Pernix Sleep 10Q 2006 Q3 Quarterly report

UNITED STATES SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, DC 20549

FORM 10-Q

(Mark One)


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

For the quarterly period ended September 30, 2006


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

For the transition period from to

Commission file number: 000-51665

Somaxon Pharmaceuticals, Inc.

(Exact name of registrant as specified in its charter)


Delaware (State or other jurisdiction of incorporation or organization)		20-0161599 (I.R.S. Employer Identification No.)

3721 Valley Centre Drive, Suite 500, San Diego, CA (Address of principal executive offices)		92130 (Zip Code)

(858) 480-0400
(Registrant’s telephone number, including area code)

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

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act (check one):

Large accelerated filero Accelerated filero Non-accelerated filerþ

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

Yeso Noþ

The number of outstanding shares of the registrant’s common stock, par value $0.0001 per share, as of November 6, 2006 was 18,071,496.

SOMAXON PHARMACEUTICALS, INC.

FORM 10-Q — QUARTERLY REPORT
FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2006

TABLE OF CONTENTS


	Page
PART I – FINANCIAL INFORMATION

Item 1. Financial Statements

Condensed Balance Sheets at September 30, 2006 and December 31, 2005		1

Condensed Statements of Operations for the three and nine months ended September 30, 2006 and 2005		2

Condensed Statements of Redeemable Convertible Preferred Stock and Stockholders’ Equity and Comprehensive Loss		3

Condensed Statements of Cash Flows for the nine months ended September 30, 2006 and 2005		5

Notes to Condensed Financial Statements		6

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations		18

Item 3. Quantitative and Qualitative Disclosures about Market Risk		30

Item 4. Controls and Procedures		31

PART II – OTHER INFORMATION

Item 1. Legal Proceedings		31

Item 1A. Risk Factors		31

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds		44

Item 3. Defaults Upon Senior Securities		44

Item 4. Submission of Matters to a Vote of Security Holders		44

Item 5. Other Information		44

Item 6. Exhibits		45

SIGNATURES		46
EXHIBIT 31.1
EXHIBIT 31.2
EXHIBIT 32.1

PART I — FINANCIAL INFORMATION

Item 1. Financial Statements

Somaxon Pharmaceuticals, Inc.
(A development stage company)

BALANCE SHEETS
(unaudited)


	September 30,			December 31,
	2006			2005
ASSETS
Current assets
Cash and cash equivalents	$	46,576,160		$	100,918,088
Short-term investments		20,550,580			3,047,086
Other current assets		1,322,131			1,923,466

Total current assets		68,448,871			105,888,640
Long-term restricted cash		600,000			—
Property and equipment, net		278,503			190,045
Other assets		160,000			177,259

Total assets	$	69,487,374		$	106,255,944


LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities
Accounts payable	$	9,736,158		$	11,881,616
Accrued liabilities		950,331			919,090

Total current liabilities		10,686,489			12,800,706


Commitments and contingencies: (Note 4)

Stockholders’ equity
Preferred stock, $0.0001 par value; 10,000,000 shares authorized, none issued and outstanding		—			—
Common stock, $0.0001 par value; 100,000,000 shares authorized; 18,071,337 and 18,045,366 shares issued and outstanding at September 30, 2006 and December 31, 2005, respectively		1,807			1,804
Additional paid-in capital		150,455,204			150,802,850
Deferred compensation		—			(3,801,897	)
Deficit accumulated during the development stage		(91,652,506	)		(53,547,519	)
Accumulated other comprehensive loss		(3,620	)		—

Total stockholders’ equity		58,800,885			93,455,238

Total liabilities and stockholders’ equity	$	69,487,374		$	106,255,944

The Accompanying Notes are an Integral Part of these Financial Statements

Somaxon Pharmaceuticals, Inc.
(A development stage company)

STATEMENTS OF OPERATIONS
(unaudited)


													Period from
													August 14,
													2003
													(inception)
	Three months ended						Nine months ended						through
	September 30,						September 30,						September 30,
	2006			2005			2006			2005			2006
Operating expenses
License fees	$	203,750		$	98,750		$	511,250		$	341,210		$	5,551,315
Research and development		7,906,306			10,937,209			32,546,781			17,577,114			69,241,310
Marketing, general and administrative expenses		2,689,186			1,367,822			8,170,448			3,059,656			15,905,705
Remeasurement of Series C warrant liability		—			3,084,057			—			5,648,612			5,648,612

Total operating expenses		10,799,242			15,487,838			41,228,479			26,626,592			96,346,942

Loss from operations		(10,799,242	)		(15,487,838	)		(41,228,479	)		(26,626,592	)		(96,346,942	)
Interest and other income		965,157			519,679			3,123,492			752,148			4,694,436

Net loss		(9,834,085	)		(14,968,159	)		(38,104,987	)		(25,874,444	)		(91,652,506	)
Accretion of redeemable convertible preferred stock to redemption value		—			(39,731	)		—			(52,968	)		(86,102	)

Net loss applicable to common stockholders	$	(9,834,085	)	$	(15,007,890	)	$	(38,104,987	)	$	(25,927,412	)	$	(91,738,608	)


Basic and diluted net loss applicable to common stockholders per share	$	(0.55	)	$	(24.59	)	$	(2.12	)	$	(45.83	)
Shares used to calculate net loss applicable to common stockholders per share		18,006,693			610,251			17,967,649			565,675

The Accompanying Notes are an Integral Part of these Financial Statements

Somaxon Pharmaceuticals, Inc.
(A development stage company)

STATEMENTS OF REDEEMABLE CONVERTIBLE PREFERRED STOCK AND STOCKHOLDERS’ EQUITY AND COMPREHENSIVE LOSS
For the period from August 14, 2003 (inception) through September 30, 2006 (unaudited)


																		Deficit
																		Accumulated			Accumulated
	Series C Redeemable												Additional		Deferred			During the			Other
	Convertible Preferred Stock				Convertible Preferred Stock				Common Stock				Paid-in		Stock			Development			Comprehensive
	Shares		Amount		Shares		Amount		Shares		Amount		Capital		Compensation			Stage			Loss		Total
Issuance of common stock for cash to founders at $0.0006 per share in August		—	$	—		—	$	—		583,333	$	58	$	292	$	—		$	—		$	—	$	350
Issuance of Series A convertible preferred stock for cash at $1.00 per share in August, November, and December		—		—		2,281,538		2,281,538		—		—		—		—			—			—		2,281,538
Net Loss		—		—		—		—		—		—		—		—			(1,463,182	)		—		(1,463,182	)

Balance at December 31, 2003		—		—		2,281,538		2,281,538		583,333		58		292		—			(1,463,182	)		—		818,706


Issuance of Series A convertible preferred stock for cash at $1.00 per share in January		—		—		18,462		18,462		—		—		—		—			—			—		18,462
Issuance of Series B convertible preferred stock for cash at $1.00 per share in April and June, net of issuance costs of $97,295		—		—		23,000,000		22,902,705		—		—		—		—			—			—		22,902,705
Issuance of common stock in April at $1.20 per share for license agreement		—		—		—		—		84,058		8		100,862		—			—			—		100,870
Common stock issued from exercise of stock options		—		—		—		—		55,833		6		3,494		—			—			—		3,500
Deferred compensation associated with stock option grants		—		—		—		—		—		—		110,917		(110,917	)		—			—		—
Amortization of deferred compensation		—		—		—		—		—		—		—		13,425			—			—		13,425
Expense related to non-employee stock options		—		—		—		—		—		—		14,205		—			—			—		14,205
Net Loss		—		—		—		—		—		—		—		—			(13,597,770	)		—		(13,597,770	)

Balance at December 31, 2004		—		—		25,300,000		25,202,705		723,224		72		229,770		(97,492	)		(15,060,952	)		—		10,274,103

Somaxon Pharmaceuticals, Inc.
(A development stage company)


																							Deficit
																							Accumulated			Accumulated
	Series C Redeemable																Additional			Deferred			During the			Other
	Convertible Preferred Stock						Convertible Preferred Stock						Common Stock				Paid-in			Stock			Development			Comprehensive
	Shares			Amount			Shares			Amount			Shares		Amount		Capital			Compensation			Stage			Loss			Total
Issuance of Series C redeemable convertible preferred stock for cash at $1.35 per share in June and September, net of issuance costs of $152,712		48,148,455			64,847,703			—			—			—		—		—			—			—			—			—
Series C proceeds allocated to warrant instrument		—			(647,684	)		—			—			—		—		—			—			—			—			—
Additional paid-in capital from the exercise of the Series C warrant instrument		—			—			—			—			—		—		6,296,296			—			—			—			6,296,296
Accretion of Series C redeemable convertible preferred stock to redemption value		—			86,102			—			—			—		—		(86,102	)		—			—			—			(86,102	)
Issuance of common stock in initial public offering at $11.00 per share in December 2005, net of issuance costs of $5,179,780		—			—			—			—			5,000,000		500		49,819,720			—			—			—			49,820,220
Conversion of redeemable convertible preferred stock into common stock		(48,148,455	)		(64,286,121	)		—			—			8,024,721		802		64,285,319			—			—			—			64,286,121
Conversion of convertible preferred stock into common stock		—			—			(25,300,000	)		(25,202,705	)		4,216,661		422		25,202,283			—			—			—			—
Common stock issued from exercise of stock options		—			—			—			—			80,760		8		176,672			—			—			—			176,680
Deferred compensation associated with stock option grants		—			—			—			—			—		—		4,741,609			(4,741,609	)		—			—			—
Amortization of deferred compensation		—			—			—			—			—		—		—			1,037,204			—			—			1,037,204
Expense related to non-employee stock options		—			—			—			—			—		—		137,283			—			—			—			137,283
Net loss		—			—			—			—			—		—		—			—			(38,486,567	)		—			(38,486,567	)

Balance at December 31, 2005		—		$	—			—		$	—			18,045,366	$	1,804	$	150,802,850		$	(3,801,897	)	$	(53,547,519	)	$	—		$	93,455,238


Net loss		—			—			—			—			—		—		—			—			(38,104,987	)		—			(38,104,987	)
Change in unrealized loss on available-for-sale investments		—			—			—			—			—		—		—			—			—			(3,620	)		(3,620	)

Comprehensive loss																														(38,108,607	)

Elimination of deferred stock compensation upon adoption of SFAS No. 123R		—			—			—			—			—		—		(3,801,897	)		3,801,897			—			—			—
Exercise of stock options		—			—			—			—			25,971		3		126,350			—			—			—			126,353
SFAS No. 123R Stock option expense		—			—			—			—			—		—		3,166,029			—			—			—			3,166,029
Expense related to non-employee stock options		—			—			—			—			—		—		118,811			—			—			—			118,811
Vesting of early exercised stock options		—			—			—			—			—		—		43,061			—			—			—			43,061

Balance at September 30, 2006		—		$	—			—		$	—			18,071,337	$	1,807	$	150,455,204		$	—		$	(91,652,506	)	$	(3,620	)	$	58,800,885

The Accompanying Notes are an Integral Part of these Financial Statements

Somaxon Pharmaceuticals, Inc.
(A development stage company)

STATEMENTS OF CASH FLOWS
(unaudited)


							Period from
							August 14, 2003
							(inception)
	Nine Months Ended						through
	September 30,						September 30,
	2006			2005			2006
Cash flows from operating activities
Net loss	$	(38,104,987	)	$	(25,874,444	)	$	(91,652,506	)
Adjustments to reconcile net loss to net cash used in operating activities:
Depreciation		74,151			32,248			150,676
Expense related to stock option issuance		3,284,840			724,139			4,486,957
Issuance of stock for license agreement		—			—			100,870
Remeasurement of Series C warrant		—			5,648,612			5,648,612
Loss on disposal of equipment		—			1,782			1,782
Changes in operating assets and liabilities:
Other current assets		601,335			(1,329,447	)		(1,322,131	)
Other assets		17,259			98,091			(160,000	)
Accounts payable		(2,145,458	)		7,349,676			9,736,158
Accrued liabilities		74,302			(151,520	)		924,165

Net cash used in operating activities		(36,198,558	)		(13,500,863	)		(72,085,417	)


Cash flows from investing activities
Purchases of property and equipment		(162,609	)		(117,876	)		(430,961	)
Purchases of short-term investments		(19,507,114	)		(3,016,211	)		(22,554,200	)
Sales and maturities of short-term investments		2,000,000			—			2,000,000
Restricted cash deposit		(600,000	)		—			(600,000	)

Net cash used in investing activities		(18,269,723	)		(3,134,087	)		(21,585,161	)


Cash flows from financing activities
Issuance of common stock, net of issuance costs		—			—			49,820,570
Issuance of preferred stock, net of issuance costs		—			64,847,703			90,050,408
Exercise of stock options		126,353			159,500			375,760

Net cash provided from financing activities		126,353			65,007,203			140,246,738

Increase (Decrease) in cash and cash equivalents		(54,341,928	)		48,372,253			46,576,160
Cash and cash equivalents at beginning of the period		100,918,088			12,835,318			—

Cash and cash equivalents at end of the period	$	46,576,160		$	61,207,571		$	46,576,160


Supplemental disclosure of non-cash investing and financing activities
Accretion to redemption value of redeemable convertible preferred stock	$	—		$	52,968		$	86,102
Conversion of preferred stock into common stock upon completion of initial public offering	$	—		$	—		$	89,488,826

The Accompanying Notes are an Integral Part of these Financial Statements

Somaxon Pharmaceuticals, Inc.
(A development stage company)

Notes to Financial Statements
(unaudited)

Note 1. Organization and Summary of Significant Accounting Policies

Business

Somaxon Pharmaceuticals, Inc. (“Somaxon” or the “Company”) is a Delaware corporation founded on August 14, 2003. The Company is a specialty pharmaceutical company focused on the in-licensing and development of proprietary product candidates for the treatment of diseases and disorders in the fields of psychiatry and neurology.

To date, the Company has in-licensed three product candidates. The lead product candidate, SILENOR™ (doxepin hydrochloride), is in Phase 3 clinical trials for the treatment of insomnia. The product candidate nalmefene hydrochloride is in a Phase 2/3 clinical trial for the treatment of pathological gambling and has completed an exploratory study for smoking cessation. The Company is also developing a new formulation of acamprosate calcium for the treatment of certain movement disorders. The Company intends to continue to build a portfolio of product candidates that are approved in the United States but with significant commercial potential for proprietary new uses, new dosages or alternative delivery systems, products that are currently commercialized outside the United States but not available in the United States, or product candidates that are in late stages of clinical development.

Capital Resources

The Company expects to continue to incur losses and have negative cash flows from operations in the foreseeable future as it continues to engage in development and clinical trial activities for its product candidates and seek to commercialize these product candidates. The Company may be required to raise additional funds through public or private financings, strategic relationships, or other arrangements and cannot assure that the funding will be available on attractive terms, or at all. Also, additional equity financing may be dilutive to stockholders, and debt financing, if available, may involve restrictive covenants. The Company’s failure to raise capital as and when needed could have a negative impact on the financial condition and the ability to implement the Company’s business strategy, including completing current clinical development programs, commercializing products, and in-licensing other products.

Basis of Presentation

The accompanying unaudited condensed financial statements have been prepared in accordance with U.S. generally accepted accounting principles and the rules and regulations of the Securities and Exchange Commission related to a quarterly report on Form 10-Q. Accordingly, they do not include all of the information and disclosures required by U.S. generally accepted accounting principles for complete financial statements. The balance sheet at December 31, 2005 has been derived from the audited financial statements at that date, but does not include all disclosures required by accounting principles generally accepted in the United States. However, the Company believes that the disclosures are adequate to make the information presented not misleading. The interim financial statements reflect all adjustments which, in the opinion of management, are necessary for a fair statement of the financial condition and results of operations for the periods presented. All such adjustments are of a normal recurring nature.

Operating results for the three and nine months ended September 30, 2006 are not necessarily indicative of the results that may be expected for any future periods. For further information, please see the financial statements and related disclosures included in the Company’s Form 10-K for the year ended December 31, 2005.

