DURECT (DRRX) 10-K 2003 FY Annual report

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Form 10-K

(Mark One)

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

For the fiscal year ended December 31, 2003

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:  000-31615

DURECT CORPORATION

(Exact name of registrant as specified in its charter)

Delaware	94-3297098
(State or other jurisdiction of incorporation or organization)	(I.R.S. Employer Identification No.)

10240 Bubb Road

Cupertino, CA 95014

(Address of principal executive offices, including zip code)

Registrant’s telephone number, including area code:  (408) 777-1417

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

None

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

Common Stock, $0.0001 par value

(Title of Class)

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 than 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 if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.    ¨

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act).     YES  x    NO  ¨

The aggregate market value of the voting stock held by non-affiliates of the registrant was approximately $84,845,570 as of June 30, 2003 based upon the closing sale price on the Nasdaq National Market reported for such date. Shares of Common Stock held by each officer and director and by each person who may be deemed to be an affiliate have been excluded. This determination of affiliate status is not necessarily a conclusive determination for other purposes.

There were 51,175,284 shares of the registrant’s Common Stock issued and outstanding as of February 27, 2004.

DOCUMENTS INCORPORATED BY REFERENCE

Part III incorporates information by reference from the definitive Proxy Statement for the 2004 annual meeting of stockholders, which is expected to be filed not later than 120 days after the Registrant’s fiscal year ended December 31, 2003.

DURECT CORPORATION

ANNUAL REPORT ON FORM 10-K

FOR THE FISCAL YEAR ENDED DECEMBER 31, 2003

TABLE OF CONTENTS

		Page
	PART I
ITEM 1:	Business	1
ITEM 2:	Properties	23
ITEM 3:	Legal Proceedings	23
ITEM 4:	Submission of Matters to a Vote of Security Holders	23
	PART II
ITEM 5:	Market for the Registrant’s Common Equity and Related Stockholder Matters	24
ITEM 6:	Selected Financial Data	26
ITEM 7:	Management’s Discussion and Analysis of Financial Condition and Results of Operations	27
ITEM 7A:	Quantitative and Qualitative Disclosures About Market Risk	57
ITEM 8:	Financial Statements and Supplementary Data	59
ITEM 9:	Changes in and Disagreements with Accountants on Accounting and Financial Disclosure	87
ITEM 9A:	Controls and Procedures	87
	PART III
ITEM 10:	Directors and Executive Officers of the Registrant	88
ITEM 11:	Executive Compensation	88
ITEM 12:	Security Ownership of Certain Beneficial Owners and Management	88
ITEM 13:	Certain Relationships and Related Transactions	88
ITEM 14:	Principal Accountant Fees and Services	88
	PART IV
ITEM 15:	Exhibits, Financial Statement Schedules and Reports on Form 8-K	88
Signatures		93

PART I

Item 1.    Business.

Overview

We are pioneering the treatment of chronic diseases and conditions by developing and commercializing pharmaceutical systems to deliver the right drug to the right place in the right amount at the right time. Our pharmaceutical systems combine engineering innovations and delivery technology from the drug delivery and medical device industries with our proprietary pharmaceutical and biotechnology drug formulations. By integrating these technologies, we are able to control the rate and duration of drug administration as well as target the delivery of the drug to its intended site of action, allowing our pharmaceutical systems to meet the special challenges associated with treating chronic diseases or conditions. Our pharmaceutical systems can enable new drug therapies or optimize existing therapies based on a broad range of compounds, including small molecule pharmaceuticals as well as biotechnology molecules such as proteins, peptides and genes.

Our pharmaceutical systems are suitable for providing long-term drug therapy because they store highly concentrated, stabilized drugs in a small volume and can protect the drug from degradation by the body. This, in combination with our ability to continuously deliver precise and accurate doses of a drug, allows us to extend the therapeutic value of a wide variety of drugs, including those which would otherwise be ineffective, too unstable, too potent or cause adverse side effects. In some cases, delivering the drug directly to the intended site of action can improve efficacy while minimizing unwanted side effects elsewhere in the body, which often limit the long-term use of many drugs. Our pharmaceutical systems can thus provide better therapy for chronic diseases or conditions by replacing multiple injection therapy or oral dosing, improving drug efficacy, reducing side effects and ensuring dosing compliance. Our pharmaceutical systems can improve patients’ quality of life by eliminating more repetitive treatments, reducing dependence on caregivers and allowing patients to lead more independent lives.

Our lead product, the CHRONOGESIC^® (sufentanil) Pain Therapy System, intended for treatment of chronic pain, combines the DUROS^® technology, a proven and patented drug delivery platform we licensed for specified fields of use from ALZA Corporation (ALZA), a Johnson & Johnson company, with a proprietary formulation of sufentanil, a potent opioid currently used in hospitals as an analgesic. As of December 31, 2003, we have completed an initial Phase I trial, a Phase II clinical trial, a pilot Phase III clinical trial and a pharmacokinetic trial for this product. We do not currently have any on-going clinical trials with respect to this product and are engaged in implementing some necessary design and manufacturing enhancements to the CHRONOGESIC product. We anticipate that we will again re-start clinical trials to support regulatory approval of the product in the U.S. and other countries of the world commencing in the second half of 2004 after we have implemented the required design and manufacturing enhancements to the product. This product is aimed at the approximately $3 billion opioid market for the treatment of chronic pain and will compete with oral opioids, analgesic patches and external and implantable infusion pumps.

We are also developing a sustained release injectible product intended to treat post-operative pain which uses our SABER^™ delivery system and a local anesthetic. This product is designed to be administered around a surgical site after surgery to provide local analgesia for up to three days, which we believe coincides with the time period of the greatest need for post surgical pain control in most patients. Bupivacaine, the active agent for the product, is currently FDA-approved for use in hospitals as a local anesthetic. In 2003, we successfully completed a Phase I clinical trial for our post-operative pain product. The clinical trial was conducted in Europe

NOTE: CHRONOGESIC^®, IntraEAR^®, ALZET^®, SABER^™, DURIN^™ and MICRODUR^™ are trademarks of DURECT Corporation. LACTEL^® is a trademark of Absorbable Polymers International Corporation (formerly Birmingham Polymers, Inc.), a wholly owned subsidiary of DURECT Corporation. DUROS^® is a trademark of ALZA Corporation, a Johnson & Johnson company. Other trademarks referred to belong to their respective owners.

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and enrolled 12 normal, healthy subjects. The objectives of the clinical study were to determine the safety and tolerability of the SABER delivery system and the SABER-bupivacaine combination and to evaluate the pharmacokinetics of our SABER product versus current treatment methods.

We are also currently researching and developing pharmaceutical systems in a variety of therapeutic areas, including chronic pain, local post-operative pain, central nervous system disorders, cardiovascular disease and cancer based on our proprietary SABER^™, DURIN^™ and MICRODUR^™ drug delivery platform technologies, as well as based on the DUROS technology. Our SABER Delivery System is a patented controlled-release technology that can be formulated for systemic or local administration of active agents such as proteins and small molecules via the parenteral (i.e., non-oral) route. The potential advantages of the SABER system over other available injectable controlled release technologies include less burst upon injection, higher drug loading and greater ease of administration and manufacturing. In addition, we are exploring the use of our SABER system as the core vehicle for controlled release oral pharmaceutical products. Our DURIN technology consists of a polymer-based biodegradeable implant that enables parenteral delivery of drugs from several weeks to six months or more. Our MICRODUR technology consists of a biodegradable microparticulate controlled release injectable which can provide sustained release of drug from a few days to many months. The DUROS technology is a miniature drug dispensing pump that releases minute quantities of concentrated drug formulations in a continuous, consistent flow over months or years using an osmotic engine. The miniature pump, made out of titanium, can be as small as a wooden matchstick and can be implanted under the skin. We intend to continue to develop and acquire additional pharmaceutical systems technologies consistent with our objective of delivering the right drug to the right place in the right amount at the right time.

Industry Background

Chronic Diseases and Conditions

Although the pharmaceutical, biotechnology and medical device industries have played key roles in increasing life expectancy and improving health, many chronic, debilitating diseases continue to be inadequately addressed with current drugs or medical devices. Cardiovascular disease, cancer, neurodegenerative diseases, diabetes, arthritis, epilepsy and other chronic diseases claim the lives of millions of Americans each year. These illnesses are prolonged, are rarely cured completely, and pose a significant societal burden in mortality, morbidity and cost. The Centers for Disease Control estimates that the major chronic diseases are responsible for approximately 70% of all deaths in the U.S., and medical care costs for these conditions totaled more than $400 billion annually. Currently, more than 60% of total health care spending in the U.S. is devoted to the treatment of chronic diseases. Demographic trends suggest that, as the U.S. population ages, the cost of treating chronic diseases as a proportion of total health care spending will increase.

Current Approaches to Treatment

Drugs are available to treat many chronic diseases, but harmful side effects can limit prolonged treatment. In addition, patients with chronic diseases commonly take multiple medications, often several times a day, for the remainder of their lives. If patients fail to take drugs as prescribed, they often do not receive the intended benefits or may experience side effects, which are harmful or decrease quality of life. These problems become more common as the number of drugs being taken increases, the regimen of dosing becomes more complicated, or the patient ages or becomes cognitively impaired. It is estimated that only half of prescribed medicines are taken correctly.

The Pharmaceutical Industry.    The pharmaceutical industry has traditionally focused on the chemical structure of small molecules to create drugs that can treat diseases and medical conditions. The ability to use these molecules as drugs is based on their potency, safety and efficacy. Therapeutic outcome and ultimately the suitability of a molecule as a drug depends to a large extent on how it gets into the body, distributes throughout the body, reacts with its intended site of action and is eliminated from the body. However, small molecules can act in diverse tissues throughout the body resulting in unwanted side effects.

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Most drugs require a minimum level in blood and tissues to have significant therapeutic effects. Above a maximum level, however, the drug becomes toxic or has some unwanted side effects. These two levels define the therapeutic range of the drug. With conventional oral dosing and injections, typically a large quantity of drug is administered to the patient at one time, which results in high blood levels of drug immediately after dosing. Because of these high levels, the patient can be over-medicated during the period immediately following dosing, resulting in wasted drug and possible side effects. Due to distribution processes and drug clearance, the blood level of drug falls as time elapses from the last dose. For some duration, the patient is within the desired therapeutic range of blood levels. Eventually, the blood level of drug falls sufficiently such that the patient becomes under-medicated and experiences little or no drug effect until the next dose is administered.

When drugs are administered orally, transdermally or by injection, they are absorbed into the systemic circulation and distributed throughout the body. Because the drug is dispersed throughout the body, relatively large quantities are necessary to create the desired effect at the intended site of action. In addition, systemic administration of drugs in this fashion may result in unwanted side effects, because the drug has access to many tissues and organs in the body other than the intended site of action.

The Biotechnology Industry.    Over the past twenty years, the biotechnology revolution and the expanding field of genomics have led to the discovery of huge numbers of proteins and genes. Tremendous resources have been committed in the hope of developing drug therapies that would better mimic the body’s own processes and allow for greater therapeutic specificity than is possible with small molecule drugs. Unfortunately, this huge effort has led to only a limited number of therapeutic products. The proteins and genes identified by the biotechnology industry are large, complex, intricate molecules, and many are unsuitable as drugs. If these molecules are given orally, they are often digested before they can have an effect; if given by injection, they may be destroyed by the body’s natural processes before they can reach their intended sites of action. The body’s natural elimination processes require frequent, high dose injections that may result in unwanted side effects. As a result, the development of biotechnology molecules for the treatment of human diseases has been limited.

The Drug Delivery Industry.    In the last thirty years, a multibillion dollar drug delivery industry has developed on the basis that medicine can be improved by delivering drugs to patients in a precise, controlled fashion. Several commercially successful oral controlled release products, transdermal controlled release patches, and injectable controlled release formulations have been developed. These products demonstrate that the delivery system can be as important to the ultimate therapeutic value of a pharmaceutical product as the drug itself. However, to date, most drug delivery products deliver drug systemically and do not target delivery to the intended site of action. In addition, drug delivery products are generally limited to durations of one day for oral products and a maximum of one week for transdermal products and therefore may be less desirable for treating chronic diseases. Furthermore, oral and transdermal products are generally not capable of administering biotechnology agents such as proteins, peptides and genes.

The Medical Device Industry.    Advances in the field of medical device technology have dramatically improved device miniaturization and sophistication and allowed minimally invasive surgical access to remote locations within the body. For example, a coronary bypass patient can be treated with a stent in a procedure with a relatively short recovery, rather than with major surgery. Most devices, however, apply only mechanical solutions, rather than delivering chemical or biological agents.

The DURECT Solution: Pharmaceutical Systems

We are pioneering the treatment of chronic diseases and conditions by developing and commercializing pharmaceutical systems that will deliver the right drug to the right place in the right amount at the right time. By integrating chemistry and engineering advancements, we can achieve what drugs or devices alone cannot. Our pharmaceutical systems enable optimized therapy for a given disease or patient population by controlling the rate and duration of drug administration. In addition, if advantageous for the therapy, our pharmaceutical systems can target the delivery of the drug to its intended site of action.

· The Right Drug: By precisely controlling the dosage or targeting delivery to a specific site, we can expand the therapeutic use of compounds that otherwise would be too potent to be administered

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systemically, do not remain in the body long enough to be effective, or have significant side effects when administered systemically. This flexibility allows us to work with a variety of drug candidates including small molecules, proteins, peptides or genes.

· The Right Place: In addition to enabling systemic delivery, if advantageous for the therapy, with precise placement of our proprietary catheters or biodegradable drug delivery formulations, we can design our pharmaceutical systems to deliver drugs directly to the intended site of action. This can ensure that the drug reaches the target tissue in effective concentrations, eliminate many side effects caused by delivery of drug to unintended sites in the body, and reduce the total amount of drug administered to the body.

· The Right Amount: Our pharmaceutical systems can automatically deliver drug dosages continuously within the desired therapeutic range for the duration of the treatment period, from days to up to one year, without the fluctuations in drug levels associated with conventional pills or injections. This can reduce side effects, eliminate gaps in drug therapy, conveniently ensure accurate dosing and patient compliance, and may reduce the total amount of drug administered to the body.

· The Right Time: Our pharmaceutical systems technologies are designed to minimize the need for intervention by the patient or care-giver and enhance dosing compliance. In addition to reducing the cost of care, continuous drug therapy frees the patient from repeated treatment or hospitalization, improving convenience and quality of life. Our systems are well-suited for treating chronic, debilitating diseases such as chronic pain, cancer, heart disease, and neurodegenerative diseases that last for months or years. We believe that it is more effective to treat chronic diseases with continuous, long-term therapy than with alternatives such as multiple conventional injections or oral dosage forms that create short-term effects.

DURECT Pharmaceutical Systems Technology

DURECT’s pharmaceutical systems combine technology innovations from the drug delivery and medical device industries with proprietary pharmaceutical and biotechnology drug formulations. These capabilities can enable new drug therapies or optimize existing therapies based on a broad range of compounds, including small molecule pharmaceuticals as well as biotechnology molecules such as proteins, peptides and genes. We currently have four major technology platforms:

DUROS Technology

The technological foundation of our lead product, CHRONOGESIC, is the DUROS implant technology. The DUROS system is a miniature drug-dispensing pump made out of titanium which can be as small as a wooden matchstick. We have licensed the DUROS technology for specified fields of use from ALZA. The potential of the DUROS technology as a platform for providing drug therapy was demonstrated by the Food and Drug Administration’s approval in March 2000 of ALZA’s VIADUR^® product (leuprolide acetate implant), a once-yearly implant for the palliative treatment of prostate cancer, the first approved product to incorporate the DUROS implant technology. By leveraging this proven technology, we believe we can reduce our development risk and more rapidly introduce new products to the market.

The DUROS pump operates like a miniature syringe. Through osmosis, water from the body is slowly drawn through a semi-permeable membrane into the pump by salt residing in the engine compartment. This water fills the engine compartment and slowly and continuously pushes a piston to dispense minute amounts of drug formulation from the drug reservoir. The osmotic engine does not require batteries, switches or other electromechanical parts in order to operate. The amount of drug delivered by the system is regulated by the semi-permeable membrane’s control of the rate of body water entering the engine compartment and the concentration of the drug formulation.

The DUROS system has performance characteristics that cannot be matched by drug delivery pumps on the market today. First, the engine can generate sufficient pressure to deliver highly concentrated and viscous

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formulations. Second, the system can be engineered to deliver a drug formulation at the desired dosing rate with a high degree of precision, to less than 1/100th of a drop per day on a continuous basis. The titanium shell of the DUROS system protects the drug formulation from degradation by enzymes and clearance processes within the body. As a result, the DUROS system can store drugs for up to one year as they are being released into the body.

The DUROS system can be used for therapies requiring systemic or site-specific administration of drug. To deliver drugs systemically as in our CHRONOGESIC product, the DUROS system is placed just under the skin, for example in the upper arm, in an outpatient procedure that is completed in just a few minutes using local anesthetic. Removal or replacement of the product is also a simple and quick procedure completed in the doctor’s office.

To deliver drug to a specific site, we are developing proprietary miniaturized catheter technology that can be attached to the DUROS system to direct the flow of drug directly to a target organ, tissue or synthetic medical structure, such as a graft. Site specific delivery enables a therapeutic concentration of a drug to be present at the desired target without exposing the entire body of the patient to a similar dose. The precision, size and performance characteristics of the DUROS system will allow for continuous site-specific delivery to a variety of precise locations within the body.

By concentrating drug in proprietary formulations, we can store enough drug in our pharmaceutical systems to dose a patient for extended periods of time, for up to one year. Our proprietary formulations of traditional small molecule drugs are much more concentrated than those currently available on the market. Concentrated formulations allow our pharmaceutical systems to be significantly smaller than alternative drug delivery systems available today. We also believe that we can keep these formulations chemically and physically stable for extended periods of time at body temperature. Our formulation expertise, combined with the protection provided by the reservoir of the DUROS system, may allow for the stable storage and delivery of proteins, peptides, and other large molecule agents in a long-term continuous fashion, thus enabling the full therapeutic potential of a wide range of biotechnology compounds.

The SABER Delivery System

Controlled Release Injectable Dosage Forms

The SABER system is a patented controlled-release technology that can be formulated for systemic or local administration of active agents via the parenteral or oral route. We are researching and developing a variety of controlled-release products based on the SABER technology. These include injectable controlled release products for systemic and local delivery and oral products.

We believe that our SABER system can provide the basis for the development of a state-of-the-art biodegradable, controlled-release injectable. The SABER system uses a high-viscosity base component, such as sucrose acetate isobutyrate (SAIB), to provide controlled release of the drug. When the high viscosity SAIB is formulated with drug, a biocompatible solvent and other additives, the resulting formulation is liquid enough to inject easily with standard syringes and needles. After injection of a SABER formulation, the solvent diffuses away, leaving a viscous depot. Depending on how it is formulated, the SABER system can successfully deliver therapeutic levels of a wide spectrum of drugs from 1 day to 3 months from a single injection. Based on research and development work to date, our SABER technology has shown the following advantages:

· Peptide/Protein Delivery — The chemical nature of the SABER system tends to repel water and body enzymes from its interior and thereby stabilizes proteins and peptides. For this reason, we believe that the SABER system is well suited as a platform for biotechnology therapeutics based on proteins and peptides.

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· Less Burst — Typically, controlled release injections are associated with an initial higher release of drug immediately after injection (a so called “burst”). Animal studies have shown that injectables based on the SABER technology can be associated with less post-injection burst than is typically associated with other commercially available injectable controlled release technologies.

· High Drug Concentration — Drug concentration in a SABER formulation can be as high as 30%, considerably greater than is typical with other commercially available injectable controlled release technologies, thus smaller injection volumes are possible with this technology.

· Ease of Administration — Prior to injection, SABER formulations are fairly liquid and therefore can be injected through small needles. Additionally, because of the higher drug concentration of SABER formulations, less volume is required to be injected. Small injection volumes and more liquid solutions are expected to result in easier, less painful administration.

· Strong Patent Protection — The SABER system, SABER-like materials, and various applications of this technology to pharmaceuticals, medical devices and drug delivery are covered by United States and foreign patents. See “Patents, Licenses and Proprietary Rights” below.

· Ease of Manufacture — Compared to microspheres and other polymer-based controlled release injectable systems, SABER is readily manufacturable at low cost.

In 2003 we successfully completed a Phase I clinical trial of our most advanced injectable product based on the SABER Technology. In this clinical study, SABER formulations were safe and well-tolerated, and no significant side effects or adverse events were reported.

SABER Oral Dosage Forms

We also believe that the SABER technology can be used as the basis for controlled release oral technology, which can transform short-acting oral capsule dosage forms into controlled release oral products. Oral dosage forms based on the SABER technology may also have the added benefit of being less prone to abuse than other controlled release dosage forms on the market today.

In December 2002, we entered into an agreement with Pain Therapeutics Inc. under which we granted Pain Therapeutics, Inc. the exclusive right to develop and commercialize selected long-acting oral opioid products using the SABER system. The first product being developed under the collaboration is Remoxy^™, a novel long-acting oral formulation of the opioid oxycodone that utilizes our SABER technology and which is targeted to decrease the potential for oxycodone abuse. In January 2004, our partner Pain Therapeutics, Inc. began Phase I clinical testing of the Remoxy product.

The DURIN Biodegradeable Implant Technology

Our DURIN technology is a proprietary biodegradable implant that enables parenteral delivery of drugs from several weeks to six months or more using our Lactel^® brand polymers and co-polymers of lactic and glycolic acid. The DURIN technology can deliver a wide variety of drugs including small and large molecule compounds. Our proprietary implant design allows for a variety of possible delivery profiles including constant rate delivery. Because DURIN implants are biodegradable, at the end of its delivery life, what remains of the DURIN implant is absorbed by the body. DURECT is researching and developing products based on the DURIN technology for a variety of chronic disease applications.

The MICRODUR Biodegradable Microparticulate Technology

Our MICRODUR technology is a patented biodegradable microparticulate depot injectable. We have experience in microencapsulation of a broad spectrum of drugs using our Lactel^® brand polymers and co-polymers of lactic and glycolic acid. In our MICRODUR process, both standard and proprietary polymers are

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used to entrap an active agent in solid matrices or capsules comprising particles generally between 10 and 125 microns in diameter. Through suitable choice of polymers and processing, sustained release from a few days to many months can be achieved. As with the DURIN technology, MICRODUR particles degrade fully in the body after the active agent is released. Our range of experience extends from manufacture of the polymer raw material to process and product development, scale up and cGMP manufacture.

DURECT Strategy

Our objective is to develop and commercialize pharmaceutical systems that address significant medical needs and improve patients’ quality of life. To achieve this objective, our strategy includes the following key elements:

Focus on Chronic Debilitating Medical Conditions.    Many of the diseases that present the greatest challenges to medicine are chronic, debilitating diseases such as chronic pain, central nervous system disorders, cardiovascular disorders, cancer and degenerative neurological diseases. Our initial efforts will focus on using our versatile drug delivery platform technologies to develop products that address these diseases.

Minimize Product Development Risk and Speed Time-to-Market.    Initially, we intend to minimize product development risk and speed time-to-market by using our drug delivery platform technologies to administer drugs for which medical data on efficacy and safety are available. This strategy reduces much of the development risk that is inherent in traditional pharmaceutical product discovery. We anticipate that we can expand the medical usefulness of existing well-characterized drugs in several ways:

· expand uses or create new uses for existing drugs by delivering drugs continuously for convenient long dosing intervals;

· create new uses for drugs which were previously considered to be too potent to be used safely by precisely controlling dosing or by delivering them directly to the site of action; and

· enhance drug performance by minimizing side effects.

We anticipate that our products can be more rapidly developed at lower cost than comparable products that are developed purely based on chemical solutions to the problems of efficacy, side effects, stability and delivery of the active agent. We believe that our ability to innovate more rapidly will allow us to respond more quickly to market feedback to optimize our existing products or develop line extensions that address new market needs.

Enable the Development of Pharmaceutical Systems Based on Biotechnology and Other New Compounds.    We believe there is a significant opportunity for pharmaceutical systems to add value to therapeutic medicine by administering biotechnology products, such as proteins, peptides and genes. We believe our technologies will improve the specificity, potency, convenience and cost-effectiveness of proteins, genes and other newly discovered drugs. Our systems can enable these compounds to be effectively administered, thus allowing them to become viable medicines. We can address the stability and storage needs of these compounds through our advanced formulation technology and package them in a suitable pharmaceutical system for optimum delivery. Through continuous administration, the DUROS, SABER, MICRODUR and DURIN technology platforms may eliminate the need for multiple injections of these drugs. In addition, through the use of our proprietary miniature catheter technology or by precise placement of our proprietary biodegradable drug formulations, proteins and genes can be delivered to specific tissues for extended periods of time, thus ensuring that large molecule agents are present at the desired site of action and minimizing the potential for adverse side effects elsewhere in the body.

Expand Our Technology Platforms.    Beyond our four core technology platforms, we will continue to develop, license and acquire other technologies consistent with our objective of delivering the right drug to the right place in the right amount at the right time. For example, through our April 2001 acquisition of Southern

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BioSystems, Inc. (SBS), we acquired an experienced team of specialists and patented technologies in the field of controlled release injectables, implants, microspheres and biodegradable polymers. This acquisition, along with our internal development activities, has increased the breadth and depth of our technology platforms. We expect to continue to license or acquire technology that will complement our core capabilities.

Enable Product Development Through Strategic Partnerships.    We believe that selective partnering of our product development programs can enhance the success of our product development and commercialization, diversify our product portfolio and enable us to better manage our operating costs. We currently have the following product collaborations with third party companies:

· Endo Pharmaceuticals Holdings Inc.    In November 2002, we entered into a development, commercialization and supply license agreement with Endo Pharmaceuticals Holdings Inc. (Endo) under which the companies will collaborate on the development and commercialization of our CHRONOGESIC product for the U.S. and Canada. In January 2004, we amended the agreement to take into account the delay in the CHRONOGESIC development program due to DURECT’s implementation of necessary design and manufacturing enhancements to the product. In connection with the execution of the agreement, Endo purchased 1,533,742 shares of newly issued common stock of DURECT at an aggregate purchase price of approximately $5.0 million. Under the terms of the agreement, as amended, we will be responsible for the CHRONOGESIC product’s design and development. For the period commencing January 1, 2004 until the earlier of January 1, 2005 or the commencement of a specified clinical trial, Endo will fund 25% of the ongoing development costs for the CHRONOGESIC product in the U.S. and Canada excluding system redesign costs and pharmacokinetic trials necessitated by any system redesign up to an aggregate amount of $250,000 for the period. Commencing on January 1, 2005 or, if earlier, the commencement of a specified clinical trial for the CHRONOGESIC product, Endo will fund 50% of the ongoing development costs and will reimburse us for a portion of our prior development costs for the product upon the achievement of certain milestones. Development-based milestone payments made by Endo under this agreement could total up to $52 million. Under the agreement, Endo has licensed exclusive promotional rights to the CHRONOGESIC product in the U.S. and Canada. Endo will be responsible for marketing, sales and distribution, including providing specialty sales representatives dedicated to supplying technical and training support for CHRONOGESIC therapy and will pay for product launch costs. We will be responsible for the manufacture of the CHRONOGESIC product. We will share profits from the commercialization of the product in the U.S. and Canada with Endo based on the financial performance of the CHRONOGESIC product. Based on our projected financial performance of the product in the U.S. and Canada, we anticipate that our share of such profits from commercialization of the product will be approximately 50%. Our agreement with Endo provides each party with specified termination rights. In particular, our agreement can be terminated by Endo in January 2005 in the event we have not commenced a specified clinical trial by January 1, 2005.

· Pain Therapeutics Inc.    In December 2002, we entered into an exclusive agreement with Pain Therapeutics Inc. (Pain Therapeutics) to develop and commercialize on a worldwide basis selected long-acting oral opioid products using the SABER system. The agreement also provides Pain Therapeutics with the exclusive right to commercialize products developed under the agreement on a worldwide basis. In connection with the execution of the agreement, Pain Therapeutics paid us an upfront fee. We will receive payments upon the achievement of certain development and regulatory milestones, payments for research and development expenditures, as well as royalties based on product sales.

· Voyager Pharmaceutical Corporation.    In July 2002, we entered into a development and commercialization agreement with Voyager Pharmaceutical Corporation (Voyager). Under the terms of the agreement, we will collaborate with Voyager to develop a product using our DURIN technology to provide a sustained release therapy based on Voyager’s patented method of treatment of Alzheimer’s disease. The agreement also provides Voyager with the right to commercialize the product on a worldwide basis. We will receive payments upon the achievement of certain development and

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regulatory milestones, payments for research and development expenditures, as well as royalties based on product sales.

· Thorn BioSciences, LLC.    In July 2002, we entered into an agreement with Thorn BioScience LLC (Thorn) under which we licensed to Thorn exclusive rights to develop and commercialize products using our SABER delivery system in selected animal health and veterinary fields of use. We will receive royalties based on Thorn’s net sales of products developed under this agreement. This agreement superseded and replaced several agreements that our subsidiary SBS (now merged into DURECT) had entered into with Thorn in the veterinary field prior to SBS’s acquisition by DURECT.

We expect to continue to partner select product development activities when it is advantageous to DURECT from a financial and risk management perspective.

Product Research and Development Programs

Our development efforts are focused on the application of our pharmaceutical systems technologies to potential products in a variety of chronic disease areas including pain, cardiovascular disease, CNS disorders and other chronic diseases. Our ongoing product research and development efforts in these areas are set forth in the following table:

Disease/Indication	Product	Partner	Technology Platform	Stage
Chronic Pain	•  Systemic sufentanil (CHRONOGESIC)	•  Yes	•  DUROS	•  Phase II/III
Chronic Pain	•  Oral controlled release opioid (Remoxy)	•  Yes	•  SABER	•  Phase I
Post Operative Pain	•  Controlled Release Injection of Local Anesthetic	•  No	•  SABER	•  Phase I
Alzheimer’s Disease	•  Controlled Release Implant	•  Yes	•  DURIN	•  Preclinical Stage
Central Nervous System Disorders	•  Various	•  No	•  SABER/DUROS/DURIN	•  Preclinical/Research Stages
Cardiovascular Disorders	•  Various	•  No	•  SABER/DUROS/DURIN	•  Research Stage
Asthma/Allergic Rhinitis	•  Controlled Release Injection of Cromolyn Sodium	•  No	•  SABER/DURIN	•  Clinical Feasibility Stage

Chronic Pain (Systemic)

Market Opportunity.    Chronic pain, defined as pain lasting 6 months or longer, is a significant problem associated with chronic diseases, including cancer and various neurological and skeletal disorders. Chronic nonmalignant pain affects as many as 34 million Americans annually. In addition, the National Cancer Institute estimates that 8.4 million Americans alive today have a history of cancer. About 1.2 million new cancer cases are expected to be diagnosed annually, and about 50%-70% of cancer patients experience chronic pain during the course of the disease. Sales of opioids for the treatment of malignant and nonmalignant pain exceed $3.0 billion.

Development Strategy.    We are developing the CHRONOGESIC (sufentanil) Pain Therapy System, a subcutaneous, implantable DUROS-based system that delivers sufentanil systemically at a constant rate for 3 months. This product is intended for patients with chronic pain that is stable and opioid responsive and results from a variety of causes. Sufentanil is an off-patent, highly potent opioid that is currently used in hospitals as an analgesic. If approved for marketing and sale, this product will provide an alternative to current therapies for the treatment of chronic pain such as pills and patches, as well as ensuring improved patient compliance and

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convenience. We will develop a family of dosage strengths, tailored to meet market needs. We have completed an initial Phase I clinical trial, a Phase II clinical trial, a pilot Phase III clinical trial and a pharmacokinetic trial for our CHRONOGESIC product.

We initiated our first pivotal Phase III clinical trial for the CHRONOGESIC product in June 2002. In August 2002, the FDA requested that we delay enrolling new patients in our Phase III clinical trial initiated in June 2002 until the clinical trial protocol is revised and approved by the FDA to provide for additional patient monitoring and data collection. These requested protocol changes were not in response to any observed patient safety or adverse event. We subsequently discontinued all patients from the clinical trial at our discretion in September 2002. Independently from the FDA’s request for protocol changes, in October 2002, we started to implement manufacturing process enhancements to the CHRONOGESIC product to permit terminal sterilization of the product and system design enhancements to prevent a premature shutdown in the delivery of drug prior to the end of the intended 3-month delivery period which was observed in a number of units utilizing the previous system design. We have stopped all clinical trials for the CHRONOGESIC product until the system design is completed. We anticipate that we will again re-start clinical trials to support regulatory approval of the product in the U.S. and other countries of the world commencing in the second half of 2004 after we have implemented the system enhancements to the product.

