense for the three and nine months ended September 30, 2008 and 2007, respectively.

SFAS No. 109, “Accounting for Income Taxes”, requires that a valuation allowance be established when it is more likely than not that its recorded net deferred tax asset will not be realized. In determining whether a valuation allowance is required, a company must make take into account all positive and negative evidence with regard to the utilization of a deferred tax asset. SFAS No. 109 further states that it is difficult to conclude that a valuation allowance is not needed when there is negative evidence such as cumulative losses in recent years. The Company plans to continue to provide a full valuation allowance on future tax benefits until it can sustain an appropriate level of profitability and until such time, the Company would not expect to recognize any significant tax benefits in its future results of operations.

On January 1, 2007, the Company adopted FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes—an interpretation of FASB Statement No. 109” (“FIN 48”). Under FIN 48, tax positions are evaluated for recognition using a more-likely-than-not threshold, and those tax positions requiring recognition are measured as the largest amount of tax benefit that is greater than 50 percent likely of being realized upon ultimate settlement with a taxing authority that has full knowledge of all relevant information.

As of September 30, 2008 and December 31, 2007, the Company had no unrecognized tax benefits, including interest and penalties, and does not expect a significant change in the unrecognized tax benefits in the next twelve months. The Company recognizes interest and penalties to unrecognized tax benefits through interest and operating expenses, respectively. There were no interest and penalties recorded as of September 30, 2008.

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SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS

This Quarterly Report on Form 10-Q contains forward-looking statements that are based upon current expectations within the meaning of the Private Securities Litigation Reform Act of 1995. It is our intent that such statements be protected by the safe harbor created thereby and we disclaim any duty or obligation to update such statements. Forward-looking statements involve risks and uncertainties and our actual results and the timing of events may differ significantly from the results discussed in the forward-looking statements. Forward-looking statements include information concerning possible or assumed future results of our operations. Also, when we use words such as “believes,” “expects,” “anticipates” or similar expressions, we are making forward-looking statements. Examples of such forward-looking statements include, but are not limited to, statements about:

• Our capital requirements and resources;

• Our strategy;

• Development of new products;

• Intent to develop and sell products and services to companies in the pharmaceutical industry;

• Technological change and uncertainty of new and emerging technologies;

• Potential competitors or products;

• Future employment of our key employees;

• Development of strategic relationships;

• Statements about potential future dividends;

• Statements about protection of our intellectual property; and

• Possible changes in legislation.

Such forward-looking statements are inherently subject to risks and uncertainties, and actual results and outcomes may differ materially from the results and outcomes discussed in or anticipated by the forward-looking statements.

All forward-looking statements attributable to us or persons acting on our behalf are expressly qualified in their entirety by the cautionary statements set forth in this report. Except as required by federal securities laws, we are under no obligation to update any forward-looking statement, whether as a result of new information, future events, or otherwise.

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

Present Situation – Liquidity Issues

We have significant liquidity and capital resource issues relative to our recurring losses from operations, which raises substantial doubt about our ability to continue as a going concern. We have incurred losses and negative cash flows from operations since inception and we have an accumulated deficit of $15.3 million at September 30, 2008. Those losses are attributable to a lack of significant revenue since inception. We do not anticipate any meaningful revenue in future periods until such time that we are able to obtain approval to sell our proposed pharmaceutical products in the U.S. from the FDA. Additionally, our continued lack of adequate funding and working capital has prevented us from complying with the FDA’s requirements to obtain approval to sell our proposed products. Finally, even if we succeed in our attempt to raise additional funds, there can be no assurance that we will be successful in obtaining FDA approval to sell our proposed products, or if we are able to obtain FDA approval to sell our proposed products, there can be no assurance that we will be successful in selling significant quantities of those proposed products at a price that will enable us to achieve profitability.

As described elsewhere, without an infusion of cash, we will exhaust our existing cash reserves within months, and as a result, we may have to cease operations. As of September 30, 2008, we have a cash balance of approximately $780,000. In addition, as more fully described in Footnote 5 to the financial statements above, in September 2008, the Company entered into a Purchase Agreement with Avalon. Avalon is a current stockholder, owning 7,670,442 shares of the Company’s stock, or 31% of shares outstanding as of September 30, 2008. Pursuant to the Purchase Agreement, we have the ability to sell to Avalon one or more Notes in an aggregate principal amount of up to $2.0 million. Of that amount, we sold Avalon a Note with a principal balance of $1.0 million in September 2008, which leaves us with the ability to sell Avalon one or more additional Notes with an aggregate principal balance of $l.0 million.