Recent Accounting Pronouncements

In June 2006, the Financial Accounting Standards Board (“FASB”) issued FASB Interpretation No. (“FIN”) 48,Accounting for Uncertainty in Income Taxes—an interpretation of FASB Statement No. 109. This interpretation

Somaxon Pharmaceuticals, Inc.
(A development stage company)

Notes to Financial Statements
(unaudited)

clarifies the accounting for uncertainty in income taxes recognized in accordance with FASB Statement No. 109,Accounting for Income Taxes. FIN 48 defines the criterion an uncertain tax benefit position must meet for it to be recognized. Additionally, FIN 48 provides guidance on measurement of the amount to be recognized or derecognized, treatment of interest and penalties, and balance sheet classification and disclosures. This interpretation is effective for fiscal years beginning after December 15, 2006 and will first be effective for the Company for the year beginning January 1, 2007. The Company is in the process of analyzing the effects of this pronouncement.

In September 2006, the Securities and Exchange Commission issued Staff Accounting Bulletin (“SAB”) No. 108,Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements.SAB No. 108 requires analysis of misstatements using both an income statement (rollover) approach and a balance sheet (iron curtain) approach in assessing materiality and provides for a one-time cumulative effect transition adjustment. SAB No. 108 is effective for fiscal years ending after November 15, 2006 and will first be effective for the Company for the year ended December 31, 2006. The Company is in the process of analyzing the effects of SAB No. 108 and does not expect that the adoption will have a significant impact on the Company’s financial statements.

In September 2006, the FASB issued Statement of Financial Accounting Standard (“SFAS”) No. 157,Fair Value Measurement. This statement does not require any new fair value measurements, but rather applies to other accounting pronouncements that require or permit fair value measurements. SFAS No. 157 defines and establishes a framework for measuring fair value and expands disclosures. This statement is effective for fiscal years beginning after November 15, 2007 and will first be effective for the Company for the year beginning January 1, 2008. The Company is in the process of analyzing the effects of this pronouncement.

Share-Based Compensation Expense

On January 1, 2006, the Company adopted Statement of Financial Accounting Standards (“SFAS”) No. 123(R),Share-Based Payment,which requires the measurement and recognition of compensation expense, based on estimated fair values, in the statement of operations for all share-based payment awards made to employees and directors, including employee stock options. Prior to adopting SFAS No. 123(R), the Company accounted for share-based awards to employees and directors using the intrinsic value method in accordance with Accounting Principles Board Opinion No. 25Accounting for Stock Issued to Employees(“APB 25”) as allowed under SFAS No. 123Accounting for Stock-Based Compensation. Under the intrinsic value method, deferred stock compensation was recognized in the statement of operations to the extent the price of the underlying common stock, as determined in the retrospective fair value analysis performed in conjunction with the Company’s initial public offering, exceeded the exercise price of the stock options at the date of grant. Pro-forma disclosure of stock based compensation under SFAS No. 123 was provided in the notes to the financial statements.

In March 2005, the Securities and Exchange Commission issued SAB No. 107 relating to SFAS No. 123(R), which the Company has applied in its adoption of SFAS No. 123(R). The Company has two share-based payment plans: the stock option plan and employee stock purchase plan. SFAS No. 123(R) is applicable only to the Company’s stock option plan as the terms of the Company’s employee stock purchase plan make it non-compensatory under the provisions of SFAS No. 123(R).

The Company adopted SFAS No. 123(R) using the modified prospective transition method, under which prior period financial statements are not restated for the impact of SFAS No. 123(R). Stock options granted prior to the adoption of SFAS No. 123(R), but not yet fully vested at the time of adoption, are included in compensation expense based on the grant date fair value estimated in accordance with the pro-forma provisions of SFAS No. 123. SFAS No. 123(R) requires compensation expense to be reduced for an estimate of forfeitures such that expense is recognized for those stock options which ultimately vest. The Company’s pro-forma accounting under SFAS No. 123 also included an estimate for forfeitures; however the Company did not use an estimate of forfeitures when recognizing compensation expense in the statement of operations under APB 25. The cumulative effect of not using

Somaxon Pharmaceuticals, Inc.
(A development stage company)

Notes to Financial Statements
(unaudited)

an estimate of forfeitures when recognizing compensation expense under APB 25 was immaterial and no cumulative effect from a change in accounting principle was recognized when the Company adopted SFAS No. 123(R).

SFAS No. 123(R) requires the fair value of share-based payment awards to be estimated on the date of grant using an option-pricing model, such as the Black-Scholes valuation model which the Company uses. The Black-Scholes valuation model requires multiple subjective inputs, including a measure of expected future volatility. The Company’s stock did not have a readily available market prior to the initial public offering in December 2005, creating a short history from which to obtain data to estimate volatility for the Company’s stock price. Consequently, the Company estimates its expected future volatility based on comparable companies when determining the grant date calculated value for stock options.

The Company recognizes the calculated value of the portion of the awards that are ultimately expected to vest over the requisite service period, which is the vesting period for the Company’s stock options. Share-based compensation expense recognized under SFAS No. 123(R) for employees and directors for the three months ended September 30, 2006 was $1,263,635, of which $230,232 was included in research and development expense and $1,033,403 was included in marketing, general and administrative expense. Stock based compensation expense for the nine months ended September 30, 2006 was $3,166,029, of which $616,047 was included in research and development expense and $2,549,982 was included in marketing, general and administrative expense. Pro-forma stock based compensation as determined under SFAS No. 123 for the three and nine months ended September 30, 2005 was $561,951 and $835,293, respectively. See Note 3 for additional information.

Use of Estimates

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

Comprehensive Income (Loss)

SFAS No. 130,Reporting Comprehensive Income (Loss),requires that all components of comprehensive income (loss) be reported in the financial statements in the period in which they are recognized. Comprehensive income (loss) is net income (loss), plus certain other items that are recorded directly to stockholders’ equity, which for Somaxon consists of changes in unrealized gains and losses on securities classified as available-for-sale.

The following table summarizes the Company’s comprehensive loss.


	Three months ended						Nine months ended
	September 30,						September 30,
	2006			2005			2006			2005
Net loss	$	(9,834,085	)	$	(14,968,159	)	$	(38,104,987	)	$	(25,874,444	)
Unrealized gain (loss) on available-for-sale investments		81,449			—			(3,620	)		—

Comprehensive loss	$	(9,752,636	)	$	(14,968,159	)	$	(38,108,607	)	$	(25,874,444	)

Segment Information

Management has determined that the Company operates in one reportable segment which is the development and commercialization of pharmaceutical products.

Somaxon Pharmaceuticals, Inc.
(A development stage company)

Notes to Financial Statements
(unaudited)

Net Loss per Share

Net loss applicable to common stockholders per share is calculated in accordance with SFAS No. 128,Earnings Per Share,and SAB No. 98. Basic earnings per share (“EPS”) is calculated by dividing net income or loss applicable to common stockholders by the weighted average number of common shares outstanding for the period, reduced by the weighted average number of unvested common shares subject to repurchase. Basic EPS excludes the effects of common stock equivalents. Diluted EPS is computed in the same manner as basic EPS, but includes the effects of common stock equivalents using the treasury-stock method to the extent they are dilutive. Common stock equivalents include convertible preferred stock, options, and warrants. The Company incurred a net loss in all periods presented, causing inclusion of any potentially dilutive securities to have an anti-dilutive affect, resulting in basic and dilutive loss per share applicable to common stockholders to be equivalent.

The following table summarizes the Company’s EPS calculations.


	Three months ended						Nine months ended
	September 30,						September 30,
	2006			2005			2006			2005
Numerator:
Net loss	$	(9,834,085	)	$	(14,968,159	)	$	(38,104,987	)	$	(25,874,444	)
Accretion of redeemable convertible preferred stock to redemption value		—			(39,731	)		—			(52,968	)

Net loss applicable to common stockholders	$	(9,834,085	)	$	(15,007,890	)	$	(38,104,987	)	$	(25,927,412	)


Denominator:
Weighted average common shares		18,048,360			714,418			18,024,941			693,568
Weighted average unvested common shares subject to repurchase	(41,667		)	(104,167		)	(57,292		)	(127,893		)
Denominator for basic and diluted net loss per share		18,006,693			610,251			17,967,649			565,675

Basic and diluted net loss per share	$	(0.55	)	$	(24.59	)	$	(2.12	)	$	(45.83	)


Weighted average anti-dilutive securities not included in net loss per share:
Weighted average convertible preferred shares outstanding		—			11,223,888			—			7,306,866
Weighted average stock options outstanding		2,389,273			1,094,621			2,290,472			621,266
Weighted average unvested common shares subject to repurchase		41,667			104,167			57,292			127,893

Total weighted average anti-dilutive securities not included in diluted net loss per share		2,430,940			12,422,676			2,347,764			8,056,025

At September 30, 2005, the Company had 2,300,000 and 23,000,000 shares of Series A and Series B convertible preferred stock issued and outstanding, respectively, and 48,148,455 shares of Series C redeemable convertible preferred stock issued and outstanding. During the Company’s initial public offering in December 2005, these shares were converted into 12,241,382 shares of common stock at a ratio of six shares of preferred stock into one share of common stock. No preferred shares were issued and outstanding at September 30, 2006.

The Company adopted SFAS No. 123(R) on January 1, 2006, which requires stock option expense to be recognized in the statement of operations. Prior to adoption of SFAS No. 123(R), stock based compensation was recognized in the statement of operations using the intrinsic value method prescribed under APB 25 as allowed

Somaxon Pharmaceuticals, Inc.
(A development stage company)

Notes to Financial Statements
(unaudited)

under SFAS No. 123. The pro-forma net loss disclosed pursuant to requirements under SFAS No. 123 approximated the net loss and net loss per share that would have resulted had the Company applied the provisions of SFAS No. 123(R) in prior periods.

The following table provides the pro-forma net loss and pro-forma net loss per share disclosed under SFAS No. 123 for periods prior to the adoption of SFAS No. 123(R) to provide a comparison with the amounts recognized in the statements of operations upon adopting SFAS No. 123(R).


	Three months ended						Nine months ended
	September 30,						September 30,
	2006			2005			2006			2005
Net loss applicable to common stockholders as reported	$	(9,834,085	)	$	(15,007,890	)	$	(38,104,987	)	$	(25,927,412	)
Add: Share-based employee compensation expense included in net loss		N/A			497,383			N/A			684,330
Less: Share-based employee compensation expense using the fair value method		N/A			(561,951	)		N/A			(835,293	)

Pro-forma net loss applicable to common stockholders	$	(9,834,085	)	$	(15,072,458	)	$	(38,104,987	)	$	(26,078,375	)

Basic and diluted net loss applicable to common stockholders per share as reported	$	(0.55	)	$	(24.59	)	$	(2.12	)	$	(45.83	)
Pro-forma basic and diluted net loss applicable to common stockholders per share	$	(0.55	)	$	(24.70	)	$	(2.12	)	$	(46.10	)

Note 2. Composition of Certain Balance Sheet Items

Short-term investments

Short-term investments consist of the following:


	September 30,			December 31,
	2006			2005
United States government agency notes	$	13,925,774		$	3,047,086
Corporate notes and commercial paper		6,628,426			—

Total investments at amortized cost		20,554,200			3,047,086
Unrealized loss		(3,620	)		—

Total investments at market	$	20,550,580		$	3,047,086

Somaxon Pharmaceuticals, Inc.
(A development stage company)

Notes to Financial Statements
(unaudited)

Other Current Assets

Other current assets consist of the following:


	September 30,		December 31,
	2006		2005
Deposits	$	637,176	$	768,275
Investment interest receivable		153,099		—
Prepaid clinical research fees		189,410		952,282
Prepaid insurance		206,135		72,387
Other current assets		136,311		130,522

Total other current assets	$	1,322,131	$	1,923,466

Property and Equipment

Property and equipment consists of the following:


	September 30,			December 31,
	2006			2005
Office furniture and equipment	$	213,311		$	169,001
Computer equipment		215,141			96,842

Property and equipment, at cost		428,452			265,843
Less: accumulated depreciation		(149,949	)		(75,798	)

Property and equipment, net	$	278,503		$	190,045

Depreciation expense was $31,051, and $14,433 for the three months ended September 30, 2006 and 2005, respectively and $74,151 and $32,248 for the nine months ended September 30, 2006 and 2005, respectively.

Accrued Liabilities

Accrued liabilities consist of the following:


	September 30,		December 31,
	2006		2005
Accrued license fees	$	135,000	$	138,750
Accrued compensation and benefits		749,238		610,863
Refundable proceeds from unvested exercised stock options		26,166		69,227
Other accrued liabilities		39,927		100,250

Total accrued liabilities	$	950,331	$	919,090

Somaxon Pharmaceuticals, Inc.
(A development stage company)

Notes to Financial Statements
(unaudited)

Note 3. Share-based compensation

Employee Stock Purchase Plan

On December 15, 2005, the Company implemented its employee stock purchase plan (the “ESPP”) which allows employees to contribute up to 20% of their cash earnings, subject to certain maximums, to be used to purchase shares of the Company’s common stock on each semi-annual purchase date. The purchase price is equal to 95% of the market value per share on each purchase date. The Company has initially reserved 300,000 shares of common stock for issuance under the ESPP. The number of shares reserved for issuance increases on the first day of each year beginning January 1, 2007 and ending January 1, 2015 equal to the lesser of: (i) 300,000 shares, (ii) 1% of the outstanding capital stock on each January 1, or (iii) an amount determined by the Company’s board of directors. As of September 30, 2006, no shares were issued under the ESPP.

Stock Options

The Company has stock options outstanding under two stock option plans for the benefit of its eligible employees, consultants, and directors. The Somaxon Pharmaceuticals, Inc. 2004 Equity Incentive Award Plan (the “2004 Plan”) allowed for a maximum issuance of up to 1,250,000 shares. As a result of the Company’s IPO in December 2005, no additional options will be granted under the 2004 Plan and all options that are repurchased, forfeited, cancelled or expire will become available for grant under the 2005 Equity Incentive Award Plan (the “2005 Plan”).

In November 2005, the stockholders approved the 2005 Plan. As of September 30, 2006, 2,000,000 shares of common stock were reserved for issuance under the 2005 Plan, plus an additional 25,073 shares from stock options which were available for issuance under the 2004 Plan. The 2005 Plan contains an “evergreen provision” that allows for an annual increase in the number of shares available for issuance on the first day of each fiscal year beginning January 1, 2007 and expiring January 1, 2015 equal to the lesser of: (i) 2,000,000 shares, (ii) 5% of the outstanding capital stock on each January 1, or (iii) an amount determined by the Company’s board of directors.

The Company’s stock options generally vest over a period of between one and four years and have a ten year term. Certain of the stock options were exercised in advance of becoming vested. Unvested shares obtained from the early exercise of stock options are subject to repurchase by the Company at the original exercise price in the event of termination or separation from the Company. The Company recognized a liability for the proceeds received from the exercise of unvested options of $26,166 and $69,227 at September 30, 2006 and December 31, 2005, respectively. No unvested shares have been repurchased by the Company as of September 30, 2006.

Somaxon Pharmaceuticals, Inc.
(A development stage company)

Notes to Financial Statements
(unaudited)

The following table summarizes the Company’s stock option activity for employee and director stock options.


						Weighted
				Weighted		Average Grant
				Average		Date Calculated
	Shares			Exercise Price		Value per Share
Outstanding at December 31, 2004		260,333		$	1.20

Stock options granted during 2005:
Quarter ended March 31, 2005		147,250		$	2.40	$	3.47
Quarter ended June 30, 2005		54,167			2.40		4.00
Quarter ended September 30, 2005		676,166			3.04		7.54
Quarter ended December 31, 2005		331,243			11.08		6.52

Total stock options granted during 2005		1,208,826		$	5.13	$	6.60


Stock options exercised during 2005:
Quarter ended March 31, 2005		—		$	—
Quarter ended June 30, 2005		(20,000	)		2.40
Quarter ended September 30, 2005		(37,500	)		2.82
Quarter ended December 31, 2005		(19,094	)		1.20

Total 2005 stock options exercised		(76,594	)	$	2.32

Stock options forfeited during 2005:
Quarter ended June 30, 2005		(26,736	)	$	1.20

Outstanding at December 31, 2005		1,365,829		$	4.62


Stock options granted during 2006:
Quarter ended March 31, 2006		764,590		$	11.13	$	7.83
Quarter ended June 30, 2006		274,300			16.79		12.34
Quarter ended September 30, 2006		1,450			10.82		8.08

Total stock options granted during 2006 to date		1,040,340		$	12.62	$	9.02


Stock options exercised during 2006:
Quarter ended September 30, 2006		(25,971	)	$	4.87

Stock options forfeited during 2006:
Quarter ended September 30, 2006		(28,195	)	$	11.00

Outstanding at September 30, 2006		2,352,003		$	8.08

The intrinsic value of stock options at the date of exercise is the difference between the fair value of the stock at the date of exercise and the exercise price. During the nine month period ended September 30, 2006, employees and directors exercised 25,971 stock options with an intrinsic value of $211,789 and they exercised 57,500 stock options with an estimated intrinsic value of $328,483 during the nine month period ended September 30, 2005. In determining the intrinsic value of stock options exercised prior to the initial public offering in December 2005, the Company estimated the fair value of its underlying common stock through a retrospective analysis of the stock price performed in conjunction with the initial public offering. The intrinsic value of employee and director stock options outstanding at September 30, 2006, based on a closing stock price of $12.31 per share, was $11.5 million.

