Pernix Sleep 10Q 2007 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, 2007


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

3721 Valley Centre Drive, Suite 500, San Diego, CA		92130
(Address of principal executive offices)		(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 filerþ Non-accelerated filero

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 5, 2007 was 18,452,765.

SOMAXON PHARMACEUTICALS, INC.

FORM 10-Q — QUARTERLY REPORT
FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2007

TABLE OF CONTENTS


	Page
PART I – FINANCIAL INFORMATION
Item 1. Financial Statements
Condensed Balance Sheets at September 30, 2007 and December 31, 2006		1
Condensed Statements of Operations for the three and nine months ended September 30, 2007 and 2006		2
Condensed Statements of Redeemable Convertible Preferred Stock, Stockholders’ Equity and Comprehensive Loss		3
Condensed Statements of Cash Flows for the nine months ended September 30, 2007 and 2006		5
Notes to Condensed Financial Statements		6
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations		17
Item 3. Quantitative and Qualitative Disclosures about Market Risk		28
Item 4. Controls and Procedures		28
PART II – OTHER INFORMATION
Item 1. Legal Proceedings		28
Item 1A. Risk Factors		28
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds		38
Item 3. Defaults Upon Senior Securities		38
Item 4. Submission of Matters to a Vote of Security Holders		38
Item 5. Other Information		39
Item 6. Exhibits		39
SIGNATURES		40
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)

(in thousands, except par value)


	September 30,				December 31,
	2007				2006
ASSETS
Current assets
Cash and cash equivalents	$	14,068			$	28,783
Short-term investments		26,730				29,131
Other current assets		1,025				515

Total current assets		41,823				58,429
Long-term restricted cash		600				600
Property and equipment, net		196				263
Other assets		60				160

Total assets	$	42,679			$	59,452


LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities
Accounts payable	$	1,502			$	5,731
Accrued liabilities		1,408				1,364

Total current liabilities		2,910				7,095
				��

Commitments and contingencies: (Note 4)

Stockholders’ equity
Preferred stock, $0.0001 par value; 10,000 shares authorized, none issued and outstanding		—				—
Common stock, $0.0001 par value; 100,000 shares authorized; 18,251 and 18,082 shares issued and outstanding at September 30, 2007 and December 31, 2006, respectively		2				2
Additional paid-in capital		158,303				152,311
Deficit accumulated during the development stage		(118,564	)			(99,958	)
Accumulated other comprehensive income		28				2

Total stockholders’ equity		39,769				52,357

Total liabilities and stockholders’ equity	$	42,679			$	59,452

The Accompanying Notes are an Integral Part of these Financial Statements

Somaxon Pharmaceuticals, Inc.
(A development stage company)

STATEMENTS OF OPERATIONS

(unaudited)

(in thousands, except per share amounts)


													Period from
													August 14,
													2003
													(inception)
	Three months ended						Nine months ended						through
	September 30,						September 30,						September 30,
	2007			2006			2007			2006			2007
Operating expenses
License fees	$	154		$	204		$	461		$	511		$	6,666
Research and development		2,843			7,906			9,636			32,547			83,793
Marketing, general and administrative expenses		3,280			2,689			10,396			8,170			29,875
Remeasurement of Series C warrant liability		—			—			—			—			5,649

Total operating expenses		6,277			10,799			20,493			41,228			125,983

Loss from operations		(6,277	)		(10,799	)		(20,493	)		(41,228	)		(125,983	)
Interest and other income		564			965			1,887			3,123			7,419

Net loss		(5,713	)		(9,834	)		(18,606	)		(38,105	)		(118,564	)
Accretion of redeemable convertible preferred stock to redemption value		—			—			—			—			(86	)

Net loss applicable to common stockholders	$	(5,713	)	$	(9,834	)	$	(18,606	)	$	(38,105	)	$	(118,650	)


Basic and diluted net loss per share	$	(0.31	)	$	(0.55	)	$	(1.02	)	$	(2.12	)
Shares used to calculate net loss per share		18,231			18,007			18,166			17,968

The Accompanying Notes are an Integral Part of these Financial Statements

Somaxon Pharmaceuticals, Inc.
(A development stage company)

STATEMENTS OF REDEEMABLE CONVERTIBLE PREFERRED STOCK, STOCKHOLDERS’ EQUITY AND COMPREHENSIVE LOSS

For the period from August 14, 2003 (inception) through September 30, 2007 (unaudited)

(in thousands, except per share amounts)


																							Deficit
	Series C Redeemable																						Accumulated			Accumulated
	Convertible Preferred						Convertible Preferred										Additional			Deferred			During the			Other
	Stock						Stock						Common Stock				Paid-in			Stock			Development			Comprehensive
	Shares			Amount			Shares			Amount			Shares		Amount		Capital			Compensation			Stage			Loss		Total
Issue common stock for cash to founders at $0.0006 per share in August		—		$	—			—		$	—			583	$	—	$	—		$	—		$	—		$	—	$	—
Issue Series A convertible preferred stock for cash at $1.00 per share in August, November, and December		—			—			2,282			2,282			—		—		—			—			—			—		2,282
Net Loss		—			—			—			—			—		—		—			—			(1,463	)		—		(1,463	)

Balance at December 31, 2003		—		$	—			2,282		$	2,282			583	$	—	$	—		$	—		$	(1,463	)	$	—	$	819

Issue Series A convertible preferred stock for cash at $1.00 per share in January		—		$	—			18		$	18			—	$	—	$	—		$	—		$	—		$	—	$	18
Issue Series B convertible preferred stock for cash at $1.00 per share in April and June, net of issuance costs of $97		—			—			23,000			22,903			—		—		—			—			—			—		22,903
Issue common stock in April at $1.20 per share for license agreement		—			—			—			—			84		—		101			—			—			—		101
Exercise of stock options		—			—			—			—			56		—		4			—			—			—		4
Deferred compensation associated with employee stock option grants		—			—			—			—			—		—		111			(111	)		—			—		—
Amortization of deferred compensation		—			—			—			—			—		—		—			13			—			—		13
Consultant stock option expense		—			—			—			—			—		—		14			—			—			—		14
Net Loss		—			—			—			—			—		—		—			—			(13,598	)		—		(13,598	)

Balance at December 31, 2004		—		$	—			25,300		$	25,203			723	$	—	$	230		$	(98	)	$	(15,061	)	$	—	$	10,274
Issue Series C redeemable convertible preferred stock for cash at $1.35 per share in June and September, net of issuance costs of $152		48,148		$	64,848			—		$	—			—	$	—	$	—		$	—		$	—		$	—	$	—
Series C proceeds allocated to warrant		—			(648	)		—			—			—		—		—			—			—			—		—
Additional paid-in capital from the exercise of the Series C warrant		—			—			—			—			—		—		6,297			—			—			—		6,297
Accretion of Series C redeemable convertible preferred stock to redemption value		—			86			—			—			—		—		(86	)		—			—			—		(86	)
Issue common stock in initial public offering in December at $11.00 per share, net of issuance costs of $5,180		—			—			—			—			5,000		—		49,820			—			—			—		49,820
Conversion of convertible preferred stock into common stock		(48,148	)		(64,286	)		(25,300	)		(25,203	)		12,242		2		89,487			—			—			—		64,286
Exercise of stock options		—			—			—			—			80		—		177			—			—			—		177
Deferred compensation associated with employee stock option grants		—			—			—			—			—		—		4,741			(4,741	)		—			—		—
Amortization of deferred compensation		—			—			—			—			—		—		—			1,037			—			—		1,037
Consultant stock option expense		—			—			—			—			—		—		137			—			—			—		137
Net loss		—			—			—			—			—		—		—			—			(38,487	)		—		(38,487	)

Balance at December 31, 2005		—		$	—			—		$	—			18,045	$	2	$	150,803		$	(3,802	)	$	(53,548	)	$	—	$	93,455

Somaxon Pharmaceuticals, Inc.
(A development stage company)

STATEMENTS OF REDEEMABLE CONVERTIBLE PREFERRED STOCK, STOCKHOLDERS’ EQUITY AND COMPREHENSIVE LOSS

For the period from August 14, 2003 (inception) through September 30, 2007 (unaudited)

(in thousands, except per share amounts)


																		Deficit
	Series C Redeemable																	Accumulated			Accumulated
	Convertible Preferred				Convertible Preferred								Additional			Deferred		During the			Other
	Stock				Stock				Common Stock				Paid-in			Stock		Development			Comprehensive
	Shares		Amount		Shares		Amount		Shares		Amount		Capital			Compensation		Stage			Loss		Total
Net loss		—	$	—		—	$	—		—	$	—	$	—		$	—	$	(46,410	)	$	—	$	(46,410	)
Change in unrealized gain on available-for-sale investments		—		—		—		—		—		—		—			—		—			2		2