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At September 30, 2008, we have accrued expenses and accounts payable of approximately $627,000. In addition, the principal balances on the outstanding Avalon Note and bank debt as of that date are $1.0 million and $500,000, respectively. Also, in August 2008, we authorized the initiation of the Preclinical Safety Studies with CRL. If each Preclinical Safety Study is completed, we anticipate that these fees will total $1,200,000, of which, as of September 30, 2008, based on the criterion described in Footnote 4 we have expensed and recorded in research and development expenses approximately $844,000, of which approximately $389,000 is included in accounts payable in the accompanying financial statements as of that date. The remaining amount will be incurred across multiple reporting periods. However, if we elect to terminate either Preclinical Safety Study prior to the completion thereof, we will only be obligated to pay CRL a pro rata portion of the fees applicable to such Preclinical Safety Study based on the progress of such Preclinical Safety Study at the time of termination. Our monthly recurring cash expenditures are approximately $125,000, which includes principal and interest payments on our bank debt. Additional development work on our proposed pharmaceutical products will depend on the future availability of cash.

Our future working capital requirements and our ability to continue operations are based on various factors and assumptions, which are subject to substantial uncertainty and risks beyond our control and no assurances can be given that those expectations will prove correct. The occurrence of adverse developments related to those risks and uncertainties or others could result in our being unable to continue the development of our proposed pharmaceutical products. Any such adverse developments may also result in the incurrence of unforeseen expenses or our being unable to control expected expenses and overhead. If we incur unforeseen expenses or fail to control our expected expenses and overhead, we will likely be unable to continue operations in the absence of obtaining additional sources of cash.

In addition to routinely taking measures to control overhead costs and operating expenses, our management continues to undertake steps as part of a plan to attempt to continue to improve our liquidity with the goal of sustaining our operations. Those steps include seeking (a) to obtain additional financing; and/or (b) to enter into a strategic partnership to finance the development of our proposed products.

The Company

We are currently an early stage biopharmaceutical company engaged in the discovery, development and commercialization of ethical pharmaceuticals for the treatment of metabolic diseases, such as diabetes, obesity, dyslipidemias, and muscle wasting. We have been granted patents and filed patent applications for a proprietary therapy for use in the treatment of Type 2 diabetes. Our products have demonstrated preliminary evidence of lowering and controlling blood glucose levels in patients with Type 2 diabetes. As well, we are aggressively pursuing the potential in-licensure of additional assets to expand our pipeline of potential metabolic-disease therapies.

The following management’s discussion and analysis of financial condition and results of operations contains forward-looking statements that involve risks and uncertainties. As described above, our actual results may differ materially from the results discussed in the forward-looking statements.

Research and Development Projects

The current primary focus of the Company is the development of AKP-020, a proprietary, vanadium-based monotherapy for the treatment of Type 2 diabetes. The initial human Phase I data for AKP-020 showed that AKP-020 has advantages over unpatented inorganic vanadyl sulfate with respect to dosing, pharmacokinetics and bioavailability, without signs of any significant new toxicities. This data set also includes extensive acceptable safety and efficacy profiles derived from preclinical studies of AKP-020.

Previously, we entered into arrangements with CRL, pursuant to which CRL performed two 28-day non-clinical safety and toxicology studies with various doses of AKP-020. The final analysis of these studies is still ongoing. We have recently entered into arrangements with CRL to perform the Preclinical Safety Studies on AKP-020 in order to support further clinical evaluation of AKP-020, results of which we expect to be available in the first or second quarter of our 2009 fiscal year. While we remain optimistic about AKP-020 as a potential therapy for diabetes, we believe that an expansion of our preclinical programs is necessary to further our understanding of the benefit/risk profile of AKP-020 prior to the initiation of additional clinical studies. Contingent on the results of this expanded program, combined with the thorough analysis of the recent Phase IIa study of AKP-020 in diabetic subjects, we anticipate being in a position to better define our future development strategy and timeline for AKP-020.

Subsequent to the two 28-day safety and toxicology studies, we completed enrollment of 12 subjects into a 28-day, single-blinded, Phase IIa clinical trial of AKP-020 in February 2008. While we originally planned to recruit and dose 21 patients in this trial, we elected in June 2008 to discontinue the trial after enrolling 12 patients in favor of advancing to a larger, multi-center, double-blind, dose-ranging study.