At September 30, 2006, of the 2,352,003 employee and director options outstanding, 557,660 were vested and 1,794,343 were unvested. The weighted average remaining vesting term was 2.6 years and the total calculated value of outstanding stock options expected to be recognized in future periods over this weighted average remaining

Somaxon Pharmaceuticals, Inc.
(A development stage company)

Notes to Financial Statements
(unaudited)

vesting term is $11.2 million. The intrinsic value of exercisable stock options based on a stock price of $12.31 at September 30, 2006 was $4.4 million.

The calculated value of employee stock options was determined at the date of grant using the Black-Scholes option pricing model with the following assumptions:


	Nine months ended
	September 30,
	2006			2005
Risk free interest rate	4.31% to 5.10%			3.96% to 4.39%
Expected term	6.25 years			6 years
Expected volatility	76% to 85%			60% to 63%
Weighted average volatility		78	%		62	%
Expected dividend yield		0	%		0	%
Fair value of underlying stock	$10.35 to $19.74			$4.68 to $12.54

The following table summarizes the Company’s stock option activity for stock options granted to consultants.


				Weighted
				Average
	Shares			Exercise Price
Outstanding at December 31, 2004		15,833		$	1.20

Stock options granted during 2005:
Quarter ended March 31, 2005		7,500			1.60
Quarter ended December 31, 2005		20,003			13.62

Total 2005 stock options granted		27,503			10.34

Stock options exercised during 2005:
Quarter ended September 30, 2005		(4,167	)		1.20

Stock options forfeited during 2005:
Quarter ended March 31, 2005		(1,666	)		1.20

Outstanding at December 31, 2005		37,503		$	7.90


Stock options granted during 2006 to date:		—		$	—
Stock options exercised during 2006 to date:		—			—

Outstanding at September 30, 2006		37,503		$	7.90

At September 30, 2006, of the 37,503 consultant stock options outstanding, 26,201 were vested and 11,302 were unvested. In accordance with EITF Issue 96-18Accounting for Equity Investments that are Issued to Other than Employees for Acquiring or in Conjunction with Selling Goods or Services, the Company periodically re-measures the fair value of stock option grants to non-employees and recognizes the related income or expense during their vesting period. Expense recognized for stock options granted to consultants was $14,263 and $22,356, for the three months ended September 30, 2006 and 2005, respectively, and $118,811 and $39,809 for the nine months ended September 30, 2006 and 2005, respectively. Stock option expense for consultants is included within research and development expense. There were no grants, exercises, or forfeitures of stock options for consultants during the nine months ended September 30, 2006.

Somaxon Pharmaceuticals, Inc.
(A development stage company)

Notes to Financial Statements
(unaudited)

A summary of all stock options outstanding at December 31, 2005 is as follows:


	Options Outstanding					Vested Options
			Weighted	Weighted				Weighted	Weighted
			Average	Average				Average	Average
			Remaining	Exercise				Remaining	Exercise
Exercise Price	Number		Life	Price		Number		Life	Price
$1.20		229,502	8.5 Years	$	1.20		96,405	8.5 Years	$	1.20
$2.40		173,917	9.2 Years		2.40		42,917	9.2 Years		2.40
$3.00		644,246	9.6 Years		3.00		31,109	9.6 Years		3.00
$8.40		7,334	9.7 Years		8.40		—	9.7 Years		8.40
$11.00 to $13.62		348,333	10.0 Years		11.25		14,306	10.0 Years		12.02

Total stock options outstanding		1,403,332	9.4 Years	$	4.71		184,737	9.4 Years	$	2.62

A summary of all stock options outstanding at September 30, 2006 is as follows:


	Options Outstanding					Vested Options
			Weighted	Weighted				Weighted	Weighted
			Average	Average				Average	Average
			Remaining	Exercise				Remaining	Exercise
Exercise Price	Number		Life	Price		Number		Life	Price
$1.20		229,502	7.8 Years	$	1.20		139,624	7.8 Years	$	1.20
$2.40		163,917	8.5 Years		2.40		84,737	8.5 Years		2.40
$3.00		635,080	8.8 Years		3.00		218,123	8.8 Years		3.00
$8.40 to $10.99		709,524	9.3 Years		10.58		1,180	9.0 Years		8.40
$11.00 to $13.99		313,683	9.2 Years		11.28		91,733	9.2 Years		11.50
$14.00 to $15.99		172,000	9.7 Years		15.35		48,464	9.7 Years		15.32
$16.00 to $19.74		165,800	9.6 Years		18.34		—	9.6 Years		18.34

Total stock options outstanding		2,389,506	9.0 Years	$	8.08		583,861	8.6 Years	$	4.85

Shares Available for Future Grant

The following table summarizes the number of shares available for issuance under the Company’s equity compensation plans.


	Stock Options			ESPP
Shares available for issuance at December 31, 2004		84,668			—

Increase in authorized shares		2,833,333			300,000
Grants and issuances		(1,236,329	)		—
Forfeitures		28,402			—

Shares available for issuance at December 31, 2005		1,710,074			300,000


Grants and issuances		(1,040,340	)		—
Forfeitures		28,195			—

Shares available for issuance at September 30, 2006		697,929			300,000

Somaxon Pharmaceuticals, Inc.
(A development stage company)

Notes to Financial Statements
(unaudited)

Note 4. Commitments and Contingencies

Costs associated with the Company’s in-license agreements are expensed as the related research and development costs are incurred. Total future minimum obligations under the Company’s various in-license agreements are $10.4 million for milestone and license payments. The Company is also obligated to make additional milestone payments of up to $11.3 million upon achieving certain product development events, as well as revenue-based royalty payments. Minimum license payments are subject to increase based on timing of various milestones and the extent to which the in-licensed technologies are used in various treatments.

The Company’s exclusive worldwide in-license agreement with ProCom One to develop and commercialize SILENOR™ (doxepin hydrochloride) includes a $500,000 payment upon the earlier of: (i) acceptance of our New Drug Application (NDA) by the Food and Drug Administration (FDA), or (ii) December 31, 2006. The in-license agreement is cancelable by Somaxon at any time if the Company believes the use of the product poses an unacceptable safety risk or if it fails to achieve a satisfactory level of efficacy. Consequently, the Company has not accrued this milestone payment as of September 30, 2006. In addition, the Company also has entered into contracts with a clinical research organization (“CRO”) and other vendors to assist in clinical trial work. These contracts are cancelable at any time, but obligate the Company to reimburse the provider for any time or costs incurred through the date of termination.

In February 2006, the Company entered into a manufacturing supply agreement with Patheon Pharmaceuticals, Inc. to manufacture commercial quantities of SILENOR™ tablets. Under the terms of the contract, Somaxon is not obligated to purchase a minimum quantity; however, the Company is obligated to purchase specified percentages of the total annual commercial requirements of SILENOR™. The agreement has a five year term and renews for twelve-month periods thereafter. It is cancelable with written notice at least eighteen months prior to the end of the current term. Additionally, Somaxon may terminate the agreement with twelve months notice in connection with a partnering, collaboration, sublicensing, acquisition, or similar event provided that the termination does not occur within three years of the commencement of manufacturing services. The agreement is also subject to termination in the event of material breach of contract, bankruptcy, or government action inhibiting the use of the product candidate.

In June 2006, the Company entered into a sublease agreement to rent approximately 26,000 square feet of office space for its corporate headquarters. The sublease expires in February 2013 and the Company is obligated to make base monthly lease payments of $79,661 for the first year, increasing each year to a maximum of $95,119 per month in the last year of the sublease, plus additional rent for common area and pass-through expenses. The Company recognizes rent expense on a straight-line basis with a related asset or liability recorded for cumulative differences between rent payments and rent expense. As part of the sublease agreement, the Company paid a security deposit in the form of a letter of credit in the amount of $600,000 which decreases to $450,000 in July 2009 and decreases by varying amounts each year thereafter until it reaches a minimum of $250,000. Although the Company has no current intentions to do so, it has the option to terminate the sublease after three years for a fee of $350,000 plus any costs to restore the building to its original condition. The sublease also terminates if the Company becomes insolvent, fails to remedy any breach in the sublease terms, or the master lease terminates. In the event that the Company’s sublease terminates because the lessor causes or fails to reasonably prevent a termination of the master lease, the lessor is obligated to pay Somaxon $750,000 if the termination occurs in the first year, $500,000 if the termination occurs in the second year, and $350,000 thereafter.

The Company continues to be obligated to make lease payments of $9,700 per month under its lease for its previous facility through expiration in January 2007. The Company has an outstanding deposit of $8,165 relating to this facility which is expected to be returned to the Company upon expiration of the lease. The Company is also obligated under various operating leases for office equipment. Rent expense was $301,662 and $52,595 for the three months ended September 30, 2006 and 2005, respectively, and $420,154 and $111,098 for the nine months ended September 30, 2006 and 2005, respectively.

Somaxon Pharmaceuticals, Inc.
(A development stage company)

Notes to Financial Statements
(unaudited)

At September 30, 2006, the future minimum lease payments for the years then ended are as follows:


2006 (remaining three months)	$	269,087
2007		987,589
2008		1,005,701
2009		1,029,357
2010		1,060,237
Thereafter		2,407,088

Total	$	6,759,059

Note 5. Related Party Transactions

The Company in-licenses certain technologies from ProCom One (“ProCom”) which, as part of the in-license agreement, grants to ProCom the right to designate one member of the Company’s Board of Directors. The in-license agreement also provides a consulting arrangement for two ProCom affiliates under which the Company paid $63,750 and $49,999 for the three months ended September 30, 2006 and 2005, respectively, and $191,250 and $149,999 for the nine months ended September 30, 2006 and 2005, respectively.

The Company’s outside legal counsel holds 13,896 shares of common stock as a result of purchases of preferred stock which were converted into common shares during the Company’s initial public offering in December 2005. The Company paid $72,207 and $57,864 during the three months ended September 30, 2006 and 2005, respectively, and $565,664 and $244,283 for the nine months ended September 30, 2006 and 2005, respectively, for legal services rendered by the Company’s outside legal counsel.

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

The interim financial statements and this Management’s Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with the financial statements and notes thereto for the year ended December 31, 2005, and the related Management’s Discussion and Analysis of Financial Condition and Results of Operations, both of which are contained in our Annual Report onForm 10-K for the year ended December 31, 2005. In addition to historical information, this discussion and analysis contains forward-looking statements that involve risks, uncertainties, and assumptions. Our actual results may differ materially from those anticipated in these forward-looking statements as a result of certain factors, including but not limited to those set forth under the caption “Risk Factors” in theForm 10-K for the year ended December 31, 2005 and the caption “Risk Factors” in thisForm 10-Q for the quarter ended September 30, 2006.

Overview

Background

We are a specialty pharmaceutical company focused on the in-licensing and development of proprietary product candidates for the treatment of diseases and disorders in the fields of psychiatry and neurology. To date, we have in-licensed three product candidates. Our lead product candidate, SILENOR™ (doxepin hydrochloride), is in Phase 3 clinical trials for the treatment of insomnia. Our product candidate nalmefene hydrochloride is in a Phase 2/3 clinical trial for the treatment of pathological gambling and has completed a pilot Phase 2 clinical trial for smoking cessation. We are also developing a new formulation of acamprosate calcium for the treatment of certain movement disorders. We intend to continue to build a portfolio of product candidates that are approved in the United States but with significant commercial potential for proprietary new uses, new dosages or alternative delivery systems, products that are currently commercialized outside the United States but not available in the United States, or product candidates that are in late stages of clinical development.

We were incorporated in August 2003 and are a development stage company. During 2003, we focused on hiring our executive team and initial operating employees and on in-licensing our first product, SILENOR™. During 2004, we initiated two Phase 2 clinical trials for SILENOR™ and entered into in-license agreements for nalmefene and acamprosate. During 2005, we initiated Phase 3 clinical trials for SILENOR™, commenced a Phase 2/3 clinical trial on nalmefene for the treatment of pathological gambling, initiated a pilot Phase 2 clinical trial for nalmefene for smoking cessation, and began working on a new formulation for acamprosate.

In April 2006, we announced the results of our first Phase 3 clinical trial for SILENOR™. In October 2006, we announced the results of our second Phase 3 clinical trial for SILENOR™. These trials demonstrated statistically significant improvements compared to placebo in multiple measures of sleep onset and sleep maintenance. Incidences of adverse events were comparable to placebo in both trials. We have completed enrollment in our remaining two Phase 3 clinical trials for SILENOR™ in elderly patients with insomnia, which include a four week outpatient clinical trial and a three month polysomnography, or PSG, trial. We expect results from the four week trial in November of this year, and from the three month trial in December of this year.

Based on a request we received in July 2006 from the U.S. Food and Drug Administration, or FDA, we initiated a preclinical program for SILENOR™ consisting of standard genotoxicity, reproductive toxicology and carcinogenicity studies. The FDA has indicated that the data from the genotoxicity studies and reproductive toxicology studies should be included in the New Drug Application, or NDA, for SILENOR™. In September 2006, we completed the genotoxicity studies and no signal indicative of genotoxicity was found in any of the assays. We have submitted the genotoxicity data to the FDA and, based on our assessment of the data, requested that the agency permit us to submit the data from the requested carcinogenicity studies of SILENOR™ as a post-NDA approval commitment. The FDA previously indicated to us that depending on the outcome of the genotoxicity studies, it may be flexible as to the timing of the conduct of the carcinogenicity studies, including the potential that the data from those studies may be submitted post-approval. We expect the reproductive toxicology studies to be completed in the middle of 2007 and we have initiated preliminary preparatory work on our carcinogenicity program. If the FDA agrees with our assessment of the genotoxicity results, we anticipate that an NDA submission for SILENOR™ could occur in the third quarter of 2007, provided that our ongoing and planned clinical and preclinical studies are successful and proceed as currently scheduled.

In July 2006, we announced the results from our pilot Phase 2 clinical trial evaluating the use of nalmefene for smoking cessation. In this trial, nalmefene demonstrated numerically higher smoking abstinence rates relative to placebo.

Incidences of adverse events were comparable to those observed in trials previously conducted with nalmefene. The most commonly observed side effects were nausea and insomnia, both of which tended to be transient in nature and largely resolved after the first week on drug. Elevation in liver enzymes was observed with a similar frequency in all groups. Enrollment in our Phase 2/3 clinical trial evaluating nalmefene for the treatment of pathological gambling has been completed, and we expect results from this trial in December of this year.

We have incurred significant net losses since our inception. As of September 30, 2006, we had an accumulated deficit of approximately $91.7 million. We expect our accumulated deficit to continue to increase for the next several years as we pursue the clinical development and market launch of our product candidates and acquire or in-license products, technologies or businesses that are complementary to our own.

In December 2005, we completed our initial public offering which resulted in the issuance of 5,000,000 shares of common stock at a price of $11.00 per share for gross proceeds of $55.0 million. Issuance costs were $5.2 million, resulting in net proceeds from the offering of $49.8 million. In conjunction with the completion of our initial public offering, all outstanding shares of convertible preferred stock were converted into 12,241,382 shares of common stock.

This filing includes trademarks of other persons, including Ambien^®, Ambien CR^tm, Chantix™, Lunesta^tm, Luvox^®, Paxil^®, Rozerem^tm, Sonata^®, and Zyban^®.

Revenues

We have not generated any revenues to date, and we do not expect to generate any revenues from licensing, achievement of milestones or product sales until we enter into a strategic collaboration or are able to commercialize SILENOR™ ourselves.