Comprehensive loss																								(46,408	)
Deferred stock compensation eliminated upon adoption of SFAS No. 123R		—		—		—		—		—		—		(3,802	)		3,802		—			—		—
Exercise of stock options		—		—		—		—		37		—		146			—		—			—		146
Share-based compensation related to employee stock options		—		—		—		—		—		—		4,959			—		—			—		4,959
Consultant stock option expense		—		—		—		—		—		—		158			—		—			—		158
Vesting of early exercised stock options		—		—		—		—		—		—		47			—		—			—		47

Balance at December 31, 2006		—	$	—		—	$	—		18,082	$	2	$	152,311		$	—	$	(99,958	)	$	2	$	52,357


Net loss		—	$	—		—	$	—		—	$	—	$	—		$	—	$	(18,606	)	$	—	$	(18,606	)
Change in unrealized gain on available-for-sale investments		—		—		—		—		—		—		—			—		—			26		26

Comprehensive loss																								(18,580	)
Exercise of stock options		—		—		—		—		169		—		681			—		—			—		681
Share-based compensation related to employee stock options		—		—		—		—		—		—		5,225			—		—			—		5,225
Consultant stock option expense		—		—		—		—		—		—		73			—		—			—		73
Vesting of early exercised stock options		—		—		—		—		—		—		13			—		—			—		13

Balance at September 30, 2007		—	$	—		—	$	—		18,251	$	2	$	158,303		$	—	$	(118,564	)	$	28	$	39,769

The Accompanying Notes are an Integral Part of these Financial Statements

Somaxon Pharmaceuticals, Inc.
(A development stage company)

STATEMENTS OF CASH FLOWS

(unaudited)

(in thousands)


	��							Period from
								August 14,
								2003
								(inception)
		Nine Months Ended						through
		September 30,						September 30,
		2007			2006			2007
Cash flows from operating activities
Net loss		$	(18,606	)	$	(38,105	)	$	(118,564	)
Adjustments to reconcile net loss to net cash used in operating activities
Depreciation			86			74			268
Amortization of debt investment discount or premium			(18	)		—			(172	)
Stock option expense			5,298			3,285			11,616
Issuance of stock for license agreement			—			—			101
Remeasurement of Series C warrant			—			—			5,649
Loss on disposal of equipment			1			—			3
Changes in operating assets and liabilities
Other current assets			(510	)		601			(1,025	)
Other assets			100			17			(60	)
Accounts payable			(4,229	)		(2,145	)		1,502
Accrued liabilities			57			75			1,400

Net cash used in operating activities			(17,821	)		(36,198	)		(99,282	)


Cash flows from investing activities
Purchases of property and equipment			(20	)		(163	)		(467	)
Purchases of short-term investments			(39,099	)		(19,507	)		(74,817	)
Sales and maturities of short-term investments			41,544			2,000			48,287
Restricted cash deposit			—			(600	)		(600	)

Net cash provided from (used in) investing activities			2,425			(18,270	)		(27,597	)


Cash flows from financing activities
Issuance of common stock, net of issuance costs			—			—			49,820
Issuance of preferred stock, net of issuance costs			—			—			90,051
Exercise of stock options			681			126			1,076

Net cash provided from financing activities			681			126			140,947

Increase (Decrease) in cash and cash equivalents			(14,715	)		(54,342	)		14,068
Cash and cash equivalents at beginning of the period			28,783			100,918			—

Cash and cash equivalents at end of the period		$	14,068		$	46,576		$	14,068


Supplemental disclosure of non-cash investing and financing activities
Accretion to redemption value of redeemable convertible preferred stock		$	—		$	—		$	86
Conversion of preferred stock into common stock upon completion of initial public offering		$	—		$	—		$	89,489

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. Somaxon has completed its Phase 3 clinical program for its lead product candidate, SILENOR™ (doxepin hydrochloride) for the treatment of insomnia. The Company is currently in the process of preparing its New Drug Application, or NDA, for SILENOR™.

The Company has in-licensed two product candidates in addition to SILENOR™. The Company has completed a pilot Phase 2 clinical trial for nalmefene in smoking cessation with positive results. It also completed a Phase 2/3 clinical trial for nalmefene for the treatment of pathological gambling that did not achieve statistical significance for the primary or secondary endpoints. The Company is evaluating the results from both of these clinical trials before making determinations regarding the future of the nalmefene program. The Company is also developing a new formulation of acamprosate calcium for the treatment of certain movement disorders. The Company has completed a Phase 1 clinical trial of several formulations of acamprosate and is currently analyzing the data from this trial.

Capital Resources

The Company expects to continue to incur losses and have negative cash flows from operations in the foreseeable future as it prepares the NDA filing for SILENOR™ and seeks its commercialization, and to the extent it continues to engage in development activities for its other 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 Company’s financial condition. The ability to implement the Company’s business strategy, including conducting current development programs, commercializing products, and potentially in-licensing other products, could be limited.

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, 2006 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 and recurring nature.

Operating results for the three and nine months ended September 30, 2007 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, 2006.

Somaxon Pharmaceuticals, Inc.
(A development stage company)

Notes to Financial Statements
(unaudited)

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.

Recent Accounting Pronouncements

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 the Company for the year beginning January 1, 2008. The Company is in the process of analyzing the effects of this pronouncement.

Net Loss per Share

Net loss per share is calculated in accordance with SFAS No. 128,Earnings Per Share,and the Securities and Exchange Commission’s Staff Accounting Bulletin (“SAB”) No. 98. Basic earnings per share (“EPS”) excludes the effects of common stock equivalents and is calculated by dividing net income or loss 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. 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 outstanding stock options. Basic and dilutive net loss per share are equivalent because the Company incurred a net loss in all periods presented, causing inclusion of any potentially dilutive securities to have an anti-dilutive affect.

Somaxon Pharmaceuticals, Inc.
(A development stage company)

Notes to Financial Statements
(unaudited)

The following table summarizes the Company’s EPS calculations:


	Three months ended						Nine months ended
	September 30,						September 30,
	2007			2006			2007			2006
	(in thousands, except per share amounts)
Numerator
Net loss	$	(5,713	)	$	(9,834	)	$	(18,606	)	$	(38,105	)


Denominator
Weighted average common shares		18,240			18,071			18,182			18,054
Weighted average unvested common shares subject to repurchase		(9	)		(64	)		(16	)		(86	)

Denominator for basic and diluted net loss per share		18,231			18,007			18,166			17,968

Basic and diluted net loss per share	$	(0.31	)	$	(0.55	)	$	(1.02	)	$	(2.12	)


Weighted average anti-dilutive securities not included in diluted net loss per share
Weighted average stock options outstanding		3,159			2,389			3,000			2,290
Weighted average unvested common shares subject to repurchase		9			64			16			86

Total weighted average anti-dilutive securities not included in diluted net loss per share		3,168			2,453			3,016			2,376

Income Taxes

In July 2006, the FASB issued Interpretation No. 48,Accounting for Uncertainty in Income Taxes – An Interpretation of FASB Statement No. 109(“FIN 48”). FIN 48 clarifies the accounting for uncertainty in income taxes recognized in an entity’s financial statements in accordance with FASB Statement No. 109,Accounting for Income Taxes, and prescribes a recognition threshold and measurement attributes for financial statement disclosure of tax positions taken or expected to be taken on a tax return. Under FIN 48, the impact of an uncertain income tax position on the income tax return must be recognized at the largest amount that is more-likely-than-not to be sustained upon audit by the relevant taxing authority. An uncertain income tax position will not be recognized if it has less than a 50% likelihood of being sustained. Additionally, FIN 48 provides guidance on de-recognition, classification, interest and penalties, accounting in interim periods, disclosure and transition. FIN 48 is effective for fiscal years beginning after December 15, 2006.

The Company adopted the provisions of FIN 48 on January 1, 2007. Upon adoption of FIN 48, the Company recognized a $635,000 reduction in gross deferred tax assets, offset by an equal reduction in the deferred tax asset valuation allowance. None of the amount included in the balance of unrecognized tax benefits at January 1, 2007 would affect the effective tax rate if recognized because the Company’s deferred tax assets are fully reserved. Included in the balance of unrecognized tax benefits at January 1, 2007, are $635,000 of tax benefits that, if recognized, would result in adjustments to other tax accounts, primarily deferred taxes. There was no change in the unrecognized tax benefits reflected in our financials as of September 30, 2007. It is expected that the amount of unrecognized tax benefits may change over the course of the year; however, the Company does not expect the change to have a significant impact on its results of operations, cash flows or financial position.

The Company’s accounting policy is to record interest and penalties related to unrecognized tax benefits in income tax expense. No interest or penalties have been accrued as of September 30, 2007.

Somaxon Pharmaceuticals, Inc.
(A development stage company)

Notes to Financial Statements
(unaudited)

The Company is subject to taxation in the United States and California. The Company’s tax years for 2003 and forward are subject to examination by the United States and California tax authorities due to the carryforward of net operating losses and research and development credits.