16

In the single-blinded study, two patients withdrew due to non-drug related issues. Ultimately seven Type 2 diabetic patients were dosed in the fasted state with AKP-020 and two patients were dosed with placebo for 28 days (one subject was dosed with AKP-020 in the fed state). Over the 28-day period, both placebo patients showed an increase in fasting plasma glucose (FPG) levels. In contrast, in five out of the seven patients on active drug treatment, there was a consistent decrease in FPG (range between subjects: 10%-43%), while two of the treated patients showed variable responses (range: +20% to -9%). The average change of the group was significant compared to the group average baseline. Similarly, the average reduction in the Area Under the Curve (AUC) for the 2h oral glucose tolerance test was over 10%. More in-depth analysis of this data indicated that naïve AKP-020-treated diabetic subjects (n=3) showed a more profound decrease in fasting blood glucose (mean range: -15% to -35%) when compared to diabetic subjects that were previously treated with metformin and given a 2-3week washout period prior to the commencement of dosing with AKP-020 (mean range: -1% to -9%). A similar trend of greater AKP-020 treatment associated decreases in the oral glucose tolerance test AUC for naïve versus metformin pre-treated subjects was also observed.

The levels of glycosylated hemoglobin (HbA1c) are usually measured over three months for definitive demonstration of anti-diabetic activity. Evaluating the trend out to day 28, in the two placebo patients there was a consistent increase up to 0.5% in absolute terms, or a variable response, respectively. In the treatment arm, in two subjects there was a consistent decrease of 0.5% and 1.1%, in three subjects essentially no change, and in the final two subjects an increase of 0.2% and 0.3%, respectively. After treatment the average HbA1c continued to decline in the treatment group. A similar trend of greater AKP-020 treatment associated decreases in HbA1c decreases for naïve versus metformin pre-treated subjects was also observed. We plan to determine the statistical significance of these results in future trials.

We also further evaluated the mechanism of action of AKP-020 by analyzing the hyperglycemic-euglycemic clamp portion of this study. While in certain subjects there was an indication that AKP-020 treatment was associated with an increase in glucose metabolic rate, this did not hold true across the entire treatment group. We plan on doing further mechanistic studies as part of our continued development efforts.

Importantly, no drug related adverse events were observed during the study. The final interpretation of these results will be made in conjunction with discussions with the FDA once all of the data is collected. We cannot be certain when all data will be collected, or what the results of our analyses or the feedback and interpretation of the FDA will be.

In summary, based on this clinical data, we believe that AKP-020 may be an effective approach to improving the health of certain individuals with Type 2 diabetes. However, there can be no assurance that the results of more extensive human studies will be consistent with those obtained thus far.

Finally, the Company has filed for additional intellectual property protection for AKP-020. The Company intends for these new filings to provide for an additional 20 years of protection in the United States and certain non-United States territories.

The risks and uncertainties associated with completing the development of our products on schedule, or at all, include the following, as well as other risk factors contained in our Annual Report on Form 10-KSB for the fiscal year ended December 31, 2007:

• Our products may not be shown to be safe and efficacious in the clinical trials;

• We may be unable to obtain regulatory approval of our products or be unable to obtain such approval on a timely basis;

• The intellectual property rights underlying our products may not be enforceable or may be found to infringe on the intellectual property rights of third parties;

• We may be unable to recruit enough patients to complete the clinical trials in a timely manner; and

• We may not have adequate funds to complete the development of our products even if we secure the additional amount of capital we have targeted if we have underestimated the cost of the clinical trials.

If our products fail to achieve statistically significant results in the clinical trials, or we do not complete the clinical trials on a timely basis, our operations, financial position and liquidity could be severely impaired, including as follows:

• It could make it more difficult for us to consummate partnering opportunities in the pharmaceutical industry, or at all.

• Our reputation among investors might be harmed, which could make it more difficult for us to obtain equity capital on attractive terms, or at all.

17

Because of the many risks and uncertainties relating to the completion of clinical trials, consummation of partnering opportunities in the pharmaceutical industry, receipt of marketing approvals and acceptance in the marketplace, we cannot predict the period in which material cash inflows from our products will commence, if ever.

Results of Operations for the Three Months and Nine Months ended September 30, 2008

Three Months Ended September 30, 2008 Compared with Three Months Ended September 30, 2007

Research and Development Expenses

In May 2006, we began the development of a clinical research protocol and began conducting other activities to support the initiation of new clinical trials related to AKP-020. The cost of our research and development activities during the three months ended September 30, 2008 was $1,177,823 compared to $1,072,648 for the three months ended September 30, 2007. The primary research and development expenditures during both periods were for preclinical safety studies. During the third quarter of 2007, those expenditures were for a 28-day preclinical safety study, as well as product design and manufacturing-related costs. We conducted a Phase IIa human clinical trial during the first and second quarters of 2008. During the third quarter of 2008 we incurred costs related to studying the data from the human clinical trial and we initiated a Preclinical Safety Study.