In November 2002, we entered into a development, commercialization and supply license agreement with Endo Pharmaceuticals Holdings Inc. (Endo) under which the companies will collaborate on the development and commercialization of our CHRONOGESIC product for the U.S. and Canada. In January 2004, we amended the agreement to take into account the delay in the CHRONOGESIC development program due to DURECT’s implementation of necessary design and manufacturing enhancements to the product. In connection with the execution of the agreement, Endo purchased 1,533,742 shares of newly issued common stock of DURECT at an aggregate purchase price of approximately $5.0 million. Under the terms of the agreement, as amended, we will be responsible for the CHRONOGESIC product’s design and development. For the period commencing January 1, 2004 until the earlier of January 1, 2005 or the commencement of a specified clinical trial, Endo will fund 25% of the ongoing development costs for the CHRONOGESIC product in the U.S. and Canada excluding system redesign costs and pharmacokinetic trials necessitated by any system redesign up to an aggregate amount of $250,000 for the period. Commencing on January 1, 2005 or, if earlier, the commencement of a specified clinical trial, Endo will fund 50% of the ongoing development costs and will reimburse us for a portion of our prior development costs for the product upon the achievement of certain milestones. Development-based milestone payments made by Endo under this agreement could total up to $52 million. In addition, under the agreement, Endo has licensed exclusive promotional rights to the CHRONOGESIC product in the U.S. and Canada. Endo will be responsible for marketing, sales and distribution, including providing specialty sales representatives dedicated to supplying technical and training support for CHRONOGESIC therapy and will pay for product launch costs. We will be responsible for the manufacture of the CHRONOGESIC product. We will share profits from the commercialization of the product in the U.S. and Canada with Endo based on the financial performance of the CHRONOGESIC product. Based on our projected financial performance of the product in the U.S. and Canada, we anticipate that our share of such profits from commercialization of the product will be approximately 50%.

In addition to our development efforts on the CHRONOGESIC product, in December 2002, we entered into an exclusive agreement with Pain Therapeutics Inc. (Pain Therapeutics) to develop and commercialize on a worldwide basis selected long-acting oral opioid products using the SABER system. The agreement also provides Pain Therapeutics with the exclusive right to commercialize products developed under the agreement on a world-wide basis. In connection with the execution of the agreement, Pain Therapeutics paid us an upfront fee. We will receive payments upon the achievement of certain development and regulatory milestones, payments for research and development expenditures, as well as royalties based on product sales. The first product being developed under the collaboration is Remoxy^™, a novel long-acting oral formulation of the opioid oxycodone that utilizes our SABER technology and which is targeted to decrease the potential for oxycodone abuse. In January 2004, our partner Pain Therapeutics, Inc. began Phase I clinical testing of the Remoxy product.

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Local Post-Operative Pain

Market Opportunity.    More than 60% of patients who undergo surgery experience moderate to extreme-post operative pain. In the United States, over 25 million patients are afflicted with post surgical pain annually. The current standard of care for post surgical pain includes oral opiate and non-opiate analgesics, transdermal opiate patches and muscle relaxants. While oral analgesics can effectively control post surgical pain, they commonly cause side effects such as drowsiness, constipation and cognitive impairment. Effective pain management can be compromised if patients fail to adhere to recommended dosing regimens because they are sleeping or disoriented. The majority of post surgical pain can be localized to the incision site. Post surgical pain can be treated effectively with local anesthetics; however, the usefulness of these medications is limited by their short duration of action. In general, post-operative pain is either undertreated or poorly treated.

Development Strategy.    We are developing a sustained-release formulation of a local anesthetic using our SABER delivery system for the treatment of post surgical pain. The physician would administer this product at the time of surgery. Placed in the tissues immediately adjacent to the surgical site, this formulation is designed to provide sustained regional analgesia from a single dose. We believe that by delivering effective amounts of a potent analgesic to the location from which the pain originates, adequate pain control can be achieved with minimal exposure to the remainder of the body, and hence minimal side effects. The duration of local delivery of the anesthetic by the product is expected to be a few days, which coincides with the typical timeline by which post surgical pain resolves in most patients. We are currently conducting preclinical studies on this product.

In 2003 we successfully completed a Phase I clinical trial for our post-operative pain product. The clinical trial was conducted in Europe and enrolled 12 normal, healthy subjects. The objectives of the clinical study were to determine the safety and tolerability of the SABER delivery system and the SABER-bupivacaine combination and to evaluate the pharmacokinetics of our SABER product versus current treatment methods. Additional clinical and pre-clinical studies are planned in 2004.

Alzheimer’s Disease

Market Opportunity.    Alzheimer’s disease is an incurable, neurodegenerative disorder that affects over 4 million Americans. This disease typically leads to progressive memory loss, impairments in behavior and language, and physical deterioration. The market potential for Alzheimer’s disease treatments is estimated to be in excess of $10 billion.

Development Strategy.    In July 2002, we entered into a development and commercialization agreement with Voyager Pharmaceutical Corporation (Voyager). Under the terms of the agreement, we will collaborate with Voyager to develop a product using our DURIN technology to provide a sustained release therapy based on Voyager’s patented method of treatment of Alzheimer’s disease. The agreement also provides Voyager with the right to commercialize the product on a worldwide basis. We will receive payments upon the achievement of certain development and regulatory milestones, payments for research and development expenditures, as well as royalties based on product sales.

Central Nervous System Disorders

Market Opportunity.    Millions of people suffer from chronic diseases and disorders of the central nervous system (CNS), including brain and spinal cord tumors, chronic pain, psychosis, epilepsy, spasticity, spinal meningitis, Parkinson’s disease, and multiple sclerosis. The following are some therapeutic opportunities that we are pursuing in this area:

It is estimated that 180,000 new brain tumors are diagnosed in the United States every year. In addition, approximately 350,000 patients are living with primary brain tumors, of which, about 25% are malignant. Current treatments for CNS tumors include radiation, resection and chemotherapy. Treatment success rates vary

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by tumor type, but are generally low, and the risk of side effects or disability is high. It is generally recognized that improvements in treating primary metastatic brain tumors are needed, particularly for those which are inoperable.

Schizophrenia, a disease of the brain that manifests itself through multiple signs and symptoms involving thought, perception and behavior, is another CNS disorder estimated to affect about 2.5 million patients in the U.S.; worldwide, the incidence is about 250 million. Patients typically begin exhibiting symptoms early in life and the illness is usually severe and long lasting, requiring lifelong treatment. Adherence to prescribed drug regimens is recognized as a significant treatment obstacle in the schizophrenic population. Although it is estimated that 50% of patients in the U.S. are either untreated or under treated, the aggregated sales of antipyschotic medications in 2002 exceeded $5.7 billion. Opportunities exist to apply our pharmaceutical systems for treatment of these and other CNS disorders.

Development Strategy.    We are developing the DUROS platform technology in combination with various catheter systems for targeted treatment of select CNS disorders. We are also developing our biodegradable platform technologies for systemic and targeted delivery of drugs to treat select CNS disorders.

We also currently have a collaboration with the Johns Hopkins University, Department of Neurology/Neurosurgery, exploring the feasibility of treating tumors of the brain stem by site specific delivery of a chemotherapeutic agent directly to the tumor via a DUROS system attached to a catheter. The program is currently in preclinical development studies in primates. We view this development program as a proof-of-concept application of the DUROS and catheter technologies to treat CNS disorders. Once we have demonstrated proof-of-concept, our long-term plan is to use the DUROS platform with other therapeutic agents to develop products for a broader range of CNS disorders.

In addition, we are conducting preclinical research on a SABER-based injectable controlled release product to deliver a potent antipsychotic agent in a controlled fashion, with a goal to deliver medication for 30 days from a single injection.

Cardiovascular Disease

Market Opportunity.    Cardiovascular disease, principally heart disease and stroke, accounts for 40% of all deaths, or 960,000 fatalities, annually in the U.S. About 58 million Americans, roughly 25% of the population, are currently living with some form of cardiovascular disease. The aggregate annual cost of cardiovascular disease in the U.S., including treatment and lost productivity, is estimated at $274 billion.

Ischemic heart disease, one of the major forms of cardiovascular disease, is the leading cause of death worldwide. Existing treatments for ischemia, or insufficient blood flow to the heart muscle, include cardiovascular bypass, angioplasty and the use of cardiovascular stents and similar medical devices. While effective, these treatments are invasive, and in roughly 40% of patients, ischemia returns within 2 years. There is a need for less invasive and more long lasting treatments for ischemic heart disease.

Development Strategy.    In collaboration with the University of Maastricht in The Netherlands, we are working to develop methods for treating ischemic heart disease and other chronic cardiovascular diseases through continuous delivery of drugs to the pericardial sac of the heart, a thin membrane that envelops the heart. To date, our research in animal models suggests that ischemic heart disease may be treated by the induction of new blood vessel growth as a way of regenerating normal blood flow to the heart and thereby restoring function to the diseased heart. Our research data showed that the delivery of a proprietary angiogenic factor directly to the pericardial sac of a test animal resulted in the growth of new blood vessels and increased bloodflow in the heart. Should we choose to develop and commercialize a product using such proprietary angiogenic factor or other proprietary agent, we may be required to obtain a license to use such agent in our product. Any required licenses may not be available to us on acceptable terms, if at all. See “Factors that May Affect Future Results—We may be required to obtain rights to certain drugs.”

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Asthma/Allergic Rhinitis

Market Opportunity.    Asthma is a serious, chronic, potentially life-threatening condition that affects approximately 20 million people in the U.S.. Allergic rhinitis (seasonal allergies) is the fifth most common chronic disease in the U.S., and affects as many as 40 million people in the U.S.. Sales of asthma and allergic rhinitis treatments exceeded $5 billion in 2000.

Development Strategy.    We are researching and developing a product for the treatment of asthma and allergic rhinitis utilizing one of our proprietary drug delivery platforms. Cromolyn sodium, a non-steroidal anti-allergy medication, is an FDA-approved drug for the management of mild-to-moderate persistent asthma and is recommended for early intervention and daily anti-inflammatory therapy. Cromolyn sodium has an excellent safety profile, and its position in asthma therapy is well-established. In 2002, we completed an initial clinical feasibility study where we infused the drug intravenously to test the efficacy of delivery of cromolyn sodium when delivered parenterally (i.e., not by inhalation as the drug is conventionally administered). We anticipate that we will be pursuing additional clinical testing of this product concept.

ALZET Business

We currently make and sell the ALZET^® product on a worldwide basis. We market the ALZET product through a direct sales force in the U.S. and through a network of distributors outside the U.S.

The ALZET product is a miniature, implantable osmotic pump used for experimental research in mice, rats and other laboratory animals. These pumps are neither approved nor intended for human use. ALZET pumps continuously deliver drugs, hormones and other test agents at controlled rates from one day to four weeks without the need for external connections, frequent handling or repeated dosing. In laboratory research, these infusion pumps can be used for systemic administration when implanted under the skin or in the body. They can be attached to a catheter for intravenous, intracerebral, or intra-arterial infusion or for targeted delivery, where the effects of a drug or test agent are localized in a particular tissue or organ.

We acquired the ALZET product and assets used primarily in the manufacture, sale and distribution of this product from ALZA in April 2000. We believe that the ALZET business provides us with innovative design and application opportunities for potential new products.

Absorbable Polymers International Corporation (API)

Absorbable Polymers International Corporation (API), formerly known as Birmingham Polymers Inc., an Alabama corporation, is a wholly-owned subsidiary of DURECT that designs, develops and manufactures for pharmaceutical and medical device clients a wide range of standard and custom polymers based on lactide, glycolide and caprolactone under the Lactel^® brand. These materials are manufactured and sold by API directly from its facilities in Birmingham and Pelham, Alabama and are used by DURECT and other API customers for a variety of controlled-release and medical-device applications, including several FDA-approved commercial products. After the acquisition of Absorbable Polymers Technologies, Inc (APT) in August 2003, Birmingham Polymers, Inc. (BPI) changed its name to API. BPI was a wholly-owned subsidiary of SBS when we acquired SBS on April 30, 2001. BPI became a wholly-owned subsidiary of DURECT when SBS was merged with and into DURECT on December 31, 2002.

API has approximately 10 employees and operates from a leased facility located in Pelham, Alabama.

Marketing and Sales

In general, we intend to establish strategic distribution and marketing alliances for our pharmaceutical systems. We recognize that pharmaceutical companies have established sales organizations in markets we are

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targeting. We plan to leverage these sales organizations to achieve greater market penetration for our products than we could on our own. Because our first products combine drugs for which medical data on efficacy and safety are available with a proven technology platform, we believe we have the flexibility to enter into these alliances at a later stage of clinical development, when the product development risk is diminished, in order to retain greater economic participation. We may also establish our own sales force when strategically or economically advantageous.

We market and sell our ALZET product in the U.S. through a direct sales force, and we have a network of distributors for this product outside of the U.S.

Customers

A substantial portion of our product revenues is derived from sale of the ALZET product line. Until such time that we are able to bring our pharmaceutical systems to market, if at all, we expect this trend to continue. Since our acquisition of the ALZET product line in April 2000, one customer accounted for 8%, 11% and 11% of our total revenue in 2003, 2002 and 2001, respectively. We also receive revenue from collaborative research and development arrangements with our strategic partners.

Manufacturing

The process for manufacturing our pharmaceutical systems is technically complex, requires special skills, and must be performed in a qualified facility. For our CHRONOGESIC product, we subcontract to third parties the manufacture of components of the DUROS system, which we then assemble. In 2001, we completed the construction of a flexible manufacturing facility to produce product for our clinical trials required for regulatory approval and market launch of our CHRONOGESIC product and to serve as a pilot facility for additional DUROS-based products under development. In 2002, we completed qualification and validation of this facility and used it to make clinical supplies for the Phase III trial that was initiated in June 2002 and subsequently discontinued. In addition, we are evaluating alternative strategies to meet our long-term commercial manufacturing needs.

We manufacture our ALZET product in a leased facility located in Vacaville, California.

Development and Commercialization Agreement with ALZA Corporation

On April 21, 1998, we entered into a Development and Commercialization Agreement with ALZA Corporation (presently a Johnson & Johnson company), which was amended and restated on April 28, 1999, April 14, 2000 and October 1, 2002. Pursuant to this agreement, ALZA granted to us exclusive, worldwide rights under ALZA intellectual property, including patents, trade secrets and know-how, to develop and commercialize products using the DUROS drug delivery technology in the fields of the delivery of drugs by catheter (except for the sufentanil product) to the central nervous system to treat selected central nervous system disorders, the delivery of drugs by catheter to the middle and inner ear, the delivery of drugs by catheter into the pericardial sac of the heart, the delivery of selected drugs by catheter into vascular grafts and the delivery of selected cancer antigens. Pursuant to amendments made to the agreement in October 1, 2002, our maintenance of exclusivity in these licensed fields is no longer subject to minimum annual requirements for development spending or the number of products under development by us. In addition, as part of the amendments made to the agreement in October 1, 2002, ALZA may obtain from us, for its own behalf or on behalf of one of its affiliates, the exclusive right to develop and commercialize a product in a field of use exclusively licensed to us, provided that such product does not incorporate a drug in the same drug class and is not intended for the same therapeutic indication as a product which is then being developed or commercialized by us or for which we have made commitments to a third party. In the event that ALZA or an affiliate commercializes such a product, ALZA or its affiliate will pay us a royalty on sales of such product at a specified rate.

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We have the exclusive right to commercialize each product developed under the agreement for a period of 20 years from the first commercial sale of the product in the U.S., Canada, Japan, France, Germany, Italy or the United Kingdom. We can extend this commercialization period at our option on a year-by-year basis. We must diligently procure required regulatory approvals and commercialize the products in order to maintain commercialization rights for such product. Under the agreement, we retain exclusive commercialization rights to products developed under this Agreement on a worldwide basis as long as DURECT has commercialized such products in selected major market countries. If we fail to meet the various diligence requirements, we may lose rights to commercialize products in some or all countries, including the U.S. and these rights would revert to ALZA. If we develop or commercialize any drug delivery technology for use in a manner similar to the DUROS technology in a field covered in our license agreement with ALZA, then we may lose our exclusive rights to use the DUROS technology in such field as well as the right to develop new products using DUROS technology in such field.

Under this agreement, we initiate product development by sending ALZA a written notice containing a description of the proposed product and proposed target dates for key milestones. These target dates are subject to ALZA’s reasonable approval and may be adjusted from time to time by mutual agreement. We have the right to subcontract to third parties product development activities including development of components of the DUROS system, provided that design of the DUROS system and other development activities relating to the DUROS system must be performed by ourselves or ALZA unless ALZA permits us to subcontract out such development. We also have the right to partner with third parties to commercialize our products on a product-by-product basis, provided that ALZA has options to distribute our cancer antigen products which do not incorporate proprietary molecules owned by a third party throughout the world. We must allow ALZA an opportunity to negotiate in good faith for commercialization rights to our products developed under the agreement prior to granting these rights to a third party, other than products that are subject to ALZA’s option or products for which we have obtained funding or access to a proprietary drug from a third party to whom we have granted commercialization rights prior to commencement of human clinical trials.

We have the right to subcontract manufacturing activities relating to our products other than the assemblage of the components of the DUROS system itself. In the event of a change in our corporate control, including an acquisition of us, our right to develop and manufacture the DUROS system would terminate, and ALZA would have the right to develop and manufacture DUROS systems for us for so long as ALZA can meet our specification and supply requirements following such change in control. If ALZA elects to manufacture the DUROS system for us after such change in control, we will pay ALZA its manufacturing costs plus 25% of such costs provided that ALZA may not charge us more than our fully allocated manufacturing costs (for the four calendar quarters prior to the commencement of supply by ALZA) plus 25% of such costs. If ALZA and we agree to have ALZA provide development services related to the DUROS system for us, we will pay ALZA its development costs, including research expenses (both direct and indirect, which are billed at a rate of 160% of direct research salaries), general and administrative expenses (at a rate of 80% of direct research salaries) and capital asset expenditures. In the years ended December 31, 2001, 2002 and 2003, we incurred development expenses of $98,000, $19,000 and $13,000, respectively, for work performed by ALZA under the Development and Commercialization Agreement relating to our CHRONOGESIC and other DUROS-based products. ALZA invoices us quarterly for development services performed, with payments due within 30 days of our receipt of the invoice. See “Factors That May Affect Future Results—Our agreement with ALZA limits our fields of operation for our DUROS-based pharmaceutical systems, requires us to spend significant funds on product development and gives ALZA a first right to negotiate to distribute selected products for us.”

Any inventions and related intellectual property rights developed by us or ALZA under the agreement which relate to the DUROS system or its manufacture or to any combination of the DUROS system with other components, active agents, features or processes, shall be owned exclusively by ALZA. All other inventions and related intellectual property rights developed under the agreement, whether by us or ALZA, shall be owned exclusively by us. In addition, ALZA was granted a non-exclusive license to any proprietary technology we may develop relating to a means of connecting a catheter to the DUROS system.

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In consideration for the rights granted to us under this agreement, ALZA received 5,600,000 shares of our Series A-1 Preferred Stock which was converted into 5,600,000 shares of our common stock concurrent with our initial public offering of common stock. As additional consideration, ALZA is entitled to receive a royalty on the net sales of products in an amount not less than 2.5% nor more than 5% of such net sales for so long as we sell the product. ALZA is also entitled to a percentage of any up-front license fees, milestone or any special fees, payments or other consideration we receive, excluding research and development funding, in an amount of 5% of such payment. In addition, commencing upon commercial sale of a product developed under the agreement, we are obligated to make minimum quarterly product payments at an annual rate of 1.5% of projected annual net product sales to ALZA based on our good faith projections for such net product sales, which minimum payments will be fully credited against the product royalty payments we must make to ALZA under the agreement. In connection with the amendment to the agreement made in April 2000, ALZA received 1,000,000 shares of our common stock and a warrant to purchase 1,000,000 shares of our common stock at an exercise price of $12.00 per share.

The term of our agreement with ALZA is for so long as we are obligated to make product payments to ALZA. Either party has the right to terminate the agreement in the event that the other party breaches a material obligation under the agreement and does not cure the breach in a timely manner. In addition, ALZA has the right to terminate the agreement if, at any time prior to July 2006, we solicit for employment or hire, without ALZA’s consent, a person who is or within the previous 180 days has been an employee of ALZA in the DUROS technology group. In the event that our rights terminate with respect to any product or country, or the agreement terminates or expires in its entirety (except for termination by us due to a breach by ALZA), ALZA will have the exclusive right to use all our data, rights and information relating to the products developed under the agreement as necessary for ALZA to commercialize products which rights have reverted to ALZA, subject to payment of a royalty to us based on the net sales of the products by ALZA. The agreement is assignable by either party to an acquiror of all or substantially all of such party’s business.

Patents, Licenses and Proprietary Rights

Our success depends in part on our ability to obtain patents, to protect trade secrets, to operate without infringing upon the proprietary rights of others and to prevent others from infringing on our proprietary rights. Our policy is to seek to protect our proprietary position by, among other methods, filing U.S. and foreign patent applications related to our proprietary technology, inventions and improvements that are important to the development of our business. As of December 31, 2003, we held 19 issued U.S. patents and 7 issued foreign patents. In addition, we have 41 pending U.S. patent applications and have filed 40 patent applications under the Patent Cooperation Treaty, from which 69 national phase applications are currently pending in Europe, Australia, Japan, Canada, Mexico, New Zealand, Brazil and China. Our patents expire at various dates starting in the year 2012. In addition, pursuant to our agreement with ALZA, we have a license under a portfolio of pending, issued and future patents of ALZA which may cover our DUROS-based products depending on the attributes of such products.

Proprietary rights relating to our planned and potential products will be protected from unauthorized use by third parties only to the extent that they are covered by valid and enforceable patents or are effectively maintained as trade secrets. Patents owned by or licensed to us may not afford protection against competitors, and our pending patent applications now or hereafter filed by or licensed to us may not result in patents being issued. In addition, the laws of certain foreign countries may not protect our intellectual property rights to the same extent as do the laws of the U.S.

The patent positions of biopharmaceutical companies involve complex legal and factual questions and, therefore, their enforceability cannot be predicted with certainty. Our patents or patent applications, or those licensed to us, if issued, may be challenged, invalidated or circumvented, and the rights granted thereunder may not provide proprietary protection or competitive advantages to us against competitors with similar technology. Furthermore, our competitors may independently develop similar technologies or duplicate any technology

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developed by us. Because of the extensive time required for development, testing and regulatory review of a potential product, it is possible that, before any of our products can be commercialized, any related patent may expire or remain in existence for only a short period following commercialization, thus reducing any advantage of the patent, which could adversely affect our ability to protect future product development and, consequently, our operating results and financial position.

Because patent applications in the U.S. are maintained in secrecy for at least 18 months after filing and since publication of discoveries in the scientific or patent literature often lag behind actual discoveries, we cannot be certain that we were the first to make the inventions covered by each of our issued or pending patent applications or that we were the first to file for protection of inventions set forth in such patent applications. Our planned or potential products may be covered by third-party patents or other intellectual property rights, in which case we would need to obtain a license to continue developing or marketing these products.

Any required licenses may not be available to us on acceptable terms, if at all. If we do not obtain any required licenses, we could encounter delays in product introductions while we attempt to design around these patents, or could find that the development, manufacture or sale of products requiring such licenses is foreclosed. Litigation may be necessary to defend against or assert such claims of infringement, to enforce patents issued to us, to protect trade secrets or know-how owned by us, or to determine the scope and validity of the proprietary rights of others. In addition, interference proceedings declared by the U.S. Patent and Trademark Office may be necessary to determine the priority of inventions with respect to our patent applications. Litigation or interference proceedings could result in substantial costs to and diversion of effort by us, and could have a material adverse effect on our business, financial condition and results of operations. These efforts by us may not be successful.

We may rely, in certain circumstances, on trade secrets to protect our technology. However, trade secrets are difficult to protect. We seek to protect our proprietary technology and processes, in part, by confidentiality agreements with our employees and certain contractors. There can be no assurance that these agreements will not be breached, that we will have adequate remedies for any breach, or that our trade secrets will not otherwise become known or be independently discovered by competitors. To the extent that our employees, consultants or contractors use intellectual property owned by others in their work for us, disputes may also arise as to the rights in related or resulting know-how and inventions.

Government Regulation

The FDA and comparable regulatory agencies in state and local jurisdictions and in foreign countries impose substantial requirements upon the clinical development, manufacture and marketing of pharmaceutical products. These agencies and other federal, state and local entities regulate research and development activities and the testing, manufacture, quality control, safety, effectiveness, labeling, storage, record keeping, approval, advertising and promotion of our products. We believe that our initial products will be regulated as drugs by the FDA rather than as biologics or devices, whereas later products may be regulated as combination products with a device designation for all or some of the final product components.

The process required by the FDA under the new drug provisions of the Federal Food, Drug and Cosmetics Act before our initial products may be marketed in the U.S. generally involves the following:

· preclinical laboratory and animal tests;

· submission of an IND application which must become effective before clinical trials may begin;

· adequate and well-controlled human clinical trials to establish the safety and efficacy of the proposed pharmaceutical in our intended use; and

· FDA approval of a new drug application.

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The testing and approval process requires substantial time, effort, and financial resources and we cannot be certain that any approval will be granted on a timely basis, if at all.

Preclinical tests include laboratory evaluation of the product, its chemistry, formulation and stability, as well as animal studies to assess the potential safety and efficacy of the product. We then submit the results of the preclinical tests, together with manufacturing information and analytical data, to the FDA as part of an IND, which must become effective before we may begin human clinical trials. The IND automatically becomes effective 30 days after receipt by the FDA, unless the FDA, within the 30-day time period, raises concerns or questions about the conduct of the trials as outlined in the IND and imposes a clinical hold. In such a case, the IND sponsor and the FDA must resolve any outstanding concerns before clinical trials can begin. Our submission of an IND may not result in FDA authorization to commence clinical trials. Further, an independent Institutional Review Board at each medical center proposing to conduct the clinical trials must review and approve any clinical study.

Human clinical trials are typically conducted in three sequential phases which may overlap:

· PHASE I:    The drug is initially introduced into healthy human subjects or patients and tested for safety, dosage tolerance, absorption, metabolism, distribution and excretion.

· PHASE II:    Involves studies in a limited patient population to identify possible adverse effects and safety risks, to determine the efficacy of the product for specific targeted diseases and to determine dosage tolerance and optimal dosage.

· PHASE III:    When Phase II evaluations demonstrate that a dosage range of the product is effective and has an acceptable safety profile, Phase III trials are undertaken to further evaluate dosage, clinical efficacy and to further test for safety in an expanded patient population, often at geographically dispersed clinical study sites.

In the case of products for severe diseases, such as chronic pain, or life-threatening diseases such as cancer, the initial human testing is often conducted in patients with disease rather than in healthy volunteers. Since these patients already have the target disease or condition, these studies may provide initial evidence of efficacy traditionally obtained in Phase II trials and thus these trials are frequently referred to as Phase I/II trials. We cannot be certain that we will successfully complete Phase I, Phase II or Phase III testing of our product candidates within any specific time period, if at all. Furthermore, the FDA or the Institutional Review Board or the sponsor may suspend clinical trials at any time on various grounds, including a finding that the subjects or patients are being exposed to an unacceptable health risk.

The results of product development, preclinical studies and clinical studies are submitted to the FDA as part of a new drug application for approval of the marketing and commercial shipment of the product. The FDA may deny a new drug application if the applicable regulatory criteria are not satisfied or may require additional clinical data. Even if such data is submitted, the FDA may ultimately decide that the new drug application does not satisfy the criteria for approval. Once issued, the FDA may withdraw product approval if compliance with regulatory standards is not maintained or if safety problems occur after the product reaches the market. In addition, the FDA requires surveillance programs to monitor approved products which have been commercialized, and the agency has the power to require changes in labeling or to prevent further marketing of a product based on the results of these post-marketing programs.

In addition to the drug approval requirements applicable to our initial product for the treatment of chronic pain through the Center for Drug Evaluation and Research (CDER), the FDA may require an intercenter consultation review by the Center for Devices and Radiological Health (CDRH). This request for consultation may be based on the device-like nature of a number of aspects of the DUROS technology.

Satisfaction of the above FDA requirements or similar requirements of state, local and foreign regulatory agencies typically takes several years and the actual time required may vary substantially, based upon the type,

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complexity and novelty of the pharmaceutical product. Government regulation may delay or prevent marketing of potential products for a considerable period of time and impose costly procedures upon our activities. We cannot be certain that the FDA or any other regulatory agency will grant approval for any of our products under development on a timely basis, if at all. Success in preclinical or early stage clinical trials does not assure success in later stage clinical trials. Data obtained from preclinical and clinical activities is not always conclusive and may be susceptible to varying interpretations which could delay, limit or prevent regulatory approval. Even if a product receives regulatory approval, the approval may be significantly limited to specific indications. Further, even after regulatory approval is obtained, later discovery of previously unknown problems with a product may result in restrictions on the product or even complete withdrawal of the product from the market. Delays in obtaining, or failures to obtain regulatory approvals would have a material adverse effect on our business. Marketing our products abroad will require similar regulatory approvals and is subject to similar risks. In addition, we cannot predict what adverse governmental regulations may arise from future U.S. or foreign governmental action.

Any products manufactured or distributed by us pursuant to FDA clearances or approvals are subject to pervasive and continuing regulation by the FDA, including record-keeping requirements and reporting of adverse experiences with the drug. Drug manufacturers and their subcontractors are required to register their establishments with the FDA and state agencies, and are subject to periodic unannounced inspections by the FDA and state agencies for compliance with good manufacturing practices, which impose procedural and documentation requirements upon us and our third party manufacturers. We cannot be certain that we or our present or future suppliers will be able to comply with the GMP regulations and other FDA regulatory requirements.

The FDA regulates drug labeling and promotion activities. The FDA has actively enforced regulations prohibiting the marketing of products for unapproved uses. Under the FDA Modernization Act of 1997, the FDA will permit the promotion of a drug for an unapproved use in certain circumstances, but subject to very stringent requirements. We and our products are also subject to a variety of state laws and regulations in those states or localities where our products are or will be marketed. Any applicable state or local regulations may hinder our ability to market our products in those states or localities. We are also subject to numerous federal, state and local laws relating to such matters as safe working conditions, manufacturing practices, environmental protection, fire hazard control, and disposal of hazardous or potentially hazardous substances. We may incur significant costs to comply with such laws and regulations now or in the future.

The FDA’s policies may change and additional government regulations may be enacted which could prevent or delay regulatory approval of our potential products. Moreover, increased attention to the containment of health care costs in the U.S. and in foreign markets could result in new government regulations that could have a material adverse effect on our business. We cannot predict the likelihood, nature or extent of adverse governmental regulation that might arise from future legislative or administrative action, either in the U.S. or abroad.

Competition

We may face competition from other companies in numerous industries including pharmaceuticals, medical devices and drug delivery. Our CHRONOGESIC product, if approved, will compete with oral opioids, transdermal opioid patches, and implantable and external infusion pumps which can be used for infusion of opioids. Products of these types are marketed by Purdue Pharma, Knoll, Janssen, Medtronic, AstraZeneca, Arrow International, Tricumed and others. Numerous companies are applying significant resources and expertise to the problems of drug delivery and several of these are focusing or may focus on delivery of drugs to the intended site of action, including Alkermes, Atrix, Genetronics, The Liposome Company, Focal, Matrix Pharmaceuticals and others. Although we have exclusivity with respect to our license of the DUROS technology in specific fields of therapy, ALZA is also a potential competitor with technologies other than DUROS.

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Some of these competitors may be addressing the same therapeutic areas or indications as we are. Our current and potential competitors may succeed in obtaining patent protection or commercializing products before us. Any products we develop using our pharmaceutical systems technologies will compete in highly competitive markets. Many of our potential competitors in these markets have greater development, financial, manufacturing, marketing, and sales resources than we do and we cannot be certain that they will not succeed in developing products or technologies which will render our technologies and products obsolete or noncompetitive. In addition, many of those potential competitors have significantly greater experience than we do in their respective fields.

Corporate History, Headquarters and Website Information

DURECT Corporation was incorporated in Delaware in February 1998. We completed our initial public offering on September 28, 2000. Our principal executive offices are located at 10240 Bubb Road, Cupertino, California, 95014. Our telephone number is (408) 777-1417, and our web site address is www.durect.com. We make our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports available free of charge on our web site as soon as reasonably practicable after we file these reports with the Securities and Exchange Commission.

Employees

As of February 27, 2004, including API, we had 108 employees, including 59 in research and development, 19 in manufacturing and 30 in selling, general and administrative. From time to time, we also employ independent contractors to support our research, development and administrative organizations. None of our employees are represented by a collective bargaining unit and we have never experienced a work stoppage. We consider our relations with our employees to be good.

Executive Officers of the Registrant.