Note 2. Composition of Certain Balance Sheet Items

Cash, Cash Equivalents, and Short-term Investments

Cash, cash equivalents, and short-term investments consisted of the following at September 30, 2007:


			Gross		Gross
	Amortized		Unrealized		Unrealized			Market
	Cost		Gain		(Loss)			Value
	(in thousands)
Cash and money market funds	$	7,383	$	—	$	—		$	7,383
Commercial paper and corporate notes		27,419		26		(4	)		27,441
United States government agency notes		5,968		6		—			5,974

Total cash, cash equivalents and investments	$	40,770	$	32	$	(4	)	$	40,798

Cash, cash equivalents, and short-term investments consisted of the following at December 31, 2006:


			Gross		Gross
	Amortized		Unrealized		Unrealized			Market
	Cost		Gain		(Loss)			Value
	(in thousands)
Cash and money market funds	$	7,947	$	—	$	—		$	7,947
Commercial paper and corporate notes		38,283		8		—			38,291
United States government agency notes		11,682		—		(6	)		11,676

Total cash, cash equivalents and investments	$	57,912	$	8	$	(6	)	$	57,914

There were no realized gains or losses on sales of available-for-sale securities for the nine months ended September 30, 2007 and for the year ended December 31, 2006. At September 30, 2007, and December 31, 2006, the Company also had a $600,000 restricted cash balance for a deposit on the Company’s office space (see Note 4). This restricted cash is invested in certificates of deposit.

Other Current Assets

Other current assets consist of the following:


	September 30,		December 31,
	2007		2006
	(in thousands)
Investment interest receivable	$	141	$	190
Prepaid insurance		307		58
Deposits and prepaid clinical research fees		401		163
Other current assets		176		104

Total other current assets	$	1,025	$	515

Somaxon Pharmaceuticals, Inc.
(A development stage company)

Notes to Financial Statements
(unaudited)

Property and Equipment

Property and equipment consists of the following:


	September 30,			December 31,
	2007			2006
	(in thousands)
Office furniture and equipment	$	226		$	213
Computer equipment		237			232

Property and equipment, at cost		463			445
Less: accumulated depreciation		(267	)		(182	)

Property and equipment, net	$	196		$	263

Depreciation expense was $28,000 and $31,000 for the three month periods ended September 30, 2007 and 2006, respectively, and $86,000 and $74,000 for the nine months ended September 30, 2007 and 2006, respectively.

Accrued Liabilities

Accrued liabilities consist of the following:


	September 30,		December 31,
	2007		2006
	(in thousands)
Accrued license fees	$	135	$	139
Accrued compensation and benefits		1,211		1,182
Other accrued liabilities		62		43

Total accrued liabilities	$	1,408	$	1,364

Note 3. Share-based compensation

On January 1, 2006, the Company adopted 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 employee stock options, based on estimated fair values. SFAS No. 123(R) could potentially be applicable to both of the Company’s stock option plans as well as the Company’s employee stock purchase plan; however, it is applicable only to the Company’s stock options because the Company’s employee stock purchase plan is non-compensatory under the terms of SFAS No. 123(R).

The following table summarizes stock-based compensation expense, a non-cash expense, recorded under SFAS No. 123(R):


	Three months ended				Nine months ended
	September 30,				September 30,
	2007		2006		2007		2006
	(in thousands)
Stock-based compensation expense included in research and development expense	$	433	$	230	$	1,246	$	616
Stock-based compensation expense included in marketing, general and administrative expense		1,375		1,033		3,979		2,550

Total stock-based compensation expense	$	1,808	$	1,263	$	5,225	$	3,166

Somaxon Pharmaceuticals, Inc.
(A development stage company)

Notes to Financial Statements
(unaudited)

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. As of September 30, 2007, 481,000 shares of common stock were reserved for issuance under the ESPP. The ESPP contains an “evergreen provision” that allows for annual increases in the number of shares available for issuance on the first day of each fiscal 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. Under the evergreen provision, 181,000 additional shares were reserved for issuance beginning January 1, 2007. As of September 30, 2007, 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, of which 25,000 shares were available for issuance when the plan was discontinued upon adopting the 2005 Equity Incentive Award Plan (the “2005 Plan”) . These 25,000 available shares were aggregated with the 2,000,000 initially available shares for issuance under the 2005 Plan for a total number of available shares at the adoption of the 2005 Plan of 2,025,000 shares. No additional options will be granted under the 2004 Plan. All options that are repurchased, forfeited, cancelled or expire under either the 2004 Plan or 2005 Plan will become available for grant.

As of September 30, 2007, 2,929,000 shares of common stock were reserved for issuance under the 2005 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. Under the evergreen provision, 904,000 additional shares were reserved for issuance beginning January 1, 2007.

The Company’s stock options generally vest over a four year term for employees and a period of one to three years for members of the Company’s board of directors. Certain stock options vest upon achieving specific targets generally relating to the acceptance or approval by the FDA of the NDA for SILENOR™. Certain of the stock options were exercised in advance of becoming vested and any unvested shares are subject to repurchase by the Company at the original exercise price in the event of termination or separation. The Company recognized a liability for the proceeds received from the exercise of unvested options of $9,000 and $22,000 at September 30, 2007 and December 31, 2006, respectively. No unvested shares have been repurchased by the Company as of September 30, 2007.

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 (in thousands, except per share amounts).


						Weighted
				Weighted		Average Grant
				Average		Date Calculated
	Shares			Exercise Price		Value per Share
Outstanding at December 31, 2005		1,366		$	4.62

Stock options granted during 2006		1,073			12.68	$	9.07
Stock options exercised during 2006		(37	)		3.94
Stock options forfeited during 2006		(28	)		11.00

Outstanding at December 31, 2006		2,374		$	8.20

Stock options granted year-to-date 2007		1,012			12.58	$	8.87
Stock options exercised year-to-date 2007		(166	)		4.08
Stock options forfeited year-to-date 2007		(76	)		10.48

Outstanding at September 30, 2007		3,144		$	9.77

The intrinsic value of exercised stock options 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, 2007, employees and directors exercised 166,000 stock options with an intrinsic value of $1,750,000. During the nine month period ended September 30, 2006, employees and directors exercised 26,000 stock options with an intrinsic value of $212,000.

At September 30, 2007, of the 3,144,000 employee and director stock options outstanding, 1,189,000 were vested and 1,955,000 were unvested. The weighted average remaining vesting term was 2.0 years and the total calculated value of outstanding stock options expected to be recognized in future periods over this weighted average remaining vesting term was $14,609,000. Based on a closing stock price of $10.17 per share at September 28, 2007, the intrinsic value of outstanding employee and director stock options at September 30, 2007 was $6,530,000 and the intrinsic value of exercisable stock options was $3,928,000.

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


	Nine months ended
	September 30,
	2007	2006
Risk free interest rate	4.18% to 4.86%	4.31% to 5.10%
Expected term	6.25 years	6.25 years
Expected volatility	70% to 79%	76% to 85%
Weighted average volatility	76%	78%
Expected dividend yield	0%	0%
Fair value of underlying stock	$11.00 to $15.00	$10.35 to $19.74

In addition to the outstanding stock options held by employees and directors, the Company had 34,000 stock options which had been granted to consultants outstanding as of September 30, 2007, of which 33,000 were vested and 1,000 were unvested. No stock options were granted to consultants during the nine month periods ended September 30, 2007 and 2006. During the nine month period ended September 30, 2007, consultants exercised 3,000 stock options with a weighted average exercise price of $1.20 per share. No stock options were exercised by consultants during the nine month period ended September 30, 2006. In accordance with Emerging Issues Task Force (“EITF”) Issue 96-18Accounting for Equity Investments that are Issued to Other than Employees for

Somaxon Pharmaceuticals, Inc.
(A development stage company)

Notes to Financial Statements
(unaudited)

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. Stock options granted to consultants resulted in expense of $15,000 and $14,000 for the three month periods ended September 30, 2007 and 2006, respectively, and $73,000 and $119,000 for the nine month periods ended September 30, 2007 and 2006, respectively. Stock option expense for consultants is included within research and development expense.