License Fees

Our license fees consist of the costs incurred to in-license our product candidates. We charge all license fees and milestone payments for acquired development and commercialization rights to operations as incurred since the underlying technology associated with these expenditures relates to our research and development efforts and has no alternative future use.

Research and Development Expenses

Our research and development expenses consist primarily of salaries and related employee benefits, share-based compensation expense, costs associated with preclinical testing and clinical trials managed by our clinical research organizations, or CROs, and costs associated with non-clinical activities, such as regulatory expenses. Our most significant costs are for clinical trials. These expenses include payments to vendors such as CROs, investigators, clinical suppliers and related consultants. Our historical research and development expenses relate predominately to the clinical trials for SILENOR™.

We charge all research and development expenses to operations as incurred. We expect our research and development expenses to remain a significant component of our operating expenses in the future as we continue to develop our product candidates and if we are able to in-license additional product candidates.

We use our internal research and development resources across several projects and many resources are not attributable to specific projects. Accordingly, we do not account for our internal research and development costs on a project basis. We use external service providers to conduct our preclinical testing and clinical trials and to manufacture our product candidates to be used in these studies. These external costs are tracked on a project basis and are expensed as incurred.

At this time, due to the risks inherent in the preclinical and clinical development process, and given the nature of our product development programs, we are unable to estimate with any certainty the costs we will incur in the continued development of our product candidates for potential commercialization. Preclinical and clinical development timelines, the probability of success and development costs vary widely. We are currently focused on advancing each of our product development programs and will make determinations as to the scientific and clinical success of each product candidate, as well as assess each product candidate’s commercial potential. In addition, we cannot forecast with any degree of certainty which product candidates will be subject to future collaborations, when such arrangements will be secured, if at all, and to

what degree such arrangements would affect our development plans and capital requirements. As a result, we cannot be certain when and to what extent we will receive cash inflows from the commercialization of our product candidates or collaboration agreements, if at all.

We expect our on-going development expenses to be substantial as we continue the advancement of our product development programs. We received the results from our first Phase 3 clinical trial for SILENOR™ in April 2006 and the results from our second Phase 3 clinical trial for SILENOR™ in October 2006. Results from two additional SILENOR™ Phase 3 clinical trials are expected to be reported later this year. We have initiated a preclinical program for SILENOR™ consisting of standard genotoxicity, reproductive toxicology and carcinogenicity studies and we received the results from our genotoxicity studies in September 2006. In July 2006, we received the results from our pilot Phase 2 clinical trial evaluating the use of nalmefene for smoking cessation and we expect to have the results from our Phase 2/3 clinical trial evaluating nalmefene for the treatment of pathological gambling later this year. We are also working on a new formulation for acamprosate. The lengthy process of completing preclinical testing and clinical trials and seeking regulatory approval for our product candidates requires the expenditure of substantial resources. Any failure by us or delay in completing preclinical testing or clinical trials, or in obtaining regulatory approvals, would cause our research and development expense to increase and, in turn, have a material adverse effect on our results of operations.

Marketing, General and Administrative

Our marketing, general and administrative expenses consist primarily of salaries, benefits, share-based compensation expense, advertising, market research costs, insurance and facility costs, and professional fees related to our administrative, finance, human resources, legal and internal systems support functions. We anticipate increases in marketing, general and administrative expenses as we add personnel, comply with obligations applicable to publicly-held companies, and continue to develop and prepare for the commercialization of our product candidates.

Interest and Other Income

Interest and other income consist primarily of interest earned on our cash, cash equivalents, and short-term investments.

Critical Accounting Policies and Estimates

Management’s discussion and analysis of our financial condition and results of operations is based on our financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates and assumptions that affect the reported amounts of assets, liabilities, expenses and related disclosures. Actual results could differ from those estimates. We believe the following accounting policies to be critical to the judgments and estimates used in the preparation of our financial statements.

Clinical Trial Expenses

Expenditures relating to clinical trials are expensed as incurred and included within research and development expenses. Our clinical trial expenses are based on estimates of the services received and efforts expended to date pursuant to contracts with research institutions and CROs that conduct and manage clinical trials on our behalf. Measurement of clinical trial expenses requires subjective judgments as we may not have been invoiced or otherwise notified of actual costs, making it necessary to estimate the efforts completed to date and related expense. The period over which services are performed, the level of services performed as of a given date, and the cost of such services are often subjective determinations.

Our principal vendors operate within terms of contracts which establish program costs and estimated timelines. We assess the status of our programs through regular discussions between our program management team and the related vendors. Based on these assessments, we determine the status of our programs in relation to the scope of work outlined in the contracts, and recognize the related amount of expense accordingly. A significant portion of the estimated clinical trial cost normally relates to the cost to treat a patient during the trial. We recognize this cost over the estimated term of the trial beginning with patient enrollment. We adjust our estimates as actual costs become known to us. Changes in estimates could materially affect our results of operations.

License Fees

Costs related to patents and acquisition of intellectual property are expensed as incurred since the underlying technology associated with these expenditures is in connection with our development efforts and has no alternative future use. Certain of our in-license agreements contain provisions which obligate us to make milestone payments or provide other consideration if specified events occur. Determining whether these events will occur, and the timing of such events, requires judgment on the part of management. The subjective nature of these estimates can make it difficult to determine the extent to which a milestone obligation may be earned, and the period to which the related expense will apply.

Share-based Compensation

On January 1, 2006, we adopted Statement of Financial Accounting Standards, or SFAS, No. 123(R),Share-Based Payment,which requires the measurement and recognition of compensation expense in the statement of operations for all share-based payment awards made to employees and directors, including stock options, based on estimated fair values. Prior to adopting SFAS No. 123(R), we accounted for share-based awards to employees and directors using the intrinsic value method in accordance with Accounting Principals Board Opinion No. 25Accounting for Stock Issued to Employees,or APB 25, and provided pro-forma disclosure of net income (loss) as if a fair value method had been applied in measuring compensation expense in accordance with SFAS No. 123,Accounting for Stock-Based Compensation. Under the intrinsic value method, deferred stock compensation was recognized to the extent that the price of the underlying common stock at the date of grant, as determined in our retrospective fair value analysis performed in conjunction with our initial public offering, exceeded the exercise price of the stock options.

Measurement and recognition of share-based compensation involves significant estimates and the use of an option valuation model, such as the Black-Scholes model which we use. Determining the fair value of share-based payment awards on the date of grant is affected by many complex and subjective assumptions, including estimates of our future volatility, employee exercise behavior, and the number of options expected to ultimately vest. Our expected future volatility is based on the volatility of comparable companies since the volatility of our own stock price has minimal observable history as a result of our recent initial public offering in December 2005. We applied the guidance in the Securities and Exchange Commission’s Staff Accounting Bulletin No. 107 in estimating the expected service period for our options. Share-based compensation recorded in our statement of operations is based on awards expected to ultimately vest and has been reduced for estimated forfeitures. The value of options which ultimately vest is recorded as amounts become known in future periods.

Net Operating Losses and Tax Credit Carryforwards

We have incurred significant net operating losses to date which have resulted in net operating loss carryforwards which begin to expire 20 years after being generated for federal purposes and 10 years after being generated for California tax purposes. We also have research and development credits which begin to expire 20 years after being generated for federal purposes, and do not expire for California tax purposes. We have fully reserved our net operating loss carryforwards and research and development credits until such time that it is more likely than not that they will be realized.

Pursuant to Sections 382 and 383 of the Internal Revenue Code, annual use of our net operating loss carryforwards and tax credits may be limited in the event a cumulative change in ownership of more than 50% occurs within a three-year period. We determined that such an ownership change occurred as of June 30, 2005 as a result of various stock issuances used to finance our development activities. This ownership change resulted in limitations on the utilization of tax attributes, including net operating loss carryforwards and tax credits. We estimate that $0.3 million of our California net operating loss carryforwards were effectively eliminated and $18.3 million of our federal and $17.3 million of our state net operating loss carryforwards were subject to limitation. An additional $0.9 million of our federal research and development credits were also subject to limitation. A portion of the limited net operating loss carryforwards becomes available for use each year. We estimate that approximately $2.8 million of the restricted net operating loss carryforwards become available each year between 2006 and 2010, decreasing to approximately $1.0 million thereafter. Net operating loss carryforwards and research and development credits generated subsequent to the ownership change are currently not subject to limitations, but could be subject to limitations in the future if additional ownership changes occur.

Results of Operations

Comparisons of the Three Months Ended September 30, 2006, 2005 and 2004

License fees. License fees were $0.2 million, $0.1 million and $0.4 million for the three month periods ended September 30, 2006, 2005, and 2004, respectively. The following table summarizes the key components of our license fees.


	Three Months Ended September 30,						Dollar Change					Percent Change
							2006 vs.		2005 vs.			2006 vs.			2005 vs.
	2006		2005		2004		2005		2004			2005			2004
	(dollar amounts in thousands)
SILENOR™	$	—	$	—	$	—	$	—	$	—			0	%		0	%
Nalmefene		54		24		200		30		(176	)		125	%		-88	%
Acamprosate		150		75		163		75		(88	)		100	%		-54	%

Total license fees	$	204	$	99	$	363	$	105	$	(264	)		106	%		-73	%

License fees increased $0.1 million for the three month period ended September 30, 2006 compared to the three month period ended September 30, 2005 primarily due to payments to our licensors for nalmefene and acamprosate.

License fees decreased $0.3 million for the three month period ended September 30, 2005 compared to the three month period ended September 30, 2004 primarily due to in-licensing our nalmefene and acamprosate product candidates during 2004.

Research and Development Expenses. Research and development expenses were $7.9 million, $10.9 million and $3.3 million for the three month periods ended September 30, 2006, 2005, and 2004, respectively. The following table summarizes the key components of our research and development expenses.


	Three Months Ended September 30,						Dollar Change					Percent Change
							2006 vs.			2005 vs.		2006 vs.			2005 vs.
	2006		2005		2004		2005			2004		2005			2004
	(dollar amounts in thousands)
SILENOR™ clinical trials	$	4,426	$	8,616	$	3,111	$	(4,190	)	$	5,505		-49	%		177	%
Nalmefene clinical trials		1,441		1,561		—		(120	)		1,561		-8	%		N/A
Acamprosate drug development		274		40		4		234			36		585	%		900	%
Personnel and other costs		1,521		636		201		885			435		139	%		216	%
Employee and consultant stock options		244		84		3		160			81		190	%		2,700	%

Total research and development expense	$	7,906	$	10,937	$	3,319	$	(3,031	)	$	7,618		-28	%		230	%

Research and development expenses decreased $3.0 million for the three month period ended September 30, 2006 compared to the three month period ended September 30, 2005 primarily due to a $4.2 million decrease in expenses associated with SILENOR™ clinical trials as a result of enrollment in our SILENOR™ Phase 3 clinical trials being complete as of the end of the third quarter of 2006. Our Phase 3 SILENOR™ clinical trial program was actively enrolling during the third quarter of 2005. This $4.2 million decrease in expenses associated with SILENOR™ clinical trials was offset by a $0.9 million increase in personnel and other costs mainly due to an increase in headcount in order to conduct and manage the growth in clinical trial activities. Employee and consultant stock option expense increased $0.2 million

primarily due to the adoption of SFAS No. 123(R) on January 1, 2006 and the resulting recognition of share-based compensation expense associated with our employee stock options.

Research and development expenses increased $7.6 million for the three month period ended September 30, 2005 compared to the three month period ended September 30, 2004 primarily due to a $5.5 million increase in SILENOR™ clinical trial expense due to conducting more costly Phase 3 SILENOR™ clinical trials during the third quarter of 2005 compared to Phase 2 SILENOR™ clinical trials during the third quarter of 2004. Additionally, expenses associated with nalmefene clinical trials increased $1.6 million primarily due to the pathological gambling clinical trial and the smoking cessation pilot trial which were underway during the third quarter of 2005, while nalmefene had not yet been in-licensed as of the third quarter of 2004. Personnel and other costs increased $0.4 million mainly as a result of increased headcount in order to conduct and manage the significant growth in clinical trial activities as well as the adoption of our corporate bonus plan in 2005.

Marketing, General and Administrative Expenses.Marketing, general and administrative expenses were $2.7 million, $1.4 million and $0.5 million for the three month periods ended September 30, 2006, 2005, and 2004, respectively. The following table summarizes the key components of our marketing, general and administrative expenses.


	Three Months Ended September 30,						Dollar Change				Percent Change
							2006 vs.		2005 vs.		2006 vs.			2005 vs.
	2006		2005		2004		2005		2004		2005			2004
	(dollar amounts in thousands)
Marketing, personnel and general costs		1,656		933		506		723		427		77	%		84	%
Share-based compensation		1,033		435		4		598		431		137	%		10,775	%

Total marketing, general and administrative expenses	$	2,689	$	1,368	$	510	$	1,321	$	858		97	%		168	%

Marketing, general and administrative expenses increased $1.3 million for the three month period ended September 30, 2006 compared to the three month period ended September 30, 2005 primarily due to a $0.7 million increase in marketing, personnel and general costs which was the result of higher costs associated with complying with the regulations applicable to a public company, an increase in marketing, general and administrative headcount as our operations continued to grow, and an increase in market research and branding efforts associated with SILENOR™. Share-based compensation increased $0.6 million primarily due to the adoption of SFAS No. 123(R) on January 1, 2006, resulting in the recognition of share-based compensation expense associated with our stock options.

Marketing, general and administrative expenses increased $0.9 million for the three month period ended September 30, 2005 compared to the three month period ended September 30, 2004 primarily due to a $0.4 million increase in marketing, personnel and general costs which was the result of an increase in marketing, general and administrative headcount as our operations continued to grow, an increase in market research and branding efforts associated with SILENOR™, and the adoption of our corporate bonus plan in 2005. Share-based compensation increased $0.4 million due to an increase in stock options issued during 2005.

Remeasurement of Series C Warrant Liability.Remeasurement of Series C warrant liability was zero, $3.1 million and zero for the three month periods ended September 30, 2006, 2005, and 2004, respectively. The following table summarizes the expense related to the remeasurement of our Series C warrant liability.


	Three Months Ended September 30,						Dollar Change					Percent Change
							2006 vs.			2005 vs.		2006 vs.			2005 vs.
	2006		2005		2004		2005			2004		2005			2004
	(dollar amounts in thousands)
Remeasurement of Series C warrant liability	$	—	$	3,084	$	—	$	(3,084	)	$	3,084		-100	%		N/A

Remeasurement of Series C warrant liability of $3.1 million incurred during the third quarter of 2005 was due to a financial instrument that was issued in conjunction with our Series C financing during June 2005 which provided for the sale of additional shares of Series C redeemable preferred stock at either the election of the company or the Series C investors. The fair value of this instrument was determined at the time of grant and recorded as a liability with subsequent changes in its fair value recorded through the statement of operations. In September 2005, the financial instrument was exercised, resulting in the issuance of additional shares of Series C redeemable preferred stock. Immediately prior to the exercise, the financial instrument was remeasured to fair value resulting in the $3.1 million expense recognized during the third quarter of 2005, with no further expense recognized thereafter.

Interest and Other Income.Interest and other income was $1.0 million, $0.5 million and $0.1 million for the three month periods ended September 30, 2006, 2005, and 2004, respectively. The following table summarizes our interest and other income.


	Three Months Ended September 30,						Dollar Change				Percent Change
							2006 vs.		2005 vs.		2006 vs.			2005 vs.
	2006		2005		2004		2005		2004		2005			2004
	(dollar amounts in thousands)
Interest and other income	$	965	$	520	$	69	$	445	$	451		86	%		654	%

Interest and other income increased $0.4 million for the three month period ended September 30, 2006 compared to the three month period ended September 30, 2005 primarily due to higher average cash and investment balances during the third quarter of 2006 compared to the third quarter of 2005 as a result of our initial public offering in December 2005. Interest rates earned on our cash and investments were also higher during the third quarter of 2006 compared to the third quarter of 2005.

Interest and other income increased $0.5 million for the three month period ended September 30, 2005 compared to the three month period ended September 30, 2004 as a result of our Series C redeemable preferred stock issuance during June 2005 and September 2005 which resulted in higher cash and investment balances during the third quarter of 2005 compared to the third quarter of 2004. Interest rates earned on our cash and investments were also higher during the third quarter of 2005 compared to the third quarter of 2004.