The executive officers of DURECT Corporation and their ages as of February 27, 2004 are as follows:

Name	Age	Position
Felix Theeuwes, D.Sc.	66	Chairman, Chief Scientific Officer and Director
James E. Brown, D.V.M.	47	President, Chief Executive Officer and Director
Thomas A. Schreck	46	Chief Financial Officer and Director
Jean I Liu	35	Senior Vice President, Legal and General Counsel
Timothy S. Nelson	40	Senor Vice President, Business and Commercial Development
Arthur J. Tipton, Ph.D.	46	Senior Vice President, Bioerodible Product Development
Su Il Yum, Ph.D.	64	Senior Vice President, Engineering
Tai Wah Chan, Ph.D.	59	Vice President, Pharmaceutical Research and Development
Edward M. Gillis	42	Vice President, Product Engineering
Steven Halladay, Ph.D.	56	Vice President, Clinical and Regulatory
Randolph M. Johnson, Ph.D.	53	Vice President, Pre-Clinical Research and Director of CNS Programs
Jian Li	33	Vice President, Finance and Corporate Controller
Michael J. Taylor, Ph.D.	50	Vice President, Nonclinical Research

Felix Theeuwes, D.Sc. co-founded DURECT in February 1998 and has served as our Chairman, Chief Scientific Officer and a Director since July 1998. Prior to that, Dr. Theeuwes held various positions at ALZA Corporation, a pharmaceutical and drug delivery company which is an affiliate of us, including President of New Ventures from August 1997 to August 1998, President of ALZA Research and Development from 1995 to August 1997, President of ALZA Technology Institute from 1994 to April 1995 and Chief Scientist from 1982 to June 1997. Dr. Theeuwes is also a director of Genetronics, a medical device company. Dr. Theeuwes holds a

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D.Sc. degree in Physics from the University of Leuven (Louvain), Belgium. He also served as a post-doctoral fellow and visiting research assistant professor in the Department of Chemistry at the University of Kansas and has completed the Stanford Executive Program.

James E. Brown, D.V.M. co-founded DURECT in February 1998 and has served as our President, Chief Executive Officer and a Director since June 1998. He previously worked at ALZA Corporation as Vice President of Biopharmaceutical and Implant Research and Development from June 1995 to June 1998. Prior to that, Dr. Brown held various positions at Syntex Corporation, a pharmaceutical company, including Director of Business Development from May 1994 to May 1995, Director of Joint Ventures for Discovery Research from April 1992 to May 1995, and held a number of positions including Program Director for Syntex Research and Development from October 1985 to March 1992. Dr. Brown holds a B.A. from San Jose State University and a D.V.M. (Doctor of Veterinary Medicine) from the University of California, Davis where he also conducted post-graduate work in pharmacology and toxicology.

Thomas A. Schreck co-founded DURECT in February 1998 and served as Chief Executive Officer, Chief Financial Officer and President from February 1998 to June 1998. Since June 1998, he has served as our Chief Financial Officer and a Director. Prior to founding DURECT, he founded and was President of Schreck Merchant Group, Inc., an investment bank specializing in private placements and mergers and acquisitions, from June 1994 to February 1998. Mr. Schreck also founded and served as Risk Manager to Genesis Merchant Group/Portola Capital Partners, L.P., a convertible arbitrage fund, from 1993 to 1994. He also served as a Manager of the Convertible Securities Department at Montgomery Securities, from 1988 to 1991. Mr. Schreck holds a B.A. from Williams College.

Jean I Liu has served as our Senior Vice President and General Counsel since February 2003. Prior to that, she served as our Vice President of Legal and General Counsel from February 1999 to February 2003. Previously, from October 1998, Ms. Liu served as our Vice President of Legal. Prior to that, Ms. Liu worked as an attorney at Venture Law Group, a law firm, from May 1997 to October 1998. Ms. Liu worked as an attorney at Pillsbury Madison & Sutro LLP, a law firm, from September 1993 to May 1997. Ms. Liu holds a B.S. in Cellular & Molecular Biology from University of Michigan, an M.S. in Biology from Stanford University and a J.D. from Columbia University School of Law.

Timothy S. Nelson has served as our Senior Vice President of Business and Commercial Development since February 2003. Prior to that, he served as our Vice President of Business and Commercial Development from September 1998 to February 2003. Previously, Mr. Nelson held various positions at Medtronic, Inc., a medical device company, including Business Director of Neurological Division, Europe, Middle East and Africa from June 1996 to September 1998, and Manager of Drug Delivery Ventures and Business Development from August 1992 to June 1996. Mr. Nelson holds a Bachelor of Chemical Engineering degree from the University of Minnesota and a Master of Management degree with Distinction from the J.L. Kellogg Graduate School of Management, Northwestern University.

Arthur J. Tipton, Ph.D. has served as our Senior Vice President of Bioerodible Product Development since August 2003. Prior to that, he served as our Vice President of SABER Technologies from January 2003 to August 2003. From April 2001 to December 2002, Dr. Tipton was the Vice President and Chief Scientific Officer of Southern BioSystems, Inc., a wholly owned subsidiary of ours, which was merged with and into DURECT on December 31, 2002. Previously, Dr. Tipton served as the Director of Matrix Delivery Systems and Vice President and Technical Director of Southern BioSystems, Inc. from April 1993 to April 2001. Dr. Tipton holds a B.S. in chemistry from Spring Hill College and a Ph.D. in Polymer Science and Engineering from University of Massachusetts.

Dr. Su IL Yum, Ph.D., has served as our Senior Vice President, Engineering since December 2003. Previously, Dr. Yum served as our Vice President of Engineering from December 1999 to December 2003. Prior

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to joining DURECT, Dr. Yum served as Senior Technical Advisor at Amira Medical in Scotts Valley, California, where he participated in the development of a pain-free blood glucose detector called AtLast^®. Prior to joining Amira, he held a number of senior positions in project management and engineering at Alza Corporation. Dr. Yum earned his Ph.D. degree in Chemical Engineering from the University of Minnesota, and completed a Post-doctoral research in Biomedical Engineering at the University of Utah. He has more than 40 scientific publications and is the holder of more than 60 U.S. and foreign patents. Dr. Yum is a Fellow of the AAPS.

Tai Wah Chan, Ph.D. has served as our Vice President of Pharmaceutical Research and Development since August 2001. Previously, Dr. Chan served as our Executive Director of Pharmaceutical Research from February 2000 to August 2001 and served as our Senior Director of Pharmaceutical Research from November 1999 to February 2000. Prior to that, Dr. Chan was self employed as a pharmaceutical consultant from October 1997 to November 1999 and was a Senior Scientist at Oread, Inc., a pharmaceutical contract research organization, from October 1996 to October 1997. Dr. Chan holds a B.S. in Physics and Chemistry from the University of Hong Kong and a Ph.D. in Chemistry from the University of Chicago.

Edward M. Gillis has served as our Vice President of Product Engineering since March 2000. Prior to that, Mr. Gillis served as our Executive Director of Engineering from April 1999 to March 2000. Prior to that, he served as our Director of Engineering from October 1998 to April 1999. From March 1997 to October 1998, Mr. Gillis served as the Director of Pilot Manufacturing and Process Engineering at EndoTex Interventional Systems, a private medical device company. From July 1993 to March 1997, Mr. Gillis served as Director of Catheter Ablation Product Development and Manufacturing Engineering Manager at Cardiac Pathways Corporation, a medical device company. Mr. Gillis holds a B.S. in Biological Sciences and an M.S. in Plastics Engineering from the University of Lowell.

Steven Halladay, Ph.D. has served as Vice President of Clinical and Regulatory since April 2003. Prior to that, Dr. Halladay served as our Medical Director from November 2002 and April 2003. Prior to joining DURECT, Dr. Halladay held various positions at Clingenix, Inc., Research Services, Inc., Hoffmann-La Roche, Syntex Laboratories, ALZA Corporation and Dynapol. Following 20 years with Syntex and Hoffmann-La Roche, Dr. Halladay founded Research Services, Inc., an innovative pharmaceutical research company. After 5 years as President and CEO, Research Services merged with Clingenix, Inc. As Senior Executive Vice President at Clingenix his corporate responsibilities included pharmacogenomic program development, new business development, strategic alliances/relationships, and all aspects associated with clinical research and pharmacogenomic medical application. Dr. Halladay holds a B.S. from Southern Utah University, M.S. in Toxicology from University of Arizona and a Ph.D. from the Arizona Medical Center, Tucson, Arizona in Clinical Pharmacology.

Randolph M. Johnson, Ph.D. has served as our Vice President of Preclinical Research and Director of CNS (Central Nervous System) Programs since April 2000. Prior to that, he served as our Vice President of Pharmacology and Toxicology and Director of CNS Programs from September 1998 to April 2000. From October 1997 to September 1998, Dr. Johnson served as the Department Head of Molecular & Cellular Biochemistry, and from July 1995 to October 1997 as Department Head of Neurobiology in the Center for Biological Research, Neurobiology Business Unit of Roche Bioscience, a pharmaceutical company. Dr. Johnson holds a B.S. in Zoology from California State University, Long Beach, an M.A. in Biology-Physiology from California State University, Long Beach and a Ph.D. in Biomedical Science-Pharmacology from the University of South Carolina School of Medicine. In addition, he was a Postdoctoral Research Associate in the Department of Pharmacology at the University of Virginia School of Medicine.

Jian Li has served as our Vice President of Finance and Corporate Controller since December 2003. Previously, Ms. Li served as our Corporate Controller from April 2001 to December 2003, Assistant Controller from December 2000 to April 2001 and our Accounting Manager from March 2000 to December 2000. Prior to joining DURECT, she held various positions at Elan Pharmaceuticals in California and GTE Hawaiian

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Telephone in Honolulu, Hawaii in the roles of Financial Analyst, Accountant and Marketing Analyst. Ms. Li holds an M.B.A. from the University of Hawaii at Manoa. She is also a Certified Public Accountant and a member of American Institute of Certified Public Accountants.

Michael J. Taylor, Ph.D. has served as Vice President of Nonclinical Research since April 2003. Previously, Dr. Taylor served as our Executive Director, Drug Safety and Evaluation from April 2000 to March 2003. Dr. Taylor’s previous pharmaceutical experiences include Department Head, Toxicology at Roche Bioscience from April 1996 until joining DURECT and as Principal Scientist from July 1995 to March 1996. Between September 1990 and June 1995, Dr. Taylor served in various positions at Syntex. Dr. Taylor received his B.S. degree from the University of Rhode Island and his M.S. and Ph.D. degrees in Toxicology from Utah State University. Dr. Taylor’s post graduate studies include fellowships with the NIH and the CNRS of France.

Item 2.    Properties.

We are headquartered in Cupertino, California, where we lease approximately 30,000 square feet of space under a lease expiring in February 2009 with an option to extend for up to an additional five years. This facility contains both office and laboratory space and is also the site of the manufacturing facility we have constructed. In June 2001, we leased approximately 20,000 square feet of additional corporate office space in Cupertino, California, under a lease expiring in May 2006 with options to extend for up to an additional eight years. In December 2003, we leased approximately 20,000 square feet of additional corporate office and laboratory space in Cupertino, California, under a lease expiring in February 2009 with options to extend for up to an additional five years. We also lease approximately 7,800 square feet of space in Vacaville, California, which contains manufacturing space for the ALZET product. Our lease of this facility expires in August 2005 with an option to extend for two years. Pursuant to our acquisition of SBS, we assumed a lease for approximately 23,000 square feet of office and laboratory space in Birmingham, Alabama, which expires in May 2004. In connection with our acquisition of APT, we assumed a lease for approximately 6,650 square feet of office and laboratory space in Pelham, Alabama, which expires in February 2006. We believe that our existing facilities are adequate to meet our current and foreseeable requirements or that suitable additional or substitute space will be available as needed.

Item 3.    Legal Proceedings.

We are not a party to any material legal proceedings.

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

Not applicable.

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PART II

Item 5.    Market for Registrant’s Common Equity and Related Stockholder Matters.

Price Range of Common Stock

Our common stock has been listed for quotation on the Nasdaq National Market under the symbol “DRRX” since our initial public offering on September 28, 2000. The following table shows the high and low sales prices of our common stock as reported by the Nasdaq National Market for the period indicated.

Fiscal 2002	High		Low
Quarter ended March 31, 2002	$	11.60	$	6.67
Quarter ended June 30, 2002	$	9.20	$	5.90
Quarter ended September 30, 2002	$	7.73	$	2.96
Quarter ended December 31, 2002	$	3.90	$	1.97

Fiscal 2003	High		Low
Quarter ended March 31, 2003	$	2.31	$	1.12
Quarter ended June 30, 2003	$	4.00	$	1.41
Quarter ended September 30, 2003	$	3.55	$	1.87
Quarter ended December 31, 2003	$	3.99	$	2.15

The closing sale price of the common stock as reported on the Nasdaq National Market on February 27, 2004 was $2.51 per share. As of that date there were approximately 223 holders of record of the common stock. This does not include the number of persons whose stock is in nominee or “street name” accounts through brokers. The market price of our common stock has been and may continue to be subject to wide fluctuations in response to a number of events and factors, such as quarterly variations in our operating results, announcements of technological innovations or new products by us or our competitors, changes in financial estimates and recommendations by securities analysts, the operating and stock performance of other companies that investors may deem comparable to us, and news reports relating to trends in our markets. These fluctuations, as well as general economic and market conditions, may adversely affect the market price for our common stock.

Dividend Policy

We have never paid cash dividends on our common stock. We currently intend to retain any future earnings to fund the development and growth of our business. Therefore, we do not currently anticipate paying any cash dividends in the foreseeable future.

Recent Sales of Unregistered Securities

On August 15, 2003, in connection with an Agreement and Plan of Merger among us, Birmingham Polymers, Inc. and Absorbable Polymer Technologies, Inc. we issued an aggregate of 485,122 shares of our common stock to James P. English and Charlotte P. English in consideration of the merger. We also agreed to issue additional shares of our common stock or cash in connection with the first, second and third anniversaries of the merger. The sales and issuances of securities in the transaction were deemed to be exempt from registration under the Securities Act in reliance on Section 4(2) of the Securities Act as transactions by an issuer not involving any public offering. In all such transactions which relied upon the exemption set forth in Section 4(2) of the Act, the recipients of securities represented their intentions to acquire the securities for investment only and not with a view to or for sale in connection with any distribution thereof, and appropriate legends were affixed to the securities issued in such transactions.

Use of Proceeds from Sales of Registered Securities

On September 27, 2000, in connection with our initial public offering, a Registration Statement on Form S-1 (No. 333-35316) was declared effective by the Securities and Exchange Commission, pursuant to which

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7,000,000 shares of our common stock were offered and sold for our account at a price of $12.00 per share, generating gross offering proceeds of $84.0 million. The managing underwriters were Morgan Stanley Dean Witter, Chase H&Q, and CIBC World Markets. Our initial public offering closed on October 3, 2000. After deducting underwriters’ discounts and commissions and other offering expenses, the net proceeds were approximately $76.2 million. On November 1, 2000, the underwriters exercised their over-allotment option in part and purchased an additional 700,000 shares at the initial public offering price of $12.00 per share. The net proceeds of the over-allotment option, after deducting underwriters’ discount and other offering expenses, were approximately $7.8 million. After giving effect to the sale of the over-allotment shares, a total of 7,700,000 shares of common stock were offered and sold in the initial public offering with total net proceeds of $84.0 million. None of the payments for underwriting discounts and commissions and other transaction expenses represented direct or indirect payments to directors, officers or other affiliates of the Company.

On June 18, 2003, we privately placed $50,000,000 in aggregate principal amount of convertible subordinated notes. On July 14, 2003, the initial purchaser of the convertible notes purchased an additional $10,000,000 in principal amount of the convertible subordinated notes. The convertible subordinated notes are due prior to the close of business on June 15, 2008. The convertible notes may be earlier redeemed at the election of the note holders if we engage in any transaction or event in connection with which all or substantially all of our common stock is exchanged for, converted into, acquired for or constitutes solely the right to receive, consideration which is not all or substantially all common stock listed on a United States national securities exchange or approved for quotation on the NASDAQ National Market or any similar United States system of automated dissemination of quotations of securities prices, or, if for any reason, our common stock is no longer listed for trading on a United States national securities exchange nor approved for trading on the NASDAQ National Market. These convertible notes are convertible into our common stock at a conversion price of $3.15 per share (reflecting a premium of 25%, relative to the NASDAQ closing price for our common stock of $2.52 on June 12, 2003), and bear interest at a rate of 6.25% per annum. The managing underwriter was Morgan Stanley Dean Witter. After deducting underwriters’ discounts and commissions and other offering expenses, the net proceeds were approximately $56.7 million. None of the payments for underwriting discounts and commissions and other transaction expenses represented direct or indirect payments to directors, officers or other affiliates of the Company. The sales and issuances of securities in the transaction were deemed to be exempt from registration under the Securities Act in reliance on Section 4(2) of the Securities Act as transactions by an issuer not involving any public offering. In all such transactions which relied upon the exemption set forth in Section 4(2) of the Act, the recipients of securities represented their intentions to acquire the securities for investment only and not with a view to or for sale in connection with any distribution thereof, and appropriate legends were affixed to the securities issued in such transactions. The offering was made by means of an offering memorandum to qualified institutional buyers pursuant to Rule 144A of the Securities Act of 1933, as amended.

On August 15, 2003, in connection with an Agreement and Plan of Merger among us, Birmingham Polymers, Inc. and Absorbable Polymer Technologies, Inc. we issued an aggregate of 485,122 shares of our common stock to James P. English and Charlotte P. English in consideration of the merger. We also agreed to issue additional shares of our common stock or cash in connection with the first, second and third anniversaries of the merger. The sales and issuances of securities in the transaction were deemed to be exempt from registration under the Securities Act in reliance on Section 4(2) of the Securities Act as transactions by an issuer not involving any public offering. In all such transactions, which relied upon the exemption set forth in Section 4(2) of the Act, the recipients of securities represented their intentions to acquire the securities for investment only and not with a view to or for sale in connection with any distribution thereof, and appropriate legends were affixed to the securities issued in such transactions.

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Item 6.     Selected Financial Data.

The following selected consolidated financial data should be read in conjunction with and are qualified by reference to “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and our consolidated financial statements and related notes, which are included in this Form 10-K. The statement of operations data for the years ended December 31, 2003, 2002 and 2001 and the balance sheet data at December 31, 2003 and 2002 are derived from, and are qualified by reference to, the audited financial statements included elsewhere in this Form 10-K. The statement of operations data for the years ended December 31, 2000 and 1999, and the balance sheet data at December 31, 2001, 2000 and 1999 are derived from our audited statements not included in this Form 10-K. Historical operating results are not necessarily indicative of results in the future. See Note 1 of notes to consolidated financial statements for an explanation of the determination of the shares used in computing net loss per share.

	Year Ended December 31,
	2003			2002			2001			2000			1999
	(in thousands, except per share data)
Statement of Operations Data:
Product revenue, net	$	6,691		$	6,314		$	6,166		$	3,155		$	86
Collaborative research and development and other revenue		5,144			871			358			—			—
Total revenue		11,835			7,185			6,524			3,155			86
Operating expenses:
Cost of revenue		2,427			3,086			3,252			1,876			39
Research and development		20,935			29,535			24,472			12,669			5,181
Research and development—related party		13			19			98			666			1,182
Selling, general and administrative		8,498			10,970			8,779			4,874			2,109
Amortization of intangible assets		1,343			1,340			1,844			850			69
Stock-based compensation		(102	)		1,204			3,451			5,043			865
Acquired in-process research and development		—			—			14,030			—			—
Total operating expenses		33,114			46,154			55,926			25,978			9,445
Loss from operations		(21,279	)		(38,969	)		(49,402	)		(22,823	)		(9,359	)
Other income (expense):
Interest income		1,041			2,076			4,796			3,103			678
Interest expense		(2,460	)		(280	)		(322	)		(131	)		(27	)
Net other income		(1,419	)		1,796			4,474			2,972			651
Net loss		(22,698	)		(37,173	)		(44,928	)		(19,851	)		(8,708	)
Accretion of cumulative dividends on Series B convertible preferred stock		—			—			—			972			602
Net loss attributable to common stockholders	$	(22,698	)	$	(37,173	)	$	(44,928	)	$	(20,823	)	$	(9,310	)
Basic and diluted net loss attributable to common stockholders per common share	$	(0.45	)	$	(0.77	)	$	(0.97	)	$	(1.22	)	$	(1.76	)
Shares used in computing basic and diluted net loss per share		50,510			48,318			46,414			17,120			5,291
	As of December 31,
	2003			2002			2001			2000			1999
	(in thousands)
Balance Sheet Data:
Cash, cash equivalents and investments	$	85,167		$	48,268		$	76,622		$	106,084		$	18,933
Working capital		61,050			41,856			54,463			105,060			15,921
Total assets		112,407			72,971			104,943			120,612			22,463
Long-term liabilities, net of current portion		62,278			1,604			2,147			1,105			189
Stockholders’ equity		45,115			66,182			97,048			115,254			20,728

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Item 7.    Management’s Discussion and Analysis of Financial Condition and Results of Operations

This Management’s Discussion and Analysis of Financial Condition and Results of Operations as of December 31, 2003, 2002, and 2001 should be read in conjunction with our Consolidated Financial Statements, including the Notes thereto, and “Factors that May Affect Future Results” section included elsewhere in this Form 10-K. This Form 10-K contains forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended, and Section 27A of the Securities Act of 1933, as amended. When used in this report or elsewhere by management from time to time, the words “believe,” “anticipate,” “intend,” “plan,” “estimate,” and similar expressions are forward looking statements. Such forward-looking statements contained herein are based on current expectations. Any such forward-looking statements are not guarantees of future performance and involve risks and uncertainties. Actual events or results may differ materially from those discussed in the forward-looking statements as a result of various factors. For a more detailed discussion of such forward looking statements and the potential risks and uncertainties that may impact upon their accuracy, see the “Factors that May Affect Future Results” and “Overview” sections of this Management’s Discussion and Analysis of Financial Condition and Results of Operations. These forward-looking statements reflect our view only as of the date of this report. Except as required by law, we undertake no obligations to update any forward-looking statements. You should also carefully consider the factors set forth in other reports or documents that we file from time to time with the Securities and Exchange Commission.

Overview

DURECT Corporation is pioneering the treatment of chronic diseases and conditions by developing and commercializing pharmaceutical systems to deliver the right drug to the right site in the right amount at the right time. These capabilities can enable new drug therapies or optimize existing ones based on a broad range of compounds, including small molecule pharmaceuticals as well as biotechnology molecules such as proteins, peptides and genes. We focus on the treatment of chronic diseases including pain, cardiovascular diseases and central nervous system disorders and the development of pharmaceutical products incorporating biotechnology agents. We are developing these pharmaceutical system products based on our solid foundation of four proprietary drug delivery technology platforms. These platforms are DUROS^®, SABER^™, MICRODUR^™ and DURIN^™ technology platforms.

CHRONOGESIC^® (sufentanil) Pain Therapy System

Our lead product in development is the CHRONOGESIC^® (sufentanil) Pain Therapy System, an osmotic implant that continuously delivers sufentanil, an opioid medication, for three months. This product is designed to treat chronic pain, and is based on the DUROS implant technology for which we hold an exclusive license from ALZA Corporation, a Johnson & Johnson company, to develop and commercialize products in selected fields. In 2001, we successfully completed a Phase II clinical trial, a pharmacokinetic trial and a pilot Phase III clinical trial for the CHRONOGESIC product. We also completed construction of a pilot aseptic manufacturing facility designed to manufacture the CHRONOGESIC product for our Phase III clinical trials and to meet initial demand for our product if approved by the FDA.

In 2002, we announced positive results of our pilot Phase III clinical trial, validated our aseptic manufacturing facility and used the facility to manufacture clinical supplies for our initial pivotal Phase III clinical trial. We also conducted ongoing animal toxicological studies and other development activities that are necessary to support regulatory approval of the product in the U.S. and abroad. We initiated our first pivotal Phase III clinical trial for the CHRONOGESIC product in June 2002. In August 2002, the FDA requested that we delay enrolling new patients in our Phase III clinical trial initiated in June 2002 until the clinical trial protocol is revised and approved by the FDA to provide for additional patient monitoring and data collection. These requested protocol changes were not in response to any observed patient safety or adverse event. We subsequently discontinued all patients from the clinical trial at our discretion in September 2002. Independently from the FDA’s request for protocol changes, in October 2002, we started to implement manufacturing process

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changes to the CHRONOGESIC product to permit terminal sterilization of the product and system design enhancements to prevent a premature shutdown in the delivery of drug prior to the end of the intended 3-month delivery period which was observed in a number of units utilizing the previous system design. We have stopped all clinical trials for the CHRONOGESIC product until the system design is completed.

In November 2002, we entered into a development, commercialization and supply license agreement with Endo under which the companies will collaborate on the development and commercialization of our CHRONOGESIC product for the U.S. and Canada. In January 2004, we amended the agreement to take into account the delay in the CHRONOGESIC development program due to DURECT’s implementation of necessary design and manufacturing enhancements to the product. For the period commencing January 1, 2004 until the earlier of January 1, 2005 or the commencement of a specified clinical trial, Endo will fund 25% of the ongoing development costs for the CHRONOGESIC product in the U.S. and Canada exclusive of system redesign costs and pharmacokinetic trials necessitated by any system redesign up to an aggregate amount of $250,000 for the period. Commencing on January 1, 2005 or, if earlier, the commencement of a specified clinical trial for the CHRONOGESIC product, Endo will fund 50% of the ongoing development costs and will reimburse us for a portion of our prior development costs for the product upon the achievement of certain milestones. Development-based milestone payments made by Endo under this agreement could total up to $52 million. In addition, under the agreement, Endo has licensed exclusive promotional rights to the CHRONOGESIC product in the U.S. and Canada. Endo will be responsible for marketing, sales and distribution, including providing specialty sales representatives dedicated to supplying technical and training support for CHRONOGESIC therapy and will pay for all product launch costs. We will be responsible for the manufacture of the CHRONOGESIC product. We will share profits from the commercialization of the product in the U.S. and Canada with Endo based on the financial performance of the CHRONOGESIC product. Based on our projected financial performance of the product in the U.S. and Canada, we anticipate that our share of such profits from commercialization of the product will be approximately 50%.

In 2003, we continued to conduct in-vitro and animal studies, implement and evaluate system design and manufacturing process changes and revise clinical trial protocols for the CHRONOGESIC product. In October 2003, we announced that we had received data from a preclinical animal test with our CHRONOGESIC product utilizing a revised system design which indicate that a small number of units continue to experience a premature shutdown of drug delivery prior to the end of the intended 3-month delivery period. In parallel track with the CHRONOGESIC development program using the revised system design, we have been exploring additional enhancements to prevent any premature shutdown, and have already generated feasibility data relating to these enhancements. We are evaluating incorporating these mechanisms into our system design and other system design changes to prevent any premature shutdown of the system. We expect that we will restart the product’s phase III clinical program during the second half of 2004.

SABER post-operative pain depot product

We continue to research and develop other products for the treatment of chronic diseases using the DUROS system, as well as SABER, DURIN and MICRODUR technologies we acquired through the acquisition of Southern BioSystems, Inc. (SBS) in April 2001. During 2003, we also continued to research and develop a number of other pharmaceutical products including our post-operative pain depot product, a sustained release injectible using the SABER delivery system and a local anesthetic. This product is designed to be administered around a surgical site after surgery for post-operative pain relief and is intended to provide local analgesia for up to three days, which we believe coincides with the time period of the greatest need for post surgical pain control in most patients. Bupivacaine, the active agent for the product, is currently FDA-approved for use in hospitals as a local anesthetic. In June 2003, we commenced the first clinical trial for our post-operative pain product. The clinical trial was conducted in Europe and enrolled 12 normal, healthy subjects. The objectives of the clinical study were to determine the safety and tolerability of the SABER delivery system and the SABER-bupivacaine combination and to evaluate the pharmacokinetics of our SABER product versus current treatment methods, which include bupivacaine and ropivacaine. We completed this clinical trial in the third quarter of 2003 in Europe.

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Collaborative Agreements

In order to rapidly identify and fund additional product opportunities, we may partner with various companies who wish to explore the feasibility of combining their drug formulations with our drug delivery technologies to commercialize products. In addition, we may partner with companies who wish to collaborate on the development and commercialization of our existing products in development. Under these collaborative arrangements, we may agree to perform research and development activities to develop these products. We may also agree on royalty, distribution, or other rights once potential products are eventually commercialized. In 2002, we entered into the several partnering arrangements (See “DURECT Strategy—Enable Product Development Through Strategic Partnerships” in Item 1 Business). We intend to enter into additional collaborative partnering arrangements in the future.

During 2003, we also continued to make technical progress on our collaborative research and development projects with our strategic partners, such as Pain Therapeutics, Inc., BioPartners, GmbH, Voyager Pharmaceutical Corporation and others. In particular, our strategic partner, Pain Therapeutics, Inc., recently announced the commencement of a Phase I clinical trial for a novel long-acting formulation of oxycodone that utilizes our SABER delivery system, targeted to decrease the potential for oxycodone abuse. Under these collaborative agreements with the strategic partners, we perform research and development activities to develop products utilizing our drug delivery technologies and recognize collaborative research and development revenue on reimbursement payments of expenses and milestone payments from our partners. Depending on the agreement, we may also have royalty, distribution, or other rights once products are commercialized under the agreement. We intend to enter into additional collaborative partnering arrangements in the future. Our collaborative agreement with BioPartners, GmbH was terminated in December 2003.

Other Business Activities

In June and July 2003, we completed a private placement of an aggregate of $60.0 million in convertible subordinated notes. The notes bear interest at a fixed rate of 6.25% per annum and are due on June 15, 2008. The notes are convertible at the option of the note holders into our common stock at a conversion rate of 317.4603 shares per $1,000 principal amount of notes, subject to adjustment in certain circumstances. Interest on the notes is payable semi-annually in arrears in June and December. We received net proceeds of approximately $56.7 million after deducting underwriting fees of $3.0 million and related expenses of $300,000. The convertible subordinated notes are unsecured obligation of ours and are subordinate to any secured debt we currently have or any future senior indebtness we may have.

On August 15, 2003, we completed an acquisition of APT, a private Alabama corporation engaged in the business of selling biodegradable polymers, pursuant to an Agreement and Plan of Merger by and among us, Absorbable Polymer Technologies, Inc. and Birmingham Polymers, Inc. In connection with the acquisition, we issued an aggregate of 485,122 shares of our common stock and agreed to issue additional shares of our common stock or cash in connection with the first, second and third anniversaries of the closing of the merger. The total purchase price was $2.2 million. The transaction was accounted for as a purchase and is intended to qualify as a tax-free reorganization. Direct transaction costs related to the acquisition were approximately $100,000. APT was merged into Birmingham Polymers, Inc. (BPI), our wholly owned subsidiary upon closing of the merger. BPI changed its name to Absorbable Polymers International Corporation (API) in November 2003. Our financial statements for the year ended December 31, 2003 include the results of operations of APT subsequent to the acquisition date.

In the fourth quarter of 2003, we consolidated most of our operations located in Birmingham, Alabama to our headquarter in Cupertino, California to preserve capital and further focus on bringing our products to commercialization. As a result of the consolidation, approximately 10 positions were eliminated. Total severance benefits paid in 2003 were approximately $182,000. We did not have any write-down of tangible or intangible assets associated with the reduction in force in 2003. We expect to have lower employee expenses from our Birmingham Division in the near future.

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We currently generate product revenue from the sale of two product lines:

· ALZET osmotic pumps for animal research use, and

· LACTEL biodegradable polymers through our wholly owned subsidiary, API, which are used by our customers as raw materials in their pharmaceutical and medical products.

Because we consider our core business to be developing and commercializing pharmaceutical systems, we do not intend to significantly increase our investments in or efforts to sell or market any of our existing product lines. However, we expect that we will continue to make efforts to increase our revenue related to collaborative research and development by entering into additional research and development agreements with third party partners to develop products based on our drug delivery technologies.

Since our inception in 1998, we have had a history of operating losses. At December 31, 2003, we had an accumulated deficit of $136.3 million and our net losses were $22.7 million, $37.2 million and $44.9 million for the twelve months ended December 31, 2003, 2002 and 2001, respectively. These losses have resulted primarily from costs incurred to research and develop our products and to a lesser extent, from selling, general and administrative costs associated with our operations and product sales. Our net losses in 2001 also included the write-off of $14.0 million of in-process research and development acquired in our April 2001 acquisition of SBS. We expect our research and development expenses to modestly increase in the future as we continue to expand our clinical trials and research and development activities. We anticipate that we will support our research and development activities within existing corporate infrastructure, so we expect our general and administrative expenses to increase modestly in light of the additional cost of corporate governance requirements in the near future. We also expect to incur additional non-cash expenses relating to amortization of intangible assets and stock-based compensation. We do not anticipate revenues from our pharmaceutical systems, should they be approved, for at least several years. Therefore, we expect to incur continuing losses and negative cash flow from operations for the foreseeable future.

Critical Accounting Policies and Estimates

General

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 the disclosure of contingent assets and liabilities at the dates of the financial statements and the reported amounts of revenues and expenses during the reporting periods. The most significant estimates and assumptions relate to revenue recognition, the recoverability of our long-lived assets, including goodwill and other intangible assets, accrued liabilities and contract research liabilities. Actual amounts could differ significantly from these estimates.