A summary of all stock options outstanding at September 30, 2007 is as follows (shares are in thousands):


	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 to $ 3.00		877	7.6 Years	$	2.60		528	7.5 Years	$	2.52
$ 8.40 to $10.99		659	8.3 Years		10.58		270	8.3 Years		10.58
$11.00 to $13.99		1,074	9.1 Years		11.80		177	8.2 Years		11.50
$14.00 to $15.99		402	9.2 Years		15.05		189	8.9 Years		15.24
$16.00 to $19.74		166	8.6 Years		18.34		58	8.6 Years		18.29

Total stock options outstanding		3,178	8.5 Years	$	9.76		1,222	8.1 Years	$	8.32

A summary of all stock options outstanding at December 31, 2006 is as follows (shares are in thousands):


	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 to $ 3.00		1,018	8.3 Years	$	2.51		493	8.2 Years	$	2.35
$ 8.40 to $10.99		709	9.0 Years		10.58		3	8.8 Years		8.70
$11.00 to $13.99		313	8.9 Years		11.28		119	8.9 Years		11.48
$14.00 to $15.99		205	9.5 Years		15.23		85	9.4 Years		15.32
$16.00 to $19.74		166	9.3 Years		18.34		—	9.3 Years		18.34

Total stock options outstanding		2,411	8.8 Years	$	8.20		700	8.5 Years	$	5.51

Somaxon Pharmaceuticals, Inc.
(A development stage company)

Notes to Financial Statements
(unaudited)

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
	(in thousands)
Shares available for issuance at December 31, 2005		1,710			300

Grants and issuances		(1,073	)		—
Forfeitures		28			—

Shares available for issuance at December 31, 2006		665			300

Increase in authorized shares		904			181
Grants and issuances		(1,012	)		—
Forfeitures		76			—

Shares available for issuance at September 30, 2007		633			481

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 for milestones and license payments under the Company’s various in-license agreements are $9,285,000. The Company is also obligated to make additional milestone payments of up to $11,325,000 upon achieving certain product development events, the majority of which pertains to nalmefene, as well as revenue-based royalty payments. The Company is assessing the results from the nalmefene pathological gambling and smoking cessation clinical trials before making a determination regarding the future of the nalmefene program. If the nalmefene program is not continued, $10,325,000 of the $11,325,000 of milestones would not be paid. 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 remaining $1,000,000 represents a milestone payment owed to ProCom One (“ProCom”) upon approval of our NDA for SILENOR™. This milestone payment is not reflected in the September 30, 2007 financials as it is not considered to be incurred at this time.

Dosing has been completed in a Phase 1 clinical trial of several formulations of acamprosate, and the data from this study is currently being analyzed. Results are expected by the end of 2007. A milestone payment of $150,000 will be owed if the data shows positive results. This milestone payment is not reflected in the September 30, 2007 financial results as it is not known at this time whether the results from the study will be positive.

The Company has contracted with clinical research organizations (“CROs”), drug manufacturers, and other vendors to assist in clinical trial work, analysis, and the filing of the NDA with the FDA. The contracts are cancelable at any time, but obligate the Company to reimburse the providers for any time or costs incurred through the date of termination.

The Company subleases approximately 25,700 square feet of office space for its corporate headquarters under a sublease agreement which commenced in June 2006 and expires in February 2013. The Company is obligated to make base lease payments which increase at each annual lease anniversary and range from $80,000 per month in the first year of the lease to a maximum of $95,000 per month for the period from July 2012 through expiration in February 2013, plus additional rent for common area and pass-through expenses. The Company recognizes rent expense on a straight-line basis with a related liability recorded for the cumulative difference 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

Somaxon Pharmaceuticals, Inc.
(A development stage company)

Notes to Financial Statements
(unaudited)

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 $500,000 if the termination occurs prior to July 1, 2008, and $350,000 if the termination occurs on or after July 1, 2008.

The Company is also obligated under various operating leases for office equipment. Rent expense was $263,000 and $302,000 for the three month periods ended September 30, 2007 and 2006, respectively and $797,000 and $420,000 for the nine month periods ended September 30, 2007 and 2006, respectively.

At September 30, 2007, the future minimum lease payments for the years then ended are as follows (dollar amounts are in thousands):


2007 (remaining 3 months)	$	249
2008		1,008
2009		1,032
2010		1,063
2011		1,095
Thereafter		1,223

Total	$	5,670

Note 5. Related Party Transactions

The Company in-licenses certain technologies from ProCom. As part of the in-license agreement, ProCom has the right to designate one nominee to the Company’s Board of Directors. The in-license agreement also provides a consulting arrangement for two ProCom individuals, under which the Company paid a total of $64,000 during both of the three month periods ended September 30, 2007 and 2006 and $191,000 during both of the nine month periods ended September 30, 2007 and 2006.

The two individuals from ProCom had an aggregate of 120,000 stock options outstanding at September 30, 2007 of which 95,000 shares were vested. The weighted average exercise price was $11.26 and none of the stock options have been exercised as of September 30, 2007.

The Company’s outside legal counsel holds 13,000 shares of common stock at September 30, 2007 as a result of purchases of preferred shares which were converted into common shares during the Company’s initial public offering in December 2005. The Company paid $60,000 and $72,000 for legal services rendered by the Company’s outside counsel during the three month periods ended September 30, 2007 and 2006, respectively and $299,000 and $566,000 during the nine month periods ended September 30, 2007 and 2006, respectively.

Note 6. Subsequent Event

On October 8, 2007, the Company’s board of directors approved the issuance of an aggregate of 200,000 shares of restricted common stock to the Company’s executive officers and its Chairman of the Board. The stock price at the date of grant was $11.40, yielding an aggregate grant date fair value of $2,280,000. The shares vest upon achievement of certain performance conditions, with 25% of the shares vesting upon acceptance of the SILENOR™ NDA by the FDA, and the remaining 75% vesting upon approval of the SILENOR™ NDA by the FDA. The Company will recognize expense related to these restricted shares over the period from the date the performance condition is determined to be probable of occurring through the time the applicable condition is met. In the event of a change in control of the Company prior to the vesting dates, with respect to the executive officers, 50% of the shares would vest and 50% would convert into the right to receive cash based on the value of the transaction, with

Somaxon Pharmaceuticals, Inc.
(A development stage company)

Notes to Financial Statements
(unaudited)

such cash payment deferred until the performance objectives have been obtained. In the event of a termination without cause or a resignation for good reason after such a change in control with respect to any such executive officer, all of such cash would be paid upon such termination or resignation. In the event of a change in control of the Company prior to the vesting dates, with respect to the Chairman of the Board, all of the shares would vest upon consummation of the change in control.

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, 2006, 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, 2006. 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, 2006 and the caption “Risk Factors” in thisForm 10-Q for the quarter ended September 30, 2007.

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. We are currently in the process of preparing the New Drug Application, or NDA, for our lead product candidate, SILENOR™ (doxepin hydrochloride) for the treatment of insomnia, which we plan to submit to the U.S. Food and Drug Administration, or FDA, in the first quarter of 2008. We completed our Phase 3 clinical program for SILENOR™ in 2006. Our four Phase 3 clinical trials for SILENOR™ demonstrated statistically significant and clinically meaningful improvements across multiple endpoints measuring sleep onset, sleep maintenance and prevention of early awakenings. The clinical trial results also demonstrated a favorable safety and tolerability profile, with the overall incidence of adverse events comparable to placebo, a low discontinuation rate and no evidence of dependency, withdrawal, tolerance or amnesia.

Based on a request in May 2006 from the FDA in connection with a planned meeting with the FDA for SILENOR™, we initiated a non-clinical program consisting of standard genotoxicity, reproductive toxicology and carcinogenicity studies. The FDA indicated that the data from the genotoxicity studies and reproductive toxicology studies should be included in the original NDA for SILENOR™. The FDA also indicated 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 as a post-NDA approval commitment. In September 2006, we completed the genotoxicity studies and no signal indicative of genotoxicity was found in any of the assays. We submitted the results to the FDA and in February 2007, the FDA agreed with our assessment that SILENOR™ does not appear to have genotoxic potential. The FDA indicated that, unless other non-clinical data raise a concern, a complete assessment of the carcinogenic potential of SILENOR™ may not be needed prior to NDA approval. The FDA also indicated that it may accept the results of a shorter-term carcinogenicity study for approval of the NDA and allow the standard two-year carcinogenicity study to be completed as a post-approval commitment.

In May 2007, we received correspondence from the FDA which stated that the results of our ongoing 26-week transgenic mouse carcinogenicity study of SILENOR™ should be included as part of the initial NDA submission for SILENOR™. As a result, we plan to file our initial NDA submission for SILENOR™ in the first quarter of 2008, assuming that the 26-week transgenic mouse carcinogenicity study is successful and proceeds as currently scheduled. We continue to plan to conduct the standard two-year carcinogenicity study and to submit the results of this study as a post-approval commitment.

We submitted a protocol for the 26-week transgenic mouse carcinogenicity study to the FDA’s Carcinogenicity Assessment Committee, or CAC. This study was initiated in May 2007. We have also completed dose range finding studies in preparation for a standard two-year carcinogenicity study, and we submitted a protocol with our dosing recommendations for a two-year rat carcinogenicity study to the CAC. The CAC provided feedback on our dosing recommendations for this study, and we initiated the study in August 2007.

In June 2007, we completed our reproductive toxicology studies. Our interpretation of the study results is that they are consistent with our prior assessment of the safety profile of SILENOR™. We intend to include the results from these studies as part of our planned initial NDA submission for SILENOR™.

We believe that the commercial success of SILENOR™ will largely depend on gaining access to the highest prescribing physicians. IMS Health data indicates that psychiatrists, neurologists and sleep specialists represent

approximately half of the top decile of prescribers of insomnia treatments. Primary care physicians are also very important, given that according to IMS Health they wrote more than 60% of the prescriptions for insomnia during 2006. With this in mind, we are in discussions with a number of pharmaceutical companies with the goal of optimizing the commercial success of SILENOR™. The outcome of this process could vary depending on the interest and objectives of the parties and may include a licensing transaction relating to SILENOR™, an acquisition of our business relating to SILENOR™, or a transaction to acquire our company as a whole. However, we cannot assure you that we will complete any strategic transaction, or that, if completed, any strategic transaction will be successful or on attractive terms.