Comparisons of the Nine Months Ended September 30, 2006, 2005 and 2004

License fees. License fees were $0.5 million, $0.3 million and $0.5 million for the nine month periods ended September 30, 2006, 2005, and 2004, respectively. The following table summarizes the key components of our license fees.


	Nine Months Ended September 30,						Dollar Change						Percent Change
							2006 vs.			2005 vs.			2006 vs.			2005 vs.
	2006		2005		2004		2005			2004			2005			2004
	(dollar amounts in thousands)
SILENOR™	$	—	$	—	$	101	$	—		$	(101	)		0	%		-100	%
Nalmefene		61		65		200		(4	)		(135	)		-6	%		-68	%
Acamprosate		450		276		162		174			114			63	%		70	%

Total license fees	$	511	$	341	$	463	$	170		$	(122	)		50	%		-26	%

License fees increased $0.2 million for the nine month period ended September 30, 2006 compared to the nine month period ended September 30, 2005 primarily due to increased license payments to our licensor relating to our acamprosate product candidate.

License fees decreased $0.1 million for the nine month period ended September 30, 2005 compared to the nine month period ended September 30, 2004 primarily due to in-licensing our nalmefene and acamprosate product candidates during 2004.

Research and Development Expenses. Research and development expenses were $32.5 million, $17.6 million and $4.5 million for the nine month periods ended September 30, 2006, 2005, and 2004, respectively. The following table summarizes the key components of our research and development expenses.


	Nine Months Ended September 30,						Dollar Change				Percent Change
							2006 vs.		2005 vs.		2006 vs.			2005 vs.
	2006		2005		2004		2005		2004		2005			2004
	(dollar amounts in thousands)
SILENOR™ clinical trials	$	22,540	$	13,138	$	3,928	$	9,402	$	9,210		72	%		234	%
Nalmefene clinical trials		4,821		2,609		—		2,212		2,609		85	%		N/A
Acamprosate drug development		617		141		4		476		137		338	%		3,425	%
Personnel and other costs		3,834		1,561		527		2,273		1,034		146	%		196	%
Employee and consultant stock options		735		128		4		607		124		474	%		3,100	%

Total research and development expense	$	32,547	$	17,577	$	4,463	$	14,970	$	13,114		85	%		294	%

Research and development expenses increased $15.0 million during the nine month period ended September 30, 2006 compared to the nine month period ended September 30, 2005 primarily due to a $9.4 million increase in expenses associated with SILENOR™ clinical trials as a result of four Phase 3 clinical trials being underway during the nine month period ended September 30, 2006 compared to two Phase 3 clinical trials being underway during the nine month period ended September 30, 2005. Also, expenses associated with nalmefene clinical trials increased $2.2 million primarily due to the pathological gambling clinical trial having significantly greater efforts underway during 2006. Expenses associated with acamprosate clinical trials increased $0.5 million as increased drug formulation efforts were underway during 2006. Additionally, personnel and other costs increased $2.3 million mainly due to an increase in headcount in order to conduct

and manage the growth in clinical trial activities. Finally, employee and consultant stock option expense increased $0.6 million primarily due to the adoption of SFAS No. 123(R) on January 1, 2006 and the resulting recognition of share-based compensation expense associated with our employee stock options.

Research and development expenses increased $13.1 million during the nine month period ended September 30, 2005 compared to the nine month period ended September 30, 2004 primarily due to a $9.2 million increase in SILENOR™ clinical trial expense as the result of the commencement of the Phase 3 SILENOR™ clinical trial program during 2005, while we were conducting less expensive Phase 2 clinical trials during 2004. Nalmefene clinical trial expenses increased $2.6 million because we had not yet in-licensed rights to nalmefene as of September 30, 2004 while the pathological gambling clinical trial and the smoking cessation pilot trial were underway during 2005. Personnel and other costs increased $1.0 million mainly due to an increase in headcount in order to conduct and manage the growth in clinical trial activities, as well as the adoption of our corporate bonus plan in 2005.

Marketing, General and Administrative Expenses.Marketing, general and administrative expenses were $8.2 million, $3.1 million and $1.6 million for the nine month periods ended September 30, 2006, 2005, and 2004, respectively. The following table summarizes the key components of our marketing, general and administrative expenses.


	Nine Months Ended September 30,						Dollar Change				Percent Change
							2006 vs.		2005 vs.		2006 vs.			2005 vs.
	2006		2005		2004		2005		2004		2005			2004
	(dollar amounts in thousands)
Marketing, personnel and general costs		5,620		2,464		1,557		3,156		907		128	%		58	%
Share-based compensation		2,550		596		6		1,954		590		328	%		9,833	%

Total marketing, general and administrative expenses	$	8,170	$	3,060	$	1,563	$	5,110	$	1,497		167	%		96	%

Marketing, general and administrative expenses increased $5.1 million for the nine month period ended September 30, 2006 compared to the nine month period ended September 30, 2005 primarily due to a $3.2 million increase in marketing, personnel and general costs which was the result of higher costs associated with complying with the regulations applicable to a public company, an increase in marketing, general and administrative headcount as our operations continued to grow, and an increase in market research and branding efforts associated with SILENOR™. Share-based compensation increased $2.0 million primarily due to the adoption of SFAS No. 123(R) on January 1, 2006, resulting in the recognition of share-based compensation expense associated with our stock options.

Marketing, general and administrative expenses increased $1.5 million for the nine month period ended September 30, 2005 compared to the nine month period ended September 30, 2004 primarily due to a $0.9 million increase in marketing, personnel and general costs which was the result of an increase in marketing, general and administrative headcount as our operations continued to grow, an increase in market research and branding efforts associated with SILENOR™, and the adoption of our corporate bonus plan in 2005. Share-based compensation increased $0.6 million due to stock options issued during 2005.

Remeasurement of Series C Warrant Liability.Remeasurement of Series C warrant liability was zero, $5.6 million and zero for the nine month periods ended September 30, 2006, 2005, and 2004, respectively. The following table summarizes the expense related to the remeasurement of our Series C warrant liability.


	Nine Months Ended September 30,						Dollar Change					Percent Change
							2006 vs.			2005 vs.		2006 vs.			2005 vs.
	2006		2005		2004		2005			2004		2005			2004
	(dollar amounts in thousands)
Remeasurement of Series C warrant liability	$	—	$	5,649	$	—	$	(5,649	)	$	5,649		-100	%		N/A

Remeasurement of Series C warrant liability of $5.6 million incurred during the nine month period ended September 30, 2005 was due to a financial instrument that was issued in conjunction with our Series C financing during June 2005 which provided for the sale of additional shares of Series C redeemable preferred stock at either the election of the company or the Series C investors. The fair value of this instrument was determined at the time of grant and recorded as a liability with subsequent changes in its fair value recorded through the statement of operations. In September 2005, the financial instrument was exercised, resulting in the issuance of additional shares of Series C redeemable preferred stock. Immediately prior to the exercise, the financial instrument was remeasured to fair value resulting in additional expense during the third quarter of 2005 with no further expense recognized thereafter.

Interest and Other Income.Interest and other income was $3.1 million, $0.8 million and $0.1 million for the nine month periods ended September 30, 2006, 2005, and 2004, respectively. The following table summarizes our interest and other income.


	Nine Months Ended September 30,							Dollar Change				Percent Change
					��			2006 vs.		2005 vs.		2006 vs.			2005 vs.
	2006		2005			2004		2005		2004		2005			2004
	(dollar amounts in thousands)
Interest and other income	$	3,123	$	752		$	92	$	2,371	$	660		315	%		717	%

Interest and other income increased $2.4 million for the nine month period ended September 30, 2006 compared to the nine month period ended September 30, 2005 primarily due to higher average cash and investment balances during the nine month period ended September 30, 2006 as a result of the completion of our initial public offering in December 2005 as well as higher interest rates earned on our cash and investments during the nine month period ended September 30, 2006.

Interest and other income increased $0.7 million for the nine month period ended September 30, 2005 compared to the nine month period ended September 30, 2004 as a result of a $65.0 million preferred stock offering completed during the nine month period ended September 30, 2005, resulting in higher cash and investment balances than during the nine month period ended September 30, 2004. Interest rates earned on our cash and investments were also higher during the nine month period ended September 30, 2005 compared to the nine month period ended September 30, 2004.

Liquidity and Capital Resources

Since inception, our operations have been financed through the private placement of equity securities and our initial public offering. Through September 30, 2006, we have received net proceeds of approximately $139.8 million from the sale of shares of our preferred and common stock as follows:

	•		from August 2003 to January 2004, we issued and sold 2,300,000 shares of Series A preferred stock for aggregate net proceeds of $2.3 million;

	•		from April 2004 to June 2004, we issued and sold 23,000,000 shares of Series B preferred stock for aggregate net proceeds of $22.9 million;

	•		in June 2005, we issued and sold 40,741,048 shares of Series C redeemable preferred stock for aggregate net proceeds of $54.8 million;

	•		in September 2005, the Series C warrant was exercised and we issued and sold 7,407,407 shares of Series C redeemable preferred stock for aggregate net proceeds of $10.0 million; and

	•		in December 2005, we issued and sold 5,000,000 shares of our common stock for aggregate net proceeds of $49.8 million in our initial public offering. In conjunction with our initial public offering, all of our outstanding shares of preferred stock were converted into 12,241,382 shares of common stock.

As of September 30, 2006, we had $46.6 million in cash and cash equivalents and $20.6 million in short-term investments. We have invested a substantial portion of our available cash funds in commercial paper and money market funds placed with reputable financial institutions for which credit loss is not anticipated. We have established guidelines relating to diversification and maturities of our investments to preserve principal and maintain liquidity.

For the nine month period ended September 30, 2006, net cash used in operating activities was $36.2 million, compared to $13.5 million for the nine month period ended September 30, 2005. The increase in net cash used in operating activities was due primarily to an increase in our net loss as a result of increased expenses related to the clinical development of SILENOR™ and nalmefene, and increased salaries and overhead of company personnel. We cannot be certain if, when or to what extent we will receive cash inflows from the commercialization of our product candidates. We expect our development expenses to be substantial and to increase over the next few years as we continue the advancement of our product development programs.

As a specialty pharmaceutical company focused on acquiring and developing proprietary pharmaceutical product candidates, we have entered into several in-license agreements to acquire the rights to develop and commercialize three product candidates. Pursuant to these agreements, we obtained exclusive licenses to the patent rights and know-how for certain indications and have the right to enter into sublicense agreements. We generally were required to make upfront payments and we may be required to make additional payments upon the achievement of specific development and regulatory approval milestones. We are also obligated to pay royalties under the agreements until the later of the expiration of the applicable patents or the applicable last date of market exclusivity following the first commercial sale.

The following table describes our commitments to settle contractual obligations in cash as of September 30, 2006:


	Payments Due by Period
			2007		2009
	Remainder		through		through		After
	of 2006		2008		2010		2010		Total
	(in thousands)
Operating lease obligations	$	269	$	1,993	$	2,090	$	2,407	$	6,759
Payments under license agreements		654		1,230		1,230		7,290		10,404

Total	$	923	$	3,223	$	3,320	$	9,697	$	17,163

In addition, under our in-license agreements we are obligated to make additional milestone payments of up to $11.3 million upon the occurrence of certain product-development events as well as revenue-based royalty payments. License payments are subject to increase based on the timing of various milestones and the extent to which the in-licensed technologies are pursued for other indications. These milestone payments and royalty payments under our in-license agreements are not included in the table above because we cannot, at this time, determine when or if the related milestones will be achieved or the events triggering the commencement of payment obligations will occur.

We also enter into agreements with third parties to manufacture our product candidates, conduct our preclinical studies and clinical trials, and perform data collection and analysis. We determine the status of the work completed in relation to the scope of the work outlined in the contracts and record a liability for work which has been incurred but not yet paid. These amounts are included in accounts payable in our balance sheets and are not included in the table above. Our future payment obligations under these agreements depend upon the progress of our development programs and we are unable to estimate with certainty the future costs we will incur under the agreements.

We do not have any off balance sheet arrangements.

Our future capital uses and requirements depend on numerous forward-looking factors. These factors include but are not limited to the following:

	•		the progress of our preclinical testing and clinical trials;

	•		our ability to establish and maintain strategic collaborations, including licensing and other arrangements that we have or may establish, including those resulting in milestone payments to ProCom One, BioTie Therapies Corp. and/or Synchroneuron LLC;

	•		the costs involved in obtaining, enforcing or defending patent claims or other intellectual property rights;

	•		the costs and timing of regulatory approvals;

	•		the costs of establishing manufacturing, sales or distribution capabilities;

	•		the success of the commercialization of our products; and

	•		the extent to which we acquire or invest in other products, technologies and businesses.

We believe that our existing cash and investments will be sufficient to meet our projected operating requirements into 2008. We believe that our funds will allow us to finance our remaining Phase 3 clinical trials and NDA submission for SILENOR™, our Phase 2/3 clinical trial for nalmefene for the treatment of pathological gambling, and certain of our formulation and drug development work for acamprosate.

Until we can generate significant cash from our operations, we expect to continue to fund our operations with existing cash resources generated from the proceeds of offerings of our equity securities. In addition, we may finance future cash needs through the sale of other equity securities, strategic collaboration agreements and debt financing. However, we may not be successful in entering into collaboration agreements, or in receiving milestone or royalty payments under those agreements. In addition, we cannot be sure that our existing cash and investment resources will be adequate, or that additional financing will be available when needed, or that, if available, financing will be obtained on terms favorable to us or our stockholders. Having insufficient funds may require us to delay, scale-back or eliminate some or all of our development programs, relinquish some or even all rights to product candidates at an earlier stage of development, or negotiate less favorable terms than we would otherwise choose. Failure to obtain adequate financing also may adversely affect our ability to operate as a going concern. If we raise additional funds by issuing equity securities, substantial dilution to existing stockholders would likely result. If we raise additional funds by incurring debt financing, the terms of the debt may involve significant cash payment obligations as well as covenants and specific financial ratios that may restrict our ability to operate our business.

New Accounting Pronouncements

In June 2006, the Financial Accounting Standards Board, or FASB, issued FASB Interpretation No., or FIN, 48,Accounting for Uncertainty in Income Taxes—an interpretation of FASB Statement No. 109. This interpretation clarifies the accounting for uncertainty in income taxes recognized in accordance with FASB Statement No. 109,Accounting for Income Taxes. FIN 48 defines the criterion an uncertain tax benefit position must meet for it to be recognized. Additionally, FIN 48 provides guidance on measurement of the amount to be recognized or derecognized, treatment of interest and penalties, and balance sheet classification and disclosures. This interpretation is effective for fiscal years beginning after December 15, 2006 and will first be effective for us beginning January 1, 2007. We are in the process of analyzing the effects of FIN 48.

In September 2006, the Securities and Exchange Commission issued Staff Accounting Bulletin, or SAB, No. 108,Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements.SAB No. 108 requires analysis of misstatements using both an income statement (rollover) approach and a balance sheet (iron curtain) approach in assessing materiality and provides for a one-time cumulative effect transition adjustment. SAB No. 108 is effective for fiscal years ending after November 15, 2006 and will first be effective for us for the year ended December 31, 2006. We are in the process of analyzing the effects of SAB No. 108 and do not expect that the adoption will have a significant impact on our financial statements.

In September 2006, the FASB issued SFAS No. 157,Fair Value Measurement. This statement does not require any new fair value measurements, but rather applies to other accounting pronouncements that require or permit fair value measurements. SFAS No. 157 defines and establishes a framework for measuring fair value and expands disclosures. This statement is effective for fiscal years beginning after November 15, 2007 and will first be effective for us for the year beginning January 1, 2008. We are in the process of analyzing the effects of this pronouncement.

Caution on Forward-Looking Statements

Any statements in this report about our expectations, beliefs, plans, objectives, assumptions or future events or performance are not historical facts and are forward-looking statements. You can identify these forward-looking statements by the use of words or phrases such as “believe,” “may,” “could,” “will,” “estimate,” “continue,” “anticipate,” “intend,” “seek,” “plan,” “expect,” “should” or “would.” Among the factors that could cause actual results to differ materially from those indicated in the forward-looking statements are risks and uncertainties inherent in our business including, without limitation: the potential for SILENOR™ to receive regulatory approval for one or more indications on a timely basis or at all; the results of pending clinical trials or preclinical studies for SILENOR™ or our other product candidates; unexpected adverse side effects or inadequate therapeutic efficacy of SILENOR™ or our other products that could delay or prevent regulatory approval or commercialization, or that could result in recalls or product liability claims; other difficulties or delays in development, testing, manufacturing and marketing of and obtaining regulatory approval for SILENOR™ or our other product candidates; the scope and validity of patent protection for SILENOR™ and our other product candidates; the market potential for insomnia and other target markets, and our ability to compete; the potential to attract one or more strategic collaborators and the terms of any related transaction; our ability to raise sufficient capital and other risks detailed in this report under Part II – Item 1A – Risk Factors below.