Selling, General and Administrative Expenses

Selling, general and administrative expenses for the three months ended September 30, 2008 were $570,532 as compared to $385,298 for the three months ended September 30, 2007. The increase for the three months ended September 30, 2008 when compared to the three months ended September 30, 2007, resulted from an increase in personnel costs due to the addition of one senior level employee and salary increases to the other two employees. In addition, legal fees increased during the three months ended September 30, 2008, when compared to the three months ended September 30, 2007, due primarily to assistance provided to us by our attorneys in evaluating strategic options being studied by us as described in the Company’s Current on Report Form 8-K, as amended, filed with the SEC on October 8, 2008 and October 22, 2008, which is hereby incorporated by reference herein.

Interest (Expense) Income, net

Interest (expense)/income, net for the three months ended September 30, 2008 and 2007, was $(14,962) and $4,592, respectively. The primary cause for the change was that, as more fully explained in the following section, Liquidity and Capital Resources, in June 2007, we borrowed $1 million from the Bank. Consequently, we had significantly more interest expense for the three months ended September 30, 2007 when compared to the three months ended September 30, 2008 as a result of a lower average principal balance due to the Bank during the third quarter of 2008. However, offsetting the higher interest expense in the third quarter of 2007, we had significantly more interest income during the three months ended September 30, 2007 than we did during the three months ended September 30, 2008 when our average cash balance was much higher than it was during the three months ended September 30, 2008. The higher average cash balance during the third quarter of 2007 was the result of an equity financing in November 2006 that resulted in net proceeds to us of approximately $4.247 million in addition to the $1 million we borrowed from the Bank in June 2007.

Nine Months Ended September 30, 2008 Compared with Nine Months Ended September 30, 2007

Research and Development Expenses

In May 2006, we began the development of a clinical research protocol and began conducting other activities to support the initiation of new clinical trials related to AKP-020. The cost of our research and development activities during the nine months ended September 30, 2008 was $2,474,932 compared to $1,491,741 for the nine months ended September 30, 2007. The primary reason for the increase in research and development expense between the two periods is that, during the nine months ended September 30, 2007, we were still in the planning phase of our clinical trials whereas, the clinical trials actually commenced in February 2008 and concluded in June 2008. In addition, at the conclusion of the Phase IIa clinical trial in June 2008, we incurred a milestone payment related to our license agreement with UBC, and we also incurred certain sponsored research fees at UBC during the nine months ended September 30, 2008.

18

Selling, General and Administrative Expenses

Selling, general and administrative expenses for the nine months ended September 30, 2008 were $1,586,291 as compared to $1,359,268 for the nine months ended September 30, 2007. The increase for the nine months ended September 30, 2008 resulted from the addition of a senior level employee in June 2008 and salary increases for the other two employees in June 2008, as well as the retention of a government affairs consultant in July 2007. The contract with the government affairs consultant was terminated June 30, 2008. In addition, our expenses associated with our public relations and investor relations efforts increased during the nine months ended September 30, 2008.

Interest (Expense) Income, net

Interest (expense)/income, net for the nine months ended September 30, 2008 and 2007, was $(46,362) and $55,429, respectively. The primary cause for the change was that, as more fully explained in the following section, Liquidity and Capital Resources, in June 2007, we borrowed $1 million from the Bank. Consequently, we had significantly more interest expense for the nine months ended September 30, 2008 when compared to the nine months ended September 30, 2007 as a result of incurring interest expense for nine months during the nine months ended September 30, 2008 compared to only three months during the nine months ended September 30, 2007. In addition, during the nine months ended September 30, 2007, we had significantly more interest income than we did during the nine months ended September 30, 2008 since our average cash balance was much higher during the nine months ended September 30, 2007 than it was during the nine months ended September 30, 2008. The higher average cash balance during the nine months ended September 30, 2007, was the result of an equity financing in November 2006 that resulted in net proceeds to us of approximately $4.247 million in addition to the $1 million we borrowed from the bank in June 2007.