We have in-licensed two product candidates in addition to SILENOR™. We have completed a pilot Phase 2 clinical trial for nalmefene in smoking cessation with positive results. We also completed a Phase 2/3 clinical trial for nalmefene for the treatment of pathological gambling that did not achieve statistical significance for the primary or secondary endpoints. We are evaluating the results from both of these clinical trials before making determinations regarding the future of the nalmefene program. We are also developing a new formulation of acamprosate calcium for the treatment of certain movement disorders. Acamprosate is a compound characterized by poor bioavailability (11%). As a result, the approved form of acamprosate requires patients to take two tablets, three times a day for the current indication. If a formulation is achieved that can significantly reduce the amount of drug required to demonstrate a clinical effect, it may result in less frequent and/or lower dosages than required using the approved form of the drug. We have completed dosing in a Phase 1 clinical trial of several formulations of acamprosate, and data from this trial is currently being analyzed. We expect to announce results by the end of 2007.

We are a development stage company and have incurred significant net losses since our inception. As of September 30, 2007, we had an accumulated deficit of approximately $118.6 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 SILENOR™ and selectively pursue development of our other product candidates.

Revenues

As a development stage company, 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 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 costs associated with our non-clinical program for SILENOR™, clinical trials managed by our clinical research organizations, or CROs, costs associated with the preparation of our NDA for SILENOR™, regulatory expenses, drug development costs, salaries and related employee benefits, as well as share-based compensation expense. Our most significant costs incurred to date relate to conducting our clinical trials for SILENOR™, while our more recent costs relate primarily to the non-clinical program for SILENOR™ and the preparation of the NDA.

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 our non-clinical studies and prepare for our potential NDA filing for SILENOR™, selectively further the development of our other product candidates, and possibly if we 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 non-clinical studies and clinical trials and to manufacture the product candidates used in our 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 filing of our planned NDA for SILENOR™ and non-clinical 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 regulatory filing process and continued development of our product candidates. Non-clinical and clinical development timelines, the probability of success and the costs of development of our product candidates vary widely. The lengthy process of completing non-clinical testing, conducting clinical trials, and seeking regulatory approval for our product candidates requires the expenditure of substantial resources. Any failure by us or delay in obtaining regulatory approval, or completing non-clinical testing or clinical trials, would cause our research and development expense to increase and, in turn, have a material adverse effect on our results of operations.

We cannot forecast with any degree of certainty which product candidates will be subject to future collaborations or other strategic transactions, 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 collaboration agreements or the commercialization of our product candidates, if at all.

Marketing, General and Administrative

Our marketing, general and administrative expenses consist primarily of salaries, benefits, share-based compensation expense, advertising and 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, Non-clinical Study and New Drug Application Expenses

Expenditures relating to our clinical trials, non-clinical studies, and our NDA filing for SILENOR™ are expensed as incurred and included within research and development expenses. Our clinical trials, non-clinical studies, and NDA expenses are based on estimates of the services received and efforts expended to date pursuant to contracts with research institutions, CROs and other vendors that conduct and manage clinical trials, non-clinical studies and regulatory filings on our behalf. Measurement of expenses related to our clinical trials, non-clinical studies, and NDA preparation require judgment as we may not have been invoiced or otherwise notified of actual costs, making it necessary to estimate the efforts completed to date and the 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 progress of our programs in relation to the scope of work outlined in the contracts, and recognize the related amount of expense accordingly. 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. Expenses associated with license fees are recorded as management determines them to be incurred and payment is probable.

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 option grants, based on estimated fair values. SFAS No. 123(R) could potentially be applicable to all of our stock option plans and our employee stock purchase plan; however, its provisions apply only to our stock option plans because our employee stock purchase plan is non-compensatory under the terms of SFAS No. 123(R).

Measurement and recognition of share-based compensation under SFAS No. 123(R) involves significant estimates and subjective inputs into an option valuation model, such as the Black-Scholes model which we use. The grant date fair value of share-based payment awards and the amount of expense recognized during the period 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 for comparable companies because the volatility of our own stock price does not have sufficient observable history. Our common stock did not trade in an active market prior to our initial public offering in December 2005. As a result, periodic common stock price observations were unavailable prior to our initial public offering. In estimating the expected service period for our options, we applied the guidance in the Securities and Exchange Commission’s Staff Accounting Bulletin No. 107, which provides a formula-driven approach for determining the expected service period. Share-based compensation recorded in our Statement of Operations is based on awards expected to ultimately vest and has been reduced for estimated forfeitures. Share-based compensation is adjusted to reflect the value of options which ultimately vest as such amounts become known in future periods.

As a result of these subjective and forward-looking estimates, the actual value of our stock options could differ significantly from those amounts recorded in our financial statements.

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. In addition, $18.3 million of our federal net operating loss carryforwards, $17.3 million of our state net operating loss carryforwards, and $0.9 million of our federal research and development credits were 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 are determined to have occurred under the provisions of Sections 382 and 383 of the Internal Revenue Code.

Results of Operations

Comparisons of the Three Months Ended September 30, 2007, 2006 and 2005

License fees.License fees for the three month periods ended September 30, 2007, 2006, and 2005 are summarized in the following table.


	Three Months Ended September 30,						Dollar Change					Percent Change
							2007 vs.			2006 vs.		2007 vs.			2006 vs.
	2007		2006		2005		2006			2005		2006			2005
			(dollar amounts in thousands)
SILENOR™	$	—	$	—	$	—	$	—		$	—		0	%		0	%
Nalmefene		4		54		24		(50	)		30		-93	%		125	%
Acamprosate		150		150		75		—			75		0	%		100	%

Total license fees	$	154	$	204	$	99	$	(50	)	$	105		-25	%		106	%

License fees decreased $0.1 million for the three month period ended September 30, 2007 compared to the three month period ended September 30, 2006 primarily due to a milestone payment made upon completion of the pilot nalmefene smoking cessation clinical trial in the third quarter of 2006.

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 an increase in quarterly payments to our licensor for acamprosate

Research and Development Expenses.Research and development expenses for the three month periods ended September 30, 2007, 2006, and 2005 are summarized in the following table.


	Three Months Ended September 30,						Dollar Change						Percent Change
							2007 vs.			2006 vs.			2007 vs.			2006 vs.
	2007		2006		2005		2006			2005			2006			2005
			(dollar amounts in thousands)
SILENOR™ development work	$	804	$	4,426	$	8,616	$	(3,622	)	$	(4,190	)		-82	%		-49	%
Nalmefene and acamprosate development work		—		1,715		1,601		(1,715	)		114			-100	%		7	%
Personnel and other costs		1,591		1,521		636		70			885			5	%		139	%
Employee and consultant stock options		448		244		84		204			160			84	%		190	%

Total research and development expense	$	2,843	$	7,906	$	10,937	$	(5,063	)	$	(3,031	)		-64	%		-28	%

Research and development expenses decreased $5.1 million for the three month period ended September 30, 2007 compared to the three month period ended September 30, 2006 primarily due to a $3.6 million decrease in expenses associated with SILENOR™ clinical trials as a result of the completion of our SILENOR™ Phase 3 clinical trial program at the end of 2006. SILENOR™ expenses for 2007 relate primarily to non-clinical studies and expenses incurred in the preparation of our NDA. Expenses related to our acamprosate and nalmefene clinical programs decreased $1.7 million primarily due to the completion of our nalmefene clinical trials for smoking cessation and the treatment of pathological gambling at the end of 2006. During the first half of 2007, we incurred costs relating to our acamprosate Phase 1 clinical trial. This trial has since been completed and we are currently analyzing the data. Employee and consultant stock option expense, which is a non-cash expense, increased $0.2 million primarily due to stock options granted subsequent to the third quarter of 2006.

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. We were actively enrolling patients in our SILENOR™ Phase 3 clinical trial program 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.

Marketing, General and Administrative Expenses. Marketing, general and administrative expenses for the three month periods ended September 30, 2007, 2006, and 2005 are summarized in the following table.


	Three Months Ended September 30,						Dollar Change				Percent Change
							2007 vs.		2006 vs.		2007 vs.			2006 vs.
	2007		2006		2005		2006		2005		2006			2005
			(dollar amounts in thousands)
Marketing, personnel and general costs	$	1,905	$	1,656	$	933	$	249	$	723		15	%		77	%
Employee and director stock option expense		1,375		1,033		435		342		598		33	%		137	%

Total marketing, general and administrative expenses	$	3,280	$	2,689	$	1,368	$	591	$	1,321		22	%		97	%

Marketing, general and administrative expenses increased $0.6 million for the three month period ended September 30, 2007 compared to the three month period ended September 30, 2006 due to a $0.2 million increase in marketing, personnel and general costs as a result of an increase in headcount and related expenses for our marketing, general and administrative functions, as well as higher professional fees. In addition, share-based compensation expense increased $0.3 million due to stock options granted subsequent to the third quarter of 2006.