Revenue Recognition

Revenue from the sale of products is recognized at the time the product is shipped and title transfers to customers, provided no continuing obligation exists and the collectibility of the amounts owed is reasonably assured. Incorrect assumptions at the time of sale about our customers’ ability to pay could result in an overstatement of revenue.

Revenue related to collaborative research and development with our corporate partners is recognized as the related research and development services are performed over the related funding periods for each agreement. The payments received under each respective agreement are not refundable and are generally based on reimbursement of qualified expenses, as defined in the agreements. Research and development expenses under the collaborative and development research agreements approximate or exceed the revenue recognized under such agreements over the term of the respective agreements. Deferred revenue may result when we do not

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expend the required level of effort during a specific period in comparison to funds received under the respective agreement. Milestone and royalties payments, if any, will be recognized as earned. Incorrect determination of qualified expenses could result in greater or lesser revenue being recorded.

Revenue on cost-plus-fee contracts, such as other contract research and development revenue, is recognized only to the extent of reimbursable costs incurred plus estimated fees thereon. Revenue on fixed price contracts is recognized on a percentage-of-completion method based on cost incurred in relation to total estimated cost. In all cases, revenue is recognized only after a signed agreement is in place. For contracts that have a ceiling price or contract value, losses on contracts are recognized in the period in which the losses become known and estimable. Incorrect estimates as to percentage of completion or losses expected to be incurred could result in greater or lesser revenues or losses being recorded.

Intangible Assets and Goodwill

We record intangible assets when we acquire other companies. The cost of an acquisition is allocated to the assets acquired and liabilities assumed, including intangible assets, with the remaining amount being classified as goodwill. Certain intangible assets such as completed or core technology are amortized over time, while acquired in-process research and development is recorded as a one-time charge on the acquisition date. We recorded a charge for acquired in-process research and development of $14.0 million during the year ended December 31, 2001, resulting from the acquisition of SBS in April 2001. This amount represented the value of research projects in process at the time of acquisition which had not yet reached technological feasibility, and which had no alternative future use. The determination of the amount of acquired in-process research and development involves several estimates and judgments, including the percentage of completion of the in-process technology and assumptions about future cash flows to be derived from the technology and discount rates. Different assumptions employed in determining the value of in-process research and development could have resulted in a greater or lesser amount being recorded.

As of January 1, 2002, goodwill is not amortized to expense but rather periodically assessed for impairment. The allocation of the cost of an acquisition to intangible assets and goodwill therefore has a significant impact on our future operating results. The allocation process requires the extensive use of estimates and assumptions, including estimates of future cash flows expected to be generated by the acquired assets. We are also required to estimate the useful lives of those intangible assets subject to amortization, which determines the amount of amortization that will be recorded in a given future period and how quickly the total balance will be amortized. We periodically review the estimated remaining useful lives of our intangible assets. A reduction in our estimate of remaining useful lives, if any, could result in increased amortization expense in future periods.

We assess the impairment of identifiable intangible assets, long-lived assets and goodwill whenever events or changes in circumstances indicate that the carrying value may not be recoverable. Factors we consider important which could trigger an impairment review include the following:

· significant underperformance relative to expected historical or projected future operating results;

· significant changes in the manner of our use of the acquired assets or the strategy for our overall business;

· significant negative industry or economic trends;

· significant decline in our stock price for a sustained period; and

· our market capitalization relative to net book value.

When we determine that the carrying value of intangibles, long-lived assets and goodwill may not be recoverable based upon the existence of one or more of the above indicators of impairment, we measure any impairment based on a projected discounted cash flow method using a discount rate determined by our

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management to be commensurate with the risk inherent in our current business model. The amount of any impairment charge is significantly impacted by and highly dependent upon assumptions as to future cash flows and the appropriate discount rate. Management believes that the discount rate used in this analysis is reasonable in light of currently available information. The use of different assumptions or discount rates could result in a materially different impairment charge.

In 2002, Statement of Financial Accounting Standards No. 142,Goodwill and Other Intangible Assets (SFAS 142) became effective. As a result, we ceased amortizing approximately $4.7 million of goodwill and assembled workforce. In lieu of amortization, we performed an initial impairment review of our goodwill in 2002 and will perform an annual impairment review thereafter. We completed our initial review during the second quarter of 2002. We concluded that our goodwill was fairly stated as of January 1, 2002 and no accounting change adjustment was necessary. We also conducted an impairment review of our goodwill in the fourth quarter of 2002 and 2003 and concluded that our goodwill was not impaired as of December 31, 2002 and 2003. However, there can be no assurance that at the time other periodic reviews are completed, a material impairment charge will not be recorded.

Accrued Liabilities and Contract Research Liabilities

We incur significant costs associated with third party consultants and organizations for clinical trials, engineering, validation, testing, and other research and development-related services. We are required to estimate periodically the cost of services rendered but unbilled based on managements’ estimates of project status. If these good faith estimates are inaccurate, actual expenses incurred could materially differ from our estimates.

The above listing is not intended to be a comprehensive list of all of our accounting policies. In many cases, the accounting treatment of a particular transaction is specifically dictated by accounting principles generally accepted in the United States, with no need for management’s judgment in their application. There are also areas in which management’s judgment in selecting any available alternative would not produce a materially different result. See our audited consolidated financial statements and notes thereto in Item 8 of our Form 10-K which contain accounting policies and other disclosures required by generally accepted accounting principles.

Results of Operations

Comparison of years ended December 31, 2003 and 2002

Revenue.    Total revenues were $11.8 million in 2003 compared to $7.2 million in 2002. A significant portion of our revenues is derived from our product sales, which include our ALZET mini pump product line, and to a lesser extent our polymer and ear catheter products. The increase in total revenue was primarily attributable to higher collaborative research and development revenue recognized from our collaborative agreements with various strategic partners.

Net product revenues were $6.7 million in 2003 compared to $6.3 million in 2002. The increase was primarily due to a modest increase in revenue from our ALZET mini pump product line and API biodegradable polymer product line. We ceased selling IntraEAR catheter products in September 2003 due to a change in business strategic focus. IntraEAR products comprised $81,000 and $149,000 of revenue in 2003 and 2002, respectively.

We also recognize a portion of our revenue from collaborative research and development activities and service contract revenue. We recorded $5.0 million of collaborative research and development revenue in 2003 compared to $507,000 in 2002. Collaborative research and development revenue represent reimbursement of qualified expenses related to the collaborative agreements we signed in 2002 with various corporate partners to research, develop and commercialize potential products using our drug delivery technologies. Total other revenue from service contracts was $149,000 in 2003 compared to $364,000 in 2002. The other revenues in 2003 were related to polymer service contracts provided by API, whereas the service contract revenues in 2002 were related to certain feasibility evaluation agreements.

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In the future, we do not intend to significantly increase our investments in or efforts to sell or market any of our existing product lines. In addition, we do not expect to generate any service contract revenues in the future. However, we will continue to make efforts to increase our revenue related to collaborative research and development by entering into additional research and development agreements with third party partners to develop products based on our drug delivery technologies.

In the fiscal years 2003 and 2002, one customer accounted for 8% and 11% of our total revenues respectively.

Cost of revenue.    Cost of revenue decreased to $2.4 million in 2003 from $3.1 million in 2002. Cost of revenue includes cost of product revenue and to a lesser extent, cost of contract services provided by us. The decrease in cost of revenue was primarily due to manufacturing efficiencies achieved in our ALZET product line. Cost of revenue associated with the product revenue decreased to $2.3 million in 2003 from $2.6 million in 2002. Cost of other revenue from service contracts decreased to $119,000 in 2003 from $503,000 in 2002 as we incurred final costs related to service contracts activities in 2002. As of December 31, 2003, we had 20 manufacturing employees compared with 18 as of the corresponding date in 2002. We expect cost of revenue to remain comparable in the future, as we do not expect product revenues to increase significantly in the future.

Research and development.    Research and development expenses decreased to $20.9 million in 2003 from $29.5 million in 2002. The decrease was primarily attributable to the lower development costs related to our lead product CHRONOGESIC, offset by a slight increase in research and development expenses for our post-operative pain product and other direct expenses incurred under our collaborative agreements. The decrease in the research and development expenses also resulted from lower personnel expenses in 2003 compared with the same period of 2002. In the fourth quarter of 2002, we reduced our research and development workforce in order to conserve capital following the discontinuation of our pivotal Phase III clinical trial for CHRONOGESIC. As of December 31, 2003, we had 60 research and development employees compared with 79 as of the corresponding date in 2002. We expect research and development expenses to slightly decrease in the near term until the restart of clinical trials for CHRONOGESIC. However, we will continue to research and develop other products using our proprietary drug delivery platform technologies, and we expect research and development expenses to increase once we restart clinical trials for CHRONOGESIC.

Selling, general and administrative.    Selling, general and administrative expenses decreased to $8.5 million in 2003 from $11.0 million in 2002. The decrease was primarily due to effective cost controls in the existing corporate infrastructure in 2003 and a one-time expense of $1.7 million for strategic partner advisory services in connection with the Endo agreement, which was executed in the fourth quarter of 2002. As of December 31, 2003, we had 31 selling, general and administrative personnel compared with 38 as of the corresponding date in 2002. We expect selling, general and administrative expenses to increase modestly in light of the additional cost of corporate governance requirements in the near future even through we strive to conserve cash and leverage our existing infrastructure to support our current business activities.

Amortization of intangible assets.    Amortization of intangible assets was $1.3 million in each of 2003 and 2002. In 2003 and 2002, goodwill was evaluated for impairment in accordance with SFAS 142. Based on our evaluation, no indicators of impairment were noted. Should goodwill become impaired in the future, we may be required to record an impairment charge to write the goodwill down to its estimated fair value.

The net amount of intangible assets at December 31, 2003 was $3.0 million, which will be amortized as follows: $1.2 million in each of the years 2004 and 2005, $424,000 in the year 2006, $31,000 in each of the years 2007, 2008 and 2009, and $19,000 in the year 2010. Should other intangible assets become impaired, the Company will write them down to their estimated fair value.

Stock-based compensation.    Since inception, we have recorded aggregate deferred compensation charges of $11.2 million in connection with stock options granted to employees and directors, including $918,000 that we

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recorded at the time of our acquisition of SBS in April 2001 for the assumption of outstanding unvested stock options granted to employees and directors of that company. Of the total amount, we have amortized or reversed (due to employee terminations) $11.1 million through December 31, 2003. We reversed $276,000 of employee stock-based compensation in 2003. We recorded $1.2 million of employee stock-based compensation in 2002. Of these amounts, employee stock compensation related to the following: cost of revenue of $18,000 in 2003 and $72,000 for 2002; research and development expenses of ($306,000) in 2003 and $490,000 in 2002; and selling, general and administrative expenses of $90,000 in 2003 and $507,000 for 2002.

Non-employee stock compensation related to research and development expenses was $96,000 in 2003 and $132,000 in 2002. Non-employee stock compensation related to selling, general and administrative expenses was none in 2003 and $3,000 in 2002. Expenses for non-employee stock options are recorded over the vesting period of the options, with the amount determined by the Black-Scholes option valuation method and remeasured over the vesting term.

The remaining deferred employee stock compensation at December 31, 2003 was $59,000, which will be amortized as follows: $45,000 in 2004, $13,000 in 2005, and $1,000 in 2006. Termination of employment of option holders could cause stock-based compensation in future years to be less than indicated.

Other income (expense).    Interest income decreased to $1.0 million in 2003 from $2.1 million in 2002. The decrease in interest income was primarily attributable to lower yields on debt security investments, partially offset by higher outstanding investment balances from the net issuance of our convertible subordinated notes. We expect interest income to decline as our average outstanding investment balances decline. The increase in interest expense of $2.5 million for 2003 from $280,000 for 2002 was primarily due to interest expense incurred on the $60.0 million of convertible subordinated notes issued in June and July 2003. We expect interest expense to increase as we continue to make interest payments on our convertible notes and to amortize the issuance costs to interest expenses.

Income taxes.    We have no provision for income taxes, as we have incurred losses for all periods presented. As of December 31, 2003, we had net operating loss carryforwards for federal income tax purposes of approximately $107.0 million, which expire in the years 2018 through 2023 and federal research and development tax credits of approximately $1.2 million, which expire at various dates beginning in 2018 through 2023, if not utilized.

As of December 31, 2003, we had net operating loss carryforwards for state income tax purpose of approximately $35.0 million, which expire in the years 2008 through 2013 and state research and development tax credits of approximately $1.1 million, which do not expire.

Utilization of the net operating losses may be subject to a substantial annual limitation due to federal and state ownership change limitations. The annual limitation may result in the expiration of net operating losses and credits before utilization.

As of December 31, 2003 and 2002, we had net deferred tax assets of $44.5 million and $36.1 million. Deferred tax assets reflect the net tax effects of net operating loss and credit carryforwards and the temporary differences between the carrying amounts of assets and liabilities for financial reporting and the amounts used for income tax purposes. Realization of deferred tax assets is dependent upon future earnings, if any, the timing and amount of which are uncertain. Accordingly, the net deferred tax assets have been fully offset by a valuation allowance.

Comparison of years ended December 31, 2002 and 2001

Revenue.    Total revenues were $7.2 million in 2002 compared to $6.5 million in 2001. A significant portion of our revenues is derived from our product sales, which include our ALZET mini pump product line,

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and to a lesser extent our polymer and ear catheter products. Net product revenues were $6.3 million in 2002 compared to $6.2 million in 2001. The increase was primarily due to a modest increase in revenue from our ALZET mini pump product line.

We also recognize a portion of our revenue from collaborative research and development activities and service contract revenue. We recorded $507,000 of collaborative research and development revenue in 2002 compared to none in 2001. Collaborative research and development revenue represent reimbursement of qualified expenses related to the collaborative agreements we signed in 2002 with various corporate partners to research, develop and commercialize potential products using our drug delivery technologies. Total other revenue from service contracts was $364,000 in 2002 compared to $358,000 in 2001. The service contract revenues were related to certain feasibility evaluation agreements.

In each of the fiscal years 2002 and 2001, one customer accounted for 11% of our revenues.

Cost of revenue.    Cost of revenue decreased to $3.1 million in 2002 from $3.3 million in 2001. Cost of revenue includes cost of product revenue and to a lesser extent, cost of contract services. The decrease in cost of revenue was primarily due to manufacturing efficiencies achieved in our ALZET product line, partially offset by higher cost from performing contract services. Cost of revenue associated with the product revenue decreased to $2.6 million in 2002 from $3.0 million in 2001. Cost of revenue on contract services increased to $503,000 in 2002 from $221,000 in 2001 as we incurred final costs related to these activities in 2002. As of December 31, 2002, we had 18 manufacturing employees compared with 21 as of the corresponding date in 2001.

Research and development.    Research and development expenses increased to $29.5 million in 2002 from $24.5 million in 2001. The increase was attributable to expanded research and development activities, especially related to the initiation of our pivotal Phase III clinical trial and continuing animal toxicological studies for our lead product, CHRONOGESIC. The increase was also attributable to continued investments in the research and development of other pharmaceutical systems based on our SABER and DURIN technologies and the hiring of additional research and development personnel during the first nine months of 2002. In the fourth quarter of 2002, we reduced our research and development workforce in order to conserve capital following the discontinuation of our pivotal Phase III clinical trial for CHRONOGESIC. As of December 31, 2002, we had 79 research and development employees compared with 78 as of the corresponding date in 2001.

Selling, general and administrative.    Selling, general and administrative expenses increased to $11.0 million in 2002 from $8.8 million in 2001. The increase was primarily due to a one-time expense of $1.7 million for strategic partner advisory services in connection with the Endo agreement, which was executed in the fourth quarter of 2002. As of December 31, 2002, we had 38 selling, general and administrative personnel compared with 43 as of the corresponding date in 2001.

Amortization of intangible assets.    In connection with our acquisitions of businesses and technologies, we acquired goodwill and assembled workforce of $5.8 million and other intangible assets of $7.1 million. Beginning in January 2002, we ceased amortizing goodwill, which included amounts previously classified as assembled workforce in accordance with SFAS 142. Amortization of intangible assets decreased to $1.3 million for 2002 from $1.8 million in 2001, primarily due to the adoption of SFAS 142. In 2002, goodwill was evaluated for impairment in accordance with SFAS 142. Based on our evaluation, no indicators of impairment were noted. Should goodwill become impaired in the future, we may be required to record an impairment charge to write the goodwill down to its estimated fair value.

Stock-based compensation.    We recorded $1.2 million of employee stock-based compensation, compared with $3.5 million for 2001. Of these amounts, employee stock compensation related to the following: cost of revenue of $72,000 for 2002 and $146,000 for 2001; research and development expenses of $490,000 in 2002 and $2.1 million in 2001; and selling, general and administrative expenses of $507,000 for 2002 and $961,000 in 2001.

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Non-employee stock compensation related to research and development expenses was $132,000 in 2002 and $217,000 in 2001. Non-employee stock compensation related to selling, general and administrative expenses was $3,000 in 2002 and $109,000 in 2001. Expenses for non-employee stock options are recorded over the vesting period of the options, with the amount determined by the Black-Scholes option valuation method and remeasured over the vesting term.

The remaining deferred employee stock compensation at December 31, 2002 was $732,000, which will be amortized as follows: $610,000 in 2003, $102,000 in 2004, $18,000 in 2005, and $2,000 in 2006. Termination of employment of option holders could cause stock-based compensation in future years to be less than indicated.

Acquired in-process research and development.    Acquired in-process research and development was none for 2002 and $14.0 million for 2001. This charge resulted from the acquisition of SBS in April 2001 and represents the value of research projects in process at the time of acquisition which had not yet reached technological feasibility, and which had no alternative future use.

Other income (expense).    Interest income decreased to $2.1 million from $4.8 million in 2001. The decrease in interest income was primarily attributable to lower average outstanding balances of cash and investments that resulted from cash consumed by operations. The decrease in interest expense of $280,000 for 2002 from $322,000 for 2001 was primarily due to the reduction in our overall debt obligations as principal is repaid.

Liquidity and Capital Resources

We had cash, cash equivalents, and investments totaling $85.2 million, $48.3 million and $76.6 million at December 31, 2003, 2002 and 2001, respectively. This includes $3.1 million, $2.9 million and $3.4 million of interest-bearing marketable securities classified as restricted investments on our balance sheet as of December 31, 2003, 2002 and 2001 respectively, which serve as collateral for letters of credit securing a leased facility and SBS bond payments. The letters of credit related to security deposit of the leased facility and the SBS bonds will expire in June 2006 and November 2009, respectively. From inception through the time of our initial public offering, we raised $53.2 million, net of issuance costs, through convertible preferred stock financings. We raised $84.0 million, net of issuance costs, through our sale of stock in our initial public offering in 2000. We received $56.7 million, net of issuance costs, through our issuance of $60.0 million aggregate principal amount of convertible subordinated notes due 2008 in June and July of 2003. The decrease in cash, cash equivalents and investments from 2001 to 2002 was primarily the result of increased operating and capital expenditures. The increase in cash, cash equivalents and investments from 2002 to 2003 was primarily the result of receipt of net proceeds from issuance of the convertible subordinated notes and payments received from customers and collaborative partners, partially offset by ongoing operating expenses.

Working capital was $61.1 million, $41.9 million and $54.5 million at December 31, 2003, 2002 and 2001, respectively. The decrease from 2001 to 2002 was primarily attributable to expenditures related to our research and development efforts in general, the construction of our new manufacturing facility, and purchases of certain long-term investments. The increase from 2002 to 2003 was primarily attributable to the net proceeds from $60.0 million convertible notes, offset by our operating expenditures related to our research and development efforts.

We used $19.2 million, $31.3 million and $22.4 million of cash for operations in the years ended December 31, 2003, 2002, and 2001, respectively. The decrease in 2003 compared to 2002 was primarily due to the lower development expenses related to our lead product CHRONOGESIC and lower personnel related expenses in 2003. The increase in 2002 compared to 2001 was primarily attributable to higher operating expenses and continuing net losses, offset by fewer non-cash charges.

We used $30.9 million of cash from investing activities in the year ended December 31, 2003, compared with $27.9 million of cash received from investing activities in the year ended December 31, 2002, and

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$11.8 million of cash used in the year ended December 31, 2001. The decrease in cash provided by investing activities in 2003 compared to 2002 was primarily due to higher purchases of investments in 2003. The increase in cash provided by investing activities in 2002 compared to 2001 was due to higher net proceeds from the maturities of investments and lower capital expenditures related to the construction and validation of our manufacturing facility in 2002.

We received $57.3 million, $4.9 million and $131,000 of cash from financing activities in the years ended December 31, 2003, 2002 and 2001, respectively. In 2003, cash received from financing activities was primarily due to the net proceeds from our $60.0 million aggregate principal amount of convertible notes. In 2002, cash received related primarily to $5.0 million of proceeds from the sale of stock to Endo Pharmaceutical, a collaborative partner. In 2001, cash received from financing activities was primarily due to proceeds from exercises of stock options and purchases of our common stock under our employee stock purchase plan, offset by payments on equipment loans.

In conjunction with the acquisition of SBS in April 2001, the Company assumed Alabama State Industrial Development Bonds (“SBS Bonds”) with remaining principal payments of $1.7 million and a current interest rate of 6.35% increasing each year up to 7.20% at maturity on November 1, 2009. As part of the acquisition agreement, the Company was required to guarantee and collateralize these bonds with a letter of credit of approximately $2.4 million that the Company secured with investments deposited with a financial institution in July 2001. Interest payments are due semi-annually and principal payments are due annually. Principal payments increase in annual increments from $150,000 to $240,000 over the term of the bonds until the principal is fully amortized in 2009. The Company has an option to call the SBS Bonds at any time, and must pay a call premium if the bonds are called prior to November 2004. The call premium decreases annually from 1 ¹/2% if the Company calls the bonds in November 2001 to 0% in November 2004.

In January 2003, we refinanced an equipment loan and leases obligations with a three-year term loan with a local bank. The principal of the new term loan was $850,000 with a fixed interest rate of 4.95%. The term loan is secured with a certificate of deposit we placed with the same bank. We do not have any lines of credit or available balances on any lease lines.

In June and July 2003, we completed a private placement of an aggregate of $60.0 million in convertible subordinated notes. The notes bear interest at a fixed rate of 6.25% per annum and are due on June 15, 2008. The notes are convertible at the option of the note holders into our common stock at a conversion rate of 317.4603 shares per $1,000 principal amount of notes, subject to adjustment in certain circumstances. Interest on the notes is payable semi-annually in arrears in June and December. We received net proceeds of approximately $56.7 million after deducting underwriting fees of $3.0 million and related expenses of $300,000. The convertible subordinated notes are unsecured obligation of ours and are subordinate to any secured debt we currently have or any future senior we may have. The proceeds from the convertible notes will be used to fund the research, development, manufacture and commercialization of existing and future products and for general corporate purpose, including working capital and capital expenditures.

On August 15, 2003, we completed an acquisition of APT pursuant to an Agreement and Plan of Merger by and among us, Absorbable Polymer Technologies, Inc. and Birmingham Polymers, Inc. In connection with the acquisition, we issued an aggregate of 485,122 shares of our common stock, valued at $1.1 million and agreed to pay the remaining purchase consideration of $1.0 million through the issuance of additional shares of our common stock or cash in connection with the first, second and third anniversaries of the closing of the merger.

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We anticipate that cash used in operating and investing activities will stay at current level or slightly decrease in the near future as we continue to research, develop, and manufacture our products through internal efforts and partnering activities, and service our debt obligations. In aggregate, we are required to make future payments pursuant to our existing contractual obligations as follows:

Contractual Obligations	2004		2005		2006		2007		Thereafter		Total
Convertible subordinated notes (1)	$	3,750	$	3,750	$	3,750	$	3,750	$	61,875	$	76,875
Long-term debt (1)		268		266		263		258		516		1,571
Term loan (1)		306		292		24		—		—		622
APT acquisition consideration payable (2)		250		250		500		—		—		1,000
Operating lease obligations		2,823		2,662		1,739		1,139		1,343		9,706
Total contractual cash obligations	$	7,397	$	7,220	$	6,276	$	5,147	$	63,734	$	89,774

Note (1): Includes principal and interest payments

Note (2): To be paid by our common stock or cash

We also anticipate incurring capital expenditures of at least $1 million over the next 12 months to purchase research and development and manufacturing equipment. The amount and timing of these capital expenditures will depend, among other things, on the success of clinical trials for our products and our collaborative research and development activities.

We believe that our existing cash, cash equivalents and investments will be sufficient to fund our planned operations, existing debt and contractual commitments, and planned capital expenditures through at least 12 months. We may consume available resources more rapidly than currently anticipated, resulting in the need for additional funding. Additionally, we do not expect to generate revenues from our pharmaceutical systems currently under development for at least the next several years, if at all. Accordingly, we may be required to raise additional capital through a variety of sources, including:

· the public equity market;

· private equity financing;

· collaborative arrangements; and

· public or private debt.

There can be no assurance that additional capital will be available on favorable terms, if at all. If adequate funds are not available, we may be required to significantly reduce or refocus our operations or to obtain funds through arrangements that may require us to relinquish rights to certain of our products, technologies or potential markets, either of which could have a material adverse effect on our business, financial condition and results of operations. To the extent that additional capital is raised through the sale of equity or convertible debt securities, the issuance of such securities would result in ownership dilution to our existing stockholders.

We have not utilized and do not intend to utilize “off-balance sheet” arrangements, special purpose entities, hedging and derivative strategies, or other complex financial techniques to fund our operations or otherwise manage our financial position.

Our cash and investments policy emphasizes liquidity and preservation of principal over other portfolio considerations. We select investments that maximize interest income to the extent possible given these two constraints. We satisfy liquidity requirements by investing excess cash in securities with different maturities to match projected cash needs and limit concentration of credit risk by diversifying our investments among a variety of high credit-quality issuers.

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Recent Accounting Pronouncements

In November 2002, the Emerging Issues Task Force (EITF) reached a consensus regarding EITF Issue 00-21,Accounting for Revenue Arrangements with Multiple Deliverables. The consensus addresses not only when and how an arrangement involving multiple deliverables should be divided into separate units of accounting, but also how the arrangement’s consideration should be allocated among separate units. The pronouncement is effective for revenue arrangements entered into in fiscal periods beginning after June 15, 2003. The adoption of EITF Issue 00-21 did not have a material effect on our results of operations or financial position.

In January 2003, the FASB issued Financial Interpretation No. 46,Consolidation of Variable Interest Entities (FIN 46). FIN 46 addresses consolidation by business enterprises of variable interest entities. Under that interpretation, certain entities known as Variable Interest Entities (VIEs) must be consolidated by the primary beneficiary of the entity. The primary beneficiary is generally defined as having the majority of the risks and rewards arising from the VIE. For VIEs in which a significant (but not majority) variable interest is held, certain disclosures are required. It applies immediately to variable interest entities created after January 31, 2003, and applies in the first year or interim period ending after December 15, 2003 to variable interest entities in which an enterprise holds a variable interest that it acquired before February 1, 2003. The adoption of FIN 46 did not have a material effect on our results of operations or financial position.

In May 2003, the FASB issued Statement of Financial Accounting Standards No. 150,Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity (SFAS 150). The Statement establishes standards for classifying and measuring as liabilities certain financial instruments that embody obligations of the issuer and have characteristics of both liabilities and equity. The Statement is effective for all financial instruments created or modified after May 31, 2003, and to other instruments for periods beginning after June 15, 2003. The adoption of SFAS 150 did not have a material effect on our results of operations or financial position.

Recently Passed Legislation

On July 30, 2002, President Bush signed into law the Sarbanes-Oxley Act of 2002 (the “Act”), which impact Securities and Exchange Commission registrants, public accounting firms, lawyers and securities analysts. This legislation is expected to have far reaching effects on the standards of integrity for corporate management, board of directors, and executive management. Additional disclosures, certifications and possibly procedures will be required of the Company. The Company does not expect any material change in its practices as a result of the passage of this legislation; however, the full scope of the Act has not yet been determined. The Act calls for additional regulations and requirements of publicly-traded companies, many of which have yet to be issued.

Factors that May Affect Future Results

In addition to the other information in this Form 10-K, the following factors should be considered carefully in evaluating our business and prospects:

We have not completed development of any of our pharmaceutical systems, and we cannot be certain that our pharmaceutical systems will be able to be commercialized

To be profitable, we must successfully research, develop, obtain regulatory approval for, manufacture, introduce, market and distribute our pharmaceutical systems under development. For each pharmaceutical system that we intend to commercialize, we must successfully meet a number of critical developmental milestones for each disease or medical condition that we target, including:

· selecting and developing drug delivery platform technology to deliver the proper dose of drug over the desired period of time;

· selecting and developing catheter technology, if appropriate, to deliver the drug to a specific location within the body;

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· determining the appropriate drug dosage for use in the pharmaceutical system;

· developing drug compound formulations that will be tolerated, safe and effective and that will be compatible with the system; and

· demonstrating the drug formulation will be stable for commercially reasonable time periods.

The time frame necessary to achieve these developmental milestones for any individual product is long and uncertain, and we may not successfully complete these milestones for any of our products in development. We have not yet completed development of any pharmaceutical systems, and DURECT has limited experience in developing such products. We have not completed the system design of our lead product, CHRONOGESIC, and must still complete necessary design changes and enhancements to the product to prevent the occurrence of any premature shutdown of the system prior to the end of the intended 3-month delivery period prior to continuing clinical trials for the product. Although we have been exploring additional system enhancements to prevent this identified issue and have already generated feasibility data relating to these enhancements, we may not be able to implement these enhancements or these enhancements may not ultimately prevent the occurrence of premature shutdown. If we fail to timely finalize the design of the CHRONOGESIC product, this will harm the long-term viability of the product. In addition, even after we complete the final design of the product, the product must still complete required clinical trials and additional safety testing in animals before approval for commercialization. See “We must conduct and satisfactorily complete required laboratory performance and safety testing, animal studies and clinical trials for our pharmaceutical systems before we can sell them.”

We have not selected the drug dosages nor finalized the formulation or the system design of any other pharmaceutical system including those based on our SABER^™, DURIN^™ and MICRODUR^™ delivery platforms, and we may not be able to finalize the design or formulation of any additional products. We are continuing testing and development of our products and may explore possible design or formulation changes to address issues of safety, manufacturing efficiency and performance. We may not be able to complete development of any products that will be safe and effective and that will have a commercially reasonable treatment and storage period. If we are unable to complete development of our CHRONOGESIC product or other products, we will not be able to earn revenue from them, which would materially harm our business.

We must conduct and satisfactorily complete required laboratory performance and safety testing, animal studies and clinical trials for our pharmaceutical systems before we can sell them

Before we can obtain government approval to sell any of our pharmaceutical systems, we must demonstrate through laboratory performance studies and safety testing, preclinical (animal) studies and clinical (human) trials that each system is safe and effective for human use for each targeted disease. As of September 30, 2003, for our lead product, CHRONOGESIC, we have completed an initial Phase I clinical trial using an external pump to test the safety of continuous chronic infusion of sufentanil, a Phase II clinical trial, a pilot Phase III clinical trial and a pharmacokinetic trial. We are currently in the preclinical or research stages with respect to all our other products under development. We plan to continue extensive and costly tests, clinical trials and safety studies in animals to assess the safety and effectiveness of our CHRONOGESIC product. These studies include laboratory performance studies and safety testing, pivotal Phase III and other clinical trials and animal toxicological studies necessary to support regulatory approval of the product in the United States and other countries of the world. These studies are costly, complex and last for long durations, and may not yield the data required for regulatory approval of our product. In addition, we plan to conduct extensive and costly clinical trials and animal studies for our other potential products. We may not be permitted to begin or continue our planned clinical trials for our potential products or, if our trials are permitted, our potential products may not prove to be safe or produce their intended effects. In addition, we may be required by regulatory agencies to conduct additional animal or human studies regarding the safety and efficacy of our products, including CHRONOGESIC, which we have not planned or anticipated that could delay commercialization of such products and harm our business and financial conditions.

We initiated our first pivotal Phase III clinical trial for the CHRONOGESIC product in June 2002. In August 2002, the FDA requested that we delay enrolling new patients in our Phase III clinical study initiated in

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June 2002 until the clinical trial protocol is revised by us and approved by the FDA to provide for additional patient monitoring and data collection. These requested protocol changes were not in response to any observed patient safety or adverse event. We subsequently discontinued all patients from the clinical trial at our discretion in September 2002. Independently from the FDA’s request for protocol changes, in October 2002, we started to implement manufacturing process changes to the CHRONOGESIC product to permit terminal sterilization of the product and system design enhancements to prevent a premature shutdown in the delivery of drug prior to the end of the intended 3-month delivery period which was observed in a number of units utilizing the previous system design. We have stopped all clinical trials for the CHRONOGESIC product until the system design is finalized. In October 2003, we announced that we received data from a preclinical animal test with our CHRONOGESIC product utilizing a revised system design which indicate that a small number of units continue to experience a premature shutdown of drug delivery prior to the end of the intended 3-month delivery period. We expect that we will restart the product’s phase III clinical program during the second half of 2004.