Liquidity and Capital Resources

We have significant liquidity and capital resources issues relative to our recurring losses from operations, which raises substantial doubt about our ability to continue as a going concern. We have incurred losses and negative cash flows from operations since inception and we have an accumulated deficit of $15.3 million at September 30, 2008. As of September 30, 2008, we have a cash balance of approximately $780,000. In addition, as more fully described below and in Footnote 5 to the financial statements above, in September 2008, the Company entered into a Purchase Agreement with Avalon. Avalon is a current stockholder, owning 7,670,442 shares of the Company’s stock, or 31% of shares outstanding as of September 30, 2008. Pursuant to the Purchase Agreement, we have the ability to sell to Avalon one or more Notes in an aggregate principal amount of up to $2.0 million. Of that amount, we sold Avalon a Note with a principal balance of $1.0 million in September 2008, which leaves us with the ability to sell Avalon one or more additional Notes with an aggregate principal balance of $l.0 million.

At September 30, 2008, we have accrued expenses and accounts payable as of that date of approximately $627,000. In addition, the principal balances on the outstanding Avalon Note and bank debt as of that date are $1.0 million and $500,000, respectively. Also, in August 2008, we authorized the initiation of the Preclinical Safety Studies with CRL. If each Preclinical Safety Study is completed, we anticipate that these fees will total approximately $1,200,000, of which, as of September 30, 2008, based on the criterion described in Footnote 4 we have expensed and recorded in research and development expenses approximately $844,000, of which approximately $389,000 is included in accounts payable in the accompanying financial statements. The remaining amount will be incurred across multiple reporting periods. However, if we elect to terminate either Preclinical Safety Study prior to the completion thereof, we will only be obligated to pay CRL a pro rata portion of the fees applicable to such Preclinical Safety Study based on the progress of such Preclinical Safety Study at the time of termination. Our monthly recurring cash expenditures are approximately $125,000, which includes principal and interest payments on our bank debt. Additional development work on our proposed pharmaceutical products will depend on the future availability of cash.

Our future working capital requirements and our ability to continue operations are based on various factors and assumptions, which are subject to substantial uncertainty and risks beyond our control and no assurances can be given that those expectations will prove correct. If those assumptions prove incorrect, the duration of the time period during which we could continue operations could be materially shorter. Also, the occurrence of adverse developments related to those risks and uncertainties or others could result in our being unable to continue the development of our proposed pharmaceutical products. Any such adverse developments may also result in the incurrence of unforeseen expenses or our being unable to control expected expenses and overhead.

Based on those circumstances, our existing cash reserves may be exhausted in a matter of months. As a result, we may have to cease operations unless we are able to obtain an infusion of cash. In that regard, we are actively pursuing potential sources of financing for the Company, but there can be no assurance we can successfully complete a financing before we exhaust our cash resources. Accordingly, our ability to continue as a going concern and proceed with the development work on our proposed pharmaceutical products is uncertain and dependent upon obtaining additional capital and/or entering into a strategic partner relationship.

19

We have financed our operations primarily through the sale of equity securities, the Bridge Financing and borrowings under a credit facility with the Bank. We invest excess cash in a money market account that will be used to fund future operating costs. Cash and cash equivalents totaled $779,616 at September 30, 2008, compared to $1,110,196 at December 31, 2007. The primary reason our cash did not significantly decrease during that period despite our operating loss of approximately $4.1 million for the nine months ended September 30, 2008 is the Bridge Financing and equity financing we entered into with Avalon in September 2008 and March 2008, respectively, as described below. We primarily fund current operations with our existing cash and cash equivalents. Cash used in operating activities for the nine months ended September 30, 2008 totaled $3,014,291.

We believe that minimum proceeds of approximately $10 million of additional capital will be required to enable us to fund the continued development of our proposed pharmaceutical products, as well as all of our general and administrative expenses, through March 2010. Our actual capital requirements will depend upon numerous factors, including:

• the rate of progress and costs of our clinical trials and research and development activities;

• actions taken by the FDA and other regulatory authorities;

• the timing and amount of milestone or other payments we might receive from or owe to potential strategic partners;

• our degree of success in commercializing our product candidates;

• the emergence of competing technologies and products, and other adverse market developments; and

• the costs of preparing, filing, prosecuting, maintaining and enforcing patent claims and other intellectual property rights.

There can be no assurance that we will be able to obtain needed additional capital or enter into relationships with corporate partners on a timely basis, on favorable terms, or at all. Conditions in the capital markets in general, and the life science capital market specifically, may affect our potential financing sources and opportunities for strategic partnering.

In September 2008 the Company entered into the Purchase Agreement with Avalon. Avalon is a current stockholder, owning 7,670,442 shares of the Company’s stock, or 31% of shares outstanding as of September 30, 2008. Pursuant to the Purchase Agreement, the Company has the ability to sell to Avalon one or more Notes in an aggregate principal amount of up to $2.0 million, each of which will be issued together with a corresponding Warrant.