Although we believe that the expectations reflected in our forward-looking statements are reasonable, we cannot guarantee future results, events, levels of activity, performance or achievement. We undertake no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise, unless required by law. This caution is made under the safe harbor provisions of the Private Securities Litigation Reform Act of 1995.

Item 3. Quantitative and Qualitative Disclosures about Market Risk

Our cash and cash equivalents and investments as of September 30, 2006 consisted primarily of money market funds, commercial paper and U.S. government agency notes. Our primary exposure to market risk is interest rate sensitivity, which is affected by changes in the general level of U.S. interest rates, particularly because the majority of our investments are in short-term marketable securities. The primary objective of our investment activities is to preserve principal while at the same time maximizing the income we receive from our investments without significantly increasing risk. Some of the securities that we invest in may be subject to market risk. This means that a change in prevailing interest rates may cause the value of the investment to fluctuate. For example, if we purchase a security that was issued with a fixed interest rate and the prevailing interest rate later rises, the value of our investment will probably decline. To minimize this risk, we intend to continue to maintain our portfolio of cash equivalents and short-term investments in a variety of securities including commercial paper, money market funds and government and non-government debt securities, all with various maturities. In general, money market funds are not subject to market risk because the interest paid on such funds fluctuates with the prevailing interest rate.

As of September 30, 2006 we have incurred an unrealized holding loss on our investments of $3,620 primarily as a result of an increase in interest rates which has decreased the value of certain of our securities with fixed interest rates. To the extent that we hold these securities to their maturity, this holding loss will not be realized.

Item 4. Controls and Procedures

We maintain disclosure controls and procedures that are designed to ensure that information required to be disclosed in our Exchange Act reports is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms and that such information is accumulated and communicated to our management, including our chief executive officer and chief financial officer, as appropriate, to allow for timely decisions regarding required disclosure. In designing and evaluating the disclosure controls and procedures, management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and management is required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures.

As required by Securities and Exchange Commission Rule 13a-15(b), we carried out an evaluation, under the supervision and with the participation of our management, including our chief executive officer and chief financial officer, of the effectiveness of the design and operation of our disclosure controls and procedures as of the end of the period covered by this report. Based on the foregoing, our chief executive officer and chief financial officer concluded that our disclosure controls and procedures were effective at the reasonable assurance level.

There has been no change in our internal control over financial reporting during our most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

PART II — OTHER INFORMATION

Item 1. Legal Proceedings

Not applicable.

Item 1A. Risk Factors

Investing in our common stock involves a high degree of risk. Our Annual Report on Form 10-K for the year ended December 31, 2005 includes a detailed discussion of our risk factors under the heading “Part I, Item 1A—Risk Factors.” Set forth below are certain changes from the risk factors previously disclosed in our Annual Report onForm 10-K. You should carefully consider the risk factors discussed in our Annual Report onForm 10-K as well as the other information in this report, before deciding whether to invest in shares of our common stock. The occurrence of any of the risks discussed in the Annual Report onForm 10-K or this report could harm our business, financial condition, results of operations or growth prospects. In that case, the trading price of our common stock could decline, and you may lose all or part of your investment.

Risks Related to Our Business

Our near-term success is dependent on the success of our lead product candidate, SILENOR^tm(doxepin hydrochloride), and we cannot be certain that it will receive regulatory approval or be successfully commercialized.

We have received the results from two of our four Phase 3 clinical trials for SILENOR^tm and have completed patient enrollment in two additional Phase 3 clinical trials underway to evaluate SILENOR™ for the treatment of insomnia. The completion of at least two well controlled clinical trials is required before we are able to submit our new drug application, or NDA, to the United States Food and Drug Administration, or FDA. We believe that positive results from one of our remaining two studies may be necessary to support an NDA filing for SILENOR™. Like many companies, we also plan to submit the results of additional trials for the purpose of supporting the claims we plan to request in our label for SILENOR™. We expect to have results from one of our remaining two SILENOR™ Phase 3 clinical trials in November 2006, and we expect to have results from the other remaining Phase 3 SILENOR™ clinical trial in December 2006.

In addition, based on a request from the FDA in connection with a planned pre-NDA meeting for SILENOR™, we have initiated a preclinical program consisting of standard genotoxicity, reproductive toxicology and carcinogenicity studies. The FDA has indicated that the data from the genotoxicity studies and reproductive toxicology studies should be included in the original NDA for SILENOR™. We completed the genotoxicity studies, and no signal indicative of

genotoxicity was found in any of the assays. We have submitted the data to the FDA and, based on our assessment of the data, requested that the agency permit us to submit the data from the requested carcinogenicity studies of SILENOR™ as a post-NDA approval commitment. Depending on the results of the genotoxicity studies, the FDA has indicated flexibility on the timing of submission of data from the carcinogenicity studies, including the potential that the FDA may allow the data from those studies to be submitted post-approval. We expect the reproductive toxicology studies to be completed in the middle of 2007 and we have initiated preliminary preparatory work on our carcinogenicity program. If the FDA does not grant our request to submit the carcinogenicity studies post-approval, delays in our NDA submission and/or regulatory approval are likely to occur.

Any delays in our preclinical and clinical development program are likely to result in delays in the NDA submission for SILENOR™, and may result in additional costs in completing the studies. Any delay in submission or acceptance for filing of the NDA for SILENOR™ will result in a delay in regulatory approval, if any, and in our ability to derive revenues from sales of the product, if any.

If our preclinical and clinical development program fails to demonstrate that SILENOR™ is safe and effective, it will not receive regulatory approval. Even if our preclinical studies and clinical trials are completed as planned, their results may not support our assumptions or our intended product claims, and additional studies or trials may be required.

While we are seeking a strategic collaborator for SILENOR^tm, we may not be successful in our efforts to consummate a strategic collaboration. If a collaboration agreement becomes effective prior to the filing of the NDA, actions on the part of our collaborator could delay our NDA filing. In addition, we may have inadequate financial or other resources to pursue this product candidate through the development process or through commercialization. Even if SILENOR^tm receives FDA approval, it may never be successfully commercialized.

We do not have patent protection for SILENOR^tm in any jurisdiction outside the United States, which may limit our ability to commercialize SILENOR^tm. Furthermore, the patent protection in the United States for SILENOR^tm for the treatment of insomnia is limited to dosages ranging from a lower limit of 0.5 mg to various upper limits up to 20 mg of its active ingredient, doxepin. Doxepin is prescribed at dosages ranging from 75 mg to 300 mg daily for the treatment of depression and anxiety and is available in generic form in strengths as low as 10 mg in capsule form as well as a concentrated liquid form dispensed by a marked dropper and calibrated for 5 mg. As a result, we may face competition from the off-label use of these or other dosage forms of generic doxepin. Off-label use occurs when a drug that is approved by the FDA for one indication is prescribed by physicians for a different, unapproved indication. We have submitted additional patent applications for SILENOR™, but we cannot assure that these will result in issued patents or additional protection in the United States or other jurisdictions. If we are unable to obtain regulatory approval for, or are unable to successfully commercialize, SILENOR^tm, we may be unable to generate revenue, become profitable, or continue our operations.

We expect intense competition in the insomnia marketplace for SILENOR^tmand in the target markets for our other product candidates, and new products may emerge that provide different and/or better therapeutic alternatives for the disorders that our product candidates are intended to treat.

We are developing SILENOR^tm for the treatment of insomnia, which will compete with well established drugs for this indication, including: Sanofi-Synthélabo, Inc.’s Ambien, King Pharmaceuticals, Inc.’s Sonata, and Sepracor Inc.’s Lunesta, all of which are GABA-acting hypnotics, Takeda Pharmaceuticals North America, Inc.’s Rozerem, a melatonin receptor antagonist, and Sanofi-Synthélabo Inc.’s Ambien CR, a controlled-release formulation of the current GABA-acting hypnotic product, Ambien. An NDA for at least one other product, Neurocrine Biosciences, Inc.’s indiplon, a GABA-acting hypnotic, has been submitted to the FDA, and Merck and Company, Inc’s gaboxadol is currently in Phase 3 trials. In May 2006, the FDA issued Neurocrine an approvable letter for indiplon 5 mg and 10 mg immediate release capsules and a not approvable letter for indiplon 15 mg extended release tablets. The implications and timing for regulatory approval of indiplon is unclear. Vanda Pharmaceuticals Inc. is conducting a Phase 3 transient insomnia trial of VEC-162, a melatonin receptor agonist, and has indicated it will require additional Phase 3 trials before seeking FDA approval. In addition, we have become aware that Takeda Pharmaceuticals North America, Inc. is conducting a clinical study to evaluate the administration of a combination of Takeda’s product Rozerem^TM and 3 mg of doxepin in patients with insomnia.

Furthermore, the original patent for Sanofi-Synthélabo, Inc.’s form of zolpidem (Ambien), which accounted for $2.3 billion of the $3.3 billion insomnia market in 2005, expires in October 2006. Sanofi-Synthélabo, Inc. is pursuing strategies that could extend the patent until the first quarter of 2007. Generic versions of Ambien are expected to reach the market shortly after patent protection for Ambien expires, which can be expected to be priced significantly lower than

approved, branded insomnia products. Sales of all of these drugs may reduce the available market for, and the price we are able to charge for, any product developed by us for this indication.

We are developing nalmefene for the treatment of pathological gambling. Currently, there are no FDA-approved products for this indication. However, controlled clinical trials using the opioid antagonist, naltrexone, which is available in generic form, have demonstrated clinical benefit for patients diagnosed with pathological gambling. Additionally, some controlled clinical trials suggest that selective serotonin reuptake inhibitors, or SSRIs, such as GlaxoSmithKline plc’s Paxil and Solvay Pharmaceutical’s Luvox, may have a potential clinical effect for the treatment of pathological gambling.

We are also exploring the use of nalmefene as a potential aid to smoking cessation. The majority of FDA-approved products for this indication are nicotine replacement therapies, such as nicotine gums, patches, nasal sprays, inhalers and lozenges. There are two additional FDA-approved products for this indication, GlaxoSmithKline plc’s Zyban, an aminoketone antidepressant, and Pfizer, Inc.’s Chantix, a nicotine receptor partial agonist, neither of which delivers nicotine to the patient. In addition, Nabi Biopharmaceuticals is developing a vaccine to aid in smoking cessation.

We are developing a new formulation of acamprosate for the treatment of tardive dyskinesia. There are no FDA-approved products for the treatment of tardive dyskinesia, although several companies are reportedly in Phase 2 and Phase 3 clinical trials to evaluate product candidates for this condition. Juvantia Pharma Ltd. is investigating fipamezole, an adrenergic antagonist, in Phase 2 clinical trials for treatment-associated dyskinesias in Parkinson’s disease, and Acadia Pharmaceuticals Inc. is investigating ACP-103, a 5-HT2A inverse agonist, in Phase 1/2 clinical trials for levodopa-induced dyskinesias in patients with Parkinson’s disease. These product candidates may be approved by the FDA or other regulatory authorities and commercialized ahead of acamprosate.

The biotechnology and pharmaceutical industries are subject to rapid and intense technological change. We face, and will continue to face, competition in the development and marketing of our product candidates from academic institutions, government agencies, research institutions and biotechnology and pharmaceutical companies. There can be no assurance that developments by others, including the development of other drug technologies and methods of preventing the incidence of disease, will not render SILENOR^tm or our other product candidates obsolete or noncompetitive.

Compared to us, many of our potential competitors have substantially greater:

	§		capital resources;

	§		research and development resources, including personnel and technology;

	§		regulatory experience;

	§		preclinical study and clinical trial experience and resources;

	§		expertise in prosecution of intellectual property rights; and

	§		manufacturing, distribution and sales and marketing experience.

As a result of these factors, our competitors may obtain regulatory approval of their products more rapidly than we can or may obtain patent protection or other intellectual property rights or seek to invalidate or otherwise challenge our intellectual property rights, limiting our ability to develop or commercialize our product candidates. Our competitors may also develop drugs that are more effective, useful and less costly than ours and may also be more successful than us in manufacturing and marketing their products.

In addition, if we receive regulatory approvals for our products, manufacturing efficiency and marketing capabilities are likely to be significant competitive factors. We currently have no commercial manufacturing capability, sales force or marketing infrastructure.

Delays in the commencement or completion of preclinical studies or clinical testing could result in increased costs to us and delay or limit our ability to generate revenues.

Delays in the commencement or completion of preclinical or clinical testing could significantly affect our product development costs. We have initiated a preclinical program consisting of standard genotoxicity, reproductive toxicology and carcinogenicity studies for SILENOR^tm. We have completed the genotoxicity studies and submitted the data to the FDA for review, but the remainder of the program is in progress. Delays in this program could occur for a number of reasons, including:

	§		reaching agreement on acceptable terms with prospective clinical research organizations, or CROs, the terms of which can be subject to extensive negotiation and may vary significantly among different CROs;

	§		failures on the part of our CROs in developing study procedures or otherwise conducting the studies on timeframes requested by us;

	§		changes in regulatory requirements or other standards or guidance relating to preclinical testing, including testing of pharmaceutical products in animals;

	§		a lack of availability of animals that are suitable for the types of studies we plan to conduct; and

	§		unforeseen results of preclinical studies that require us to amend study designs or delay future preclinical studies, clinical trials and related regulatory filings.

In addition, we do not know whether planned clinical trials will begin on time or be completed on schedule, if at all. The commencement and completion of clinical trials can be delayed for a variety of reasons, including delays related to:

	§		obtaining regulatory approval to commence a clinical trial;

	§		identifying appropriate trial sites and reaching agreement on acceptable terms with prospective CROs and trial sites, the terms of which can be subject to extensive negotiation and may vary significantly among different CROs and trial sites;

	§		manufacturing sufficient quantities of a product candidate;

	§		obtaining institutional review board approval to conduct a clinical trial at a prospective site;

	§		recruiting and enrolling patients to participate in clinical trials for a variety of reasons, including competition from other clinical trial programs for the same indication as our product candidates; and

	§		retaining patients who have initiated a clinical trial but may be prone to withdraw due to side effects from the therapy, lack of efficacy or personal issues, or who are lost to further follow-up.

In addition, a clinical trial may be suspended or terminated by us, the FDA or other regulatory authorities due to a number of factors, including:

	§		failure to conduct the clinical trial in accordance with regulatory requirements or our clinical protocols;

	§		inspection of the clinical trial operations or trial sites by the FDA or other regulatory authorities resulting in the imposition of a clinical hold;

	§		unforeseen safety issues; or

	§		lack of adequate funding to continue the clinical trial.

Additionally, changes in regulatory requirements and guidance relating to clinical trials may occur and we may need to amend clinical trial protocols to reflect these changes. Amendments may require us to resubmit our clinical trial protocols to institutional review boards for reexamination, which may impact the costs, timing or successful completion of a clinical trial.

If we experience delays in completion of, or if we terminate, our clinical trials or preclinical studies, the commercial prospects for our product candidates will be harmed, and our ability to generate product revenues will be delayed. For example, if the FDA requires us to complete our planned carcinogenicity studies for SILENOR^tm as a prerequisite to accepting our NDA submission for filing, the timing of that submission, as well as any revenues we may generate from SILENOR^tm, will be significantly delayed. In addition, many of the factors that cause, or lead to, a delay in the commencement or completion of clinical trials or preclinical studies may also ultimately lead to the denial of regulatory approval of a product candidate. Even if we are able to ultimately commercialize our product candidates, other therapies for the same indications may have been introduced to the market and established a competitive advantage.

Our preclinical testing and clinical trials may fail to demonstrate the safety and efficacy of our product candidates, which could prevent or significantly delay their regulatory approval.