We expect our pivotal Phase III trials for CHRONOGESIC collectively to include over 900 patients. The length of our clinical trials will depend upon, among other factors, the rate of trial site and patient enrollment and the number of patients required to be enrolled in such studies. We may fail to obtain adequate levels of patient enrollment in our clinical trials. Delays in planned patient enrollment may result in increased costs, delays or termination of clinical trials, which could have a material adverse effect on us. In addition, even if we enroll the number of patients we expect in the time frame we expect, our clinical trials may not provide the data necessary to support regulatory approval for the products for which they were conducted. Additionally, we may fail to effectively oversee and monitor these clinical trials, which would result in increased costs or delays of our clinical trials. Even if these clinical trials are completed, we may fail to complete and submit a new drug application as scheduled. Even if we are able to submit a new drug application as scheduled, the Food and Drug Administration may not clear our application in a timely manner or may deny the application entirely.

Data already obtained from preclinical studies and clinical trials of our pharmaceutical systems do not necessarily predict the results that will be obtained from later preclinical studies and clinical trials. Moreover, preclinical and clinical data such as ours is susceptible to varying interpretations, which could delay, limit or prevent regulatory approval. A number of companies in the pharmaceutical industry have suffered significant setbacks in advanced clinical trials, even after promising results in earlier trials. The failure to adequately demonstrate the safety and effectiveness of a product under development could delay or prevent regulatory clearance of the potential product, resulting in delays to the commercialization of our products, and could materially harm our business. Our clinical trials may not demonstrate the sufficient levels of safety and efficacy necessary to obtain the requisite regulatory approvals for our products, and thus our products may not be approved for marketing.

Failure to obtain product approvals or comply with ongoing governmental regulations could delay or limit introduction of our new products and result in failure to achieve anticipated revenues

The manufacture and marketing of our products and our research and development activities are subject to extensive regulation for safety, efficacy and quality by numerous government authorities in the United States and abroad. We must obtain clearance or approval from applicable regulatory authorities before we can market or sell our products in the U.S. or abroad. Before receiving approval or clearance to market a product in the U.S. or in any other country, we will have to demonstrate to the satisfaction of applicable regulatory agencies that the product is safe and effective on the patient population and for the diseases that will be treated. Clinical trials, manufacturing and marketing of products are subject to the rigorous testing and approval process of the FDA and equivalent foreign regulatory authorities.

The Federal Food, Drug and Cosmetic Act and other federal, state and foreign statutes and regulations govern and influence the testing, manufacture, labeling, advertising, distribution and promotion of drugs and medical devices. These laws and regulations are complex and subject to change. Furthermore, these laws and regulations may be subject to varying interpretations, and we may not be able to predict how an applicable

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regulatory body or agency may choose to interpret or apply any law or regulation. As a result, clinical trials and regulatory approval can take a number of years to accomplish and require the expenditure of substantial resources. We may encounter delays or rejections based upon administrative action or interpretations of current rules and regulations. For example, in August 2002, the FDA requested that we delay enrolling new patients in our Phase III clinical study for the CHRONOGESIC product initiated in June 2002 until the clinical trial protocol is amended and approved by the FDA to provide for additional patient monitoring and data collection. We may not be able to timely reach agreement with the FDA on our clinical trial protocols or on the required data we must collect to continue with our clinical trials or eventually commercialize our product.

We may also encounter delays or rejections based upon additional government regulation from future legislation, administrative action or changes in FDA policy during the period of product development, clinical trials and FDA regulatory review. We may encounter similar delays in foreign countries. Sales of our products outside the U.S. are subject to foreign regulatory standards that vary from country to country. The time required to obtain approvals from foreign countries may be shorter or longer than that required for FDA approval, and requirements for foreign licensing may differ from FDA requirements. We may be unable to obtain requisite approvals from the FDA and foreign regulatory authorities, and even if obtained, such approvals may not be on a timely basis, or they may not cover the clinical uses that we specify. If we fail to obtain timely clearance or approval for our products, we will not be able to market and sell our products, which will limit our ability to generate revenue.

Marketing or promoting a drug is subject to very strict controls. Furthermore, clearance or approval may entail ongoing requirements for post-marketing studies. The manufacture and marketing of drugs are subject to continuing FDA and foreign regulatory review and requirements that we update our regulatory filings. Later discovery of previously unknown problems with a product, manufacturer or facility, or our failure to update regulatory files, may result in restrictions, including withdrawal of the product from the market. Any of the following events, if they were to occur, could delay or preclude us from further developing, marketing or realizing full commercial use of our products, which in turn would materially harm our business, financial condition and results of operations:

· failure to obtain or maintain requisite governmental approvals;

· failure to obtain approvals for clinically intended uses of our products under development; or

· identification of serious and unanticipated adverse side effects in our products under development.

Manufacturers of drugs also must comply with the applicable FDA good manufacturing practice regulations, which include production design controls, testing, quality control and quality assurance requirements as well as the corresponding maintenance of records and documentation. Compliance with current good manufacturing practices regulations is difficult and costly. Manufacturing facilities are subject to ongoing periodic inspection by the FDA and corresponding state agencies, including unannounced inspections, and must be licensed before they can be used for the commercial manufacture of our products. We and/or our present or future suppliers and distributors may be unable to comply with the applicable good manufacturing practice regulations and other FDA regulatory requirements. We have not been subject to a good manufacturing regulation inspection by the FDA relating to our pharmaceutical systems. If we do not achieve compliance for the products we manufacture, the FDA may refuse or withdraw marketing clearance or require product recall, which may cause interruptions or delays in the manufacture and sale of our products.

Our near-term revenues depend on collaborations with other companies. If we are unable to meet milestones under these agreements or enter into additional collaboration agreements or if our existing collaborations are terminated, our revenues may decrease.

Our near-term revenues are based to a significant extent on collaborative arrangements with third parties, pursuant to which we receive payments based on our performance of research and development activities and the

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attainment of milestones set forth in the agreements. We may not be able to attain milestones set forth in any specific agreement, which could cause our revenues to fluctuate or be less than anticipated. In general, our collaboration agreements, including our agreements with Endo Pharmaceuticals, Inc., Pain Therapeutics, Inc., and Voyager Pharmaceutical Corporation, may be terminated by the other party at will or upon specified conditions including, for example, if we fail to satisfy specified performance milestones or if we breach the terms of the agreement. Our agreement with Endo for the development and commercialization of our CHRONOGESIC product in the U.S. and Canada can be terminated by Endo in January 2005 in the event we have not commenced a specified clinical trial for the CHRONOGESIC product by January 1, 2005. If the agreements are terminated, our revenues will be reduced and our products related to those agreements may not be commercialized. We have limited or no control over the resources that any collaborator may devote to our products. Any of our present or future collaborators may not perform their obligations as expected. These collaborators may breach or terminate their agreement with us or otherwise fail to conduct their collaborative activities successfully and in a timely manner. Further, our collaborators may elect not to develop or commercialize products arising out of our collaborative arrangements or not devote sufficient resources to the development, manufacture, marketing or sale of these products. If any of these events occur, we may not be able to develop our technologies or commercialize our products based on such collaborations.

We have a history of operating losses, expect to continue to have losses in the future and may never achieve or maintain profitability

We have incurred significant operating losses since our inception in 1998 and, as of December 31, 2003, had an accumulated deficit of approximately $136.3 million. We expect to continue to incur significant operating losses over the next several years as we continue to incur costs for research and development, clinical trials and manufacturing. Our ability to achieve profitability depends upon our ability, alone or with others, to successfully complete the development of our proposed products, obtain the required regulatory clearances and manufacture and market our proposed products. Development of pharmaceutical systems is costly and requires significant investment. In addition, we may choose to license either additional drug delivery platform technology or rights to particular drugs or other appropriate technology for use in our pharmaceutical systems. The license fees for these technologies or rights would increase the costs of our pharmaceutical systems.

To date, we have not generated significant revenue from the commercial sale of our products and do not expect to receive significant revenue in the near future. All revenues to date are from the sale of products we acquired in October 1999 in connection with the acquisition of substantially all of the assets of IntraEAR, Inc., the ALZET product we acquired in April 2000 from ALZA and the sale of biodegradable polymers through our wholly owned subsidiary, API, and collaborative and contract research and development revenues from our collaborations with third parties and those of our former wholly owned subsidiary, SBS, now merged into DURECT. We do not expect the product revenues to increase significantly in future periods. We do not anticipate commercialization and marketing of our products in development in the near future, and therefore do not expect to generate sufficient revenues to cover expenses or achieve profitability in the near future.

We may have difficulty raising needed capital in the future

Our business currently does not generate sufficient revenues to meet our capital requirements and we do not expect that it will do so in the near future. We have expended and will continue to expend substantial funds to complete the research, development and clinical testing of our products. We will require additional funds for these purposes, to establish additional clinical- and commercial-scale manufacturing arrangements and facilities and to provide for the marketing and distribution of our products. Additional funds may not be available on acceptable terms, if at all. If adequate funds are unavailable from operations or additional sources of financing, we may have to delay, reduce the scope of or eliminate one or more of our research or development programs which would materially harm our business, financial condition and results of operations.

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We believe that our cash, cash equivalents and investments, will be adequate to satisfy our capital needs for at least the next 12 months. However, our actual capital requirements will depend on many factors, including:

· continued progress and cost of our research and development programs;

· success in entering into collaboration agreements and meeting milestones under such agreements;

· progress with preclinical studies and clinical trials;

· the time and costs involved in obtaining regulatory clearance;

· costs involved in preparing, filing, prosecuting, maintaining and enforcing patent claims;

· costs of developing sales, marketing and distribution channels and our ability to sell our products;

· costs involved in establishing manufacturing capabilities for clinical and commercial quantities of our products;

· competing technological and market developments;

· market acceptance of our products; and

· costs for recruiting and retaining employees and consultants.

We may consume available resources more rapidly than currently anticipated, resulting in the need for additional funding. We may seek to raise any necessary additional funds through equity or debt financings, convertible debt financings, collaborative arrangements with corporate partners or other sources, which may be dilutive to existing stockholders and may cause the price of our common stock to decline. In addition, in the event that additional funds are obtained through arrangements with collaborative partners or other sources, we may have to relinquish rights to some of our technologies, product candidates or products under development that we would otherwise seek to develop or commercialize ourselves. If adequate funds are not available, we may be required to significantly reduce or refocus our product development efforts, resulting in loss of sales, increased costs, and reduced revenues.

Investors may experience substantial dilution of their investment

In the past, we have issued and have assumed, pursuant to the SBS acquisition, options and warrants to acquire common stock. To the extent these outstanding options are ultimately exercised, there will be dilution to investors. In addition, conversion of some or all of the $60.0 million aggregate principal amount of convertible subordinated notes that we issued in June and July 2003 will dilute the ownership interests of investors. Investors may experience further dilution of their investment if we raise capital through the sale of additional equity securities or convertible debt securities. See “Liquidity and Capital Resources”. Any sales in the public market of the common stock issuable upon such conversion could adversely affect prevailing market prices for our common stock.

If we do not generate sufficient cash flow through increased revenues or raising additional capital, then we may not be able to meet our substantial debt obligations.

As of December 31, 2003, we had approximately $60.0 million in long-term convertible subordinated notes, $307,000 in non-current term loan obligations, $1.1 million in non-current bonds payable and $906,000 in other long-term liabilities. Our substantial indebtedness, which totals $62.3 million, has and will continue to impact us by:

· making it more difficult to obtain additional financing; and

· constraining our ability to react quickly in an unfavorable economic climate.

Currently we are not generating positive cash flow. Delay in the approval of CHRONOGESIC, or other adverse occurrences related to our product development efforts will adversely impact our ability to meet our

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obligations to repay the principal amounts on our convertible subordinated notes and debentures when due. In addition, if the market price of our common stock on the due date of our notes is below the equity conversion price of the notes, it will be highly unlikely that the holders of a large percentage of our outstanding convertible subordinated noteswill convert such securities to equity in accordance with their existing terms. If we are unable to satisfy our debt service requirements, substantial liquidity problems could result. As of December 31, 2003 we had cash, cash equivalents and short-term investments valued at approximately $85.2 million. We expect to use substantially all of these assets to fund our on-going operations over the next few years. As of December 31, 2003, we had approximately $60.0 million outstanding convertible subordinated notes, which will mature in June 2008. We may not generate sufficient cash from operations to repay our convertible subordinated notes or satisfy any other of these obligations when they become due and may have to raise additional financing from the sale of equity or debt securities or otherwise restructure our obligations in order to do so. There can be no assurance that any such financing or restructuring will be available to us on commercially acceptable terms, if at all.

We may not be able to manufacture sufficient quantities of our products and components to support the clinical and commercial requirements of our partners and ourselves at an acceptable cost, and we have limited manufacturing experience

We must manufacture our products and components in clinical and commercial quantities, either directly or through third parties, in compliance with regulatory requirements and at an acceptable cost. The manufacture of our DUROS-based pharmaceutical systems is a complex process. Although we have completed development of an initial manufacturing process for our CHRONOGESIC product, we are currently pursuing necessary enhancements of such manufacturing process to take into account any changes to the system design, satisfy regulatory requirements, improve product performance and quality, increase efficiencies and lower cost. If we fail to timely complete such necessary manufacturing process enhancements, we will not be able to timely produce product for our clinical trials and commercialization of our CHRONOGESIC product. In the future, we will continue to consider ways to optimize our manufacturing process and to explore possible changes to improve product performance and quality, increase efficiencies and lower costs. We have also committed to manufacture and supply products or components under a number of our collaborative agreements with third party companies. We have not yet completed development of the manufacturing process for any products or components other than for the CHRONOGESIC product. If we fail to develop manufacturing processes to permit us to manufacture a product or component at an acceptable cost, then we and our third party partners may not be able to commercialize that product or we may be in breach of our supply obligations to our third party partners.

We completed construction of a manufacturing facility for our DUROS-based pharmaceutical systems in May 2001 in accordance with our initial plans, and we expect that this facility will be capable of manufacturing supplies for our Phase III and other clinical trials required for regulatory approval and commercial launch of our CHRONOGESIC product and for our other DUROS-based products on a pilot scale. As of December 31, 2003, we have completed validating and qualifying our manufacturing facility from which we will manufacture supplies of the CHRONOGESIC product for our Phase III and other clinical trials once all necessary product design and manufacturing process enhancements have been finalized and implemented. In the future, we may need to build or acquire other space or facilities for manufacture of products and components for our third party partners and ourselves. We have limited experience building and validating manufacturing facilities, and we may not be able to timely accomplish these tasks.

In order to manufacture clinical and commercial supplies of our pharmaceutical systems or components for our third party partners or ourselves, we must attain and maintain compliance with applicable federal, state and foreign regulatory standards relating to manufacture of pharmaceutical products which are rigorous, complex and subject to varying interpretations. Furthermore, our facilities will be subject to government audits to determine compliance with good manufacturing practices regulations, and we may be unable to pass inspection with the applicable regulatory agencies or may be asked to undertake corrective measures which may be costly and cause delay.

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If we are unable to manufacture product or components in a timely manner or at an acceptable cost, quality or performance level, and attain and maintain compliance with applicable regulations, the clinical trials and the commercial sale of our pharmaceutical systems and those of our third party partners could be delayed. Additionally, we may need to alter our facility design or manufacturing processes, install additional equipment or do additional construction or testing in order to meet regulatory requirements, optimize the production process, increase efficiencies or production capacity or for other reasons, which may result in additional cost to us or delay production of product needed for the clinical trials and commercial launch of our products and those of our third party partners. We may also choose to subcontract with third party contractors to perform manufacturing steps of our pharmaceutical systems or components in which case we will be subject to the schedule, expertise and performance of third parties as well as incur significant additional costs. See “We rely heavily on third parties to support development, clinical testing and manufacturing of our products.” Under our development and commercialization agreement with ALZA, we cannot subcontract the manufacture of subassemblies of the DUROS system components of our DUROS-based pharmaceutical system products to third parties which have not been approved by ALZA. If we cannot manufacture product or components in time to meet the clinical or commercial requirements of our partners or ourselves or at an acceptable cost, our operating results will be harmed.

In April 2000, we acquired the ALZET product and related assets from ALZA. We manufacture subassemblies of the ALZET product at our Vacaville facility. We currently rely on ALZA to perform the coating process for the manufacture of the ALZET product, but we will be required to perform this process ourselves starting April 2004 or sooner. We have limited experience manufacturing this product, and we may not be able to successfully or consistently manufacture this product at an acceptable cost, if at all.

We could be exposed to significant product liability claims which could be time consuming and costly to defend, divert management attention and adversely impact our ability to obtain and maintain insurance coverage

The testing, manufacture, marketing and sale of our products involve an inherent risk that product liability claims will be asserted against us. Although we are insured against such risks up to a $10.0 million annual aggregate limit in connection with clinical trials and commercial sales of our products, our present product liability insurance may be inadequate and may not fully cover the costs of any claim or any ultimate damages we might be required to pay. Product liability claims or other claims related to our products, regardless of their outcome, could require us to spend significant time and money in litigation or to pay significant damages. Any successful product liability claim may prevent us from obtaining adequate product liability insurance in the future on commercially desirable or reasonable terms. In addition, product liability coverage may cease to be available in sufficient amounts or at an acceptable cost. An inability to obtain sufficient insurance coverage at an acceptable cost or otherwise to protect against potential product liability claims could prevent or inhibit the commercialization of our pharmaceutical systems. A product liability claim could also significantly harm our reputation and delay market acceptance of our products.

Our agreement with ALZA limits our fields of operation for our DUROS-based pharmaceutical systems and gives ALZA a first right to negotiate to distribute selected products for us

In April 1998, we entered into a development and commercialization agreement with ALZA Corporation, which was amended and restated in April 1999, April 2000 and October 2002. ALZA was acquired by Johnson & Johnson in June 2001 and has since operated as a wholly owned subsidiary. Our agreement with ALZA gives us exclusive rights to develop, commercialize and manufacture products using ALZA’s DUROS technology to deliver by catheter:

· drugs to the central nervous system to treat select nervous system disorders;

· drugs to the middle and inner ear;

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· drugs to the pericardial sac of the heart; and

· select drugs into vascular grafts.

We also have the right to use the DUROS technology to deliver systemically and by catheter:

· sufentanil to treat chronic pain; and

· select cancer antigens.

We may not develop, manufacture or commercialize DUROS-based pharmaceutical systems outside of these specific fields without ALZA’s prior approval. In addition, if we develop or commercialize any drug delivery technology for use in a manner similar to the DUROS technology in a field covered in our license agreement with ALZA, then we may lose our exclusive rights to use the DUROS technology in such field as well as the right to develop new products using DUROS technology in such field. In order to maintain commercialization rights for our products on a worldwide basis, we must diligently develop our products, procure required regulatory approvals and commercialize the products in selected major market countries. If we fail to meet commercialization diligence requirements, we may lose rights for products in some or all countries, including the U.S. These rights would revert to ALZA, which could then develop DUROS-based pharmaceutical products in such countries itself or license others to do so. In addition, in the event that our rights terminate with respect to any product or country, or this agreement terminates or expires in its entirety (except for termination by us due to a breach by ALZA), ALZA will have the exclusive right to use all of our data, rights and information relating to the products developed under the agreement as necessary for ALZA to commercialize these products, subject to the payment of a royalty to us based on the net sales of the products by ALZA.

Our agreement with ALZA gives us the right to perform development work and manufacture the DUROS pump component of our DUROS-based pharmaceutical systems. In the event of a change in our corporate control, including an acquisition of us, our right to manufacture and perform development work on the DUROS pump would terminate and ALZA would have the right to manufacture and develop DUROS systems for us so long as ALZA can meet our specification and supply requirements following such change in control.

Under the ALZA agreement, we must pay ALZA royalties on sales of DUROS-based pharmaceutical systems we commercialize and a percentage of any up-front license fees, milestone or special fees, payments or other consideration we receive, excluding research and development funding. In addition, commencing upon the commercial sale of a product developed under the agreement, we are obligated to make minimum product payments to ALZA on a quarterly basis based on our good faith projections of our net product sales of the product. These minimum payments will be fully credited against the product royalty payments we must pay to ALZA.

ALZA may obtain from us, for its own behalf or on behalf of one of its affiliates, the exclusive right to develop and commercialize a product in a field of use exclusively licensed to us, provided that such product does not incorporate a drug in the same drug class and is not intended for the same therapeutic indication as a product which is then being developed or commercialized by us or for which we have made commitments to a third party. In the event that ALZA or an affiliate commercializes such a product, ALZA or its affiliate will pay us a royalty on sales of such product at a specified rate.

ALZA also has an exclusive option to distribute any DUROS-based pharmaceutical system we develop to deliver non-proprietary cancer antigens worldwide. The terms of any distribution arrangement have not been set and are to be negotiated in good faith between ALZA and us. ALZA’s option to acquire distribution rights limits our ability to negotiate with other distributors for these products and may result in lower payments to us than if these rights were subject to competitive negotiations. We must allow ALZA an opportunity to negotiate in good faith for commercialization rights to our products developed under the agreement prior to granting these rights to a third party. These rights do not apply to products that are subject to ALZA’s option or products for which we have obtained funding or access to a proprietary drug from a third party to whom we have granted commercialization rights prior to the commencement of human clinical trials.

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ALZA has the right to terminate the agreement in the event that we breach a material obligation under the agreement and do not cure the breach in a timely manner. In addition, ALZA has the right to terminate the agreement if at any time prior to July 2006, we solicit for employment or hire, without ALZA’s consent, a person who is or within the previous 180 days has been an employee of ALZA in the DUROS technology group.

We may be required to obtain rights to certain drugs

Some of the pharmaceutical systems that we are currently developing require the use of proprietary drugs to which we do not have commercial rights. For example, our research collaboration with the University of Maastricht has demonstrated that the use of a proprietary angiogenic factor in a pharmaceutical system can lead to elevated local concentration of the angiogenic factor in the pericardial sac of the heart, resulting in physical changes, including the growth of new blood vessels. We do not currently have a license to develop or commercialize a product containing such proprietary angiogenic factor.

To complete the development and commercialization of pharmaceutical systems containing drugs to which we do not have commercial rights, we will be required to obtain rights to those drugs. We may not be able to do this at an acceptable cost, if at all. If we are not able to obtain required rights to commercialize certain drugs, we may not be able to complete the development of pharmaceutical systems which require use of those drugs. This could result in the cessation of certain development projects and the potential write-off of certain assets.

Technologies and businesses which we have acquired may be difficult to integrate, disrupt our business, dilute stockholder value or divert management attention. We may also acquire additional businesses or technologies in the future, which could have these same effects

We may acquire technologies, products or businesses to broaden the scope of our existing and planned product lines and technologies. For example, in October 1999, we acquired substantially all of the assets of IntraEAR, Inc., in April 2000 we acquired the ALZET product and related assets from ALZA, in April 2001, we completed the acquisition of SBS and in August 2003, we acquired APT. These and our future acquisitions expose us to:

· increased costs associated with the acquisition and operation of the new businesses or technologies and the management of geographically dispersed operations;

· the risks associated with the assimilation of new technologies, operations, sites and personnel;

· the diversion of resources from our existing business and technologies;

· the inability to generate revenues to offset associated acquisition costs;

· the requirement to maintain uniform standards, controls, and procedures; and

· the impairment of relationships with employees and customers as a result of any integration of new management personnel.

Acquisitions may also result in the issuance of dilutive equity securities, the incurrence or assumption of debt or additional expenses associated with the amortization of acquired intangible assets or potential businesses. Past acquisitions, such as our acquisitions of IntraEAR, ALZET, SBS and APT, as well future acquisitions, may not generate any additional revenue or provide any benefit to our business.

Our limited operating history makes evaluating our stock difficult

Investors can only evaluate our business based on a limited operating history. We were incorporated in February 1998 and have engaged primarily in research and development, licensing technology, raising capital and recruiting scientific and management personnel. This short history may not be adequate to enable investors to fully assess our ability to successfully develop our products, achieve market acceptance of our products and

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respond to competition. Furthermore, we anticipate that our quarterly and annual results of operations will fluctuate for the foreseeable future. We believe that period-to-period comparisons of our operating results should not be relied upon as predictive of future performance. Our prospects must be considered in light of the risks, expenses and difficulties encountered by companies at an early stage of development, particularly companies in new and rapidly evolving markets such as pharmaceuticals, drug delivery, and biotechnology. To address these risks, we must, among other things, obtain regulatory approval for and commercialize our products, which may not occur. We may not be successful in addressing these risks and difficulties. We may require additional funds to complete the development of our products and to fund operating losses to be incurred in the next several years.

Acceptance of our products in the marketplace is uncertain, and failure to achieve market acceptance will delay our ability to generate or grow revenues

Our future financial performance will depend upon the successful introduction and customer acceptance of our future products, including our CHRONOGESIC product and our SABER-based post-operative pain product. Even if approved for marketing, our products may not achieve market acceptance. The degree of market acceptance will depend upon a number of factors, including:

· the receipt of regulatory clearance of marketing claims for the uses that we are developing;

· the establishment and demonstration in the medical community of the safety and clinical efficacy of our products and their potential advantages over existing therapeutic products, including oral medication, transdermal drug delivery products such as drug patches, or external or implantable drug delivery products; and

· pricing and reimbursement policies of government and third-party payors such as insurance companies, health maintenance organizations and other health plan administrators.

Physicians, patients, payors or the medical community in general may be unwilling to accept, utilize or recommend any of our products. If we are unable to obtain regulatory approval, commercialize and market our future products when planned and achieve market acceptance, we will not achieve anticipated revenues.

If users of our products are unable to obtain adequate reimbursement from third-party payors, or if new restrictive legislation is adopted, market acceptance of our products may be limited and we may not achieve anticipated revenues

The continuing efforts of government and insurance companies, health maintenance organizations and other payors of healthcare costs to contain or reduce costs of health care may affect our future revenues and profitability, and the future revenues and profitability of our potential customers, suppliers and collaborative partners and the availability of capital. For example, in certain foreign markets, pricing or profitability of prescription pharmaceuticals is subject to government control. In the United States, recent federal and state government initiatives have been directed at lowering the total cost of health care, and the U.S. Congress and state legislatures will likely continue to focus on health care reform, the cost of prescription pharmaceuticals and on the reform of the Medicare and Medicaid systems. While we cannot predict whether any such legislative or regulatory proposals will be adopted, the announcement or adoption of such proposals could materially harm our business, financial condition and results of operations.

Our ability to commercialize our products successfully will depend in part on the extent to which appropriate reimbursement levels for the cost of our products and related treatment are obtained by governmental authorities, private health insurers and other organizations, such as HMOs. Third-party payors are increasingly limiting payments or reimbursement for medical products and services. Also, the trend toward managed health care in the United States and the concurrent growth of organizations such as HMOs, which could control or significantly influence the purchase of health care services and products, as well as legislative proposals to reform health care or reduce government insurance programs, may limit reimbursement or payment for our

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products. The cost containment measures that health care payors and providers are instituting and the effect of any health care reform could materially harm our ability to operate profitably.

We do not control ALZA’s ability to develop and commercialize DUROS technology outside of fields licensed to us, and problems encountered by ALZA could result in negative publicity, loss of sales and delays in market acceptance of our DUROS-based pharmaceutical systems

ALZA retains complete rights to the DUROS technology for fields outside the specific fields licensed to us. Accordingly, ALZA may develop and commercialize DUROS-based products or license others to do so, so long as there is no conflict with the rights granted to us. ALZA received FDA approval to market its first DUROS-based product, VIADUR (leuprolide acetate implants) for the palliative treatment of advanced prostate cancer in March 2000. If ALZA or its commercialization partner, Bayer, fails to commercialize this product successfully, or encounters problems associated with this product, negative publicity could be created about all DUROS-based products, which could result in harm to our reputation and cause reduced sales of our products. In addition, if any third-party that may be licensed by ALZA fails to develop and commercialize DUROS-based products successfully, the success of all DUROS-based systems could be impeded, including ours, resulting in delay or loss of revenue or damage to our reputation, any one of which could harm our business.

We do not own the trademark “DUROS” and any competitive advantage we derive from the name may be impaired by third-party use

ALZA owns the trademark “DUROS.” Because ALZA is also developing and marketing DUROS-based systems, and may license third parties to do so, there may be confusion in the market between ALZA, its potential licensees and us, and this confusion could impair the competitive advantage, if any, we derive from use of the DUROS name. In addition, any actions taken by ALZA or its potential licensees that negatively impact the trademark “DUROS” could negatively impact our reputation and result in reduced sales of our DUROS-based pharmaceutical systems.

We may be sued by third parties which claim that our products infringe on their intellectual property rights, particularly because there is substantial uncertainty about the validity and breadth of medical patents

We may be exposed to future litigation by third parties based on claims that our products or activities infringe the intellectual property rights of others or that we have misappropriated the trade secrets of others. This risk is exacerbated by the fact that the validity and breadth of claims covered in medical technology patents and the breadth and scope of trade secret protection involve complex legal and factual questions for which important legal principles are unresolved. Any litigation or claims against us, whether or not valid, could result in substantial costs, could place a significant strain on our financial resources and could harm our reputation. In addition, intellectual property litigation or claims could force us to do one or more of the following, any of which could harm our business or financial results:

· cease selling, incorporating or using any of our products that incorporate the challenged intellectual property, which would adversely affect our revenue;

· obtain a license from the holder of the infringed intellectual property right, which license may be costly or may not be available on reasonable terms, if at all; or

· redesign our products, which would be costly and time-consuming.

If we are unable to adequately protect or enforce our intellectual property rights or secure rights to third-party patents, we may lose valuable assets, experience reduced market share or incur costly litigation to protect our rights

Our success will depend in part on our ability to obtain patents, maintain trade secret protection and operate without infringing the proprietary rights of others. As of December 31, 2003, we held 19 issued U.S. patents and

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7 issued foreign patents. In addition, we have 41 pending U.S. patent applications and have filed 40 patent applications under the Patent Cooperation Treaty, from which 69 national phase applications are currently pending in Europe, Australia, Japan, Canada, Mexico, New Zealand, Brazil and China. Our patents expire at various dates starting in the year 2012. Under our agreement with ALZA, we must assign to ALZA any intellectual property rights relating to the DUROS system and its manufacture and any combination of the DUROS system with other components, active agents, features or processes. In addition, ALZA retains the right to enforce and defend against infringement actions relating to the DUROS system, and if ALZA exercises these rights, it will be entitled to the proceeds of these infringement actions.

The patent positions of pharmaceutical companies, including ours, are uncertain and involve complex legal and factual questions. In addition, the coverage claimed in a patent application can be significantly reduced before the patent is issued. Consequently, our patent applications or those of ALZA that are licensed to us may not issue into patents, and any issued patents may not provide protection against competitive technologies or may be held invalid if challenged or circumvented. Our competitors may also independently develop products similar to ours or design around or otherwise circumvent patents issued to us or licensed by us. In addition, the laws of some foreign countries may not protect our proprietary rights to the same extent as U.S. law.

We also rely upon trade secrets, technical know-how and continuing technological innovation to develop and maintain our competitive position. We require our employees, consultants, advisors and collaborators to execute appropriate confidentiality and assignment-of-inventions agreements with us. These agreements typically provide that all materials and confidential information developed or made known to the individual during the course of the individual’s relationship with us is to be kept confidential and not disclosed to third parties except in specific circumstances, and that all inventions arising out of the individual’s relationship with us shall be our exclusive property. These agreements may be breached, and in some instances, we may not have an appropriate remedy available for breach of the agreements. Furthermore, our competitors may independently develop substantially equivalent proprietary information and techniques, reverse engineer our information and techniques, or otherwise gain access to our proprietary technology.

We may be unable to meaningfully protect our rights in trade secrets, technical know-how and other non-patented technology. We may have to resort to litigation to protect our intellectual property rights, or to determine their scope, validity or enforceability. Enforcing or defending our proprietary rights is expensive, could cause diversion of our resources and may not prove successful. Any failure to enforce or protect our rights could cause us to lose the ability to exclude others from using our technology to develop or sell competing products.

We rely heavily on third parties to support development, clinical testing and manufacturing of our products

We rely on third party contract research organizations, service providers and suppliers to provide critical services to support development, clinical testing, and manufacturing of our pharmaceutical systems. For example, we currently depend on third party vendors to perform blood plasma assays in connection with our clinical trials for CHRONOGESIC, to perform quality control services related to components of our DUROS-based pharmaceutical systems, and to supply us with molded rubber components of our DUROS-based pharmaceutical systems. In the past, we relied on Chesapeake Biological Labs, Inc. to perform the final manufacturing steps of our CHRONOGESIC product, and we may choose to rely on a third party manufacturer again. See “We may not be able to manufacture sufficient quantities of our products to support our clinical and commercial requirements at an acceptable cost, and we have limited manufacturing experience.” We anticipate that we will continue to rely on these and other third party contractors to support development, clinical testing, and manufacturing of our pharmaceutical systems. Failure of these contractors to provide the required services in a timely manner or on reasonable commercial terms could materially delay the development and approval of our products, increase our expenses and materially harm our business, financial condition and results of operations.