Each Note has an interest rate of 8% per annum and will mature on the Maturity Date. In the event of a Qualifying Financing prior to the Maturity Date, the Loan Balance will automatically convert into the number of Qualifying Financing Shares as is determined by dividing the then-outstanding Loan Balance by the price per Qualifying Financing Share paid by investors in connection with the Qualifying Financing.

Each Note will be issued together with a Warrant to purchase additional shares of Qualifying Financing Shares at a price per share equal to the price per Qualifying Financing Share paid by investors in the Qualifying Financing (subject to adjustment as provided in each Warrant). The number of Qualifying Financing Shares available for purchase under each Warrant shall be equal to the quotient of: (i) 15% of the initial principal amount of the corresponding Note issued to Avalon; divided by: (ii) the applicable exercise price.

Pursuant to the Purchase Agreement, an initial closing of the Bridge Financing was held on September 29, 2008, and involved the sale to Avalon of a Note (and a corresponding Warrant) representing an initial principal amount of $1.0 million. The issuance of the Note and Warrant under the Purchase Agreement was exempt from registration by virtue of Section 4(2) of the Securities Act of 1933, as amended.

Kevin Kinsella, a beneficial owner of the Company’s common stock, a holder of warrants to purchase common stock and member of the Company’s Board of Directors, is a managing member of Avalon. Jay Lichter, the Company’s Chairman of the Board of Directors and an option holder, is a member of an Avalon affiliate.

The Purchase Agreement and Bridge Financing were unanimously approved by a special committee of the Company’s board of directors comprised entirely of disinterested directors.

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In March 2008, we entered into a financing with Avalon where we sold 2,352,942 shares of our common stock at a purchase price of $0.85 per share. In addition, we issued warrants to purchase up to 352,941 shares of our common stock in connection with the financing. The warrants are exercisable for shares of the Company’s common stock until the earlier of March 25, 2011 or the date of a change of control of the Company at an exercise price per share of $0.85. The net proceeds from the financing after deducting expenses related to the financing were approximately $2 million. All the shares and warrants issued in connection with the financing were exempt from registration by virtue of Section 4(2) of the Securities Act of 1933, as amended.

In December 2006, we entered into a loan and security agreement with the Bank that provided for a loan of up to $1.0 million to finance general corporate purposes, which amount the Company borrowed in June 2007. The loan is payable in 30 monthly principal payments of $33,333 (in each case, plus monthly interest payments equal to the Bank’s prime rate plus 0.75%) and matures in December 2009. At September 30, 2008, the interest rate for the loan was5.75%, and the remaining principal balance on the loan was $500,000. The Company has granted a security interest in favor of the Bank in substantially all of its tangible assets as collateral for the loan under the loan and security agreement, and the agreement imposes certain limitations on the Company’s ability to engage in certain transactions. In connection with the agreement, the Company also issued to the Bank a warrant to purchase up to 50,000 shares of its common stock. The warrant is exercisable for seven years from the date of issuance at an exercise price per share of $0.60. The fair value of the warrant issued to the Bank was determined to be $55,505 using a Black-Scholes model, which amount was recorded as debt issuance costs and is being amortized over the life of the agreement. Interest expense, excluding amortization of debt issuance costs, for the three and nine months ended September 30, 2008 and 2007 was $8,021, $30,859, $20,996 and $26,996, respectively. Amortization of debt issuance costs for the three and nine months ended September 30, 2008 and 2007 was $7,017, $21,050, $7,017 and $20,947, respectively.

Off-Balance Sheet Arrangements

We do not have any off-balance sheet arrangements that are reasonably likely to have a current or future effect on our financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources that are material to investors.

Significant Accounting Policies

The preparation of financial statements requires the Company’s management to make estimates and assumptions that affect the reported amount of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Significant accounting policies are those that require application of management’s most difficult, subjective or complex judgments, often as a result of the need to make estimates about the effect of matters that are inherently uncertain and may change in subsequent periods. Such policies are summarized in Note 4 to the financial statements, above, and Note 2 to the financial statements in the Company’s 2007 Annual Report on Form 10-KSB. There have been no significant changes to the company’s critical accounting policies since December 31, 2007.

Effect of New Accounting Policies

In October 2008, the FASB issued FSP FAS 157-3, which clarifies the application of SFAS No. 157, “Fair Value Measurements”, in a market that is not active and provides an illustrative example. The illustrative example is intended to demonstrate how the fair value of a financial asset is determined when the market for that financial asset is inactive. FSP FAS 157-3 is effective October 10, 2008. The Company does not expect the adoption of FSP FAS 157-3 to affect future reporting or disclosures.