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 headcount and related expenses for our marketing, general and administrative functions as our operations continued to grow, and an increase in market research efforts. 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.

Interest and Other Income.Interest and other income for the three month periods ended September 30, 2007, 2006, and 2005 are summarized in the following table.


	Three Months Ended September 30,						Dollar Change					Percent Change
							2007 vs.			2006 vs.		2007 vs.			2006 vs.
	2007		2006		2005		2006			2005		2006			2005
			(dollar amounts in thousands)
Interest and other income	$	564	$	965	$	520	$	(401	)	$	445		-42	%		86	%

Interest and other income decreased $0.4 million for the three month period ended September 30, 2007 compared to the three month period ended September 30, 2006 primarily due to lower average cash balances during the third quarter of 2007 compared to the third quarter of 2006 as a result of continued net losses as a development stage company.

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.

Comparisons of the Nine Months Ended September 30, 2007, 2006 and 2005

License fees.License fees for the nine month periods ended September 30, 2007, 2006 and 2005 are summarized in the following table.


	Nine Months Ended September 30,						Dollar Change						Percent Change
							2007 vs.			2006 vs.			2007 vs.			2006 vs.
	2007		2006		2005		2006			2005			2006			2005
			(dollar amounts in thousands)
SILENOR™	$	—	$	—	$	—	$	—		$	—			0	%		0	%
Nalmefene		11		61		65		(50	)		(4	)		-82	%		-6	%
Acamprosate		450		450		276		—			174			0	%		63	%

Total license fees	$	461	$	511	$	341	$	(50	)	$	170			-10	%		50	%

License fees decreased $0.1 million for the nine month period ended September 30, 2007 compared to the nine month period ended September 30, 2006 primarily due to a milestone payment made upon completion of the pilot nalmefene smoking cessation clinical trial in the third quarter of 2006.

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 an increase in quarterly license payments to our licensor for acamprosate.

Research and Development Expenses.Research and development expenses for the nine month periods ended September 30, 2007, 2006 and 2005 are summarized in the following table.


	Nine Months Ended September 30,						Dollar Change					Percent Change
							2007 vs.			2006 vs.		2007 vs.			2006 vs.
	2007		2006		2005		2006			2005		2006			2005
			(dollar amounts in thousands)
SILENOR™ development work	$	3,320	$	22,540	$	13,138	$	(19,220	)	$	9,402		-85	%		72	%
Nalmefene and acamprosate development work		—		5,438		2,750		(5,438	)		2,688		-100	%		98	%
Personnel and other costs		4,998		3,834		1,561		1,164			2,273		30	%		146	%
Employee and consultant stock options		1,318		735		128		583			607		79	%		474	%

Total research and development expense	$	9,636	$	32,547	$	17,577	$	(22,911	)	$	14,970		-70	%		85	%

Research and development expenses decreased $22.9 million for the nine month period ended September 30, 2007 compared to the nine month period ended September 30, 2006 primarily due to a $19.2 million decrease in expenses associated with SILENOR™ clinical trials as a result of the completion of our SILENOR™ Phase 3 clinical trial program at the end of 2006. SILENOR™ expenses for 2007 relate primarily to non-clinical studies and expenses incurred in the preparation of our NDA filing. Expenses related to our nalmefene and acamprosate clinical programs decreased $5.4 million primarily due to the completion of our nalmefene clinical trials for the treatment of pathological gambling and smoking cessation at the end of 2006. During the first half of 2007, we incurred costs relating to our acamprosate Phase 1 clinical trial. This trial has since been completed and we are currently analyzing the data. During 2007, we reversed accrued expenses for SILENOR™ and nalmefene of approximately $0.6 million as a result of actual clinical trial expenses being less than previously accrued estimates. Personnel and other costs increased $1.2 million primarily due to an increase in salary and overhead costs as a result of higher research and development headcount in place during 2007 compared to 2006, as well as higher facility costs and consulting fees. Employee and consultant stock option expense, which is a non-cash expense, increased $0.6 million primarily due to stock options granted subsequent to the third quarter of 2006.

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. In addition, 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.

Marketing, General and Administrative Expenses.Marketing, general and administrative expenses for the nine month periods ended September 30, 2007, 2006 and 2005 are summarized in the following table.


	Nine Months Ended September 30,						Dollar Change				Percent Change
							2007 vs.		2006 vs.		2007 vs.			2006 vs.
	2007		2006		2005		2006		2005		2006			2005
			(dollar amounts in thousands)
Marketing, personnel and general costs	$	6,416	$	5,620	$	2,464	$	796	$	3,156		14	%		128	%
Employee and director stock option expense		3,980		2,550		596		1,430		1,954		56	%		328	%

Total marketing, general and administrative expenses	$	10,396	$	8,170	$	3,060	$	2,226	$	5,110		27	%		167	%

Marketing, general and administrative expenses increased $2.2 million for the nine month period ended September 30, 2007 compared to the nine month period ended September 30, 2006 due to a $0.8 million increase in marketing, personnel and general costs as a result of an increase in headcount and related expenses for our marketing, general and administrative functions, as well as higher professional fees and higher facility costs. In addition, share-based compensation increased $1.4 million due to stock options granted subsequent to the third quarter of 2006.

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 efforts. 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.

Interest and Other Income.Interest and other income for the nine month periods ended September 30, 2007, 2006 and 2005 are summarized in the following table.


	Nine Months Ended September 30,						Dollar Change					Percent Change
							2007 vs.			2006 vs.		2007 vs.			2006 vs.
	2007		2006		2005		2006			2005		2006			2005
			(dollar amounts in thousands)
Interest and other income	$	1,887	$	3,123	$	752	$	(1,236	)	$	2,371		-40	%		315	%

Interest and other income decreased $1.2 million for the nine month period ended September 30, 2007 compared to the nine month period ended September 30, 2006 primarily due to lower average cash balances during the first nine months of 2007 compared to the first nine months of 2006 as a result of continued net losses as a development stage company.

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.

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, 2007, we have received net proceeds of approximately $140.9 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 40,741,000 shares of Series C redeemable preferred stock for aggregate net proceeds of $54.8 million;

	•		in September 2005, the warrant to purchase Series C redeemable preferred stock was exercised and we issued and sold 7,407,000 shares of Series C redeemable preferred stock for aggregate net proceeds of $10.0 million;

	•		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 12,242,000 shares of common stock; and

	•		since inception on August 14, 2003 through September 30, 2007, we have issued approximately 342,000 shares of common stock upon exercise of stock options from which we received aggregate proceeds of $1.1 million.

As of September 30, 2007, we had $40.8 million in cash, cash equivalents and short-term investments. We have invested a substantial portion of our available cash funds in commercial paper and corporate and United States government agency notes, 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, 2007, net cash used in operating activities was $17.8 million, compared to $36.2 million for the nine month period ended September 30, 2006. The decrease in net cash used in operating activities was due primarily to a reduction in our net loss as a result of the conclusion of our SILENOR™ clinical trial program and our nalmefene clinical trials for smoking cessation and the treatment of pathological gambling by the end of 2006. This was offset in part by increased salaries and overhead costs associated with an increase in employee headcount and an expansion of our facilities. 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 operating expenses to be substantial over the next few years as we seek to file our NDA for SILENOR™ with the FDA, commercialize SILENOR™ and selectively further the development and advancement of our other product candidates.

We have entered into several in-license agreements to acquire the rights to develop and commercialize our three product candidates. Pursuant to these agreements, we obtained exclusive, sub-licensable rights to the patents and know-how for certain indications. We generally are required to make upfront payments as well as 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, 2007:


	Payments Due by Period
			2008		2010
	Remainder		through		through		After
	of 2007		2009		2011		2011		Total
	(in thousands)
Operating lease obligations	$	249	$	2,040	$	2,158	$	1,223	$	5,670
Payments under license agreements		150		1,230		1,230		6,675		9,285

Total	$	399	$	3,270	$	3,388	$	7,898	$	14,955

In addition, under our license agreements we are obligated to make revenue-based royalty payments as well as additional milestone payments of up to $11.3 million upon the occurrence of certain product-development events, the majority of which pertains to nalmefene. We are assessing the results from the nalmefene pathological gambling and smoking cessation clinical trials before making a determination regarding the future of the nalmefene program. If the nalmefene program is not continued, $10.3 million of the $11.3 million of milestone payments would not be paid. The remaining $1.0 million milestone payment is payable to ProCom One upon approval of our NDA for SILENOR™. This milestone payment is not reflected in our September 30, 2007 financial statements as it is not considered to be incurred at this time. Minimum license payments are subject to increase based on the timing of various milestones and the extent to which the licensed technologies are pursued for other indications. These milestone payments and royalty payments under our 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 have completed dosing in a Phase 1 clinical trial of several formulations of acamprosate, and the data is currently being analyzed. We expect to have results by the end of 2007. We will owe a milestone payment of $0.2 million if the data from this trial shows positive results. This milestone payment is not reflected in the September 30, 2007 financial results as it is not known at this time whether the results from the trial will be positive.