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Key components of our DUROS-based pharmaceutical systems are provided by limited numbers of suppliers, and supply shortages or loss of these suppliers could result in interruptions in supply or increased costs

Certain components and drug substances used in our DUROS-based pharmaceutical systems are currently purchased from a single or a limited number of outside sources. The reliance on a sole or limited number of suppliers could result in:

· delays associated with redesigning a product due to a failure to obtain a single source component;

· an inability to obtain an adequate supply of required components; and

· reduced control over pricing, quality and time delivery.

We have a supply agreement with Mallinckrodt, Inc. for our sufentanil requirements for our CHRONOGESIC product, which expires in September 2004. Additionally, we have a supply agreement with a third party vendor to supply us with titanium components of our DUROS-based pharmaceutical systems until April 2004. Other than these agreements, we do not have long-term agreements with any of our suppliers, and therefore the supply of a particular component could be terminated at any time without penalty to the supplier. Any interruption in the supply of single source components could cause us to seek alternative sources of supply or manufacture these components internally. If the supply of any components for our pharmaceutical systems is interrupted, components from alternative suppliers may not be available in sufficient volumes or at acceptable quality levels within required timeframes, if at all, to meet our needs. This could delay our ability to complete clinical trials and obtain approval for commercialization and marketing of our products, causing us to lose sales, incur additional costs and delay new product introductions and could harm our reputation.

We will not control sales and distribution for our pharmaceutical systems

In November 2002, we entered into an agreement with Endo Pharmaceuticals, Inc. related to the promotion and distribution of our CHRONOGESIC product in the U.S. and Canada once it is approved for commercialization. In addition, we have entered into several agreements with third party companies under which we will collaborate with such companies to develop select pharmaceutical system products and such third parties will have the right to promote and distribute the resulting developed products subject to payments to us in the form of product royalties and other payments. These agreements make us dependent on third parties to sell and distribute our pharmaceutical systems. These third parties may have similar or more established relationships with our competitors, which may reduce their interest in selling our products. In addition, these third parties may terminate these agreements under specified conditions provided in these agreements. Other than these agreements with third party companies, we have yet to establish marketing, sales or distribution capabilities for our pharmaceutical system products.

We compete with many other companies that currently have extensive and well-funded marketing and sales operations. Our marketing and sales efforts and those of our third party collaborations may be unable to compete successfully against these other companies. We may be unable to establish a sufficient sales and marketing organization on a timely basis, if at all. We may be unable to engage qualified distributors. Even if engaged, these distributors may:

· fail to satisfy financial or contractual obligations to us;

· fail to adequately market our products;

· cease operations with little or no notice to us;

· offer, design, manufacture or promote competing product lines;

· fail to maintain adequate inventory and thereby restrict use of our products; or

· build up inventory in excess of demand thereby limiting future purchases or our products resulting in significant quarter-to-quarter variability in our sales.

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If we fail to develop sales, marketing and distribution channels, we would experience delays in product sales and incur increased costs, which would harm our financial results.

If we are unable to train physicians to use our pharmaceutical systems to treat patients’ diseases or medical conditions, we may incur delays in market acceptance of our products

Broad use of our pharmaceutical systems will require extensive training of numerous physicians on the proper and safe use of our products. The time required to begin and complete training of physicians could delay introduction of our products and adversely affect market acceptance of our products. We or third parties selling our products may be unable to rapidly train physicians in numbers sufficient to generate adequate demand for our pharmaceutical systems. Any delay in training would materially delay the demand for our systems and harm our business and financial results. In addition, we may expend significant funds towards such training before any orders are placed for our products, which would increase our expenses and harm our financial results.

Some of our products contain controlled substances, the making, use, sale, importation and distribution of which are subject to regulation by state, federal and foreign law enforcement and other regulatory agencies

Some of our products currently under development contain, and our products in the future may contain, controlled substances which are subject to state, federal and foreign laws and regulations regarding their manufacture, use, sale, importation and distribution. Our CHRONOGESIC, spinal opioid and oral opiate products under development contain opioids which are classified as Schedule II controlled substances under the regulations of the U.S. Drug Enforcement Agency. For our products containing controlled substances, we and our suppliers, manufacturers, contractors, customers and distributors are required to obtain and maintain applicable registrations from state, federal and foreign law enforcement and regulatory agencies and comply with state, federal and foreign laws and regulations regarding the manufacture, use, sale, importation and distribution of controlled substances. These regulations are extensive and include regulations governing manufacturing, labeling, packaging, testing, dispensing, production and procurement quotas, record keeping, reporting, handling, shipment and disposal. Failure to obtain and maintain required registrations or comply with any applicable regulations could delay or preclude us from developing and commercializing our products containing controlled substances and subject us to enforcement action. In addition, because of their restrictive nature, these regulations could limit our commercialization of our products containing controlled substances.

Write-offs related to the impairment of long-lived assets and other non-cash charges, as well as future deferred compensation expenses may adversely impact or delay our profitability

We may incur significant non-cash charges related to impairment write-downs of our long-lived assets, including goodwill and other intangible assets. In 2002, Statement of Financial Accounting Standards No. 142,Goodwill and Other Intangible Assets (SFAS 142) became effective and as a result, we ceased to amortize approximately $4.7 million of goodwill and assembled workforce on January 1, 2002.

However, we will continue to incur non-cash charges related to amortization of other intangible assets. We are required to perform periodic impairment reviews of our goodwill at least annually. To the extent these reviews conclude that the expected future cash flows generated from our business activities are not sufficient to recover the cost of our long-lived assets, we will be required to measure and record an impairment charge to write down these assets to their realizable values. We completed our initial review during the second quarter of 2002. We concluded that our goodwill was fairly stated as of January 1, 2002 and no accounting change adjustment was required. We performed the annual assessment in the fourth quarter of 2002 and determined that goodwill was not impaired. However, there can be no assurance that upon completion of subsequent reviews a material impairment charge will not be recorded. If future periodic reviews determine that our assets are impaired and a write down is required, it will adversely impact or delay our profitability.

To date, we have recorded deferred compensation expenses related to stock options grants, including stock options assumed in our acquisition of SBS, which will be amortized through 2006. In addition, deferred

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compensation expense related to option awards to non-employees will be calculated during the vesting period of the option based on the then-current price of our common stock, which could result in significant charges that adversely impact or delay our profitability. Furthermore, we have issued to ALZA common stock and a warrant to purchase common stock with an aggregate value of approximately $13.5 million, which will be amortized over time based on sales of our products and which will also adversely impact or delay our profitability.

We depend upon key personnel who may terminate their employment with us at any time, and we need to hire additional qualified personnel

Our success will depend to a significant degree upon the continued services of key management, technical, and scientific personnel, including Felix Theeuwes, our Chairman and Chief Scientific Officer, James E. Brown, our President and Chief Executive Officer and Thomas A. Schreck, our Chief Financial Officer. Although we have obtained key man life insurance policies for each of Messrs. Theeuwes, Brown and Schreck in the amount of $1.0 million, this insurance may not adequately compensate us for the loss of their services. In addition, our success will depend on our ability to attract and retain other highly skilled personnel. Competition for qualified personnel is intense, and the process of hiring and integrating such qualified personnel is often lengthy. We may be unable to recruit such personnel on a timely basis, if at all. Our management and other employees may voluntarily terminate their employment with us at any time. The loss of the services of key personnel, or the inability to attract and retain additional qualified personnel, could result in delays to product development or approval, loss of sales and diversion of management resources.

We may not successfully manage our growth

Our success will depend on the timely expansion of our operations and the effective management of growth, which will place a significant strain on our management and on our administrative, operational and financial resources. To manage such growth, we must expand our facilities, augment our operational, financial and management systems and hire, train and supervise additional qualified personnel. If we were unable to manage growth effectively our business would be harmed.

The market for our products is new, rapidly changing and competitive, and new products or technologies developed by others could impair our ability to grow our business and remain competitive

The pharmaceutical industry is subject to rapid and substantial technological change. Developments by others may render our products under development or technologies noncompetitive or obsolete, or we may be unable to keep pace with technological developments or other market factors. Technological competition in the industry from pharmaceutical and biotechnology companies, universities, governmental entities and others diversifying into the field is intense and is expected to increase. Many of these entities have significantly greater research and development capabilities than we do, as well as substantially more marketing, manufacturing, financial and managerial resources. These entities represent significant competition for us. Acquisitions of, or investments in, competing pharmaceutical or biotechnology companies by large corporations could increase such competitors’ financial, marketing, manufacturing and other resources.

We are a new enterprise and are engaged in the development of novel therapeutic technologies. As a result, our resources are limited and we may experience technical challenges inherent in such novel technologies. Competitors have developed or are in the process of developing technologies that are, or in the future may be, the basis for competitive products. Some of these products may have an entirely different approach or means of accomplishing similar therapeutic effects than our products. Our competitors may develop products that are safer, more effective or less costly than our products and, therefore, present a serious competitive threat to our product offerings.

The widespread acceptance of therapies that are alternatives to ours may limit market acceptance of our products even if commercialized. Chronic pain can also be treated by oral medication, transdermal drug delivery

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systems, such as drug patches, or with other implantable drug delivery devices. These treatments are widely accepted in the medical community and have a long history of use. The established use of these competitive products may limit the potential for our products to receive widespread acceptance if commercialized.

Our business involves environmental risks and risks related to handling regulated substances

In connection with our research and development activities and our manufacture of materials and products, we are subject to federal, state and local laws, rules, regulations and policies governing the use, generation, manufacture, storage, air emission, effluent discharge, handling and disposal of certain materials, biological specimens and wastes. Although we believe that we have complied with the applicable laws, regulations and policies in all material respects and have not been required to correct any material noncompliance, we may be required to incur significant costs to comply with environmental and health and safety regulations in the future. Our research and development involves the use, generation and disposal of hazardous materials, including but not limited to certain hazardous chemicals, solvents, agents and biohazardous materials. The extent of our use, generation and disposal of such substances has increased substantially since we started manufacturing and selling biodegradable polymers through our subsidiary Absorbable Polymers International Corporation (API). Although we believe that our safety procedures for storing, handling and disposing of such materials comply with the standards prescribed by state and federal regulations, we cannot completely eliminate the risk of accidental contamination or injury from these materials. We currently contract with third parties to dispose of these substances generated by us, and we rely on these third parties to properly dispose of these substances in compliance with applicable laws and regulations. If these third parties do not properly dispose of these substances in compliance with applicable laws and regulations, we may be subject to legal action by governmental agencies or private parties for improper disposal of these substances. The costs of defending such actions and the potential liability resulting from such actions are often very large. In the event we are subject to such legal action or we otherwise fail to comply with applicable laws and regulations governing the use, generation and disposal of hazardous materials and chemicals, we could be held liable for any damages that result, and any such liability could exceed our resources.

Our corporate headquarters, manufacturing facilities and personnel are located in a geographical area that is seismically active

Our corporate headquarters, manufacturing facilities and personnel are located in a geographical area that is known to be seismically active and prone to earthquakes. Should such a natural disaster occur, our ability to conduct our business could be severely restricted, and our business and assets, including the results of our research and development efforts, could be destroyed.

Our stock price may fluctuate, and your investment in our stock could decline in value

The average daily trading volume of our common stock for the twelve months ending December 31, 2003, was 289,991 shares. The limited trading volume of our stock may contribute to its volatility, and an active trading market in our stock might not develop or continue. In accordance with our Common Stock Purchase Agreement with Endo, we filed a registration statement on Form S-3 with the SEC on August 29, 2003 to register 1,533,742 shares of our common stock issued to Endo and 485,122 shares issued to former APT shareholders for resale. The registration statement was declared effective by the SEC on September 26, 2003. Pursuant to a Purchase Agreement with Morgan Stanley & Co., Incorporated, we filed a registration statement with the SEC on Form S-3 to register an aggregate of $60.0 million in convertible subordinated notes for resale on August 29, 2003. The registration statement was declared effective by the SEC on November 3, 2003. The convertible subordinated notes are convertible into shares of our common stock at a conversion rate of 317.4603 shares per $1,000 principal amount of notes, subject to adjustment and will bear interest at a rate of 6.25% per annum. So long as these registration statements are effective, shares covered thereunder are tradeable without limitation. If substantial amounts of our common stock were to be sold in the public market, the market price of our common stock could fall. In addition, the existence of our convertible subordinated notes may encourage short selling by

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market participants. The market price of our common stock may fluctuate significantly in response to factors which are beyond our control. The stock market in general has recently experienced extreme price and volume fluctuations. In addition, the market prices of securities of technology and pharmaceutical companies have also been extremely volatile, and have experienced fluctuations that often have been unrelated or disproportionate to the operating performance of these companies. These broad market fluctuations could result in extreme fluctuations in the price of our common stock, which could cause a decline in the value of our investors’ stock.

We may not have the ability to raise the funds necessary to finance the fundamental change redemption option associated with our outstanding convertible subordinated notes

If we engage in any transaction or event in connection with which all or substantially all of our common stock is exchanged for, converted into, acquired for or constitutes solely the right to receive consideration which is not all or substantially all common stock listed on a United States national securities exchange or approved for quotation on the NASDAQ National Market or any similar United States system of automated dissemination of quotations of securities prices, or, if for any reason, our common stock is no longer listed for trading on a United States national securities exchange nor approved for trading on the NASDAQ National Market, we may be required to redeem all or part of the notes. We may not have enough funds to pay the redemption price for all tendered notes. In addition, any credit agreement or other agreements relating to our indebtedness may contain provisions prohibiting redemption of the notes under certain circumstances, or expressly prohibit our redemption of the notes upon a designated event or may provide that a designated event constitutes an event of default under that agreement. Our failure to redeem tendered notes would constitute an event of default under the indenture, which might also constitute a default under the terms of our other indebtedness.

The fundamental change redemption rights in our outstanding convertible subordinated notes could discourage a potential acquirer

If we engage in any transaction or event in connection with which all or substantially all of our common stock is exchanged for, converted into, acquired for or constitutes solely the right to receive, consideration which is not all or substantially all common stock listed on a United States national securities exchange or approved for quotation on the NASDAQ National Market or any similar United States system of automated dissemination of quotations of securities prices, or, if for any reason, our common stock is no longer listed for trading on a United States national securities exchange nor approved for trading on the NASDAQ National Market (a “fundamental change”), we may be required to redeem all or part of the notes and this could discourage a potential acquirer. However, this redemption feature is not the result of management’s knowledge of any specific effort to obtain control of us by means of a merger, tender offer or solicitation, or part of a plan by management to adopt a series of anti-takeover provisions. The term “fundamental change” is limited to specified transactions and may not include other events that might adversely affect our financial condition or business operations. Our obligation to offer to redeem the notes upon a fundamental change would not necessarily afford you protection in the event of a highly leveraged transaction, reorganization, merger or similar transaction involving us.

We have broad discretion over the use of our cash and investments, and their investment may not yield a favorable return

Our management has broad discretion over how our cash and investments are used and may invest in ways with which our stockholders may not agree and that do not yield favorable returns.

Executive officers, directors and entities affiliated with them have substantial control over us, which could delay or prevent a change in our corporate control favored by our other stockholders

Our directors, executive officers and principal stockholders, together with their affiliates have substantial control over us. The interests of these stockholders may differ from the interests of other stockholders. As a

56

result, these stockholders, if acting together, would have the ability to exercise control over all corporate actions requiring stockholder approval irrespective of how our other stockholders may vote, including:

· the election of directors;

· the amendment of charter documents;

· the approval of certain mergers and other significant corporate transactions, including a sale of substantially all of our assets; or

· the defeat of any non-negotiated takeover attempt that might otherwise benefit the public stockholders.

Our certificate of incorporation, our bylaws, Delaware law and our stockholder rights plan contain provisions that could discourage another company from acquiring us

Provisions of Delaware law, our certificate of incorporation, bylaws and stockholder rights plan may discourage, delay or prevent a merger or acquisition that stockholders may consider favorable, including transactions in which you might otherwise receive a premium for your shares. These provisions include:

· authorizing the issuance of “blank check” preferred stock without any need for action by stockholders;

· providing for a dividend on our common stock, commonly referred to as a “poison pill”, which can be triggered after a person or group acquires 17.5% or more of common stock;

· providing for a classified board of directors with staggered terms;

· requiring supermajority stockholder voting to effect certain amendments to our certificate of incorporation and by-laws;

· eliminating the ability of stockholders to call special meetings of stockholders;

· prohibiting stockholder action by written consent; and

· establishing advance notice requirements for nominations for election to the board of directors or for proposing matters that can be acted on by stockholders at stockholder meetings.

Item 7A.    Quantitative and Qualitative Disclosures About Market Risk.

Interest Rate Sensitivity

Our exposure to market risk for changes in interest rates relates primarily to our investment portfolio and long-term debt obligations. Fixed rate securities and borrowings may have their fair market value adversely impacted due to fluctuations in interest rates, while floating rate securities may produce less income than expected if interest rates fall and floating rate borrowings may lead to additional interest expense if interest rates increase. Due in part to these factors, our future investment income may fall short of expectations due to changes in interest rates or we may suffer losses in principal if forced to sell securities which have declined in market value due to changes in interest rates.

Our primary investment objective is to preserve principal while at the same time maximizing yields without significantly increasing risk. Our portfolio includes money markets funds, commercial paper, medium-term notes, corporate notes, government securities, auction rate securities, corporate bonds and market auction preferreds. The diversity of our portfolio helps us to achieve our investment objective. As of December 31, 2003, approximately 75% of our investment portfolio is composed of investments with original maturities of one year or less and approximately 23% of our investment portfolio matures less than 90 days from the date of purchase.

57

The following table presents the amounts of our cash equivalents and investments that may be subject to interest rate risk and the average interest rates as of December 31, 2003 by year of maturity (dollars in thousands):

	2004			2005			2006			Total
Cash equivalents:
Fixed rate	$	19,414		$	—		$	—		$	19,414
Average fixed rate		1.13	%		—			—			1.13	%
Variable rate	$	976			—			—		$	976
Average variable rate		1.00	%		—			—			1.00	%
Short-term investments:
Fixed rate	$	17,511		$	—			—		$	17,511
Average fixed rate		1.43	%		—			—			1.43	%
Variable rate	$	22,000			—			—		$	22,000
Average variable rate		1.21	%		—			—			1.21	%
Long-term investments:
Fixed rate	$	—		$	8,935		$	12,399		$	21,334
Average fixed rate		—			1.80	%		2.43	%		2.14	%
Restricted investments:
Fixed rate	$	3,119		$	—		$	—		$	3,119
Average fixed rate		1.06	%								1.06	%
Total investment securities	$	63,020		$	8,935		$	12,399		$	84,354
Average rate		1.23	%		1.80	%		2.43	%		1.51	%

The following table presents the amounts of our cash equivalents and investments that may be subject to interest rate risk and the average interest rates as of December 31, 2002 by year of maturity (dollars in thousands):

	2003			2004			Total
Cash equivalents:
Fixed rate	$	12,669			—		$	12,669
Average fixed rate		1.60	%		—			1.60	%
Variable rate	$	1,305			—			1,305
Average variable rate		1.54	%		—			1.54	%
Short-term investments:
Fixed rate	$	15,261			—		$	15,261
Average fixed rate		3.38	%		—			3.38	%
Variable rate	$	13,450			—		$	13,450
Average variable rate		1.53	%		—			1.53	%
Long-term investments:
Fixed rate	$	—		$	2,578		$	2,578
Average fixed rate		—			2.46	%		2.46	%
Restricted investments:
Fixed rate	$	2,890		$	—		$	2,890
Average fixed rate		1.49	%					1.49	%
Total investment securities	$	45,575		$	2,578		$	48,153
Average rate		2.31	%		2.46	%		2.13	%

58

Item 8.    Financial Statements and Supplementary Data.

REPORT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS

The Board of Directors and Stockholders

DURECT Corporation

We have audited the accompanying consolidated balance sheets of DURECT Corporation as of December 31, 2003 and 2002, and the related consolidated statements of operations, stockholders’ equity and cash flows for each of the three years in the period ended December 31, 2003. Our audits also included the financial statement schedule listed in the Index at Item 15(a)(2). These financial statements and schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and schedule based on our audits.

We conducted our audits in accordance with auditing standards generally accepted in the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of DURECT Corporation at December 31, 2003 and 2002, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 2003, in conformity with accounting principles generally accepted in the United States. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects the information set forth therein.

As discussed in the notes to the consolidated financial statements, in 2002 the Company changed its method of accounting for goodwill and other intangible assets.

/s/ ERNST & YOUNG LLP

Palo Alto, California

January 30, 2004

59

DURECT CORPORATION

CONSOLIDATED BALANCE SHEETS

(in thousands, except per share amounts)

	December 31,
	2003			2002
ASSETS
Current assets:
Cash and cash equivalents	$	21,203		$	14,089
Short-term investments		39,511			28,711
Accounts receivable, net of allowances of $141 and $207, respectively		1,968			944
Inventories		1,902			1,707
Prepaid expenses and other current assets		1,480			1,590
Total current assets		66,064			47,041
Property and equipment, net		9,316			11,625
Goodwill		6,399			4,716
Intangible assets, net		2,994			4,121
Long-term investments		21,334			2,578
Restricted investments		3,119			2,890
Other long-term assets		3,181			—
Total assets	$	112,407		$	72,971
LIABILITIES AND STOCKHOLDERS’EQUITY
Current liabilities:
Accounts payable	$	616		$	352
Accrued liabilities		2,618			2,123
Contract research liability		987			1,128
Accrued liabilities to related party		17			17
Interest payable on convertible notes		167			—
Deferred revenue		146			948
Equipment financing obligations and term loan, current portion		283			447
Bonds payable, current portion		180			170
Total current liabilities		5,014			5,185
Equipment financing obligations and term loan, noncurrent portion		307			134
Bonds payable, noncurrent portion		1,065			1,245
Convertible subordinated notes		60,000			—
Other long-term liabilities		906			225
Commitments
Stockholders’ equity:
Common stock, $0.0001 par value: 110,000 shares authorized at December 31, 2003 and 2002 respectively; 51,163 and 50,443 shares issued and outstanding at December 31, 2003 and 2002, respectively		5			5
Additional paid-in capital		194,968			194,312
Notes receivable from stockholders		(50	)		(469	)
Deferred compensation		(59	)		(732	)
Deferred royalties and commercial rights		(13,480	)		(13,480	)
Accumulated other comprehensive income (loss)		(15	)		102
Accumulated deficit		(136,254	)		(113,556	)
Stockholders’ equity		45,115			66,182
Total liabilities and stockholders’ equity	$	112,407		$	72,971

The accompanying notes are an integral part of these consolidated financial statements.

60

DURECT CORPORATION

CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except per share amounts)

	Year ended December 31,
	2003			2002			2001
Product revenue, net	$	6,691		$	6,314		$	6,166
Collaborative research and development and other revenue		5,144			871			358
Total revenue		11,835			7,185			6,524
Operating expenses:
Cost of revenue		2,427			3,086			3,252
Research and development		20,935			29,535			24,472
Research and development—related party		13			19			98
Selling, general and administrative		8,498			10,970			8,779
Amortization of intangible assets		1,343			1,340			1,844
Stock-based compensation(1)		(102	)		1,204			3,451
Acquired in-process research and development		—			—			14,030
Total operating expenses		33,114			46,154			55,926
Loss from operations		(21,279	)		(38,969	)		(49,402	)
Other income (expense):
Interest income		1,041			2,076			4,796
Interest expense		(2,460	)		(280	)		(322	)
Net other income (expense)		(1,419	)		1,796			4,474
Net loss	$	(22,698	)	$	(37,173	)	$	(44,928	)
Net loss per common share, basic and diluted	$	(0.45	)	$	(0.77	)	$	(0.97	)
Shares used in computing basic and diluted net loss per share		50,510			48,318			46,414

(1) Stock-based compensation related to the following:

Cost of revenue	$	18		$	72	$	146
Research and development		(210	)		622		2,235
Selling, general and administrative		90			510		1,070
	$	(102	)	$	1,204	$	3,451

The accompanying notes are an integral part of these consolidated financial statements.

61

DURECT CORPORATION

CONSOLIDATED STATEMENT OF STOCKHOLDERS’ EQUITY

(in thousands)

	Common Stock				Additional Paid-In Capital			Notes Receivable From Stockholders			Deferred Compensation			Deferred Royalties And Commercial Rights			Accumulated Other Comprehensive Income			Accumulated Deficit			Total Stockholders’ Equity
	Shares		Amount
Balance at December 31, 2000	46,565		$	4	$	165,638		$	(652	)	$	(4,830	)	$	(13,480	)	$	29		$	(31,455	)	$	115,254
Issuance of common stock upon exercise of stock options, warrants and purchases of ESPP shares	253			—		788			—			—			—			—			—			788
Repayment of notes receivable	—			—		—			55			—			—			—			—			55
Issuance of common stock and assumption of options and warrants in connection with acquisition of Southern BioSystems, Inc.	1,940			—		22,716			—			(918	)		—			—			—			21,798
Amortization of deferred stock compensation	—			—		—			—			3,125			—			—			—			3,125
Reversal of deferred compensation related to cancelled employee stock options	—			—		(72	)		—			72			—			—			—			—
Noncash charges related to equity securities issued to non-employees	—			—		326			—			—			—			—			—			326
Net unrealized gain on available-for-sale securities	—			—		—			—			—			—			630			—			630
Net loss	—			—		—			—			—			—			—			(44,928	)		(44,928	)
Total comprehensive net loss	—			—		—			—			—			—			—			—			(44,298	)
Balance at December 31, 2001	48,758		$	4	$	189,396		$	(597	)	$	(2,551	)	$	(13,480	)	$	659		$	(76,383	)	$	97,048
Issuance of common stock upon exercise of stock options, warrants and purchases of ESPP shares	251			—		579			—			—			—			—			—			579
Repurchase of unvested stock for cash and cancellation of certain notes receivable from stockholders	(100	)		—		(47	)		25			—			—			—			—			(22	)
Repayment of notes receivable	—			—		—			103			—			—			—			—			103
Issuance of common stock to corporate partner for cash.	1,534			1		4,999			—						—			—			—			5,000
Amortization of deferred stock compensation	—			—		—			—			1,069			—			—			—			1,069
Reversal of deferred compensation related to cancelled employee stock options	—			—		(750	)		—			750			—			—			—			—
Noncash charges related to equity securities issued to non-employees	—			—		135			—			—			—			—			—			135
Net unrealized loss on available-for-sale securities	—			—		—			—			—			—			(557	)		—			(557	)
Net loss	—			—		—			—			—			—			—			(37,173	)		(37,173	)
Total comprehensive net loss	—			—		—			—			—			—			—			—			(37,730	)
Balance at December 31, 2002 (carry forward)	50,443		$	5	$	194,312		$	(469	)	$	(732	)	$	(13,480	)	$	102		$	(113,556	)	$	66,182

The accompanying notes are an integral part of these consolidated financial statements.

62

DURECT CORPORATION

CONSOLIDATED STATEMENT OF STOCKHOLDERS’ EQUITY—(Continued)

(in thousands)

	Common Stock				Additional Paid-In Capital			Notes Receivable From Stockholders			Deferred Compensation			Deferred Royalties And Commercial Rights			Accumulated Other Comprehensive Income			Accumulated Deficit			Total Stockholders’ Equity
	Shares		Amount
Balance at December 31, 2002 (carry forward)	50,443		$	5	$	194,312		$	(469	)	$	(732	)	$	(13,480	)	$	102		$	(113,556	)	$	66,182
Issuance of common stock upon exercise of stock options, warrants and purchases of ESPP shares	311			—		486			—			—			—			—			—			486
Repurchase of unvested stock for cash and cancellation of certain notes receivable from stockholders	(76	)		—		(66	)		66			—			—			—			—			—
Repayment of notes receivable	—			—		—			353			—			—			—			—			353
Issuance of common stock in connection with acquisition of Absorbable Polymer Technologies, Inc.	485			—		1,053			—			—			—			—			—			1,053
Issuance costs in connection with issuance of common stock to corporate partner for cash.	—			—		(42	)		—			—			—			—			—			(42	)
Amortization of deferred stock compensation	—			—		—			—			(276	)		—			—			—			(276	)
Deferred stock compensation related to modifications of stock option terms	—			—		78			—			—			—			—			—			78
Reversal of deferred compensation related to cancelled employee stock options	—			—		(949	)		—			949			—			—			—			—
Noncash charges related to equity securities issued to non-employees	—			—		96			—			—			—			—			—			96
Net unrealized gain on available-for-sale securities	—			—		—			—			—			—			(117	)		—			(117	)
Net loss	—			—		—			—			—			—			—			(22,698	)		(22,698	)
Total comprehensive net loss	—			—		—			—			—			—			—			—			(22,815	)
Balance at December 31, 2003	51,163		$	5	$	194,968		$	(50	)	$	(59	)	$	(13,480	)	$	(15	)	$	(136,254	)	$	45,115

The accompanying notes are an integral part of these consolidated financial statements.

63

DURECT CORPORATION

CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

	Year ended December 31,
	2003			2002			2001
Cash flows from operating activities
Net loss	$	(22,698	)	$	(37,173	)	$	(44,928	)
Adjustments to reconcile net loss to net cash used in operating activities:
Depreciation		3,402			2,979			1,454
Amortization		1,343			1,340			1,844
Noncash charges related to stock-based compensation		(102	)		1,204			3,451
Acquired in-process research and development		—			—			14,030
Changes in assets and liabilities:
Accounts receivable		(956	)		(126	)		1,117
Inventories		(47	)		157			1,117
Prepaid expenses and other assets		233			735			(1,068	)
Accounts payable		264			(1,651	)		1,068
Accrued liabilities		91			(222	)		(764	)
Accrued liabilities to related party		—			2			(39	)
Contract research liability		(141	)		548			290
Interest payable on convertible notes		167			—			—
Deferred revenue		(802	)		900			—
Total adjustments		3,452			5,866			22,500
Net cash and cash equivalents used in operating activities		(19,246	)		(31,307	)		(22,428	)
Cash flows from investing activities
Purchase of property and equipment		(961	)		(1,413	)		(7,358	)
Purchase of available-for-sale securities		(113,971	)		(30,639	)		(73,906	)
Proceeds from maturities of available-for-sale securities		84,069			59,929			69,892
Payment for acquisitions, net of cash acquired		(81	)		—			(437	)
Net cash and cash equivalents provided by (used in) investing activities		(30,944	)		27,877			(11,809	)
Cash flows from financing activities
Net proceeds from convertible subordinated notes		56,700			—			—
Proceeds from term loan		850			—			—
Payments on term loan and equipment financing obligations		(873	)		(577	)		(562	)
Payment on long term debt		(170	)		(160	)		(150	)
Net proceeds from issuances of common stock and stockholders’ notes		797			5,660			843
Net cash and cash equivalents provided by financing activities		57,304			4,923			131
Net increase (decrease) in cash and cash equivalents		7,114			1,493			(34,106	)
Cash and cash equivalents at beginning of year		14,089			12,596			46,702
Cash and cash equivalents at end of year	$	21,203		$	14,089		$	12,596
Supplemental disclosure of cash flow information
Cash paid during the year for interest	$	2,073		$	294		$	268
Issuance of common stock and assumption of stock options and warrants in acquisition of Southern BioSystems, Inc.	$	—		$	—		$	22,716
Issuance of common stock for acquisition of APT	$	1,053		$	—		$	—

The accompanying notes are an integral part of these consolidated financial statements.

64

DURECT CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

1.     Summary of Significant Accounting Policies

Nature of Operations and Basis of Presentation

DURECT Corporation (the Company) was incorporated in the state of Delaware on February 6, 1998. The Company is a pharmaceutical company developing therapies for the treatment of chronic diseases and conditions with its proprietary drug formulations and delivery platform technologies. The Company’s lead product, the CHRONOGESIC^™ (sufentanil) Pain Therapy System, is intended for the treatment of chronic pain. The Company has several products under development in the areas of pain, cardiovascular diseases and central nervous system disorders. The Company also manufactures and sells osmotic pumps used in laboratory research. In addition, the Company conducts research and development of pharmaceutical products with third party pharmaceutical and biotechnology company partners.

Absorbable Polymers International Corporation, formally known as Birmingham Polymers, Inc., a wholly owned subsidiary of the Company develops and manufactures biodegradable polymers for third party pharmaceutical and biotechnology companies for use in their products. BPI was a wholly-owned subsidiary of Southern BioSystems, Inc. (SBS) when the Company acquired SBS on April 30, 2001. BPI became a wholly-owned subsidiary of the Company when SBS was merged with and into the Company on December 31, 2002. BPI changed its legal name to Absorbable Polymers International Corporation in November 2003.