In September 2008, the FASB issued FASB Staff Position FAS 133-1 and FASB Interpretation No. 45-4. The FSP is intended to improve disclosures about credit derivatives by requiring more information about the potential adverse effects of changes in credit risk on the financial position, financial performance, and cash flows of the sellers of credit derivatives. It amends SFAS No. 133 to require disclosures by sellers of credit derivatives, including credit derivatives embedded in hybrid instruments. The FSP also amends FIN 45 to require an additional disclosure about the current status of the payment/performance risk of a guarantee. The provisions of the FSP that amend SFAS No. 133 and FIN 45 are effective for reporting periods ending after November 15, 2008. Finally, the FSP clarifies that the disclosures required by SFAS No. 161 should be provided for any reporting period beginning after November 15, 2008. The Company does not expect the adoption of the FSP to affect future reporting or disclosures.

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In May 2008, the FASB issued SFAS No. 163, which requires that an insurance enterprise recognize a claim liability prior to an event of default (insured event) when there is evidence that credit deterioration has occurred in an insured financial obligation. SFAS No. 163 also clarifies how SFAS No. 60 applies to financial guarantee insurance contracts, including the recognition and measurement to be used to account for premium revenue and claim liabilities. SFAS No. 163 is effective as of the beginning of the first fiscal year beginning after December 15, 2008. The Company does not expect the adoption of SFAS No. 163 to affect future reporting or disclosures.

In May 2008, the FASB issued SFAS No. 162, which identifies the sources of accounting principles and the framework for selecting the principles to be used in the preparation of financial statements of nongovernmental entities that are presented in conformity with GAAP. SFAS No. 162 is effective 60 days following the SEC’s approval of the Public Company Accounting Oversight Board amendments to AU Section 411, “The Meaning of Present Fairly in Conformity With Generally Accepted Accounting Principles”. The Company does not expect the adoption of SFAS No. 162 to affect future reporting or disclosures.

In March 2008, the FASB issued SFAS No. 161, which is intended to improve financial reporting about derivative instruments and hedging activities by requiring enhanced disclosures to enable investors to better understand their effects on an entity’s financial position, financial performance and cash flows. It is effective for financial statements issued for fiscal years and interim periods beginning after November 15, 2008. The Company does not expect the adoption of SFAS No. 161 to affect future reporting or disclosures.

In December 2007, the FASB issued SFAS No. 160, which requires all entities to report noncontrolling (minority) interests in subsidiaries in the same way—as equity in the consolidated financial statements. Moreover, SFAS No. 160 eliminates the diversity that currently exists in accounting for transactions between an entity and noncontrolling interests by requiring they be treated as equity transactions. SFAS No. 160 is effective as of the beginning of the first fiscal year beginning after December 15, 2008. The Company does not expect the adoption of SFAS No. 160 to affect future reporting or disclosures.

In December 2007, the FASB issued SFAS No. 141(R), which creates greater consistency in the accounting and financial reporting of business combinations, resulting in more complete, comparable, and relevant information for investors and other users of financial statements. The new standard requires the acquiring entity in a business combination to recognize all (and only) the assets acquired and liabilities assumed in the transaction; establishes the acquisition-date fair value as the measurement objective for all assets acquired and liabilities assumed; and requires the acquirer to disclose to investors and other users all of the information they need to evaluate and understand the nature and financial effect of the business combination. SFAS No. 141(R) is effective as of the beginning of the first fiscal year beginning after December 15, 2008. The Company has not determined the effect of the adoption of SFAS No. 141(R) on future reporting or disclosures.

Item 3. Quantitative and Qualitative Disclosures about Market Risk

We do not use derivative financial instruments for trading or speculative purposes. However, we regularly invest excess cash in short-term investments that are subject to changes in short-term interest rates. We believe that the market risk arising from holding these financial instruments is minimal.

Because we have minimal debt, our exposure to market risks associated with changes in interest rates arise from increases or decreases in interest income earned on our investment portfolio. We attempt to ensure the safety and preservation of invested funds by limiting default risks, market risk, and reinvestment risk. We mitigate default risk by investing in short-term investments. A hypothetical 100 basis point decrease in interest rates along the entire interest rate yield curve would not materially affect the fair value of our interest sensitive financial instruments at September 30, 2008.

Item 4T. Controls and Procedures

The certifications of our Chief Executive Officer and Chief Financial Officer, filed as Exhibits 31.1, 31.2 and 32.1, should be read in conjunction with this Item 4.