We also enter into agreements with third parties to manufacture our product candidates, conduct our clinical trials and non-clinical studies, and perform data collection and analysis. Our payment obligations under these agreements depend upon the progress of our development programs. Therefore, we are unable to estimate with certainty the future costs we will incur under these 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 costs and timing of regulatory approvals;

	•		the progress of our non-clinical studies and clinical trials;

	•		our ability to establish and maintain strategic collaborations, including licensing and other arrangements that we have or may establish, including with ProCom One, BioTie Therapies and/or Synchroneuron;

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

	•		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.

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, debt financing, strategic collaborations or other strategic transactions. We have an effective shelf registration statement on Form S-3 on file with the Securities and Exchange Commission. This registration statement could allow us to obtain additional financing of up to $75.0 million. However, we may not be successful in obtaining additional financing, entering into collaboration agreements or other strategic transactions, 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, or renegotiate 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.

Recent Accounting Pronouncements

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 to enter into and the terms of any strategic transaction; the potential for SILENOR™ or our other product candidates to receive regulatory approval for one or more indications on a timely basis or at all; the results of pending non-clinical studies for SILENOR™ or our other product candidates; the timing of receipt of non-clinical study results and any NDA submission; unexpected findings relating to SILENOR™ or our other product candidates that could delay or prevent regulatory approval or commercialization, or that could result in recalls or product liability claims; the potential for the FDA to require non-clinical or clinical requirements to support an NDA filing for SILENOR™ or our other product candidates, or the imposition of additional requirements to be completed before or after regulatory approval; our ability to demonstrate to the satisfaction of the FDA that potential NDA approval of SILENOR™ is appropriate without standard, long-term carcinogenicity studies, given the context of completed trials and pending studies; 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; 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, cash equivalents and investments at September 30, 2007 consisted primarily of money market funds, commercial paper and corporate and United States government agency notes. The primary objective of our investment activities is to preserve principal while maximizing the income we receive from our investments without significantly increasing risk. Our primary exposure to market risk is interest rate sensitivity. 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, 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 interest rate sensitivity risks that would affect their value because the interest paid on such funds fluctuates with the prevailing interest rate.

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, 2006 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. Except with respect to our trademarks, the trademarks, trade names and service marks appearing in this report are the property of their respective owners.

Risks Related to Our Business

The non-clinical requirements requested by the FDA for SILENOR™ could substantially delay any regulatory approval of this product candidate.

We have completed four Phase 3 clinical trials for SILENOR™. Although we have completed all of our planned Phase 3 clinical trials for SILENOR™, based on a request in May 2006 from the FDA in connection with a planned pre-NDA meeting for SILENOR™, we initiated a non-clinical program consisting of standard genotoxicity, reproductive toxicology and carcinogenicity studies. The FDA indicated that the data from the genotoxicity studies and reproductive toxicology studies should be included in the NDA for SILENOR™. The FDA also indicated 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 as a post-NDA approval commitment. In September 2006, we completed the genotoxicity studies, and no signal indicative of genotoxicity was found in any of the assays. We submitted the results to the FDA, and in February 2007, the FDA agreed with our assessment that SILENOR™ does not appear to have genotoxic potential. The FDA indicated that, unless other non-clinical data raise a concern, a complete assessment of the carcinogenic potential of SILENOR™ may not be needed prior to NDA approval. The FDA also indicated that it may accept the results of a shorter-term carcinogenicity study for approval of the NDA and allow the standard two-year carcinogenicity study to be completed as a post-approval commitment.

In May 2007, we received correspondence from the FDA in which the FDA stated that the results of our ongoing 26-week transgenic mouse carcinogenicity study of SILENOR™ should be included as part of the initial NDA submission for SILENOR™. We continue to plan to submit the results of the standard two-year carcinogenicity study as a post-approval commitment. We have submitted a protocol for a 26-week transgenic mouse carcinogenicity study to the FDA’s Carcinogenicity Assessment Committee, or CAC. We initiated the study in May 2007. If the CAC requires modification of the protocol, we may have to modify or reinitiate the study, which may result in a delay and additional cost in completing the study. We have also completed dose range finding studies in preparation for a standard two-year carcinogenicity study, and we submitted a protocol with our dosing recommendations for a two-year rat carcinogenicity study to the CAC. The CAC provided feedback on our dosing recommendations for this study, and we initiated the study in August 2007.

In June 2007, we completed our reproductive toxicology studies. We believe the results from these studies do not unfavorably impact the safety profile of SILENOR™. We intend to include the results from these studies as part of the initial NDA submission for SILENOR™.

Any delays in our ongoing non-clinical development program or additional requests from the FDA relating to our non-clinical program are likely to result in delays in the submission, acceptance for filing or approval of the NDA 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 the FDA requires us to submit data to allow a complete assessment of the carcinogenic potential of SILENOR™, including data from standard two-year carcinogenicity studies, prior to approval of the NDA, delays in regulatory approval will occur. If toxicology questions arise as a result of our non-clinical study results, it could adversely affect our potential regulatory approval or product labeling. Even if our non-clinical studies are completed as planned, their results may not support our assumptions, and additional studies may be required.

Although we are pursuing discussions with other pharmaceutical companies to facilitate the commercialization of SILENOR™, we may be unable to complete a collaboration or other strategic transaction on acceptable terms, or at all.

Even if SILENOR™ receives FDA approval, it may never be successfully commercialized. We believe that the commercial success of SILENOR™ will largely depend on gaining access to the highest prescribing physicians. IMS Health data indicates that psychiatrists, neurologists and sleep specialists represent approximately half of the top decile of prescribers of insomnia treatments. Primary care physicians are also very important, given that according to IMS Health they wrote more than 60% of the prescriptions for insomnia during 2006. With this in mind, we are in discussions with a number of other pharmaceutical companies with the goal of optimizing the commercial success of SILENOR™. The outcome of this process could vary depending on the interest and objectives of the parties and may include a licensing transaction relating to SILENOR™, an acquisition of our business relating to SILENOR™, or a transaction to acquire our company as a whole. However, we cannot assure you that we will complete any strategic transaction, or that, if completed, any strategic transaction will be successful or on attractive terms.

If we are unable to complete any strategic transaction, we may be required to build the necessary infrastructure to commercialize SILENOR™ ourselves. This would require substantial resources and could adversely affect the timing and results of a commercial launch of the product. As a company, we have not commercialized any products and may not be able to successfully do so.

We also face competition in our search for parties with whom we may enter into a collaboration or other strategic transaction. These competitors may have access to greater financial resources than us and may have greater expertise in identifying, evaluating and consummating strategic transactions. Moreover, we may devote resources to potential collaborations or other strategic transactions that are never completed, or we may fail to realize the anticipated benefits of such efforts.

If we are able to complete a strategic transaction, depending on the timing of the transaction and the outlook of our partner or acquirer, such partner or acquirer could modify our current plans for seeking regulatory approval for and commercializing SILENOR™. Such modifications could result in additional costs or delays in the submission, acceptance for filing or approval of the NDA for SILENOR™ and any commercial launch of the product.

We expect intense competition in the insomnia marketplace for SILENOR™ and 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™ 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. 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. Neurocrine has resubmitted its NDA for indiplon immediate release capsules. Vanda Pharmaceuticals Inc. has completed a Phase 3 transient insomnia clinical trial of VEC-162, a melatonin receptor agonist, and has indicated it will require additional Phase 3 clinical trials before seeking FDA approval. In addition, Takeda Pharmaceuticals North America, Inc. has conducted a clinical study to evaluate the administration of a combination of Takeda’s product Rozerem™ and 3 mg of doxepin in patients with insomnia.

Several companies, including Sanofi-Synthélabo, Inc., Arena Pharmaceuticals, Inc. and Sepracor are evaluating 5HT2 antagonists as potential hypnotics. Additionally, several other companies are evaluating other compounds for the treatment of insomnia, including Neurogen Corporation, which is developing a GABA-acting hypnotic, and Actelion Pharmaceuticals Ltd., which is developing an orexin antagonist.

Furthermore, the original patent for Sanofi-Synthélabo, Inc.’s form of zolpidem (Ambien), which accounted for $2.4 billion of the $4.6 billion insomnia market in 2006, has expired. Generic versions of Ambien have been launched and are 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.

Currently, there are no FDA-approved products for pathological gambling. 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 Pharmaceuticals’ Luvox, may have a potential clinical effect for the treatment of pathological gambling.

The majority of FDA-approved products for smoking cessation 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. and Santhera Pharmaceuticals Holding AG are investigating fipamezole, an adrenergic antagonist, in Phase 2 clinical trials for treatment-associated dyskinesias in Parkinson’s disease. This or other 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™ 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;

	•		experience conducting non-clinical studies and clinical trials, and related 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 and useful and less costly than ours and may also be more successful than we are 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.