Basis of Consolidation

The consolidated financial statements include the accounts of the Company and its subsidiary. All significant intercompany accounts and transactions have been eliminated.

Reclassifications

Certain prior period amounts have been reclassified to conform to current period presentation. Such reclassification did not impact the Company’s net loss or financial position.

Use of Estimates

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

Cash, Cash Equivalents and Investments

The Company considers all highly liquid investments with maturities of 90 days or less from the date of purchase to be cash equivalents. Investments with maturities of greater than 90 days from the date of purchase but less than one year are classified as short-term investments, while investments with maturities beyond one year from the balance sheet date are classified as long-term investments. Management determines the appropriate classification of its cash equivalents and investment securities at the time of purchase and re-evaluates such determination as of each balance sheet date. Management has classified the Company’s cash equivalents and investments as available-for-sale securities in the accompanying consolidated financial statements. Available-for-sale securities are carried at fair value, with unrealized gains and losses reported as a component of accumulated other comprehensive income (loss). Realized gains and losses are included in interest income. There were no material realized gains or losses in the periods presented. The cost of securities sold is based on the specific identification method.

65

DURECT CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

The Company invests its excess cash in debt instruments of financial institutions and corporations, and money market funds with high credit ratings. The Company has established guidelines regarding diversification of its investments and their maturities with the objectives of maintaining safety and liquidity, while maximizing yield.

Concentrations of Credit Risk

Financial instruments that potentially subject the Company to credit risk consist principally of interest-bearing investments and trade receivables. The Company maintains cash, cash equivalents and investments with various major financial institutions. The Company performs periodic evaluations of the relative credit standing of these financial institutions and limits the amount of credit exposure with any one institution. In addition, the Company performs periodic evaluations of the relative credit quality of its investments.

Universities, pharmaceutical companies and hospitals account for a substantial portion of the Company’s trade receivables. The Company provides credit in the normal course of business to its customers and collateral for these receivables is generally not required. The risk associated with this concentration is limited due to the large number of accounts and their geographic dispersion. The Company monitors the creditworthiness of its customers to which it grants credit terms in the normal course of business. The Company maintains reserves for estimated credit losses and, to date, such losses have been within management’s expectations. At December 31, 2003, one customer accounted for 19% of the Company’s gross accounts receivable.

Customer and Product Line Concentrations

A substantial portion of our revenue is derived from our ALZET product line, which accounted for 44%, 69% and 74% of our total revenues in fiscal years 2003, 2002 and 2001. In fiscal years 2003, 2002 and 2001, one customer accounted for 8%, 11% and 11% of the Company’s revenues, respectively. Revenue by geographic region for the years 2003, 2002, and 2001 is as follows (in thousands):

	Year ended December 31,
	2003		2002		2001
United States	$	8,566	$	5,085	$	4,300
Japan		940		782		728
Europe		1,899		711		1,078
Other		430		607		418
Total	$	11,835	$	7,185	$	6,524

Revenues by geography is determined by the location of the customer.

Inventories

Inventories are stated at the lower of cost or market, with cost determined on a first-in, first-out basis. The Company’s inventories consisted of the following (in thousands):

	December 31,
	2003		2002
Raw materials	$	212	$	187
Work in-process		542		534
Finished goods		1,148		986
Total inventories	$	1,902	$	1,707

66

DURECT CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

Property and Equipment

Property and equipment are stated at cost less accumulated depreciation, which is computed using the straight-line method over the estimated useful lives of the assets, which range from three to five years. Leasehold improvements are amortized using the straight-line method over the estimated useful lives of the assets, or the terms of the related leases, whichever are shorter.

Acquired Intangible Assets and Goodwill

Acquired intangible assets consist of patents, developed technology, trademarks, assembled workforce and customer lists related to the Company’s acquisitions accounted for using the purchase method. Amortization of these purchased intangibles is calculated on a straight-line basis over the respective estimated useful lives of the assets ranging from four to seven years. Acquired in-process research and development without alternative future use is charged to operations when acquired. In July 2001, the FASB issued Statement of Financial Accounting Standards No. 142,Goodwill and Other Intangible Assets(SFAS 142), which requires the elimination of the amortization of goodwill and assembled workforce to be replaced with the periodic evaluation of intangibles for impairment. Accordingly, beginning in fiscal 2002, the Company ceased amortizing goodwill and assembled workforce, which has been reclassified to goodwill, and instead assesses goodwill for impairment on at least an annual basis in accordance with SFAS 142.

Impairment of Long-Lived Assets

In accordance with the provisions of Statement of Financial Accounting Standards No. 144,Accounting for the Impairment or Disposal of Long-Lived Assets(SFAS 144), the Company reviews long-lived assets, including property and equipment, intangible assets, and other long-term assets, for impairment whenever events or changes in business circumstances indicate that the carrying amount of the assets may not be fully recoverable. Factors we consider important which could trigger an impairment review include, but are not limited to, the following:

· significant underperformance relative to expected historical or projected future operating results;

· significant changes in the manner of our use of the acquired assets or the strategy for our overall business;

· significant negative industry or economic trends;

· significant decline in our stock price for a sustained period; and

· our market capitalization relative to net book value.

Under SFAS 144, an impairment loss would be recognized when estimated undiscounted future cash flows expected to result from the use of the asset and its eventual disposition is less than its carrying amount. Impairment, if any, is calculated as the amount by which an asset’s carrying value exceeds its fair value, typically using discounted cash flows to determine fair value. Through December 31, 2003, there have been no such impairment losses. The Company adopted the provisions of SFAS 144 effective January 1, 2002, prior to which the Company followed the provisions of Statement of Financial Accounting Standards No. 121,Accounting for the Impairment of Long-Lived Assets and for Assets to be Disposed Of.

Stock-Based Compensation

The Company accounts for stock-based employee compensation arrangements in accordance with the provisions and related interpretations of Accounting Principles Board Opinion No. 25,Accounting for Stock

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Issued to Employees (APB 25), and has elected to follow the “disclosure only” alternative prescribed by Financial Accounting Standards Board’s Statement of Financial Accounting Standards No. 123,Accounting for Stock-Based Compensation (SFAS 123). Under APB 25, stock-based compensation is based on the difference, if any, on the date of grant, between the fair value of the Company’s stock and the exercise price. Unearned compensation is amortized using the graded vesting method and expensed over the vesting period of the respective options.

At December 31, 2003, the company has five stock-based employee compensation plans, which are described more fully in Note 10. The company accounts for those plans under the recognition and measurement principles of APB Opinion No. 25,Accounting for Stock Issued to Employees, and related Interpretations. No stock-based employee compensation cost is reflected in net income, where all options granted under those plans had an exercise price equal to the market value of the underlying common stock on the date of grant. 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 FASB Statement No. 123,Accounting for Stock-Based Compensation, to stock-based employee compensation (in thousands, except per share amounts).

	Year Ended December 31
	2003			2002			2001
Net loss	$	(22,698	)	$	(37,173	)	$	(44,928	)
Add: Stock-based employee compensation expense included in reported net income		(198	)		1,070			3,125
Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards		(2,211	)		(5,337	)		(7,811	)
Pro forma net loss	$	(25,107	)	$	(41,440	)	$	(49,614	)
Net loss per share:
Basic and diluted—as reported	$	(0.45	)	$	(0.77	)	$	(0.97	)
Basic and diluted—pro forma	$	(0.50	)	$	(0.86	)	$	(1.07	)

The Company accounts for equity instruments issued to non-employees in accordance with the provisions of SFAS 123 and Emerging Issues Task Force 96-18,Accounting for Equity Instruments that are Issued to other than Employees for Acquiring, or in Conjunction with Selling, Goods or Services. The fair value of equity instruments granted to non-employees is periodically remeasured as the underlying options vest.

Revenue Recognition

Revenue from the sale of products is recognized at the time the product is shipped and title transfers to customers, provided no continuing obligation exists and the collectibility of the amounts owed is reasonably assured.

Revenue related to collaborative research and development with the Company’s corporate partners is recognized as the related research and development services are performed over the related funding periods for each agreement. The payments received under each respective agreement are not refundable and are generally based on reimbursement of qualified expenses, as defined in the agreements. Research and development expenses under the collaborative research and development agreements approximate or exceed the revenue recognized under such agreements over the term of the respective agreements. Deferred revenue may result when

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the Company does not expend the required level of effort during a specific period in comparison to funds received under the respective agreements. Milestone and royalties payments, if any, will be recognized as earned.

Revenue on cost-plus-fee contracts, such as contract research and development revenue, is recognized only to the extent of reimbursable costs incurred plus estimated fees thereon. Revenue on fixed price contracts is recognized on a percentage-of-completion method based on cost incurred in relation to total estimated cost. In all cases, revenue is recognized only after a signed agreement is in place. For contracts that have a ceiling price or contract value, losses on contracts are recognized in the period in which the losses become known and estimable.

Research and Development Expenses

Research and development costs are expensed as incurred. Research and development costs paid to third parties under sponsored research agreements are recognized as the related services are performed, generally ratably over the period of service. Purchased research and development is recognized in purchase business combinations for the portion of the purchase price allocated to the appraised value of in-process technologies. The portion assigned to in-process technologies excludes the value of core and developed technologies, which are recorded as intangible assets.

Comprehensive Loss

Unrealized gains and losses on the Company’s available-for-sale securities are included in total comprehensive loss. For the year ended December 31, 2003, the Company’s total comprehensive loss was $22.8 million compared to its net loss of $22.7 million. For the year ended December 31, 2002, the Company’s total comprehensive loss was $37.7 million compared to its net loss of $37.2 million. For the year ended December 31, 2001, the Company’s total comprehensive loss was $44.3 million compared to its net loss of $44.9 million. The difference between net loss and comprehensive loss in all periods results from unrealized gains or losses on available-for-sale investments.

Segment Reporting

The Company follows Statement of Financial Accounting Standard No. 131,Disclosures about Segments of an Enterprise and Related Information (SFAS 131). SFAS 131 establishes standards for reporting financial information about operating segments in financial statements, as well as additional disclosures about products and services, geographic areas, and major customers. The Company operates in one operating segment, research and development of pharmaceutical systems.

Net Loss Per Share

Basic net loss per share is calculated as net loss attributable to common stockholders divided by the weighted-average number of common shares outstanding, less the weighted average number of common shares during the year subject to repurchase or held in escrow pursuant to an acquisition agreement. Diluted net loss per share is computed using the weighted-average number of common shares outstanding and common stock equivalents (i.e. options and warrants to purchase common stock) outstanding during the year, if dilutive, using the treasury stock method.

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The following table presents the calculations of basic and diluted and pro forma basic and diluted net loss per share (in thousands, except per share amounts):

	Year ended December 31,
	2003			2002			2001
Net loss	$	(22,698	)	$	(37,173	)	$	(44,928	)
Basic and diluted weighted average shares:
Weighted-average shares of common stock outstanding		50,719			48,970			47,596
Less: weighted-average shares subject to repurchase and held in escrow		(209	)		(652	)		(1,182	)
Weighted-average shares used in computing basic and diluted net loss per share		50,510			48,318			46,414
Basic and diluted net loss per share	$	(0.45	)	$	(0.77	)	$	(0.97	)

The computation of diluted net loss per share for the fiscal year ended December 31, 2003 excludes the impact of options to purchase 5.9 million shares of common stock, warrants to purchase 1.0 million shares of common stock and 209,000 shares of common stock subject to repurchase, and 10.3 million shares of common stock issuable upon conversion of the subordinated notes at December 31, 2003, as such impact would be antidilutive.

The computation of diluted net loss per share for the fiscal year ended December 31, 2002 excludes the impact of options to purchase 4.2 million shares of common stock, warrants to purchase 1.1 million shares of common stock and 365,000 shares of common stock subject to repurchase, at December 31, 2002, as such impact would be antidilutive.

The computation of diluted net loss per share for the fiscal year ended December 31, 2001 excludes the impact of options to purchase 3.4 million shares of common stock, warrants to purchase 1.1 million shares of common stock and 888,000 shares of common stock subject to repurchase, at December 31, 2001, as such impact would be antidilutive.

Shipping and Handling

Costs related to shipping and handling are included in cost of good sold for all periods presented.

Recent Accounting Pronouncements

In November 2002, the Emerging Issues Task Force (EITF) reached a consensus regarding EITF Issue 00-21,Accounting for Revenue Arrangements with Multiple Deliverables. The consensus addresses not only when and how an arrangement involving multiple deliverables should be divided into separate units of accounting, but also how the arrangement’s consideration should be allocated among separate units. The pronouncement is effective for revenue arrangements entered into in fiscal periods beginning after June 15, 2003. The adoption of EITF Issue 00-21 did not have a material effect on our results of operations or financial position.

In January 2003, the FASB issued Financial Interpretation No. 46,Consolidation of Variable Interest Entities (FIN 46). FIN 46 addresses consolidation by business enterprises of variable interest entities. Under that interpretation, certain entities known as Variable Interest Entities (VIEs) must be consolidated by the primary beneficiary of the entity. The primary beneficiary is generally defined as having the majority of the risks and rewards arising from the VIE. For VIEs in which a significant (but not majority) variable interest is held, certain disclosures are required. It applies immediately to variable interest entities created after January 31, 2003, and applies in the first year or interim period ending after December 15, 2003 to variable interest entities in which an

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enterprise holds a variable interest that it acquired before February 1, 2003. The adoption of FIN 46 did not have a material effect on our results of operations or financial position.

In May 2003, the FASB issued Statement of Financial Accounting Standards No. 150,Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity (SFAS 150). The Statement establishes standards for classifying and measuring as liabilities certain financial instruments that embody obligations of the issuer and have characteristics of both liabilities and equity. The Statement is effective for all financial instruments created or modified after May 31, 2003, and to other instruments for periods beginning after June 15, 2003. The adoption of SFAS 150 did not have a material effect on our results of operations or financial position.

2.    Strategic Agreements

Agreements with ALZA

In April 1998, the Company entered into a development and commercialization agreement with ALZA Corporation (ALZA) for certain product development rights, patent rights, and other know-how relating to the DUROS system. The Company issued 5,600,000 shares of Series A-1 preferred stock, which were subsequently converted into 5,600,00 shares of common stock concurrent with our initial public offering in 2000, to ALZA in connection with this agreement and is required to pay ALZA a royalty on the net sales of products and a percentage of up-front license fees, milestone payments, or any other payments or consideration received by the Company, excluding research and development funding.

In April 2000, ALZA and the Company amended and restated their development and commercialization agreement. This amendment includes a reduction in product royalties and up-front payments to ALZA by the Company under the agreement. As consideration for these amendments, ALZA received 1,000,000 shares of the Company’s common stock and, subject to conditions on exercise, a warrant to purchase 1,000,000 shares of common stock at an exercise price of $12.00 per share. The deemed fair value of the stock and the warrant was $13.5 million (See Note 10). This value was recorded as additional paid-in capital and deferred royalties and commercial rights, included as a contra-equity account in the statement of stockholders’ equity, and will be amortized as royalty expense and sales and marketing expense, respectively, as associated product sales commence. The Company will periodically evaluate the recoverability of these amounts and assess whether any indicators of impairment have occurred. Indicators of impairment for products under the agreement may include: failure to complete product development, unfavorable outcomes from clinical trials, suspension of clinical trial activities, failure to receive approval from the FDA, and/or lack of market acceptance.

Effective October 1, 2002, the Company entered into a Third Amended and Restated Development and Commercialization Agreement with ALZA Corporation, which replaced and superseded the Second Amended and Restated Development and Commercialization Agreement entered into between ALZA and the Company effective April 28, 1999 and April 14, 2000. The agreement provides the Company with exclusive rights to develop, commercialize and manufacture products using ALZA’s patented DUROS^® technology in selected fields of use. Pursuant to amendments made to this agreement, the Company’s maintenance of exclusivity in these licensed fields is no longer subject to minimum annual requirements for development spending or the number of products under development by the Company.

In the years ended December 31, 2003, 2002 and 2001, the Company incurred development expenses of $13,000, $19,000, and $98,000, respectively, for work performed by ALZA, of which $13,000, $24,000 and $133,000 was paid during the years ended December 31, 2003, 2002 and 2001, respectively.

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Agreement with Endo Pharmaceuticals

In November 2002, the Company entered into a development, commercialization and supply license agreement with Endo Pharmaceuticals Holdings Inc. (Endo) under which the companies will collaborate on the development and commercialization of our CHRONOGESIC product for the U.S. and Canada. The agreement was amended in January 2004 to take into account the delay in the development program due to DURECT’s implementation of necessary design and manufacturing enhancements to the product. Under the terms of the agreement, as amended, the Company will be responsible for the CHRONOGESIC product’s design and development. For the period commencing January 1, 2004 until the earlier of January 1, 2005 or the commencement of a specified clinical trial, Endo will fund 25% of the ongoing development costs for the CHRONOGESIC product in the U.S. and Canada exclusive of system redesign costs and pharmacokinetic trials necessitated by any system redesign up to an aggregate amount of $250,000 for the period. Commencing on January 1, 2005 or, if earlier, the commencement of a specified clinical trial for the CHRONOGESIC product, Endo will fund 50% of the ongoing development costs and will reimburse the Company for a portion of the Company’s prior development costs for the product upon the achievement of certain milestones. Development-based milestone payments made by Endo under this agreement could total up to $52 million. In addition, under the agreement, Endo has licensed exclusive promotional rights to the CHRONOGESIC product in the U.S. and Canada. Endo will be responsible for marketing, sales and distribution, including providing specialty sales representatives dedicated to supplying technical and training support for CHRONOGESIC therapy and will pay for product launch costs. The Company will be responsible for the manufacture of the CHRONOGESIC product. The Company will share profits from the commercialization of the product in the U.S. and Canada with Endo based on the financial performance of the CHRONOGESIC product. The Company’s share of such profits from the commercialization of the product is anticipated to be 50% based on the Company’s projected financial performance of the product in the U.S. and Canada.

In connection with the execution of the agreement, Endo purchased 1,533,742 shares of newly issued common stock of DURECT at an aggregate purchase price of approximately $5.0 million. The Company paid $1,660,000 to an investment bank for strategic advisory services as a result of executing this agreement.

Agreements with other strategic partners

The Company also is party to collaboration research and development agreements with Pain Therapeutics, Inc. and Voyager Pharmaceutical Corporation to develop drugs combining with the Company’s proprietary drug delivery technologies. Under these collaborative research and development agreements, the strategic partners reimburse to the Company all or portion of the research and development expenses incurred by the Company in connection with these partnering programs. In addition, the company received an upfront payment of $900,000 from a strategic partner upon execution of the collaboration agreement in December 2002.

3.     Acquisition of Absorbable Polymer Technologies, Inc.

On August 15, 2003, the Company acquired Absorbable Polymer Technologies, Inc. (APT), a privately held Alabama Corporation pursuant to an Agreement and Plan of Merger among Durect Corporation, Birmingham Polymers, Inc. and APT (the (“Merger Agreement”) for a total cost of approximately $2.2 million including the transaction cost of approximately $100,000. In connection with the acquisition, we issued an aggregate of 485,122 shares of our common stock, valued at $1.1 million and agreed to pay the remaining purchase consideration through the issuance of additional shares of our common stock or cash in connection with the first, second and third anniversaries of the closing of the merger.

APT manufactured and sold polymer and provided analytical and product development services for third party pharmaceutical and biotechnology companies. This acquisition is intended to help the Company to gain

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market share in the polymers supply market and to expand custom polymer development capabilities. The purchase price was allocated to the tangible assets and identifiable intangible assets acquired based on their estimated fair value, as follows (in thousands):

Net tangible assets acquired	$	254
Intangible assets acquired:
Patents		56
Developed technology		160
Goodwill		1,683
Total purchase price allocation	$	2,153

Tangible net assets acquired include cash, accounts receivable, inventories and fixed assets. Liabilities assumed principally include accrued expenses and notes payable. Intangible assets represent the excess of the total acquisition cost over the fair value of identifiable net assets of business acquired. Intangible assets except goodwill are each being amortized on a straight-line basis over their estimated useful lives, which are both 7 years.

The acquisition of APT has been accounted for as a purchase, with the results of APT’s operations included in the Company’s results of operations from the date of acquisition. Pro forma financial information reflecting the acquisition of APT is not provided as the operating results of APT were not significant in relation to the Company’s operating results.

4.    Goodwill and Intangible Assets

Intangible assets recorded in connection with our acquisitions consist of the following (in thousands):

	December 31, 2003
	Gross Intangibles		Accumulated Amortization			Net Intangibles
Developed technology	$	3,600	$	(1,991	)	$	1,609
Patents		466		(252	)		214
Other intangible assets		3,260		(2,089	)		1,171
Total	$	7,326	$	(4,332	)	$	2,994
	December 31, 2002
	Gross Intangibles		Accumulated Amortization			Net Intangibles
Developed technology	$	3,440	$	(1,348	)	$	2,092
Patents		410		(190	)		220
Other intangible assets		3,260		(1,451	)		1,809
Total	$	7,110	$	(2,989	)	$	4,121

The intangible assets are being amortized on a straight-line basis over estimated useful lives ranging from four to seven years.

The net amount of intangible assets at December 31, 2003 was $3.0 million, which will be amortized as follows: $1.2 million in each of the years 2004 and 2005, $424,000 in the year 2006, $31,000 in each of the years

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2007, 2008 and 2009, and $19,000 in the year 2010. Should other intangible assets become impaired, the Company will write them down to their estimated fair value.

Goodwill totaled $6.4 million at December 31, 2003. On January 1, 2002, the Company adopted SFAS 142 and ceased amortizing goodwill. In addition, the Company reclassified the remaining balance of $855,000 of assembled workforce to goodwill. The Company also began periodically evaluating goodwill for impairment. In 2003 and 2002, goodwill was evaluated and no indicators of impairment were noted. Should goodwill become impaired, we may be required to record an impairment charge to write the goodwill down to its estimated fair value.

In accordance with SFAS 142, companies are required in the year of adoption to exclude the impact of SFAS 142 from comparable periods until pre-adoption periods are no longer presented. The following tables adjust the Company’s net loss to exclude the effects of goodwill and assembled workforce amortization during the years ended December 31, 2003, 2002 and 2001 (in thousands, except per share amounts):

	Year Ended December 31,
	2003			2002			2001
Reported net loss attributable to common stockholders	$	(22,698	)	$	(37,173	)	$	(44,928	)
Add back SFAS 142 adjustments:
Goodwill amortization		—			—			493
Assembled workforce amortization		—			—			236
Adjusted net loss attributable to common stockholders	$	(22,698	)	$	(37,173	)	$	(44,199	)
Adjusted net loss per share	$	(0.45	)	$	(0.77	)	$	(0.95	)

5.    Financial Instruments

The carrying amount of cash and cash equivalents reported on the balance sheet approximates its fair value. Short-term and long-term investments consist of marketable debt securities. The fair values of investments are based upon quoted market prices. The carrying amounts of the Company’s borrowings under its secured debt agreements approximate their fair values. The fair values are estimated using a discounted cash flow analysis based on the Company’s current incremental borrowing rates for similar types of borrowing arrangements. As of December 31, 2003, the fair market value of our convertible notes was $57.6 million compared with the carrying value of $60.0 million. The fair market value was obtained through quoted market prices.

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The following is a summary of available-for-sale securities as of December 31, 2003 and 2002 (in thousands):

	December 31, 2003
	Amortized Cost		Unrealized Gain		Unrealized Loss			Estimated Fair Value
Money market funds	$	976	$	—	$	—		$	976
Certificates of deposit		1,601		—		—			1,601
Commercial paper		26,686		1		(6	)		26,686
Market auction preferreds		22,000		—		—			22,000
Corporate bonds and notes		11,460		11		(18	)		11,453
Federal agency debt securities		19,333		30		(33	)		19,330
Others		2,313		1		(1	)		2,313
	$	84,369	$	43	$	(58	)	$	84,354
Reported as:
Cash and cash equivalents	$	20,394	$	1	$	(5	)	$	20,390
Short-term investments		39,522		5		(16	)		39,511
Long-term investments		21,334		37		(37	)		21,334
Restricted investments		3,119		—		—			3,119
	$	84,369	$	43	$	(58	)	$	84,354
	December 31, 2002
	Amortized Cost		Unrealized Gain		Unrealized Loss			Estimated Fair Value
Money market funds	$	1,305	$	—	$	—		$	1,305
Commercial paper		15,281		1		(2	)		15,280
Market auction preferreds		13,450		—		—			13,450
Corporate bonds and notes		9,319		26		—			9,345
Federal agency debt securities		8,083		60		—			8,143
Others		612		18		—			630
	$	48,050	$	105	$	(2	)	$	48,153
Reported as:
Cash and cash equivalents	$	13,970	$	4	$	—		$	13,974
Short-term investments		28,618		93		—			28,711
Long-term investments		2,570		8		—			2,578
Restricted investments		2,892		—		(2	)		2,890
	$	48,050	$	105	$	(2	)	$	48,153

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The following is a summary of the cost and estimated fair value of available-for-sale securities at December 31, 2003 and 2002, by contractual maturity (in thousands):

	2003				2002
	Amortized Cost		Estimated Fair Value		Amortized Cost		Estimated Fair Value
Mature in one year or less	$	63,035	$	63,020	$	45,480	$	45,575
Mature after one year through three years		21,334		21,334		2,570		2,578
Total	$	84,369	$	84,354	$	48,050	$	48,153

The follow is a summary of unrealized losses for available-for-sale securities at December 31, 2003 (in thousands):

	Unrealized Loss for Less than 12 Months
	Fair Value		Unrealized Loss
Commercial paper	$	9,858	$	(6	)
Corporate bonds and notes		8,047		(18	)
Federal agency debt securities		9,882		(33	)
Others		697		(1	)
	$	28,484	$	(58	)

There are no unrealized losses for available-for-sale securities that are greater than twelve months at December 31, 2003.

6.    Notes Receivable

In November 2003, we issued a promissory note in the amount of $150,000 to a private company, Sinexus, Inc. and recorded the $150,000 as part of prepaids and other current assets on our balance sheet as of December 31, 2003. Sinexus is a start-up venture developing site specific treatments for chronic sinusitis, an inflammatory disease affecting the paranasal sinuses. In order to provide bridge funding for Sinexus, we and a venture capital firm agreed to loan Sinexus $150,000 each in convertible notes as a pre-Series A seed financing of Sinexus, Inc. This note is secured by a security interest in Sinexus’ current and pending intellectual property and earns 6% interest until it is paid in full or converted to Sinexus’ preferred stock when certain conversion events occur. Our investment in Sinexus represents an interest in a “variable interest entity”. However, we are not primary beneficiary of Sinexus and our maximum exposure to loss as a result of our involvement with Sinexus is $150,000. We also perform certain research and development activities on behalf of Sinexus. Any amounts received from Sinexus in connection with our performance of research and development activities are accounted for as a direct reduction of our investment.

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7.    Property and Equipment

Property and equipment consist of the following (in thousands):

	December 31,
	2003			2002
Equipment	$	9,324		$	8,410
Leasehold improvement		8,462			8,329
Construction-in-progress		31			17
		17,817			16,756
Less accumulated depreciation		(8,501	)		(5,131	)
Property and equipment, net	$	9,316		$	11,625

At December 31, 2003, no equipment was collateralized as security for equipment financing facilities. At December 31, 2002, equipment which has been collateralized as security for the Company’s former equipment financing facility was approximately $1,618,000. Accumulated depreciation related to collateralized assets was approximately $1,162,000 as of December 31, 2002.

8.     Restricted Investments

In April 2001, the Company deposited $1.0 million in the form of a certificate of deposit with a financial institution as a letter of credit to secure a lease for the Company’s office facility in Cupertino, California. The restriction on these funds will be released upon termination of the lease in June 2006, but may be reduced by $200,000 annually provided timely rental payments are made. In 2002, $200,000 was released by the bank from restriction as of December 31, 2002. However, the Company did not request the bank to release another $200,000 from restriction in 2003.

In July 2001, the Company also deposited $2.4 million in investment grade securities with the same institution to guarantee bonds assumed in the acquisition of SBS (see Notes 3 and 10). This guarantee will be released upon the sooner of the Company’s exercise of its option to call the bonds at any time after November 2001, or the bond’s maturity date in November 2009. In 2002 and 2003, as allowed under the guarantee agreement, approximately $900,000 of this collateral was released from restriction following the exchange of the investment grade securities for corporate debt securities with a higher investment grade to conform with the Company’s investment policy.

In January 2003, the Company refinanced the previous equipment loan and lease obligations with a three-year term loan with a local bank. The principal of the new term loan was $850,000 with a fixed interest rate of 4.95%. The term loan is secured by a certificate of deposit the Company placed with the same bank. In 2003, approximately $68,000 of collateral was released from restriction. The Company does not have any lines of credit or available balances under the term loan.

9.     Equipment Financing Obligations and Term Loan

Equipment Financing Obligations

In October 1998, the Company financed the purchase of certain equipment through a bank loan. The loan was renewed in April 1999 and the amount of the loan was increased to $400,000 from $250,000 in June 1999, with an interest rate increase to 1.25% plus the bank’s base rate from 0.5% plus the bank’s base rate (weighted

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average rates of 6.00% and 7.96% in 2002 and 2001). This loan was repayable in equal monthly installments over three years (payments commenced in April 1999 and concluded in April 2002). This equipment loan was secured by substantially all of the Company’s assets. In April 2002, this term loan was fully paid off.

In January 2000, the Company amended and restated the loan agreement to include a one-time advance of $750,000. This advance was repayable in monthly installments of principal and interest over 42 months with a balloon payment of $75,000 due at the end of the term. Simultaneously, the Company entered into a lease agreement with the same bank that allows the Company to finance up to $1,500,000 of future equipment purchases and leasehold improvements. The payment terms of the lease are substantially the same as the loan, with a 10 percent balloon payment due at the end of the lease. Both the loan and the lease are secured by the equipment financed. The Company paid in full the outstanding equipment loan and lease obligations in January 2003.

Term Loan

In January 2003, the Company refinanced the previous equipment loan and lease obligations with a three-year term loan with a local bank. The principal of the new term loan was $850,000 with a fixed interest rate of 4.95%. The term loan is secured by a certificate of deposit the Company placed with the same bank. The Company does not have any lines of credit or available balances under the term loan.

Aggregate future minimum loan payments on term loan are due as follows (in thousands):

Year ended December 31,
2004	$	306
2005		292
2006		24
Total minimum principal and interest payments		622
Less: Amount representing interest		(32	)
Present value of future lease payments		590
Less: Current portion of term loan		(283	)
Long-term portion of term loan	$	307

10.     Long-term Debt and Commitments

Convertible Subordinated Notes due 2008

On June 18, 2003, the Company completed a private placement of an aggregate of $50.0 million in convertible subordinated notes (the “notes”). The notes bear interest at a fixed rate of 6.25% per annum and are due on June 15, 2008. On July 14, 2003, the initial purchaser of $50.0 million of the notes elected to exercise its option to purchase an additional $10.0 million in principal amount of such notes. The notes are convertible at the option of the note holders into our common stock at a conversion rate of 317.4603 shares per $1,000 principal amount of the notes, subject to adjustment in certain circumstances. Interest on the notes is payable semi-annually in arrears in June and December. We received net proceeds of approximately $56.7 million after deducting underwriting fees of $3.0 million and related expenses of $300,000. The total issuance cost of approximately $3.3 million has been included in other long-term assets on the balance sheet and is amortized to interest expense using the effective interest rate method over the duration of the notes, which is 5 years. The notes are unsecured obligations of the Company and are subordinate to any secured debt the Company currently has or any future senior indebtness of the Company.

78

DURECT CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

Alabama State Industrial Development Bonds

In conjunction with the acquisition of SBS in April 2001, the Company assumed Alabama State Industrial Development Bonds (“SBS Bonds”) with remaining principal payments of $1.7 million and a current interest rate of 6.35% increasing each year up to 7.20% at maturity on November 1, 2009. As part of the acquisition agreement, the Company was required to guarantee and collateralize these bonds with a letter of credit of approximately $2.4 million that the Company supported with investments deposited with a financial institution in July 2001. In 2002 and 2003, as allowed under the guarantee agreement, approximately $900,000 of this collateral was released from restriction following the exchange of the investment grade securities for corporate debt securities with a higher investment grade to conform with the Company’s investment policy.

Interest payments are due semi-annually and principal payments are due annually. Principal payments increase in annual increments from $150,000 to $240,000 over the term of the bonds until the principal is fully amortized in 2009. The Company has an option to call the SBS Bonds at any time, and must pay a call premium if the bonds are called prior to November 2004. The call premium decreases annually from 1 ¹/2% to 0% in November 2004. As of December 31, 2003, the SBS Bonds with remaining principal payments of $1.25 million were assigned to the Company as SBS was merged into and with the Company.