��Before obtaining regulatory approvals for the commercial sale of any of our product candidates, we must demonstrate through preclinical testing and clinical trials that the product is safe and effective for use in each target indication. To date, we have successfully completed two of our Phase 3 clinical trials and have not completed all planned preclinical testing and Phase 1 clinical trials for any of our product candidates. For example, in addition to our ongoing Phase 3 clinical trials for SILENOR^tm, we are undertaking a preclinical program consisting of standard genotoxicity, reproductive toxicology and carcinogenicity studies, of which we have only completed the genotoxicity study.

With regard to nalmefene, we are carefully monitoring patients for an effect on liver function in our ongoing nalmefene clinical trial. While previous alcoholism and pathological gambling studies conducted by our licensor, BioTie Therapies Corp., did not demonstrate an effect on liver function tests, a recent review of unpublished data indicates elevations of enzymes in liver function tests in a small number of patients previously studied. In addition, a small number of patients in our recently completed pilot Phase 2 clinical trial of nalmefene for smoking cessation showed elevation in liver enzymes, with a similar frequency occurring in each of the treatment and placebo groups. As with most new drugs, a Phase 1 clinical trial to evaluate the cardiac effects of nalmefene on patients measured using an electrocardiogram is planned.

With regard to acamprosate, various formulation development work, preclinical studies, and Phase 1 clinical trials are planned to facilitate the selection and evaluation of a formulation for the product candidate to be tested in subsequent clinical trials in patients with tardive dyskinesia.

The results from preclinical testing and clinical trials that we have completed may not be predictive of results obtained in future preclinical testing and clinical trials, and there can be no assurance that we will demonstrate sufficient safety and efficacy to obtain the requisite regulatory approvals or result in marketable products. A number of companies in the biotechnology and pharmaceutical industries have suffered significant setbacks in advanced clinical trials, even after promising results in earlier studies. If our drug candidates are not shown to be safe and effective in preclinical testing and clinical trials, the resulting delays in developing other compounds and conducting related preclinical testing and clinical trials, as well as the potential need for additional financing, would have a material adverse effect on our business, financial condition and results of operations.

Our product candidates may cause undesirable side effects or have other properties that could delay or prevent their regulatory approval or commercialization.

Undesirable side effects caused by our product candidates could interrupt, delay or halt clinical trials and could result in the denial of regulatory approval by the FDA or other regulatory authorities for any or all targeted indications, and in turn prevent us from commercializing our product candidates and generating revenues from their sale. For example, while previous alcoholism and pathological gambling trials conducted by our licensor, BioTie Therapies Corp., did not demonstrate an effect on liver function tests, a recent review of unpublished data indicates elevations of enzymes in liver function tests in a small number of patients previously studied. In addition, a small number of patients in our recently completed pilot Phase 2 clinical trial of nalmefene for smoking cessation showed elevation in liver enzymes, with a similar frequency occurring in each of the treatment and placebo groups.

In a Phase 1 clinical trial of nalmefene performed by our licensor, two patients were reported by the investigator to have a prolonged QTc interval, which is an electrocardiogram change in patients which, if significantly prolonged, may result in an abnormal heart rhythm with adverse consequences including fainting, dizziness, loss of consciousness and death. In a final report, based on corrected values as determined by the cardiologist responsible for the central laboratory

evaluation, these QTc findings were determined to be within the normal range of variation and incorrectly designated as adverse events. As with most new drugs, a Phase 1 clinical trial to evaluate the cardiac effects of nalmefene on patients measured using an electrocardiogram is planned and we will continue to assess the side effect profile of nalmefene and our other product candidates in our ongoing clinical development program.

In addition, if any of our product candidates receive marketing approval and we or others later identify undesirable side effects caused by the product:

	§		regulatory authorities may require the addition of labeling statements, such as a “black box” warning or a contraindication;

	§		regulatory authorities may withdraw their approval of the product or place restrictions on the way it is prescribed;

	§		we may be required to change the way the product is administered, conduct additional clinical trials or change the labeling of the product; and

	§		our reputation may suffer.

Any of these events could prevent us from achieving or maintaining market acceptance of the affected product or could substantially increase the costs and expenses of commercializing the product candidate, which in turn could delay or prevent us from generating significant revenues from its sale.

Additionally, the FDA has directed manufacturers of all antidepressant drugs to revise their product labels to include a “black box” warning and expanded warning statements regarding an increased risk of suicidal thinking and behavior in children and adolescents being treated with these drugs. The active ingredient in SILENOR^tm, doxepin, is used in the treatment of depression and the package insert includes such a “black box” warning statement. Although SILENOR^tmis not intended to be indicated for or used in the treatment of depression and our proposed dosage for insomnia is less than one-tenth of that of doxepin for the treatment of depression, and although we do not currently intend to evaluate SILENOR^tm for the treatment of insomnia in children or adolescents, we cannot be sure that a similar warning statement will not be required. If nalmefene is determined to cause an elevation in liver enzymes, the FDA may also require a “black box” warning for it similar to the current labeling for naltrexone, an opioid antagonist.

Even if our product candidates receive regulatory approval, they may still face future development and regulatory difficulties.

Even if U.S. regulatory approval is obtained, the FDA may still impose significant restrictions on a product’s indicated uses or marketing or impose ongoing requirements for potentially costly post-approval studies. For example, the label ultimately approved for SILENOR^tm, if any, may include a restriction on the term of its use or the population for which it may be used, or it may not include one or more of our intended indications— the treatment of sleep onset, maintenance and duration. Similarly, although doxepin, at higher dosages than we plan to incorporate in SILENOR^tm, is not currently and has never been a Schedule IV controlled substance and the FDA has indicated that it will not recommend that it be a Schedule IV controlled substance, we cannot be certain that SILENOR^tm will be a non-scheduled drug until the DEA completes its review. Our product candidates will also be subject to ongoing FDA requirements for the labeling, packaging, storage, advertising, promotion, record-keeping and submission of safety and other post-market information. In addition, approved products, manufacturers and manufacturers’ facilities are subject to continual review and periodic inspections. If a regulatory agency discovers previously unknown problems with a product, such as adverse events of unanticipated severity or frequency, or problems with the facility where the product is manufactured, a regulatory agency may impose restrictions on that product or us, including requiring withdrawal of the product from the market. If our product candidates fail to comply with applicable regulatory requirements, a regulatory agency may:

	§		issue warning letters or untitled letters;

	§		impose civil or criminal penalties;

	§		suspend regulatory approval;

	§		suspend any ongoing clinical trials;

	§		refuse to approve pending applications or supplements to approved applications filed by us;

	§		impose restrictions on operations, including costly new manufacturing requirements; or

	§		seize or detain products or require a product recall.

If the manufacturers upon whom we rely fail to produce our products in the volumes that we require on a timely basis, or to comply with stringent regulations applicable to pharmaceutical drug manufacturers, we may face delays in the development and commercialization of, or be unable to meet demand for, our products and may lose potential revenues.

We do not manufacture any of our product candidates, and we do not plan to develop any capacity to do so. Patheon Pharmaceuticals Inc. manufactures clinical supplies of our SILENOR^tm and nalmefene product candidates, and we have entered into a manufacturing and supply agreement with Patheon to manufacture our commercial supply of SILENOR^tm. We also plan to contract with one or more third parties to manufacture our nalmefene and acamprosate product candidates, and we have contracted with and plan to enter into additional contracts with suppliers of some key raw materials for our product candidates. The manufacture of pharmaceutical products requires significant expertise and capital investment, including the development of advanced manufacturing techniques and process controls. Manufacturers of pharmaceutical products often encounter difficulties in production, particularly in scaling up initial production. These problems include difficulties with production costs and yields, quality control, including stability of the product candidate and quality assurance testing, shortages of qualified personnel, as well as compliance with strictly enforced federal, state and foreign regulations. Our manufacturers may not perform as agreed or may terminate their agreements with us. Additionally, our manufacturers may experience manufacturing difficulties due to resource constraints as a result of labor disputes or unstable political environments. If our manufacturers were to encounter any of these difficulties, or otherwise fail to comply with their contractual obligations, our ability to provide product candidates to patients in our clinical trials would be jeopardized. Any delay or interruption in the supply of clinical trial supplies could delay the completion of our clinical trials, increase the costs associated with maintaining our clinical trial program and, depending upon the period of delay, require us to commence new trials at significant additional expense or terminate the trials completely.

We do not have alternate manufacturing plans in place at this time. If we need to change to other commercial manufacturers, the FDA and comparable foreign regulators must approve these manufacturers’ facilities and processes prior to our use, which would require new testing and compliance inspections, and the new manufacturers would have to be educated in or independently develop the processes necessary for the production of our products.

Any of these factors could cause us to delay or suspend clinical trials, regulatory submissions, required approvals or commercialization of our product candidates, entail higher costs or result in our being unable to effectively commercialize our products. Furthermore, if our manufacturers failed to deliver the required commercial quantities of raw materials, including bulk drug substance, or finished product on a timely basis and at commercially reasonable prices, we would likely be unable to meet demand for our products and we would lose potential revenues.

In addition, all manufacturers of our products must comply with current good manufacturing practice, or cGMP, requirements enforced by the FDA through its facilities inspection program. These requirements include quality control, quality assurance and the maintenance of records and documentation. Manufacturers of our products may be unable to comply with these cGMP requirements and with other FDA, state and foreign regulatory requirements. We have little control over our manufacturers’ compliance with these regulations and standards. A failure to comply with these requirements may result in fines and civil penalties, suspension of production, suspension or delay in product approval, product seizure or recall, or withdrawal of product approval. If the safety of any quantities supplied is compromised due to our manufacturers’ failure to adhere to applicable laws or for other reasons, we may not be able to obtain regulatory approval for or successfully commercialize our products.

We rely on third parties to conduct our clinical trials and prepare our electronic NDA filings. If these third parties do not successfully carry out their contractual duties or meet expected deadlines, we may not be able to obtain regulatory approval for or commercialize our product candidates.

We rely on CROs, primarily Synteract, Inc., to conduct our clinical trials for our SILENOR^tm and nalmefene product candidates, and we may depend on other CROs and independent clinical investigators to conduct our future clinical trials. We also will rely on a CRO to prepare our electronic NDA filing for SILENOR^tm. CROs play a significant role in the conduct of our clinical trials and the subsequent collection and analysis of data. CROs and investigators are not our

employees, and we cannot control the amount or timing of resources that they devote to our programs. If Synteract, other CROs or independent investigators fail to devote sufficient time and resources to our programs, or if their performance is substandard, it will delay the approval of our FDA applications and our introductions of new products. Failure of the CROs to meet their obligations could adversely affect clinical development of our products. Moreover, these independent investigators and CROs may also have relationships with other commercial entities, some of which may compete with us. If independent investigators and CROs assist our competitors at our expense, it could harm our competitive position.

Materials necessary to manufacture our product candidates may not be available on commercially reasonable terms, or at all, which may delay the development and commercialization of our product candidates.

Although we have contracted with and plan to enter into additional contracts with suppliers of some key raw materials for our product candidates, we rely on the manufacturers of our product candidates to purchase from third-party suppliers the other materials necessary to produce the compounds for our clinical trials and will rely on them for commercial distribution if we obtain marketing approval for any of our product candidates. Suppliers may not sell these materials to our manufacturers at the time we need them or on commercially reasonable terms. We do not have any control over the process or timing of the acquisition of these materials by our manufacturers. If our manufacturers are unable to obtain these materials for our clinical trials, product testing and potential regulatory approval of SILENOR™ or our other product candidates would be delayed, significantly impacting our ability to develop our product candidates. If our manufacturers or we are unable to purchase these materials after regulatory approval has been obtained for our product candidates, the commercial launch of our product candidates would be delayed or there would be a shortage in supply, which would materially affect our ability to generate revenues from the sale of our product candidates.

If any of our product candidates for which we receive regulatory approval do not achieve broad market acceptance, the revenues that we generate from their sales will be limited.

The commercial success of our product candidates for which we obtain marketing approval from the FDA or other regulatory authorities will depend upon the acceptance of these products by the medical community and reimbursement of them by third-party payors, including government payors. The degree of market acceptance of any of our approved products will depend on a number of factors, including:

	§		our ability to provide acceptable evidence of safety and efficacy;

	§		relative convenience and ease of administration;

	§		prevalence and severity of any adverse side effects;

	§		limitations or warnings contained in a product’s FDA-approved labeling, including, for example, potential “black box” warnings associated with the active ingredient in SILENOR™ or with nalmefene;

	§		availability of alternative treatments, including, in the case of SILENOR™, a number of competitive products already approved for the treatment of insomnia or expected to be commercially launched in the future;

	§		pricing and cost effectiveness;

	§		off-label substitution by chemically equivalent products;

	§		effectiveness of our or our collaborators’ sales and marketing strategies; and

	§		our ability to obtain sufficient third-party coverage or reimbursement.

If our product candidates are approved but do not achieve an adequate level of acceptance by physicians, health care payors and patients, we may not generate sufficient revenue from these products, and we may not become or remain profitable. In addition, our efforts to educate the medical community and third-party payors on the benefits of our product candidates may require significant resources and may never be successful.

We are subject to uncertainty relating to health care reform measures and reimbursement policies which, if not favorable to our product candidates, could hinder or prevent our product candidates’ commercial success.

The continuing efforts of the government, insurance companies, managed care organizations and other payors of health care services to contain or reduce costs of health care may adversely affect:

	§		our ability to set a price we believe is fair for our products;

	§		our ability to generate revenues and achieve or maintain profitability;

	§		the future revenues and profitability of our potential customers, suppliers and collaborators; and

	§		the availability of capital.

In the United States, given recent federal and state government initiatives directed at lowering the total cost of health care, Congress and state legislatures will likely continue to focus on health care reform, the cost of prescription drugs and the reform of the Medicare and Medicaid systems. For example, the Medicare Prescription Drug Improvement and Modernization Act of 2003 provides a new Medicare prescription drug benefit which became effective in January 2006 and mandates other reforms. While we cannot predict the full outcome of the implementation of this legislation, it is possible that the new Medicare prescription drug benefit, which will be managed by private health insurers and other managed care organizations, will result in additional government reimbursement for prescription drugs, which may make some prescription drugs more affordable but may further exacerbate industry-wide pressure to reduce prescription drug prices. In addition, in certain foreign markets, the pricing of prescription drugs is subject to government control and reimbursement may in some cases be unavailable or insufficient.

Our ability to commercialize our product candidates successfully will depend in part on the extent to which governmental authorities, private health insurers and other organizations establish appropriate coverage and reimbursement levels for the cost of our products and related treatments. Third-party payors are increasingly challenging the prices charged for medical products and services. Also, legislative proposals to reform health care or reduce government insurance programs may result in lower prices for our product candidates or exclusion of our product candidates from coverage and reimbursement programs. The cost containment measures that health care payors and providers are instituting and the effect of any health care reform could harm our ability to market our products and significantly reduce our revenues from the sale of any approved product.

We will need to increase the size of our organization, and we may experience difficulties in managing growth.

As of September 30, 2006, we had 37 full-time employees. We will need to continue to expand our managerial, operational, financial and other resources in order to manage and fund our operations and clinical trials, continue our development activities and commercialize our product candidates. Our management and personnel, systems and facilities currently in place may not be adequate to support this future growth. Our need to effectively manage our operations, growth and various projects requires that we:

	•		manage our clinical trials effectively, including our remaining Phase 3 clinical trials for SILENOR^tm and our Phase 2/3 clinical trial for nalmefene in pathological gambling, which are conducted at numerous clinical trial sites;

	•		manage the preparation and submission of our NDA to the FDA.

	•		manage our internal development efforts effectively while carrying out our contractual obligations to collaborators and other third parties;

	•		continue to improve our operational, financial and management controls, reporting systems and procedures; and

	•		attract and retain sufficient numbers of talented employees.

We may be unable to successfully implement these tasks on a larger scale and, accordingly, may not achieve our development and commercialization goals.

We may not be able to manage our business effectively if we are unable to attract and retain key personnel.

We may not be able to attract or retain qualified management and scientific and clinical personnel in the future due to the intense competition for qualified personnel among biotechnology, pharmaceutical and other businesses, particularly in the San Diego, California area. If we are not able to attract and retain necessary personnel to accomplish our business objectives, we may experience constraints that will significantly impede the achievement of our development objectives, our ability to raise additional capital and our ability to implement our business strategy. In particular, if we lose any members of our senior management team, we may not be able to find suitable replacements, and our business may be harmed as a result.