Evaluation of disclosure controls and procedures. Our Chief Executive Officer and our Chief Financial Officer evaluated the effectiveness of our disclosure controls and procedures as of the end of the period covered by this Form 10-Q. Based on this evaluation, our Chief Executive Officer and our Chief Financial Officer have determined that our disclosure controls and procedures were effective as of September 30, 2008.

Changes in internal control over financial reporting. Based on an evaluation performed by our Chief Executive Officer and Chief Financial Officer, we have concluded that there was no change in our internal control over financial reporting that occurred during the period covered by this Form 10-Q that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

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PART II-OTHER INFORMATION

Item 1. Legal Proceedings.

None.

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds.

Except as otherwise disclosed in its Current Reports on Form 8-K, the Company did not conduct any unregistered sales of equity securities during the three months ended September 30, 2008.

Item 3. Defaults upon Senior Securities.

None.

Item 4. Submission of Matters to a Vote of Security Holders.

None.

Item 5. Other Information.

None.

Item 6. Exhibits.

See attached Exhibit Index.

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SIGNATURE

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.

AKESIS PHARMACEUTICALS, INC.
By:	/s/ Carl P. LeBel
	Carl P. LeBel President and Chief Executive Officer
Date: November 5, 2008

Akesis Pharmaceuticals, Inc. and Subsidiaries

Exhibit Index

Exhibit Number	Description
3.1(1)	Articles of Incorporation, as amended, of the Registrant
3.2(1)	Bylaws of the Registrant
4.1(2)	Form of Warrant to Purchase Common Stock issued pursuant to that certain Common Stock and Warrant Purchase Agreement dated December 30, 2005 between the Company and the purchasers therein
4.2(2)	Form of Warrant to Purchase Common Stock issued pursuant to the Form of Finder Agreement
4.3(3)	Form of Warrant to Purchase Common Stock issued pursuant to that certain Securities Purchase Agreement dated November 21, 2006 between the Company and the purchasers therein
4.4(3)	Warrant to Purchase Common Stock dated November 21, 2006 between the Company and Globalvest Partners, LLC
4.5(4)	Form of Warrant issued to Investors in the Financing dated December 15, 2006
4.6(4)	Warrant, dated as of December 15, 2006, issued to Globalvest Partners, LLC
4.7(4)	Warrant, dated as of December 15, 2006, issued to Square 1 Bank
4.8(5)#	Warrant to Purchase Common Stock dated October 2, 2006 between the Company and Edward Wilson.
4.9(6)	Warrant, dated as of March 25, 2008, issued to Avalon Ventures VII, L.P.
4.10(10)	Form of Convertible Promissory Note issued pursuant to that certain Note and Warrant Purchase Agreement, dated as of September 29, 2008, by and between the Company and Avalon Ventures VII, L.P.
4.11(10)	Form of Warrant to Purchase Capital Stock issued pursuant to that certain Note and Warrant Purchase Agreement, dated as of September 29, 2008, by and between the Company and Avalon Ventures VII, L.P.
10.1(7)#	Form of Stand-Alone Stock Option Agreement
10.2(8)	Revised Letter of Payment Authorization, effective as of June 18, 2008, between the Company and Charles River Laboratories relating to the Preclinical Safety Studies.
10.3(9)#	Stand-Alone Stock Option Agreement dated as of June 26, 2008, by and between the Company and Dr. LeBel.
10.4(10)	Note and Warrant Purchase Agreement, dated as of September 29, 2008, by and between the Company and Avalon Ventures VII, L.P.
31.1	Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
31.2	Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

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Exhibit Number	Description
32.1	Certification of Chief Executive Officer and Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

(1) Incorporated by reference to the Company’s Form 10-K as filed with the SEC on March 24, 2005.

(2) Incorporated by reference to the Company’s Form 8-K as filed with the SEC on January 6, 2006.

(3) Incorporated by reference to the Company’s Form 8-K as filed with the SEC on November 27, 2006.

(4) Incorporated by reference to the Company’s Form 8-K as filed with the SEC on December 20, 2006.

(5) Incorporated by reference to the Company’s Form 8-K as filed with the SEC on October 3, 2006.

(6) Incorporated by reference to the Company’s Form 10-KSB as filed with the SEC on March 31, 2008.

(7) Incorporated by reference to the Company’s Form 8-K as filed with the SEC on June 19, 2008.

(8) Incorporated by reference to the Company’s Form 8-K as filed with the SEC on June 24, 2008.

(9) Incorporated by reference to the Company’s Form 8-K as filed with the SEC on July 2, 2008.

(10) Incorporated by reference to the Company’s Form 8-K as filed with the SEC on October 3, 2008.

^# Indicates management contract or compensatory plan.

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