Operating Leases

The Company leases its Cupertino, California office and research facility under a noncancelable operating lease which expires in January 2004, with two options to extend the lease for 5 years each. The company also renewed the lease in its Vacaville, California manufacturing facility under a noncancelable operating lease which expires in August 2005, with an option to extend the lease for a period of 2 years. In March 2001, the Company leased additional office space in Cupertino, California, under a noncancelable operating lease which commenced in June 2001, expires in May 2006 and has two options to extend the lease term for 3 years and 5 years each. Pursuant to the Company’s acquisition of SBS in April 2001, the Company assumed leases for approximately 23,000 square feet of office and laboratory space in Birmingham, Alabama, which expired in May 2003, with two five-year options to extend the term of the leases. The Company decided not to renew the leases for the full five-year term in May 2003 and instead renewed the lease for a one-year term, which expires in May 2004.

In connection with our acquisition of APT in August 2003, we assumed a lease for approximately 5,000 square feet of office and laboratory space in Pelham, Alabama, which expires in February 2006. In December 2003, we leased approximately 20,000 square feet of additional corporate office and laboratory space in Cupertino, California, under a lease expiring in February 2009 with options to extend for up to an additional five years.

Under these leases, the Company is required to pay certain maintenance expenses in addition to monthly rent. Rent expense is recognized on a straight-line basis over the lease term for leases that have scheduled rental payment increases. Rent expense under all operating leases was $2.7 million, $2.6 million and $1.9 million, for the years ended December 31, 2003, 2002 and 2001, respectively.

79

DURECT CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

Future minimum payments under these noncancelable leases and long-term obligations are as follows (in thousands):

Year ended December 31,	Bond Maturities		Operating Leases
2004	$	180	$	2,823
2005		190		2,662
2006		200		1,739
2007		210		1,139
2008		225		1,151
Thereafter		240		192
	$	1,245	$	9,706

11.     Stockholders’ Equity

Common Stock

As described in Note 2, in April 2000 the Company amended and restated its development and commercialization agreement with ALZA. As consideration for these amendments, ALZA received 1,000,000 shares of the Company’s common stock and, subject to conditions on exercise, a warrant to purchase 1,000,000 shares of common stock at an exercise price of $12.00 per share. The common stock issued to ALZA was valued at $7.00 per share. The fair value of the stock and the warrant was $13.5 million. The fair value of the warrant was determined to be $6,480,000, calculated using the Black-Scholes option pricing model, using the following assumptions: stock price of $12.00 per share; no dividends; contractual term of four years; risk-free interest rate of 6%; and expected volatility of 64%.

In connection with the acquisition of SBS, the Company assumed outstanding warrants to purchase 124,839 shares of common stock at the weighted-average exercise price of $2.40 per share. These warrants were exercisable immediately at the time of acquisition. The deemed fair value of the warrants was $773,000, calculated using the Black-Scholes option pricing model, using the following assumptions: stock price of $8.384 per share; no dividends; contractual term of 1 ¹/2 years; risk-free interest rate of 4.1%; and expected volatility of 64%. The fair value of the assumed outstanding warrants were included as part of the purchase price for SBS. As of December 31, 2003, warrants to purchase 91,033 shares of the company’s common stock has been exercised and the remaining unexercised warrants expired on April 30, 2003 pursuant to the terms of the warrants. As of December 31, 2003, no warrants assumed from the SBS acquisition to purchase the company’s common stock were outstanding.

In May 2001, the Company issued to a third party consultant a fully vested and exercisable warrant to purchase 770 shares of our common stock at an exercise price of $8.50 per share in connection with an Exclusive Trademark License and Assignment Agreement. The fair value of this warrant was $5,121 on the grant date.

As of December 31, 2003, shares of common stock reserved for future issuance consisted of the following:

	December 31, 2003
Warrants to purchase common stock	1,000,770
Stock options outstanding	5,615,796
Stock options available for grant	3,208,522
Employee Stock Purchase Plan	339,771
Convertible subordinated notes	19,047,618
	29,212,477

80

DURECT CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

Incentive Stock Plans

In March 1998, the Company adopted the DURECT Corporation 1998 Stock Option Plan under which incentive stock options and non-statutory stock options may be granted to employees, directors of, or consultants to, the Company and its affiliates. In January 2000, the Company ceased granting options from this plan.

In January 2000, the Company’s Board of Directors and stockholders adopted the DURECT Corporation 2000 Stock Option Plan, under which incentive stock options and non-statutory stock options and stock purchase rights may be granted to employees, consultants and non-employee directors. The 2000 Stock Option Plan was amended by written consent of the Board of Directors in March 2000 and written consent of the stockholders in August 2000. A total of 8,546,500 shares of common stock have been reserved for issuance under this plan.

Options granted under the 1998 and 2000 Stock Option Plans (“Plans”) expire no later than ten years from the date of grant. Options may be granted with different vesting terms from time to time not to exceed five years from the date of grant.

The option price of an incentive stock option granted to an employee or of a nonstatutory stock option granted to any person who owns stock representing more than 10% of the total combined voting power of all classes of stock of the Company (or any parent or subsidiary) shall be no less than 110% of the fair market value per share on the date of grant. The option price of an incentive stock option granted to any other employee shall be no less than 100% of the fair market value per share on the date of grant. The option price of a nonstatutory stock option that is granted to any other person shall be no less than 85% of the fair market value per share on the date of grant.

2000 Directors’ Stock Option Plan

In March 2000, the Board of Directors adopted the 2000 Directors’ Stock Option Plan. A total of 300,000 shares of common stock had been reserved initially for issuance under this plan. The directors’ plan provides that each person who becomes a non-employee director of the Company after the effective date of this offering will be granted a non-statutory stock option to purchase 20,000 shares of common stock on the date on which the optionee first becomes a non-employee director of the Company. This plan also provides that each option granted to a new director shall vest at the rate of 33 ¹/3% per year and each annual option of 5,000 shares shall vest in full at the end of one year. At the Company’s annual shareholders meeting in June 2002, the shareholders approved an amendment of the 2000 Directors’ Stock Option Plan to: (i) increase the number of stock options granted to a non-employee director on the date which such person first becomes a director from 20,000 to 30,000 shares of common stock; (ii) increase the number of stock options granted to each non-employee director on the date of each annual meeting of the stockholders after which the director remains on the Board from 5,000 to 12,000 shares of common stock; and (iii) reserve 200,000 additional shares of common stock for issuance under the Directors’ Stock Option Plan so that the total number of shares reserved for issuance is 500,000. As of December 31, 2003, 139,000 shares have been granted under the directors’ plan.

1993 Stock Option Plan of Southern BioSystems, Inc.

In April 2001, the Company assumed the 1993 Stock Option Plan of Southern BioSystems, Inc. (1993 SBS Plan) in connection with its acquisition of SBS. Pursuant to the 1993 SBS Plan, incentive stock options may be granted to employees, and nonstatutory stock options may be granted to employees, directors, and consultants, of the Company and its affiliates. A total of 662,191 shares of common stock have been reserved for issuance under this plan. Options granted under the 1993 SBS Plan expire no later than ten years from the date of grant. Options may be granted with different vesting terms from time to time not to exceed five years from the date of grant. As of December 31, 2003, 100,047 shares of common stock have been exercised under the 1993 SBS Plan.

81

DURECT CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

1995 Nonqualified Stock Option Plan of Southern Research Technologies, Inc.

In April 2001, the Company also assumed the 1995 Nonqualified Stock Option Plan of Southern Research Technologies, Inc. (1995 SRT Plan) in connection with its acquisition of SBS. Under this plan, non-statutory stock options may be granted to employees, directors, and consultants, of the Company and its affiliates. A total of 243,609 shares of common stock have been reserved for issuance under this plan. Options granted under the 1995 SRT Plan expire no later than ten years from the date of grant. Options may be granted with different vesting terms from time to time but not to exceed five years from the date of grant. As of December 31, 2003, 135,787 shares of common stock have been exercised under the 1995 SRT Plan.

Activity under all stock plans through December 31, 2003 is as follows:

	Shares Available for Grant		Number of Shares Granted		Weighted- Average Exercise Price
Balance at December 31, 2000	498,368		1,299,682		$	6.52
Shares authorized, net	3,155,800		—			—
Options granted	(2,305,256	)	2,305,256		$	6.11
Options exercised	—		(159,231	)	$	1.43
Options canceled	29,475		(45,082	)(1)	$	4.72
Balance at December 31, 2001	1,378,387		3,400,625		$	6.51
Shares authorized, net	2,450,000		—			—
Options granted	(1,429,207	)	1,429,207		$	7.80
Options exercised	—		(144,372	)	$	0.89
Options canceled	471,625		(476,446	)(1)	$	8.66
Balance at December 31, 2002	2,870,805		4,209,014		$	6.89
Shares authorized, net	2,250,000		—			—
Options granted	(3,078,743	)	3,078,743		$	1.71
Options exercised	—		(159,388	)	$	0.95
Options canceled	1,166,460		(1,512,573	)(1)	$	4.62
Balance at December 31, 2003	3,208,522		5,615,796		$	4.62

(1) Options to purchase 7,500, 2,500, and 35,550 shares of common stock granted under the 1998 Stock Option Plan were cancelled in 2001, 2002 and 2003, respectively and are not available for future grant. In addition, options to purchase 8,107, 2,321 and 139,198 shares of common stock under the 1993 SBS Plan in 2001, 2002 and 2003, respectively, and options to purchase 21,739 shares of common stock under the 1995 SRT Plan in 2003 were cancelled and are not available for future grant.

Since inception, the Company has recorded aggregate deferred compensation charges of $11.2 million in connection with stock options granted to employees and directors, including $918,000 recorded at the time of the Company’s acquisition of SBS in April 2001 for the assumption of outstanding stock options granted to employees and directors of that company. In 2003 and 2002, the company reversed $949,000 and $750,000 of deferred compensation, respectively, as a result of terminated employees.

The Company has amortized $9.4 million of deferred compensation, net of reversals, through December 31, 2003. The Company reversed deferred compensation of $276,000 in 2003 and amortized deferred compensation of $1.1 million in 2002 and $3.2 million in 2001. The remaining employee deferred stock compensation at December 31, 2003 was $59,000, which will be amortized as follows: $45,000 for 2004, $13,000 for 2005, and $1,000 for 2006.

82

DURECT CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

The weighted-average grant-date fair value of options granted with exercise price equal to fair market value was $1.01 in 2003, $4.15 in 2002 and $4.18 in 2001. The weighted-average grant-date fair value of options granted to purchase 905,800 shares of common stock with exercise prices lower than fair market value was $6.27 in 2001. There were no options granted with exercise prices lower than fair market value in 2003 and 2002.

In 2003, the Company issued options to purchase 67,500 shares of common stock to several third party consultants in exchange for services. In connection with these options to purchase common stock, the Company recorded a non-cash charge of $96,000 in its statement of operations for the year ended December 31, 2003.

In 2002, the Company issued options to purchase 20,307 shares of common stock to several third party consultants in exchange for services. In connection with these options to purchase common stock, the Company recorded a non-cash charge of $134,000 in its statement of operations for the year ended December 31, 2002.

In 2001, the Company issued options to purchase 38,431 shares of common stock to several third party consultants in exchange for services and assumed options to purchase 30,987 shares of common stock previously issued to third party consultants in connection with the SBS acquisition. In connection with these options to purchase common stock, the Company recorded a non-cash charge of $326,000 in its statement of operations for the year ended December 31, 2001.

Expenses for non-employee stock options are recorded over the vesting period of the options, with the amount determined by the Black-Scholes option valuation method and remeasured over the vesting term.

The following table summarizes information about stock options outstanding at December 31, 2003:

Range of Exercise Price	Number of Options Outstanding	Weighted- Average Remaining Contractual Life	Weighted- Average Exercise Price		Number of Options Exercisable	Weighted- Average Exercise Price
		(In years)
$  0.10 –  1.45	456,023	4.16	$	0.81	433,436	$	0.80
$  1.55 –  1.58	2,201,174	9.11	$	1.58	355,854	$	1.58
$  1.77 –  3.10	676,054	7.41	$	2.69	293,658	$	2.78
$  3.40 –  7.48	577,934	7.83	$	5.66	317,890	$	5.96
$  7.56 –  9.19	922,955	7.83	$	8.64	385,619	$	8.35
$  9.25 –11.63	627,151	7.03	$	11.32	414,091	$	11.39
$11.84 –12.04	104,505	6.87	$	12.01	78,442	$	12.01
$12.70 –12.70	3,500	7.48	$	12.70	1,750	$	12.70
$13.00 –13.00	13,500	7.49	$	13.00	6,750	$	13.00
$13.56 –13.56	33,000	6.95	$	13.56	24,750	$	13.56
$  0.10 –13.56	5,615,796	7.87	$	4.62	2,313,240	$	5.60

As of December 31, 2003, outstanding options to purchase an aggregate of 2,313,240 shares of common stock were vested and exerciseable at a weighted-average exercise price per share of $5.60. As of December 31, 2002, outstanding options to purchase an aggregate of 1,569,207 shares of common stock were vested and exerciseable at a weighted-average exercise price per share of $5.34. As of December 31, 2001, outstanding options to purchase an aggregate of 1,185,456 shares of common stock were vested and exerciseable at a weighted-average exercise price per share of $3.20.

83

DURECT CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

2000 Employee Stock Purchase Plan

In August 2000, the Company adopted the 2000 Employee Stock Purchase Plan. A total of 150,000 shares of common stock have been reserved for issuance under the purchase plan. This purchase plan will be implemented by a series of overlapping offering periods of approximately 24 months’ duration, with new offering periods, other than the first offering period, beginning on May 1 and November 1 of each year and ending April 30 and October 31, respectively, two years later. The purchase plan allows eligible employees to purchase common stock through payroll deductions at a price equal to the lower of 85% of the fair market value of the Company’s common stock at the beginning of each offering period or at the end of each purchase period. The initial offering period commenced on the effectiveness of the Company’s initial public offering.

Pro Forma Information

The Company has elected to follow APB 25 and related interpretations in accounting for its employee stock-based compensation plans. Because the exercise price of the employee stock options equals the market price of the underlying stock on the date of grant, no compensation expense is generally recognized. Pro forma information regarding net loss has been determined as if the Company accounted for its employee stock options (including shares issued under the Employee Stock Purchase Plan, collectively called “stock based awards”) under the fair value method prescribed by SFAS 123. The resulting effect on pro forma net loss disclosed is not likely to be representative of the effects on net loss on a pro forma basis in future years, due to additional grants and years of vesting in subsequent years. The fair value of the Company’s stock based awards granted to employees from inception (February 6, 1998) to the time of the initial public offering in September 2000, were estimated on the date of grant using the minimum value method. Stock based awards granted subsequent to the Company’s initial public offering have been valued using the Black Scholes option valuation model.

The fair value of the Company’s stock based awards to employees was estimated using the following assumptions:

	Stock Options						Employee Stock Purchase Plan
	Year ended December 31,						Year ended December 31,
	2003		2002		2001		2003		2002		2001
Risk-free interest rate	1.9-2.6	%	2.2-4.5	%	3.4-4.6	%	1.3-1.5	%	1.5-2.6	%	2.2-4.0	%
Expected dividend yield	—		—		—		—		—		—
Expected life of option (in years)	3.5		3.5		3.5		1.25		1.25		1.25
Volatility	79-90	%	73-79	%	64-73	%	79-90	%	73-79	%	64-73	%

The Black Scholes option valuation model was developed for use in estimating the fair value of traded options that have no vesting restrictions and are fully transferable. The Black Scholes model requires the input of highly subjective assumptions including the expected stock price volatility. Because the Company’s stock based awards to employees have characteristics significantly different from those of traded option, and because changes in the subjective input assumptions can materially affect the fair value estimate, in management’s opinion, the existing models do not necessarily provide a reliable single measure of the fair value of its stock based awards.

For the purposes of pro forma disclosures, the estimated fair value of the stock based awards is amortized to expense over the vesting period for options and the offering period for stock purchases under the Employee Stock Purchase Plan.

84

DURECT CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

Stockholder Rights Plan

On July 6, 2001, the Board of Directors adopted a Stockholder Rights Plan. The rights issued pursuant to the plan expire on July 6, 2011 and are exercisable ten days after a person or group either (a) announces the acquisition of 17.5 percent or more of the Company’s outstanding common stock or (b) commences a tender offer, which would result in ownership by the person or group of 17.5 percent or more of the Company’s outstanding common stock. Upon exercise, all rights holders except the potential acquiror will be entitled to acquire the Company’s common stock at a discount. Under certain circumstances, the company’s Board of Directors may also exchange the rights (other than those owned by the acquiror or its affiliates) for the company’s common stock at an exchange ratio of one share of common stock per right. The company is entitled to redeem the rights at any time on or before the tenth day following acquisition by a person or group of 17.5 percent or more of the company’s common stock.

12.     Income Taxes

Deferred tax assets and liabilities reflect the net tax effects of net operating loss and credit carryforwards and the temporary differences between the carrying amounts of assets and liabilities for financial reporting and the amounts used for income tax purposes. Significant components of the Company’s deferred tax assets are as follows (in thousands):

	December 31,
	2003			2002
Deferred tax assets:
Net operating loss carryforwards	$	38,400		$	31,400
Capitalized research and development		3,480			2,430
Other		2,660			2,310
Total deferred tax assets		44,540			36,140
Valuation allowance for deferred tax assets		(44,540	)		(36,140	)
Net deferred tax assets	$	—		$	—

Realization of deferred tax assets is dependent upon future earnings, if any, the timing and amount of which are uncertain. Accordingly, the net deferred tax assets have been fully offset by a valuation allowance. The valuation allowance increased by $8.4 million and $15.3 million during 2003 and 2002, respectively.

As of December 31, 2003, the Company had net operating loss carryforwards for federal income tax purposes of approximately $107.0 million, which expire in the years 2018 through 2023 and federal research and development tax credits of approximately $1.2 million which expire at various dates beginning in 2018 through 2023, if not utilized.

As of December 31, 2003, the Company had net operating loss carryforwards for state income tax purpose of approximately $35.0 million, which expire in the years 2008 through 2013, if not utilized and state research and development tax credits of approximately $1.1 million, which do not expire.

Utilization of the net operating losses may be subject to a substantial annual limitation due to federal and state ownership change limitations. The annual limitation may result in the expiration of net operating losses before utilization.

85

DURECT CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

13.    Unaudited Selected Quarterly Financial Data (in thousands, except per share amounts)

	First Quarter						Second Quarter						Third Quarter						Fourth Quarter
	2003			2002			2003			2002			2003			2002			2003			2002
Revenue, net	$	2,581		$	1,624		$	3,200		$	1,772		$	2,950		$	1,783		$	3,104		$	2,006
Net loss	$	(5,893	)	$	(9,749	)	$	(5,116	)	$	(9,915	)	$	(6,430	)	$	(9,050	)	$	(5,259	)	$	(8,459	)
Basic and diluted net loss per share	$	(0.12	)	$	(0.20	)	$	(0.10	)	$	(0.21	)	$	(0.13	)	$	(0.19	)	$	(0.10	)	$	(0.17	)

14.    Subsequent Event

In January 2004, the Company amended its agreement with Endo Pharmaceuticals Inc. relating to the development and commercialization of the CHRONOGESIC product in the U.S. and Canada. Prior to the amendment, in addition to other specified termination rights provided to both parties, the agreement provided Endo with a right to terminate the agreement in the event that the Company had not commenced a specified clinical trial for the CHRONOGESIC product by December 31, 2003 and an additional right to terminate the agreement in the event that the Company had not commenced such clinical trial by June 30, 2004. As part of the amendment, Endo’s first right to terminate was eliminated and the second termination right was amended to replace the June 30, 2004 date with January 1, 2005. In addition, the parties agreed, under the amendment, to change the cap of the aggregate amount of development costs (excluding system redesign costs and pharmacokinetic trials necessitated by any system redesign) that Endo would be responsible for during the period commencing January 1, 2004 until the earlier of January 1, 2005 or the commencement of a specified clinical trial to $250,000.

In February 2004, the Company renewed the lease for its headquarters located at 10240 Bubb Road in Cupertino, California for a period of five years.

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Item 9.    Changes in and Disagreements with Accountants on Accounting and Financial Disclosure.

Not applicable.

Item 9A.    Controls and Procedures

As of December 31, 2003, we evaluated our “disclosure controls and procedures” and our “internal controls and procedures for financial reporting.” This evaluation was done under the supervision and with the participation of management, including our chief executive officer and our chief financial officer.

(a)    Evaluation of disclosure controls and procedures.    Disclosure controls are procedures that are designed with the objective of ensuring that information required to be disclosed in our reports filed under the Securities Exchange Act of 1934 (the “Exchange Act”), such as this Annual Report on Form 10-K, is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s (“SEC”) rules and forms. Disclosure controls are also designed with the objective of ensuring that such information is accumulated and communicated to our management, including the chief executive officer and chief financial officer, as appropriate to allow timely decisions regarding required disclosure.

Based on their evaluation, the chief executive officer and the chief financial officer have concluded that our disclosure controls and procedures are effective to ensure that information we are required to disclose in reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in SEC rules and forms.

(b)    Changes in internal controls.    Internal Controls are procedures which are designed with the objective of providing reasonable assurance that (1) our transactions are properly authorized; (2) our assets are safeguarded against unauthorized or improper use; and (3) our transactions are properly recorded and reported, all to permit the preparation of our financial statements in conformity with accounting principles generally accepted in the United States. Among other matters, we evaluated our internal controls to determine whether there were any “significant deficiencies” or “material weaknesses,” and sought to determine whether the Company had identified any acts of fraud involving personnel who have a significant role in the Company’s internal controls. In the professional auditing literature, “significant deficiencies” are referred to as “reportable conditions”; these are control issues that could have a significant adverse effect on the ability to record, process, summarize and report financial data in the financial statements. A “material weakness” is defined in the auditing literature as a particularly serious reportable condition where the internal control does not reduce to a relatively low level the risk that misstatements caused by error or fraud may occur in amounts that would be material in relation to the financial statements and would not be detected within a timely period by employees in the normal course of performing their assigned functions.

In accordance with the requirements of the SEC, since the date of the evaluation of our disclosure controls and our internal controls to the date of this Annual Report, our chief executive officer and chief financial officer concluded that there were no significant deficiencies or material weaknesses in our internal controls. In addition, there were no significant changes in our internal controls or in other factors that could significantly affect these controls subsequent to the date of their evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.

Limitations on the Effectiveness of Controls.    Our management, including our chief executive and chief financial officer, does not expect that our disclosure controls or our internal controls will prevent all error and all fraud. A control system can provide only reasonable, not absolute, assurance that the objectives of the control system are 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 Company have been detected. These inherent limitations include the realities that

87

judgments in decision-making can be faulty, and that breakdowns can occur because of simple error or mistake. Additionally, controls can be circumvented by the individual acts of some persons, by collusion of two or more people or by management override of the control. The design of any system of controls also is based in part upon 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, control systems may become inadequate because of changes in conditions, or the degree of compliance with the policies or procedures may deteriorate. Because of the inherent limitations in a cost-effective control system, misstatements due to error or fraud may occur and not be detected.

PART III

The definitive proxy statement for our 2004 annual meeting of stockholders, when filed, pursuant to Regulation 14A of the Securities Exchange Act of 1934, will be incorporated by reference into this Form 10-K pursuant to General Instruction G (3) of Form 10-K and will provide the information required under Part III (Items 10-14), except for the information with respect to our executive officers, which is included in “Part I—Executive Officers of the Registrant.”

PART IV

Item 15.    Exhibits, Financial Statement Schedules and Reports on Form 8-K.

(a) The following documents are filed as part of this report:

(1)  Financial Statements

See Item 8 of this form 10-K

(2)  Financial Statement Schedules

Schedule II—Valuation and Qualifying Accounts

Schedules not listed above have been omitted because the information required to be set forth therein is not applicable or is shown in the financial statements or notes thereto.

(3) Exhibits are incorporated herein by reference or are filed in accordance with Item 601 of Regulation S–K.

Number	Description
2.1	Agreement and Plan of Merger dated April 18, 2001, among the Company, Target and Magnolia Acquisition Corporation (2).
3.3	Amended and Restated Certificate of Incorporation of the Company (1).
3.5	Amended and Restated Bylaws of the Company (1).
3.6	Certificate of Designation of Rights, Preferences and Privileges of Series B-1 Preferred Stock (1).
3.7	Certificate of Designation of Rights, Preferences and Privileges of Series C Preferred Stock (1).
4.2	Second Amended and Restated Investors’ Rights Agreement (1).
4.3	Preferred Shares Rights Agreement, dated as of July 6, 2001, between the Company and EquiServe Trust Company, N.A. including the Certificate of Designation, the form of the Rights Certificate and the Summary of Rights attached thereto as Exhibits A, B and C, respectively (3).
10.1	Form of Indemnification Agreement between the Company and each of its Officers and Directors (1).
10.2	1998 Stock Option Plan (1).

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Number		Description
10.3		2000 Stock Plan (1).
10.4		2000 Employee Stock Purchase Plan (1).
10.5		2000 Directors’ Stock Option Plan (1).
10.6**		Second Amended and Restated Development and Commercialization Agreement between the Company and ALZA Corporation effective April 28,1999 (1).
10.7**		Product Acquisition Agreement between the Company and ALZA Corporation dated as of April 14, 2000 (1).
10.8		Amended and Restated Loan and Security Agreement between the Company and Silicon Valley Bank dated as of October 28, 1998 (1).
10.9**		Manufacturing and Supply Agreement between Neuro-Biometrix, Inc. and Novel Biomedical, Inc. dated as of November 24, 1997 (1).
10.10	**	Master Services Agreement between the Company and Quintiles, Inc. dated as of November 1, 1999 (1).
10.11		Modified Net Single Tenant Lease Agreement between the Company and DeAnza Enterprises, Ltd. dated as of February 18, 1999 (1).
10.12		Sublease Amendment between the Company and Ciena Corporation dated as of November 29, 1999 and Sublease Agreement between Company and Lightera Networks, Inc. dated as of March 10, 1999 (1).
10.13	**	Project Proposal between the Company and Chesapeake Biological Laboratories, Inc. dated as of October 11, 1999 (1).
10.17		Common Stock Purchase Agreement between the Company and ALZA Corporation dated April 14, 2000 (1).
10.18		Warrant issued to ALZA Corporation dated April 14, 2000 (1).
10.19		Amended and Restated Market Stand-off Agreement between the Company and ALZA Corporation dated as of April 14, 2000 (1).
10.20	**	Asset Purchase Agreement between the Company and IntraEAR, Inc. dated as of September 24, 1999 (1).
10.21		Warrant issued to Silicon Valley Bank dated December 16, 1999 (1).
10.22		Amendment to Second Amended and Restated Investors’ Rights Agreement dated as of April 14, 2000 (1).
10.23	**	Master Agreement between the Company and Pacific Data Designs, Inc. dated as of July 6, 2000 (1).
10.24	**	Master Services Agreement between the Company and Clinimetrics Research Associates, Inc. dated as of July 11, 2000 (1).
10.25	**	Supply Agreement between the Company and Mallinckrodt, Inc. dated as of October 1, 2000 (5).
10.26		Lease between Sobrato Development Companies #850 and the Company (6).
10.27		Southern BioSystems, Inc. 1993 Stock Option Plan (as amended) (4).
10.28		Southern Research Technologies, Inc. 1995 Nonqualified Stock Option Plan (as amended) (4).
10.29	**	Feasibility, Development and Commercialization Agreement between Southern BioSystems, Inc., an Alabama corporation and wholly-owned subsidiary of the Company (now merged into the Company), and Voyager Pharmaceutical Corporation dated as of July 22, 2002. (7).
10.30	**	License & Option Agreement and Mutual Release between Southern BioSystems, Inc, an Alabama corporation and wholly-owned subsidiary of the Company (now merged into the Company), and Thorn BioScience LLC dated as of July 26, 2002 (7).

89

Number	Description
10.31**	Third Amended and Restated Development and Commercialization Agreement between the Company and ALZA Corporation dated as of October 1, 2002 (7).
10.32**	Development and License Agreement between the Company, Southern BioSystems, Inc, an Alabama corporation and wholly-owned subsidiary of the Company (now merged into the Company), and BioPartners, GmbH dated as of October 18, 2002.(8)
10.33**	Development, Commercialization and Supply License Agreement between the Company and Endo Pharmaceuticals Inc. dated as of November 8, 2002.(8)
10.34**	Development and License Agreement between the Company, Southern BioSystems, Inc., an Alabama corporation and wholly-owned subsidiary of the Company (now merged into the Company), and Pain Therapeutics, Inc. dated as of December 19, 2002.(8)
10.35	Sublease between the Company and Norian Corporation with commencement date of January 1, 2004.
10.36	Lease between the Company and Renault & Handley Employee Investments Co. with commencement date of January 1, 2005.
10.37	Amendment to Development, Commercialization and Supply License Agreement between the Company and Endo Pharmaceuticals Inc. dated as of January 28, 2004.
12.1	Ratio of Earnings to Fixed Charges.
21.1	Subsidiaries
23.1	Consent of Ernst & Young LLP, Independent Auditors.
24.1	Power of Attorney (see signature page of this Form 10-K).
31.1	Rule 13a-14(a) Section 302 Certification.
31.2	Rule 13a-14(a) Section 302 Certification.
32.1	Certificate pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
32.2	Certificate pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

(1) Incorporated by reference to our Registration Statement on Form S-1, as amended (File No. 333-35316), initially filed with the Securities and Exchange Commission on April 20, 2000.

(2) Incorporated by reference to our Current Report on Form 8-K (File No. 000-31615) filed with the Securities and Exchange Commission on May 15, 2001.

(3) Incorporated by reference to our Registration Statement on Form 8-A (File No. 000-31615) filed with the Securities and Exchange Commission on July 10, 2001.

(4) Incorporated by reference to our Registration Statement on Form S-8 (File No. 333-61224) filed with the Securities and Exchange Commission on May 18, 2001.

(5) Incorporated by reference to our Annual Report on Form 10-K (File No. 000-31615) filed with the Securities and Exchange Commission on March 30, 2001.

(6) Incorporated by reference to our Quarterly Report on Form 10-Q (File No. 000-31615) filed with the Securities and Exchange Commission on November 13, 2001.

(7) Incorporated by reference to our Quarterly Report on Form 10-Q (File No. 000-31615) filed with the Securities and Exchange Commission on November 14, 2002.

(8) Incorporated by reference to our Annual Report on Form 10-K (File No. 000-31615) filed with the Securities and Exchange Commission on March 14, 2003.

** Confidential treatment granted with respect to certain portions of this Exhibit.

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(b)    Durect Corporation filed a report on Form 8-K on October 9, 2003 announcing the initiation of manufacture of clinical product for its CHRONOGESIC^® (sufentanil) Pain Therapy product.

Durect Corporation filed a report on Form 8-K on October 17, 2003 announcing an update to its CHRONOGESIC^® program.

Durect Corporation filed a report on Form 8-K on November 6, 2003 announcing positive clinical results for its post-operative pain relief depot using the SABER^™ delivery system.

Durect Corporation filed a report on Form 8-K on November 6, 2003 announcing the Company’s financial results for the three months period ended September 30, 2003.

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SCHEDULE II—VALUATION AND QUALIFYING ACCOUNTS

Year Ended December 31, 2003, 2002 and 2001

(in thousands)

	Balance at beginning of year		Provision			Write Offs			Balance at end of the year
December 31, 2003 Allowance for doubtful accounts	$	207	$	70		$	(136	)	$	141
December 31, 2002 Allowance for doubtful accounts		263		(31	)		(25	)		207
December 31, 2001 Allowance for doubtful accounts		226		37			—			263

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SIGNATURES

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

DURECT CORPORATION
By:	/s/    JAMES E. BROWN
	James E. Brown President and Chief Executive Officer

Date:  March 11, 2004

POWER OF ATTORNEY

KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature appears below constitutes and appoints James E. Brown and Felix Theeuwes, jointly and severally, his or her attorneys-in-fact, each with the power of substitution, for him or her in any and all capacities, to sign any amendments to this Report on Form 10-K, and to file the same, with exhibits thereto and other documents in connection therewith with the Securities and Exchange Commission, hereby ratifying and confirming all that each of said attorneys-in-fact, or his or her substitute or substitutes may do or cause to be done by virtue hereof.

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

Signature	Title	Date
/s/    JAMES E. BROWN         James E. Brown	President, Chief Executive Officer and Director (Principal Executive Officer)	March 11, 2004
/s/    FELIX THEEUWES         Felix Theeuwes	Chairman and Chief Scientific Officer	March 11, 2004
/s/    THOMAS A. SCHRECK         Thomas A. Schreck	Chief Financial Officer and Director (Principal Financial and Accounting Officer)	March 11, 2004
/s/    DAVID R. HOFFMANN         David R. Hoffmann	Director	March 11, 2004
/s/    ARMAND P. NEUKERMANS         Armand Neukermans	Director	March 11, 2004
/s/    JON S. SAXE         Jon S. Saxe	Director	March 11, 2004
/s/    ALBERT L. ZESIGER         Albert L. Zesiger	Director	March 11, 2004

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