A 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™. 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 prior art that was identified, we initiated a reexamination of one of the patents we have in-licensed covering SILENOR™, 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 USPTO has 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 and 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. In two office actions relating to this reissue request, the USPTO raised no prior art objections to 32 of the 34 claims we are seeking and raised a prior art objection to the other two, as well as some technical objections. Each of the claims objected to by the USPTO relates to dosages above 10 mg. We have filed a response with the USPTO seeking to overcome these objections. Our failure to overcome these objections or any additional objections that may be raised by the USPTO could result in additional narrowing or cancellation of some or all of the claims of this patent.

Restrictions on our patent rights relating to our product candidates and limitations on our other intellectual property rights 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 SILENOR™ and our other product candidates, 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 a particularly effective 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 product candidates 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 induce 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 covering SILENOR™ is currently involved in post-issuance proceedings in the USPTO, and multiple other in-licensed applications and internally developed applications are pending. No assurance can be given that any claims in the in-licensed patent will survive those proceedings in their current form, or at all, and the USPTO or other applicable regulatory authorities may not allow pending applications to result in issued patents with the claims we are seeking, or at all. In addition, third parties may challenge our in-licensed patents and any of our own patents that we may obtain, which could result in the invalidation or unenforceability of some or all of the relevant patent claims.

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.

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™, if any, may include a restriction on the term of its use or the population for which it may be used, or may not include the indication statement we desire or may include a qualification to such statement.

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™, doxepin, is used in the treatment of depression and the package insert includes such a “black box” warning statement. Although SILENOR™ is 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 or market SILENOR™ for the treatment of insomnia in children or adolescents, we cannot be sure that a similar warning statement will not be required.

Recently the FDA has also requested that all manufacturers of sedative-hypnotic drug products modify their product labeling to include stronger language concerning potential risks. These risks include severe allergic reactions and complex sleep-related behaviors, which may include sleep-driving. The FDA also recommended that the drug manufacturers conduct clinical studies to investigate the frequency with which sleep-driving and other complex behaviors occur in association with individual drug products. It is unclear how and to what extent, if any, these requests and recommendations will affect SILENOR™.

Further, although doxepin, at higher dosages than we plan to incorporate in SILENOR™, is not currently and has never been a Schedule IV controlled substance and the FDA has indicated in correspondence relating to our pre-NDA meeting for SILENOR™ that it will not recommend that it be a Schedule IV controlled substance, we cannot be certain that SILENOR™ 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 on 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.

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, could result in the denial of regulatory approval by the FDA or other regulatory authorities for any or all targeted indications, or could cause us to evaluate the future of our development programs. Any of these occurrences could delay or prevent us from commercializing our product candidates and generating revenues from their sale. In addition, the FDA may require, or we may decide to undertake, additional clinical trials to support the safety profile of SILENOR™.

In addition, if any of our product candidates receives 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.

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. We have a contract with Patheon Pharmaceuticals Inc. to manufacture our future required clinical supplies, if any, of our SILENOR™

product candidate, and we have entered into a manufacturing and supply agreement with Patheon to manufacture our commercial supply of SILENOR™. 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 or 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 launch our products, if approved, or 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 clinical trials at significant additional expense or terminate the clinical trials completely.

Moreover, our manufacturers and suppliers may experience difficulties related to their overall business and financial stability. For example, Patheon reported in connection with its financial statements for its fiscal year ended October 31, 2006 that its ability to continue as a going concern was uncertain and dependent upon the successful outcome of a review of strategic and financial alternatives. In April 2007, Patheon announced that it secured $150 million in financing through the sale of its preferred stock, and that it refinanced portions of its North American and United Kingdom credit facilities. Any material adverse impact on Patheon’s overall business and financial stability could result in a delay or interruption of our supply of SILENOR™.

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. The FDA is likely to conduct inspections of our manufacturers’ facilities as part of their review of our marketing applications. If our manufacturers are not in compliance with cGMP requirements, it may delay approval of our marketing applications. These cGMP 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. 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.

Our 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 clinical trials that the product is safe and effective for use in each target indication. Although we have successfully completed all of our planned four Phase 3 clinical trials for SILENOR™, we have not received regulatory approval to market SILENOR™ in any jurisdiction. In addition, we have not completed all clinical trials for our other product candidates.

The results from clinical trials that we have completed may not be predictive of results obtained in future 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 clinical trials, the resulting delays in developing other compounds and conducting related 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.

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

As of September 30, 2007, we had 35 full-time employees. We will need to continue to expand our managerial, operational, financial and other resources in order to manage and fund 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 the preparation and submission to the FDA of our NDA for SILENOR™;

	•		manage our non-clinical studies and clinical trials effectively;

	•		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 advisors who assist us in formulating our product development, clinical, regulatory and commercialization 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 or commercialization 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™ and are able to establish a collaboration or other strategic transaction with another pharmaceutical company to broaden the potential reach of sales and marketing efforts for SILENOR™ or commercialize the product candidate ourselves.

The development and approval of SILENOR™ 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 costs and timing of regulatory approval;

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

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

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

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

	•		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, 2007, will be sufficient to fund our operations through at least the next twelve months. We believe that these funds will allow us to finance our ongoing and planned development work and our planned NDA submission for SILENOR™. We intend to seek additional funding through collaborations or other strategic transactions 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 $18.6 million for the nine month period ended September 30, 2007, $46.4 million for the year ended December 31, 2006 and $38.5 million for the year ended December 31, 2005. 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.

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 5, 2007, the trading prices for our common stock have ranged from a high of $21.24 to a low of $5.42.

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™ or our other product candidates, including requirements to conduct or results or anticipated timing of our non-clinical studies and clinical trials;

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

	•		events affecting our existing in-license agreements and any future collaborations or other strategic transactions, 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 November 1, 2007, our executive officers, directors and holders of 5% or more of our outstanding common stock beneficially owned approximately 62.7% 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.

Investors may incur substantial dilution as a result of future equity issuances, and, as a result, our stock price could decline.

We believe, based on our current operating plan, that our cash, cash equivalents and marketable securities as of September 30, 2007 will be sufficient to fund our operations through the next twelve months. Because we will need to raise additional capital to fund our commercialization plans and clinical development programs, among other things, we may conduct substantial additional equity offerings. These future equity issuances, together with the exercise of outstanding options and any additional shares issued in connection with acquisitions, will result in dilution to investors.

We expend substantial costs and management resources as a result of changes in laws and regulations relating to corporate governance matters.

As a public reporting company, we must comply with the Sarbanes-Oxley Act of 2002 and the related rules and regulations adopted by the Securities and Exchange Commission and by the Nasdaq Stock Market, including expanded disclosures, accelerated reporting requirements and more complex accounting rules. Compliance with Section 404 of the Sarbanes-Oxley Act of 2002, or Section 404, and other requirements has caused us to expend substantial costs and management resources and will continue to do so. Additionally, these laws and regulations could make it more difficult or more costly for us to obtain certain types of insurance, including director and officer liability insurance, and we may be forced to accept reduced policy limits and coverage or incur substantially higher costs to obtain the same or similar coverage. The impact of these events could also make it more difficult for us to attract and retain qualified persons to serve on our board of directors or board committees or as executive officers. We were required to comply with Section 404 of the Sarbanes-Oxley Act of 2002 by December 31, 2006. The Public Company Accounting Oversight Board approved a new auditing standard, Auditing Standard No. 5 in June 2007. In conjunction with this new auditing standard, the Securities and Exchange Commission issued guidance for management for complying with the requirements of Section 404. This new auditing standard and the related management guidance provide a more risk-based approach to compliance and testing under Section 404. However, we still expect to incur substantial costs and to devote significant management of resources to corporate governance matters. If we, or the third party service providers on which we rely, fail to comply with any of these laws or regulations, or if our auditors cannot timely attest to our evaluation of our internal controls, we could be subject to regulatory scrutiny and a loss of public confidence in our corporate governance or internal controls, which could have an adverse effect on our business and our stock price.

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

We had no unregistered sales of equity securities in the quarter ended September 30, 2007.

Use of Proceeds

Our initial public offering of common stock was affected 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. Subsequently, 5,000,000 shares of common stock were sold on our behalf on December 20, 2005, at an initial public offering price of $11.00 per share for aggregate gross proceeds 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 and incurred additional expenses associated with the offering of approximately $1.3 million. When aggregated, total offering expenses were approximately $5.2 million, resulting in net offering proceeds to us of 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, 2007, we had used $9.0 million of the net proceeds from our initial public offering with approximately $2.3 million spent for work incurred in the preparation of our planned NDA filing for SILENOR™ and in our ongoing non-clinical studies and development of SILENOR™. An additional $0.9 million was spent to pursue the development of our other product candidates and for various payments according to the terms of our in-license agreements, and $5.8 million was incurred to fund our working capital requirements and for general corporate purposes. We have invested the remaining proceeds from the offering in money market funds, commercial paper and corporate and United States government agency notes.

Issuer Purchases of Equity Securities

Not applicable.

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 8, 2007



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

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Pernix Sleep Inactive 10-Q2007 Q3 Quarterly report

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