We are highly dependent on the product acquisition, development, regulatory and commercialization expertise of our senior management. If we lose one or more of the members of our senior management team or other key employees, our ability to implement our business strategy successfully could be seriously harmed. Replacing key employees may be difficult and may take an extended period of time because of the limited number of individuals in our industry with the breadth of skills and experience required to develop, gain regulatory approval of and commercialize products successfully. Competition to hire from this limited pool is intense, and we may be unable to hire, train, retain or motivate these additional key personnel.

In addition, we have scientific and clinical advisors who assist us in formulating our product development and clinical strategies. These advisors are not our employees and may have commitments to, or consulting or advisory contracts with, other entities that may limit their availability to us, or may have arrangements with other companies to assist in the development of products that may compete with ours.

Risks Related to Our Finances and Capital Requirements

We will require substantial additional funding and may be unable to raise capital when needed, which would force us to delay, reduce or eliminate our development programs or commercialization efforts.

We are a development stage company with no revenues, and our operations to date have generated substantial needs for cash. We expect our negative cash flows from operations to continue until we obtain regulatory approval for SILENOR^tm and are able to commercialize the product candidate ourselves or establish a collaboration with a pharmaceutical company to broaden the potential reach of sales and marketing efforts for SILENOR^tm. The development and approval of SILENOR^tm and our other product candidates and the acquisition and development of additional products or product candidates by us, as well as the development of our sales and marketing organizations, will require a commitment of substantial funds. Our future capital requirements will depend on, and could increase significantly as a result of, many factors, including:

	•		the terms and timing of any collaborative, licensing and other arrangements that we may establish;

	•		the rate of progress and cost of our preclinical studies, clinical trials and other development activities;

	•		the scope, prioritization and number of development programs we pursue;

	•		the costs and timing of regulatory approval;

	•		the costs of establishing or contracting for sales and marketing capabilities;

	•		the extent to which we acquire or in-license new products, technologies or businesses;

	•		the effect of competing technological and market developments; and

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

We believe, based on our current operating plan, that our cash, cash equivalents and marketable securities as of September 30, 2006 will be sufficient to fund our operations into 2008. We believe that these funds will allow us to finance our remaining Phase 3 clinical trials and NDA submission for SILENOR™, our Phase 2/3 clinical trial for nalmefene for

the treatment of pathological gambling, and certain of our formulation and drug development work for acamprosate. We intend to seek additional funding through strategic alliances and may seek additional funding through public or private sales of our equity securities. In addition, we may obtain equipment leases and may pursue opportunities to obtain debt financing in the future. There can be no assurance, however, that additional equity or debt financing will be available on reasonable terms, if at all. If adequate funds are not available, we may be required to delay, reduce the scope of, or eliminate one or more of our planned development, commercialization or expansion activities.

We have never generated revenues or been profitable, and we may not be able to generate revenues sufficient to achieve profitability.

We are a development stage company and have not generated any revenues or been profitable since inception, and it is possible that we will not achieve profitability. We incurred net losses of approximately $38.1 million for the nine month period ended September 30, 2006, $38.5 million for the year ended December 31, 2005 and $13.6 million for the year ended December 31, 2004. We expect to continue to incur significant operating and capital expenditures. As a result, we will need to generate significant revenues to achieve and maintain profitability. We cannot assure you that we will achieve significant revenues, if any, or that we will ever achieve profitability. Even if we do achieve profitability, we cannot assure you that we will be able to sustain or increase profitability on a quarterly or annual basis in the future. If revenues grow more slowly than we anticipate or if operating expenses exceed our expectations or cannot be adjusted accordingly, our business, results of operations and financial condition will be materially and adversely affected.

Our quarterly operating results may fluctuate significantly.

We expect our operating results to be subject to quarterly fluctuations. The revenues we generate, if any, and our operating results will be affected by numerous factors, including:

	•		our addition or termination of development programs or funding support;

	•		variations in the level of expenses related to our existing three product candidates or future development programs;

	•		our execution of collaborative, licensing or other arrangements, and the timing of payments we may make or receive under these arrangements;

	•		any intellectual property infringement lawsuit in which we may become involved; and

	•		regulatory developments affecting our product candidates or those of our competitors.

If our quarterly operating results fall below the expectations of investors or securities analysts, the price of our common stock could decline substantially. Furthermore, any quarterly fluctuations in our operating results may, in turn, cause the price of our stock to fluctuate substantially. We believe that quarterly comparisons of our financial results are not necessarily meaningful and should not be relied upon as an indication of our future performance.

Risks Relating to Intellectual Property

The patent rights that we have in-licensed covering SILENOR™are limited to certain low-dosage strengths in the United States, and our market opportunity for this product candidate may be limited by the lack of patent protection for higher dosage strengths and the lack of patent protection in other territories.

Although we have an exclusive, worldwide license for SILENOR^tm for the treatment of insomnia through the life of the last patent to expire, which is expected to occur in 2020, we do not have patent protection for SILENOR^tm in any jurisdiction outside the United States. In addition, although our in-licensed patent for the treatment of transient insomnia is scheduled to expire in 2020, our in-licensed patent for the treatment of chronic insomnia is scheduled to expire in March 2013. Accordingly, in the absence of additional patents or other alternatives to obtain additional exclusivity rights for SILENOR^tm, a competitor could file an NDA for the development of doxepin for a chronic insomnia indication as early as March 2013. Furthermore, the patent protection in the United States for SILENOR^tm for the treatment of insomnia is limited to dosages ranging from a lower limit of 0.5 mg to various upper limits up to 20 mg of the active ingredient, doxepin. Doxepin is prescribed at dosages ranging from 75 mg to 300 mg daily for the treatment of depression and anxiety and is available in generic form in strengths as low as 10 mg in capsule form, as well as in a concentrated liquid form dispensed

by a marked dropper and calibrated for 5 mg. As a result, we may face competition from the off-label use of these or other dosage forms of generic doxepin. In addition, others may attempt to commercialize low-dose doxepin in the European Union, Canada, Mexico or other markets where we do not have patent protection for SILENOR^tm. Due to the lack of patent protection for doxepin in territories outside the United States and the potential for correspondingly lower prices for the drug in those markets, it is possible that patients will seek to acquire low-dose doxepin in those other territories. The off-label use of doxepin in the United States or the importation of doxepin from foreign markets could adversely affect the commercial potential for SILENOR^tm and adversely affect our overall business and financial results. We have submitted additional patent applications for SILENOR™ but we cannot assure that these will result in issued patents or additional protection in the United States or other jurisdictions.

A recent reexamination at the U.S. Patent and Trademark Office has resulted in the narrowing of certain claims and the cancellation of other claims for one of our patents covering SILENOR^tm. In addition, we have initiated a reissue of that patent which may result in the U.S. Patent and Trademark Office further narrowing certain claims and could result in the cancellation or rejection of certain or all of the claims of the patent.

Due to some recently identified prior art, we initiated a reexamination of one of the patents we have in-licensed covering SILENOR^tm, specifically U.S. Patent No. 5,502,047,“Treatment For Insomnia,”which claims the treatment of chronic insomnia using doxepin in a daily dosage of 0.5 mg to 20 mg and expires in March 2013. The reexamination proceedings have terminated and the U.S. Patent and Trademark Office has now issued a reexamination certificate narrowing certain claims, so that the broadest dosage ranges claimed by us are 0.5 mg to 20 mg for otherwise healthy patients, 0.5 mg to 20 mg for patients with insomnia resulting from depression, and 0.5 mg to 4 mg for all other chronic insomnia patients. We have also requested reissue of this same patent to add intermediate dosage ranges below 10 mg and to consider some additional prior art that is relevant primarily to claims for treating insomnia in depressed patients. During reissue, the U.S. Patent and Trademark Office could require narrowing or cancellation of certain claims or could reject all of the claims of this patent. Although we believe that our in-licensed patents will restrict the ability of competitors to market doxepin with identical drug labeling, we cannot be certain of the outcome of the U.S. Patent and Trademark Office’s pending reissue.

Restrictions on our patent rights relating to our product candidates may limit our ability to prevent third parties from competing against us.

Our success will depend on our ability to obtain and maintain patent protection for our products, preserve our trade secrets, prevent third parties from infringing upon our proprietary rights and operate without infringing upon the proprietary rights of others. The patent rights that we have in-licensed relating to our product candidates are limited in ways that may affect our ability to exclude third parties from competing against us if we receive regulatory approval to market these product candidates. In particular, we do not hold composition of matter patents covering the active pharmaceutical ingredients of any of our product candidates. Composition of matter patents on active pharmaceutical ingredients are the strongest form of intellectual property protection for pharmaceutical products as they apply without regard to any method of use or other type of limitation. As a result, competitors who obtain the requisite regulatory approval can offer products with the same active ingredients as our products so long as the competitors do not infringe any method of use or formulation patents that we may hold.

The principal patent protection that covers, or that we expect will cover, our product candidates is method of use patents. This type of patent protects the product only when used or sold for the specified method. However, this type of patent does not limit a competitor from making and marketing a product that is identical to our product for an indication that is outside of the patented method. Moreover, physicians may prescribe such a competitive identical product for off-label indications that are covered by the applicable patents. Although such off-label prescriptions may infringe or contribute to the infringement of method of use patents, the practice is common and such infringement is difficult to prevent or prosecute.

Because products with active ingredients identical to ours have been on the market for many years, there can be no assurance that these other products were never used off-label or studied in such a manner that such prior usage would not affect the validity of our method of use patents. One of our in-licensed patents is currently involved in post-issuance proceedings in the U.S. Patent and Trademark Office, and no assurance can be given that any claims will survive those proceedings in their current form, or at all.

Patent applications in the United States are confidential for a period of time until they are published, and publication of discoveries in scientific or patent literature typically lags actual discoveries by several months. As a result, we cannot be

certain that the inventors of the issued patents that we in-licensed were the first to conceive of inventions covered by pending patent applications or that the inventors were the first to file patent applications for such inventions.

We also rely upon unpatented trade secrets and improvements, unpatented know-how and continuing technological innovation to develop and maintain our competitive position, which we seek to protect, in part, by confidentiality agreements with our collaborators, employees and consultants. We also have invention or patent assignment agreements with our employees and certain consultants. There can be no assurance that inventions relevant to us will not be developed by a person not bound by an invention assignment agreement with us. There can be no assurance that binding agreements will not be breached, that we would have adequate remedies for any breach, or that our trade secrets will not otherwise become known or be independently discovered by our competitors.

Litigation or other proceedings to enforce or defend intellectual property rights is often very complex in nature, may be expensive and time-consuming and may divert our management’s attention from our core business.

Risks Relating to Securities Markets and Investment in Our Stock

There may not be a viable public market for our common stock, and market volatility may affect our stock price and the value of your investment.

Our common stock had not been publicly traded prior to our initial public offering, which was completed in December 2005, and an active trading market may not develop or be sustained. We have never declared or paid any cash dividends on our capital stock. We currently intend to retain all available funds and any future earnings to support operations and finance the growth and development of our business. We do not intend to pay cash dividends on our common stock for the foreseeable future. Therefore, investors will have to rely on appreciation in our stock price and a liquid trading market in order to achieve a gain on their investment. The market prices for securities of biotechnology and pharmaceutical companies have historically been highly volatile, and the market has from time to time experienced significant price and volume fluctuations that are unrelated to the operating performance of particular companies. Since our initial public offering through November 6, 2006, the trading prices for our common stock ranged from a high of $21.24 to a low of $9.69.

The market price of our common stock may fluctuate significantly in response to a number of factors, most of which we cannot control, including:

	•		changes in the regulatory status of SILENOR^tm or our other product candidates, including requirements to conduct or results of our preclinical studies and clinical trials;

	•		announcements of new products or technologies, commercial relationships or other events by us or our competitors;

	•		events affecting our three existing in-license agreements and any future collaborations, commercial agreements and grants;

	•		variations in our quarterly operating results;

	•		changes in securities analysts’ estimates of our financial performance;

	•		regulatory developments in the United States and foreign countries;

	•		fluctuations in stock market prices and trading volumes of similar companies;

	•		sales of large blocks of our common stock, including sales by our executive officers, directors and significant stockholders;

	•		additions or departures of key personnel; and

	•		discussion of us or our stock price by the financial and scientific press and in online investor communities.

The realization of any of the risks described in these “Risk Factors” could have a dramatic and material adverse impact on the market price of our common stock. In addition, class action litigation has often been instituted against companies whose securities have experienced periods of volatility in market price. Any such litigation brought against us could result in substantial costs and a diversion of management’s attention and resources, which could hurt our business, operating results and financial condition.

If our executive officers, directors and largest stockholders choose to act together, they may be able to control our operations and act in a manner that advances their best interests and not necessarily those of other stockholders.

As of September 30, 2006, our executive officers, directors and holders of 5% or more of our outstanding common stock beneficially owned approximately 66.5% of our common stock. As a result, these stockholders, acting together, would be able to control all matters requiring approval by our stockholders, including the election of directors and the approval of mergers or other business combination transactions. The interests of this group of stockholders may not always coincide with our interests or the interests of other stockholders, and they may act in a manner that advances their best interests and not necessarily those of other stockholders.

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

In the quarter ended September 30, 2006 we had no unregistered sales of equity securities.

Use of Proceeds

Our initial public offering of common stock was effected through a Registration Statement on Form S-1 (File No. 333-128871) that was declared effective by the Securities and Exchange Commission on December 14, 2005. On December 20, 2005, 5,000,000 shares of common stock were sold on our behalf at an initial public offering price of $11.00 per share, for an aggregate offering price of $55.0 million. Our initial public offering was managed by Morgan Stanley & Co. Incorporated, J.P. Morgan Securities Inc., Piper Jaffray & Co. and Thomas Weisel Partners LLC.

We paid to the underwriters underwriting discounts and commissions totaling approximately $3.9 million in connection with the offering. In addition, we incurred additional expenses of approximately $1.3 million in connection with the offering, which when added to the underwriting discounts and commissions paid by us, amounts to total expenses of approximately $5.2 million. Thus, the net offering proceeds to us, after deducting underwriting discounts and commissions and offering expenses, were approximately $49.8 million. No offering expenses were paid directly or indirectly to any of our directors or officers (or their associates) or persons owning ten percent or more of any class of our equity securities or to any other affiliates.

As of September 30, 2006, we had invested the $49.8 million in net proceeds from the offering in money market funds, commercial paper and U.S. government agency notes. Through September 30, 2006, we have not used the net proceeds from the offering. We intend to use the proceeds to fund clinical trials for our three development programs, for marketing, general and administrative expenses and for other research and development expenses.

Item 3. Defaults Upon Senior Securities

Not applicable.

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

Not Applicable

Item 5. Other Information

Not applicable.

Item 6. Exhibits

EXHIBIT INDEX


Exhibit
Number		Description
3.1(1)		Amended and Restated Certificate of Incorporation of the Registrant

3.2(1)		Amended and Restated Bylaws of the Registrant

4.1(2)		Form of the Registrant’s Common Stock Certificate

4.2(3)		Amended and Restated Investor Rights Agreement dated June 2, 2005

31.1		Certification of Chief Executive Officer pursuant to Rule 13a-14 and Rule 15d-14 of the Securities Exchange Act of 1934, as amended

31.2		Certification of Chief Financial Officer pursuant to Rule 13a-14 and Rule 15d-14 of the Securities Exchange Act of 1934, as amended

32.1*		Certification of Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C. 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002


(1)		Filed with Amendment No. 3 to the Registrant’s Registration Statement on Form S-1 on November 30, 2005.

(2)		Filed with Amendment No. 4 to the Registrant’s Registration Statement on Form S-1 on December 13, 2005.

(3)		Filed with the Registrant’s Registration Statement on Form S-1 on October 7, 2005.

		* These certifications are being furnished solely to accompany this quarterly report pursuant to 18 U.S.C. Section 1350, and are not being filed for purposes of Section 18 of the Securities Exchange Act of 1934 and are not to be incorporated by reference into any filing of Somaxon Pharmaceuticals, Inc., whether made before or after the date hereof, regardless of any general incorporation language in such filing.

SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

Dated: November 9, 2006


		/s/ Meg M. McGilley

		Meg M. McGilley
		Vice President and Chief Financial Officer
		(Duly Authorized Officer and Principal Financial Officer)

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Litigious
Readability	H.S. freshman Good

Pernix Sleep Inactive 10-Q2006 Q3 Quarterly report

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